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Ideas & Debate

Despite good returns private equity faces some challenges

Private Equity and Venture Capital Association
Delegates at the 16th annual African Private Equity and Venture Capital Association conference at the Radisson Blu Hotel in Nairobi last year. FILE PHOTO | NMG 

It is undeniable, private equity (PE) capital now serves as an important alternative source for financing commercial enterprises in the country, and returns on that capital have helped raise the profile of PE-investing as an asset class.

The number of PE-backed companies now dwarfs that of firms listed on all the East African stock exchanges combined – a trend that’s indicative of what’s happening around the world.

According to KPMG and EAVCA East Africa Private Equity Survey, over both 2017 and 2018, a total of 190 PE deals, with an estimated value of over Sh270 billion, were reported in East Africa.

Kenya, being the most dominant economy in the region, has enjoyed over 55 per cent market share on value and volume of deals reported in the region in the six-year period ending 2018, according to EAVCA.

That said, as more PEs hunt for higher returns in the last frontier for investing, some unintended mistakes are bound to happen – `ala Nairobi Women’s Hospital. But why are they expected to happen? Here are couple of reason why. First, flush of cash is a problem as it means more competition for the same (few quality) deals around.

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This is evidenced by the high levels of “dry powder” or un-invested cash.

The survey by KPMG and EAVCA shows that in 2017 and 2018, there was an estimated Sh60 billion of cash yet to be deployed.

Globally, estimates by Preqin show dry powder levels at Sh150 trillion– the highest on record and more than double what it was five years ago.

Consequently, entry multiples are on the rise forcing PE operators to pay expensively for assets and as a result, in order to continue delivering attractive returns, they begin “pushing” investees to adopt rather unacceptable “drastic measures.”

Globally, according to the McKinsey Global Private Markets Review 2019, valuation multiples have grown from 9.6 times in 2015 to 11.1 times in 2018, inching closer to the 2007 peak of 11.3 times.

Secondly, the chase for alpha (excess return) is another problem.

PE has long sold itself as the ultimate above-market return generator uncorrelated to other traditional asset classes. This has largely remained true for some time now.

Private equity has averaged 14.4 percent annually over the past five years – a far superior return compared to most asset classes - according to the latest data from Preqin. That notwithstanding, PE is not a guaranteed “golden goose” and often losses do occur.

Specifically, the search for “excess return” traps some clueless actors (not all PE players are clueless), increasingly in need of alpha-generating capabilities, to steer their way to winning in a wrong fashion. The end result is always disaster.

Lastly, not so many know that PE funds work with a short clock. PE investments have a lifecycle of five to 10 years, and their operators need to get the capital out of the door within a certain time frame.

The pressure to deliver a clean exit with a decent return on top may force some to act desperately careless.

In closing, this is not a bashing (and it’s not a defence either) but an alternative (hopefully balanced) view of the industry. I believe current challenges are not systemic. In my view, the entire eco-system is still solid and in-demand.

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