South Africa has managed to create the largest private equity eco-system in the African continent and this alternative investment market continues to grow, but the missing product in most private equity funds in South Africa is Private Credit. Private Credit is credit that is extended to companies on a bilateral negotiated basis outside of traditional banks and takes various legal forms including loans, mezzanine or preference shares. Private Credit is typically used in the form of direct lending, mezzanine financing and structured financing in companies that may have small or complex structures, where banks are not easily convinced to play in.
So, why does South Africa need to grow this business? A survey done by the Southern African Venture Capital and Private Equity Association (SAVCA) indicated that there was R172 billion in funds under management in Southern Africa, of which the bulk is in South Africa. This sizable fund amount is allocated among a number of private equity companies with a mostly generalist fund mandate. If the private equity companies were to consider Private Credit as an asset class, the fund size can easily triple to over R500 billion. Private credit is a less risky asset class as it generates cash flows consistently over the period as compared to a more illiquid Equity asset class. This will therefore bring more investors (or limited partners) to invest in larger funds as compared to their current investment appetite.
It has been proven that the Private Credit asset class can provide better risk adjusted returns compared to the Equity asset class, therefore a more balanced combination of assets will enhance a portfolio for the private equity fund. A survey initiated by SAVCA in 2018 reflected that that the IRR of mezzanine debt outperforms the IRR of equity in periods where the EBITDA of the asset is low (asset being the investee company). In fact, mezzanine debt performs better than equity in periods where there is zero growth in the EBITDA of the asset. The table and graph below is an illustration of the performance of mezzanine debt compared to equity in periods of low EBITDA.
Source: Sankaty Analysis, CEPRES, LSTA
The South African private equity therefore needs to consider expanding the Private Credit asset class in order to further grow funds under management and reduce the amount of funds that are given back to investors due to unutilized expired commitments.