With the increased need for patient capital both globally and in particular on the African continent, private equity (PE) continues to play a significant role in the funding of projects and deals across the continent.
Despite the collapse of Abraaj, fundraising in emerging market economies has continued and Africa remains a frontier alive with possibility and opportunity for the astute asset manager. Interestingly, capital continues to be raised in Africa predominantly in and for investment in the more developed economies such as South Africa and North Africa.
From a legal documentation perspective, fund formation in Africa continues to follow international best practice trends and the guidance on structuring and key terms set out in the Institutional Limited Partners Association (ILPA) Guidelines. To more fully assess what this means in practical terms, we analysed 12 African-focused PE funds which we assisted to achieve first close between 2018 and 2020 in order to discern common trends in the structuring and establishment of Africa focused PE Funds.
The benchmarked funds are all buyout funds investing in equity or equity-related opportunities and we will shortly release a separate infrastructure fund benchmark study. Our benchmarking analysis focuses on key terms relating to fund governance, term, domicile and structure as well as the economics such as fees and carried interest.
The 12 funds included in the study represented ZAR 26 billion (or the foreign currency equivalent) in capital commitments raised for deployment in South Africa and the rest of Africa
Growing centrality of Governance
A significant trend emerging in structuring private equity funds is an increasing focus by limited partners (LPs), who are the investors in PE funds, on the governance and transparency of those funds.
This is in line with global trends where institutional investors are paying more attention to Environmental, Social and Governance (ESG) issues in making their asset allocation decisions.
For example, LPs generally require comprehensive ESG and anti-money laundering policies for the fund to be agreed upfront. LPs are also increasingly demanding the right to call for an independent audit of the PE fund at any time, as well as the right to access the fund’s bank accounts in order to monitor cash flows, which rights are often exercised through the Limited Partner Advisory Committee (LPAC) of the fund.
In order to address these LP governance concerns fund managers are increasingly permitting LPs the right to request more detailed information with respect to the governance of the fund and its portfolio companies, provided the LP can prove the request for such information is reasonable in the circumstances, and accords with an information request that can reasonably be expected of a similarly situated investor.
Fund structuring and terms
The choice of domicile for a fund remains primarily driven by a few key factors primarily including the domicile of the LPs and their preference for, and familiarity with certain jurisdictions, the domicile of the General Partner (GP, which refers to the fund sponsor or PE management company), regulatory ease of establishing in the relevant jurisdiction and the envisaged domicile of the investments.
Most of these funds (six of the twelve considered) were set up (in whole or in part) in South Africa, primarily because South Africa is recognized as a well-established PE fund domicile, has a settled regulatory system and our clients are familiar with South Africa (given a number of them are themselves domiciled here). Mauritius was the second-most popular jurisdiction, particularly for Africa-focused funds, given its extensive network of double taxation agreements and its settled partnership legislation akin to that of the United Kingdom and Delaware in the US (although we expect to see some alternate jurisdictions come to the fore, for the next study given the current inclusion of Mauritius on the FATF grey list). In addition, given Mauritius' proximity to popular African investment hubs, setting up shop in Mauritius often allows for efficient investment into the rest of Africa.
Most of the funds in this sample had a ten-year term, which is still by far the most common fund term for pure equity funds. Typically, where a fund has development finance institution (DFI) investors, the period between first and final close (being the fundraising period available to the GP within which it is able to attract additional investment into the fund) is between 12 to 18 months. The commitment period, being the period during which the GP is able to deploy the capital raised and made available by the LPs towards the acquisition of investments, is generally five years measured from the first closing date (date of commencement of the fund) although in some funds this is measured from the final closing date. Of the funds considered, only the smaller funds, or those targeting specific assets with a shorter-term time horizon, had shorter commitment periods ranging between 3 or 4 years from the first closing date.
In line with international market standards, there are generally two one-year extensions permitted to the term of the fund. Extensions generally require either LPAC approval or the ordinary consent of LPs and a reduction in the management fee is often negotiated as a condition for such approval.
Based on our sample size, 2% remains the market standard for management fees, with a minimum of 1% and a maximum of 3%. The 2% fee is generally payable on commitments (total amount made available by LPs) during the commitment period and then on invested capital (money out the door, cash actually applied towards investments) at the end of the commitment period. It is typically paid in advance (quarterly or semi-annually) and very seldomly in arrears.
Management fees are generally negotiated fairly robustly between the GP and investors. While LPs want the management fee to be as low as possible, a fee that does not allow the manager to meet its operating expenses is not in the interests of the fund as a whole, since it restricts the manager from being able to run the fund efficiently (for example, it cannot pay competitive salaries to hire the right staff).
Despite recent moves towards lower global interest rates, the hurdle payable to LPs remains 8% in dollars and 10% in Rands. It remains standard practice for the GP to catch up 100% of its entitlement to 20% of the hurdle (called the house catch-up) and thereafter to share profits in a 20:80 ratio (the catch-up and 20% profit entitlement being the carried interest).
Carried interest is paid on a whole fund basis (measured over the life of the fund as a whole), which is referred to as a European waterfall. The American waterfall (where carried interest is paid to the GP on a deal by deal basis) is not generally used in the African market.
We welcome proposed changes to Regulation 28 of the Pension Funds Act that will allow South African pension funds to invest a greater proportion of their assets in infrastructure. It will unlock exciting opportunities for private equity funds.
However, there are some elements of the proposals released by National Treasury shortly after the National Budget that remain unclear, such as how the amendment would affect existing investments and how infrastructure investments will overlap traditional asset classes. How this will be dealt with, and what it will mean for asset managers and investors, remains to be seen.
What is clear from the trends however is that the more things change, the more they stay the same. While recent events have necessitated a greater focus on governance, a number of key fund terms generally understood to be market standard have crystallized as, and remain, best practice.
This article was first published by DealMakers AFRICA 2021 (vol 12 No.1)