The financing of black economic empowerment (BEE) equity transactions has come under intense scrutiny in the new BEE codes of good practice.
That is after most BEE equity deals concluded since 1994 yielded little in transferring real economic assets to black groups. "We have experienced thousands of BEE deals over the past few years, but black people still own only about 1% of the JSE," says BEE analyst Duma Gqubule. "I doubt if people engage in the empowerment process in good faith."
A classic example is the Johnnic Holdings experience. One of SA's grandest plans to deliver mainstream business assets to black groups, the Johnnic empowerment scheme delivered few real economic assets to the intended beneficiaries.
The main culprit in the Johnnic debacle was an unsustainable financing structure imposed on the National Empowerment Consortium (NEC), the now-defunct controlling Johnnic shareholder. The financing structure was a special purpose vehicle (SPV), which depended on unrealistic share price performance to deliver value to the NEC. The Johnnic share price did not meet these high expectations, dashing the NEC's hopes.
Many other BEE structures that adopted the same model came to nought - though the vendors and financiers received credit for facilitating BEE.
"After 10 years of difficulty, a practical funding model for BEE deals still seems elusive," says Daly Attorneys CEO Patrick Daly.
He says there are a number of steps to follow to avoid the common pitfalls. "Crucial to any solid BEE deal is the correct valuation of the assets the BEE partners are buying."
To obtain a fair valuation of an asset, Daly suggests companies guarantee their projections and share the risk evenly with the BEE buyer. "We often say to sellers, if you truly believe in the price tag, you should have no problem putting your money where your mouth is. So, if the company fails to perform at the expected level, the purchaser is not left twisting in the wind alone, trying to pay off a loan he cannot afford."
Under the new BEE codes of good practice, financing structures will have to show sustainability from day one to earn points in the ownership aspects of the scorecard. The codes introduce a principle to measure the graduation of debt structures towards net asset value accumulation. A total of seven points out of 20 of BEE ownership accrues only with compliance to the graduation principle.
That means BEE financing structures that impose unreasonable conditions on BEE partners will not be compliant.
The codes, however, do not solve the entire funding problem of BEE, which is the lack of reasonably priced capital. The codes' strict measures in assessing BEE funding may further scare away primary BEE funding, which comes in the form of mainstream financial institutions such as banks and insurance houses.
These institutions tend to be dogmatic in their approach and are willing to fund BEE deals using only extremely tight risk-and-return measures. This leads to expensive funding for BEE equity deals.
For historical reasons, BEE groups possess little if any collateral, and this draws premium interest charges on their primary funding.
However, years of struggling with finance has led to some innovation and creativity coming into the BEE funding arena.
Mezzanine finance, which takes the form of tradable instruments, is emerging as a critical factor in the funding of BEE. With a lesser rank than senior debt, mezzanine debt f ills the gap left by BEE groups that are unable to make an equity contribution in transactions. However, it is considered a high-risk instrument because in the case of liquidation it will be the last considered for recovery.
Private-sector players are slowly moving into mezzanine finance. Rand Merchant Bank (RMB) together with investment banking professionals Vusi Mahlangu and Sydney Mhlarhi launched an operation called Makalani last year. It is listed on the JSE and launched with a R2,5bn fund to focus on large BEE deals.
Commentators say that state funding institutions - mainly the National Empowerment Fund - will do well if they move aggressively into mezzanine finance.
Many BEE transactions are moving away from the SPV structure by tying BEE funding into the operations of the purchased asset and thereby to dividend income stream. In such models, dividend income is locked in until the BEE investors have significantly retired their debt.
This may take shape through a leveraged buyout, where the assets of the target company are used as collateral to help raise finance. "But, if not structured appropriately, this format has significant cost implications such as capital gains tax, tax recoupments in the vendor company and secondary tax on companies," says Deloitte corporate finance advisory manager Moatlhodi Lekaukau.
The use of preference shares is on the rise. The funder will subscribe for preference shares in a BEE special purpose vehicle for cash, which in turn acquires shares in the target company. The funder is dependent on dividend payments from the target to the special purpose vehicle for the repayment of the loan. The preference shares come with a redeemable option due to the BEE beneficiaries.
Vendor financing is increasingly becoming the norm in BEE deals. Noting that mainstream financiers are reluctant to bankroll BEE deals, corporations are facilitating the funding of their BEE partners. This can be done in a number of ways, including the provision of guarantees on behalf of a BEE party to a third-party funder.
Some corporations are digging deep into their pockets and directly loaning money to BEE players so they can buy equity. Future vendor-financed transactions will be aided by changes in the tax law, says Johan le Roux, manager corporate finance advisory at Deloitte. In terms of these changes, if more than 70% of a company is owned by one shareholder, intergroup restructuring can be undertaken while deferring potential capital gains tax implications, says Le Roux.
Vendors can also facilitate BEE equity deals through options. In this case, an option tied to certain performance measures is given to a BEE entity to acquire shares in the target company over a particular period. This allows BEE companies to assume control over the shares without having to raise enormous amounts of money to acquire equity.
