Of Risks and Private Equity

As alluded to in previous posts, the private equity market matches medium- to long-term capital with companies that are not quoted on a public equity market and which need financing to fund growth, development or business improvement.

The capital takes the form of both equity and debt. The equity elements are typically provided by private equity funds, which in turn raise their capital from investors such as funds of funds, pension funds, investment funds, endowments and high net worth individuals. The debt is typically provided by banks, including investment, commercial and retail banks. Large proportions of this debt are often distributed to other entities, either other investment, commercial or retail banks who were not the primary finance provider or institutional debt market participants. The private equity business model is not constrained to capital provision, rather it extends to the application of expertise and strategic vision to the privately owned companies.

In reviewing risks inherent to the private equity sector, a distinction has to be drawn on risks that are peculiar to privately owned companies and those that relate to private equity managers. Risks peculiar to privately owned companies include vulnerability to macroeconomic shocks such as deep recessions, to sector cycles, to poor strategy, to weak management etc. All of these factors can obviously damage a company’s trading performance and profitability. In cases were firms rely on debt, this leverage means that affected firms have less of a cushion should costs rise or revenues fall.

In terms of risks to the private equity fund managers, the failure of a cluster of large privately owned companies could obviously weaken the performance of the funds that had invested in
these entities. As fund performance weakened, so could the ability of the private equity fund managers to raise new funds. Even if fund performance were still good despite a credit event, it is possible that investors could still become concerned and reduce their exposures. Related to this, private equity fund managers are concerned about the reputational risk arising from another fund
manager making a significant mistake in an investment or behaving inappropriately and tarnishing the sector and therefore the reputation of the firm’s competitors. In summary, in developing a forward looking regulatory, risks arising within the private equity market are a
consequence of specific market practices, structures or products.

In Zimbabwe, the regulatory framework is silent on private equity. This obviously creates a channel for innovative fund managers to use public funds i.e. pension funds to set up private equity investments. Market intelligence indicate a major fund manager in Zimbabwe has already started canvassing for business from pension funds with specific intentions to set up a private equity fund. There is also strong possibility of synergy among banks and corporates to invest in unlisted corporates through Special Purpose Vehicles, and who would be grudge then given the existing under valuation of equity in Zim??