A comparative study of the South African venture capital and private equity industry with special reference to the investment decision-making process

The efficiency of the private markets is important in ensuring a healthy economy. This study sets out to shed light on the decision-making process applied by South African venture capitalists when they allocate capital. Venture capital is defined in this study as including private equity. The study comprises an extensive survey by way of a detailed questionnaire which was mailed to 66 members and non-members of the South African Venture Capital and Private Equity Association (SA VCA) and achieved a 77% response rate. The questionnaire was based on previous work done in Western and Eastern Europe, and India. This ensured that quantitative South African results could be compared with international results. Quantitative statistical analyses were conducted and the results are presented. The study first identifies the criteria applied in the general evaluation of investments. Second, the required rates of return are established for each stage in the business cycle of the potential investment. Third, various risk factors which might affect the required rate of return are considered. Fourth, the study identifies the valuation methods employed at each stage in the business cycle of the potential investment. Fifth, the use of portfolio theory by South African venture capitalists and private equity investors is examined. In keeping with most similar studies around the world, South African VCs seek out quality entrepreneurial teams. They do this using an array of evaluation criteria which endeavour to flush out the risks inherent in the investments they are evaluating. In South Africa VCs seek strong management and overwhelmingly rate integrity as the most important management quality. Far less important are market issues, followed by product or service issues. This may reflect the perceived dearth of management talent in South Africa. This study analyses the required rates of return of different groupings of VCs by investment stage. It yields results consistent with financial theory as it applies to venture capital: the earlier the stage of investment, the higher the perceived risk profile of that investment. The study finds that more mature VC funds have lower required rates of return than less mature funds. Funds with a development or empowerment objective have lower required rates of return than those without. Independent funds require higher rates of return than captive and semi-captive funds. The required rates of return have only increased by about 2% since the more buoyant mid to late 1990s. The debt-equity ratio has an increasing effect on the required rates of return as the investment moves through the earlier stages of investment to the later stages. While the required rate of return of an investment is generally determined by the risk band in which it falls, the effect of the debt equity ratio is dependent upon an assessment of the individual risk characteristics of the investment. The general and specific factors which affect risk and required rate of return are ranked by South African VCs and the results are in keeping with international results. The general factors identify the lack of importance of the state of the general economy and long-term gilts to the VC’s required rate of return, but the importance of the state of the actual sector in which the investee participates. Insofar as specific risks are concerned, management is of particular importance as an indicator of risk, both in respect of the quality of management and the predictability of management’s behaviour. An analysis was done of the valuation methods which are used at the different stages of the investment cycle. South African VCs prefer to use the discounted cash flow method of valuation at all stages of the investment, although different techniques are also used in the earlier stages of the investment cycle. A final valuation is based on a preferred method while using the other methods as a check. Gut feeling is an important component of this process. This research also confirms that the newly adopted SAVCA (BVCA) Valuation Guidelines have not affected the valuation process when an investment is made. Most South African VCs apply reasonably sophisticated portfolio theory to their investment portfolios and the majority regard their portfolios as well-diversified. Implications for both South African entrepreneurs and South African VCs are also presented.

Bibliography: leaves 145-155.
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