Dealmaking in South Africa: Interview with investor Zuko Kubukeli

Zuko Kubukeli, CEO of PAPE Fund Managers

PAPE Fund Managers is a South African private equity investment outfit launched in 2008. The firm’s most recent fund, PAPE Fund 3, invests in mid-cap, unlisted and cash generative South African businesses. How we made it in Africa speaks to Zuko Kubukeli, CEO of PAPE Fund Managers, about the firm’s investment strategy, the impact of Covid and his most successful deal to date.

From an investment perspective, which sectors of the South African economy are you most enthusiastic about?

We have three fundamental things we look for in every investment. These criteria have little to do with the current South African landscape specifically and more to do with our overall investment thesis, which must work in almost all market conditions. We haven’t had to change our investment thesis because of lockdown nor did we change it in 2008 after the financial crisis.

Firstly, we don’t like businesses dependent on regulatory approvals and where you need decisions of the day to be taken by a regulator or government. To give you an example, we wouldn’t invest in a water infrastructure business. The government controls water rights and it’s a basic human right; you can’t cut off people’s water if they are not paying. The government also won’t cut people off because there is an election every four years. So, as interesting as water might be, there are just too many philosophical, moral and regulatory issues.

Secondly, we don’t invest in companies that sell a commodity where the price is determined by something or someone other than the relationship between buyer and seller. We want to set our price directly with buyers. The price of commodities such as gold or copper is set elsewhere which means you cannot charge more. Even if you are a very low-cost producer, the Chinese can flood the market or decide they want to buy less of a particular commodity, which will send the price through the bottom.

Thirdly, we want to invest in defensive businesses where the product is a ‘need’ as opposed to a ‘want’. For example, food, insurance and medical aid are needs, whereas people can go without luxury goods.

We are less concerned with specific sectors, as long as our investments tick these three boxes.

What are some of the investment lessons you’ve learnt over the years?

It is important to understand what you are good at and know your limitations. We have been successful at investing in small- to medium-sized businesses, so cheque sizes of between R50 million ($2.9 million) and R150 million ($8.8 million). However, success is not measured when you invest, but by how you got the money back and what value you added to that business, its community and people. We have sold many of our investments to larger private equity funds. It is a niche we understand and we stick with it.

We are cautious about investing in businesses with lots of debt. When things are going well, debt enhances your equity return. However, things can just as easily go bad, as illustrated by the recent lockdowns. We prefer to protect our downside and equity capital first.

Highlight one of your most successful investments.

In 2011, we bought a South African telecommunications business called XLink, which developed technology that links point-of-sale credit card machines to banks. Whenever a customer swipes their card at a shop or a restaurant, XLink’s technology sends a message to the relevant bank to confirm the customer has money in their account. We invested R18 million and got R100 million out when we sold in 2015. It was our best return so far.

Name a deal you wish you had invested in.

We once considered investing in a crane business. I liked the defensive nature of the company and admired the owners. It was going to be our biggest investment. However, our internal approval processes took too long and the owners eventually signed a deal with someone else. That episode left a scar because we put a lot of time into the transaction. Although, I’m still friendly with the owners; they understand we were let down by our due diligence process.

How has Covid-19 impacted your portfolio companies?

One of our companies had to retrench almost 2,000 staff and close down a business unit, which has been quite costly and emotionally tough. The business is still going but it lost a limb. Just a few weeks ago, we had to inject more money into another of our businesses that supply the airline and hospitality industries with desert salt.

We also invested in a prominent five-star hotel which has been closed since the middle of March. We had a great experience over 10 years with that team at the hotel. To get it going again will require a considerable amount and we have decided to no longer be invested in that business.

That said, our other nine portfolio companies are up on their budgets, largely because they are defensive ventures that provided essential products and services during lockdown.

There has been a recent trend of private equity funds buying undervalued Johannesburg Stock Exchange-listed businesses and delisting them. Is this something you are looking at?

We’ve had a lot of those opportunities come past us. It always sounds sexy to say you’ve delisted a company and took it private. It is fantastic when everything aligns and this happens. However, it only falls into place every one out of about 30 opportunities.

There is a significant execution risk related to the delisting process and obtaining the necessary regulatory approvals. For instance, if you want to buy a JSE-listed company at R12, but the company’s net asset value is R14, you have to prove that price is fair and reasonable. Then you have to send circulars to every shareholder and these shareholders have to approve this. But then they don’t want R12, they now want R13. So, you’ve got to go through the entire process again; then suddenly the share price jumps to R15, and they want R15 instead of R13. Despite your modelling calculation of R12 as the correct price, you’ve invested so much time and effort in the deal that you either accept R15 or you have to write off millions you’ve already spent on corporate advisors to handle the process.

I’m sure there are decent take-private deals out there but in the time it takes to do a delisting, we can probably do three normal investments at half the price of doing the transaction. We prefer to negotiate directly with the owner of the business, rather than through banks or corporate advisors.