African Rainbow Capital’s valuations and management fees under the spotlight

African Rainbow Capital (ARC), whose portfolio includes prominent companies like Rain, Alexander Forbes, TymeBank, and Afrimat, has been slated for high management fees.

ARC’s valuations of companies in its portfolio also came under the spotlight as its market cap is only around 30% of its net asset value (NAV).

The company’s current market cap is R3.54 billion, well below the R11.14 billion net asset value of its investment portfolio.

What this means, in simple terms, is that the market thinks ARC is worth much less than what the company’s management thinks it is worth.

Analysts who MyBroadband spoke to put this down to three reasons – exorbitant management fees, an overvaluation of its assets, and tough market conditions.

The management fees and valuation of its assets are related as ARC charges management fees based on net asset value.

Sasfin Securities deputy chairman David Shapiro said ARC took high management fees to a new level.

“Charging fees on NAV that the directors believe is 4 times greater than the market price, sets a new high-water mark,” he said.

Jean Pierre Verster from Protea Capital Management said the market has judged ARC’s management fees harshly, and for good reason.

He explained the management fee structure does not alight outside shareholders’ interest with the management’s interest.

He said the rights issue is significantly dilutes the NAV per share. “The NAV per share therefore comes down, but the total NAV goes up,” he said.

This means shareholders have seen a significant and permanent reduction in the value of their shares.

However, the way in which ARC’s management’s performance fee has been structured means they do not get diluted from the “high water mark”.

ARC management can therefore still meet targets and charge a performance fee while shareholders do not see value in this performance.

While there were always murmurs about ARC’s management fees – which range between 1.25% and 1.75% based on its NAV – it was kept under control.

When ARC announced that it will use R205 million of the R750 million it planned to raise through a rights offer to pay management fees, the situation boiled over.

The outcry from aggrieved investors was so significant that ARC backtracked on this decision and admitted that the market does not like the high management fees.

While this addressed the immediate concern regarding the rights issue, questions regarding its NAV and management fees remained.

MyBroadband asked ARC co-CEO Johan van der Merwe for details about this issue. His answers are provided below.


Can ARC give a breakdown of its management fee structure?

The management fee has been in place since the company listed on the JSE in September 2017. There has been no amendment to the management fee structure since listing.

Fund Management Fee and Cash Management Fee

  1. Where the Opening Invested NAV is below R10 billion, 1.75% per annum on the average of the Opening Invested NAV and Closing Invested NAV of that Quarter;
  2. Where the Opening Invested NAV is between R10 billion and R15 billion, the higher of the amount determined in terms of (i) and 1.5% on the average of the Opening Invested NAV and Closing Invested NAV of that Quarter;
  3. Where the Opening Invested NAV is above R15 billion, 1.25% on the average of the Opening Invested NAV and Closing Invested NAV of that Quarter.

Some investors have signalled that our management fee is too high. Our management fee on a portfolio value of less than R10 billion is 1.75% We see ourselves as a listed Private Equity play, and if you then think that the standard Private Equity fee is 2% then it does provide some perspective.


What does ARC do to justify these fees?

The management fee is in place to ensure the optimal management of the portfolio of investments, which covers 49 companies.

For this be achieved, ongoing operating expenses have to be incurred to manage the ARC Fund, in terms of the relevant agreements ARC has in place with the General Partner of the ARC Fund.

These would typically include:

  • Sourcing of investment opportunities in accordance with the Investment Guidelines;
  • Assisting in identifying exit opportunities relating to investments;
  • Providing investment research to the General Partner in respect of investments or potential investments;
  • Assisting the General Partner to conduct or manage appropriate due diligence investigations of any potential investments in order, inter alia, to identify financial and regulatory risks and measures to mitigate against such risks;
  • Assisting the General Partner to determine the appropriate vehicle for any investment to be made by the Partnership;
  • Assisting the General Partner to structure the acquisition and/or disposal of investments by the Partnership;
  • Monitoring the status of all investments and provide such assistance to Portfolio Companies and their subsidiaries as may reasonably be required by the General Partner, including providing directors to serve on the boards and/or committees of Portfolio Companies.

With our annual financial results announced to the market on 15 September 2020, we achieved a 2% growth in the value of the portfolio. On an absolute basis, it is significantly lower than our stated objective of 16% growth. On a relative basis, and given the unique challenges of the current trading environment, it is certainly better than a number of other listed entities.

Management has no control over the share price. All we as management can do is to ensure that the underlying investments perform well so that they can start declaring dividends in future and we can start returning the cash to shareholders in the form of dividends if there are no opportunities to invest the cash from dividend proceeds.

Remuneration of staff is one component of these fees. In 2019/20, this made up less than one third of total management fees received. Managing a portfolio of 49 different companies is perhaps not as straightforward as some may think. Certainly, there is no intention of asking shareholders to invest further in our business and then using the funds to remunerate management.

There is enough cash in the company to remunerate management, regardless of the rights issue.

More specifically, the criticism has been that the fee structure favours ARC management as it is based on the net asset value of the portfolio, but should instead be based on the company’s share price. Some comments are incorrect as the management fee does not translate to remuneration for ARC management, but rather covers all operating costs to manage the portfolio of investee companies.

In these uncertain times as a result of Covid-19, we have announced the rights offer in order to shore up our cash position to ensure we are able to respond positively should an attractive investment opportunity arise. We believe ARC Investments is still in a strong growth phase.

The main rationale for the rights offer, as contained in the documentation, is to raise cash for:

  • Strengthening existing businesses in which we have invested.
  • Being prepared for new investment opportunities in the current trading.

Settling of the management fee out of the rights issue was merely an administrative/technical action to facilitate ARC (the non-listed entity) following its rights and underwriting the offer 100%, which is done at no fee.

The question should be asked why the accrual of the management fee is seen as negative because we did it to preserve cash for the portfolio during very extra-ordinary times, given the onset of the Covid-19 pandemic and a poorly performing economy.

All shareholders in ARC Investments (the listed entity) benefitted from this and ARC (the non-listed entity) was the only shareholder funding this. Although ARC (the non-listed entity) was allowed to charge interest it did not.

ARC Investments (the listed entity) has sufficient cash resources to pay the management fee before the rights issue is implemented, and the company does not have to use the rights issue proceeds to fund the payment of the management fee.

Due to the misunderstanding of the mechanism we intended to use, management decided to demonstrate that the proceeds from the rights issue is not required to pay the management fee. Management has opted to defuse the situation by issuing the SENS statement, which was done on Friday 25 September 2020, and still settle the management fee before receiving the proceeds of the rights issue.


Why is ARC trading at such a big discount to NAV?

We are obviously disappointed with the performance of our share price since listing in September 2017 – which is now 3 years on. We are in the same boat as shareholders, our intention is to grow the portfolio and improve on the cash generating ability of the fund going forward.

We believe that there are multiple reasons for the share price trading at such a significant discount to NAV, with the following three points being the main reasons:

  • JSE listed investment holding companies have been trading on average at a 15% to 20% discount to their NAV for some time now.
  • We have invested in 3 major start-ups being the telecoms company, Rain, the leading digital bank in SA, TymeBank, and the phosphate mining business, Kropz. The market is signalling that they do not attribute much value to these investments we have made as these businesses are not, with the exception of Rain, generating positive cash flow. We believe this will change over the course of the next 18 months as these businesses expand their client base, gain more operational traction and generate significant revenue and therefore cashflow.
  • Some investors have signalled that our management fee is too high. Our management fee on a portfolio value of less than R10 billion is 1.75% We see ourselves as a sort of a Private Equity play, and if you then think that the standard Private Equity fee is 2% then it does provide some perspective.

Many people questioned the valuations which ARC assigns to companies, especially as it increases fees. Do you think taking high fees on NAV which is seen as overvalued by some is fair practice?

The portfolio of investments is held in the ARC Fund which is really the asset in ARC Investments, which is the JSE listed entity. As such, we publish annual and interim financial results, as per the JSE Listing Requirements. Key to this process is the auditing of our financial statements by our auditors, which in this case is PWC as well as our internal review process under the guidance of the audit committee of UBI General Partner.

As an investment holding company, a key activity, when auditing our financial statements, is for the auditors to perform stringent valuation tests to scrutinise the value of each of our investments in the portfolio. These tests are applied industry wide.

As mentioned, there are ongoing operating expenses to manage the ARC Fund. The gap between the NAV per share and the ruling share price, does not translate into a reduced operating expense. In fact, management may have to work harder to close this discount, so there may very well be increased operating costs to incur.


ARC co-CEO Johan van der Merwe interview


Now read: Rain’s extraordinary valuation

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African Rainbow Capital’s valuations and management fees under the spotlight