It's an attempt to fund equity with debt. Bear this in mind the next time you feel inclined to judge a black economic empowerment (BEE) deal gone wrong.
Funding equity with debt makes for a razor-thin margin of error. It's an even more difficult trick to perform when the beneficiary of the target asset has zero security, which is often the case with BEE groups.
Interest on high leveraged buyouts is generally steeper, and the absence of loan security draws its own interest premium. That calls for super returns from the target asset for the BEE transaction to deliver real value.
Vendors that are unsympathetic to BEE and impose unreasonably steep prices on empowerment transactions do not help the situation, as this puts further strain on the financial viability of these transactions. That is partly why empowerment history is littered with failed attempts to transfer equity to black groups. "Vendors tend to overvalue their companies and the result is that dividend flow to BEE companies is not sufficient to service loan interest," says Kgomotso Matseke of Actis Africa Empowerment Fund.
"Crucial to any solid BEE deal is the correct valuation of the assets the BEE partners are buying," says Daly Attorneys CEO Patrick Daly. "An overpriced asset will be unattractive to prospective buyers and an underpriced asset will punish the seller," he says.
Unfortunately, sellers are inclined to exaggerate their future performance, says Daly. To gain a fair valuation for 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, trying to pay off a loan he can't afford."
This is only one part of the challenge faced by SA in its attempt to transfer economic assets to the previously excluded section of the population. It is a challenge many active BEE players, financiers and vendors face when concluding BEE deals. It requires creativity, innovation and out-of-the-box thinking. It's the art of BEE funding.
Sophisticated financial structures and ownership forms have been devised to help BEE funding. These include derivative products such as options to remove the need for BEE companies to gather enormous amounts of capital at one go. A single transaction can be manipulated to encompass different types of funding, including third-party finance, mezzanine finance, vendor finance and issuing preference shares.
"I don't think the public appreciates the amount of work and innovation that goes into structuring these deals," says Leon von Moltke, senior corporate finance executive at Rand Merchant Bank.
For BEE players, the question that arises most often is how to gain ownership without placing too much debt on their shoulders, says Daly.
These professionals spend hours trying to circumvent a conundrum born of SA's choice of a peaceful political transition. It is a challenge, but the new dispensation must be given meaning through a speedy redistribution of economic assets to the previously economically excluded section of the population.
Perhaps, in another lifetime, in another transition with less sensitive political emotions, a more patient approach would produce better long-term results. In this hypothesis the aggrieved would be more patient; they would in the short term focus on acquiring skills and experience in running enterprises and they would follow an incremental development approach: start small, build an asset base and leverage on it. By so doing they would avoid funding equity with debt.
SA's context is different. Political emotions are high, which calls for immediate results on economic transformation while tackling incremental development on a parallel line. So SA will have to achieve BEE through funding equity with debt. And the country seems to be getting better at it by the day.
The learning path has been painful. Many BEE transactions concluded around the 1994 period have collapsed. Looking back it is as if the people who put them together were intoxicated by the blind optimism of 1994. One cannot blame them. Many thought that SA, the new kid on the international block, was set for an economic boom. Many thought foreign direct investment would flood in as the African continent found new hope; in turn this would bolster economic growth and set the local equities market on a long bullish cycle.
That optimism gave rise to a BEE wave heavily dependent on the performance of the share market. Through highly indebted special purpose vehicles (SPVs), BEE groups sold stakes in listed firms in the hope that capital gains would cover a huge portion of the SPVs' liabilities. Groups such as Thebe, Nail, Johnnic, Real Africa and Worldwide Investments were part of this wave. That increased black control of the JSE's market capitalisation from zero to about 5%.
Little attention was given to the fair and reasonable pricing of assets being acquired by BEE groups, cost of capital, cash flow and the active involvement of BEE players in target companies.
Little did we know of "emerging market syndrome". Like a thief in the night came the Asian flu of 1998/1999 and together with it, the emerging markets crisis. The rand lost significant ground against hard currencies, interest rates shot up, reaching a record of 25%, and the local equities market went south.
Many BEE deals collapsed because of mounting interest bills plus the fact that shares had been depressed below strike prices, making BEE groups liable when they were designed to be beneficiaries. That put a damper on the BEE dealmaking frenzy, as many transactions were unwinding. If there was a winner during this phase it was financial institutions that held the assets affected by failed empowerment attempts.
All this prompted the country to rethink the BEE approach. With government leading the campaign there was a call for a more sober and sustainable approach to BEE funding. This call eventually culminated in code 100 in the new BEE codes of good practice. To be made law next year, the codes have been designed to serve as a principal guideline to the implementation and measurement of BEE value, using relatively more sustainable financial tools.
The codes have introduced more alignment of interests in the making of BEE deals. Only genuine structures which deliver value to black partners will be recognised in the awarding of BEE points.
The shift has largely been defined by tying the BEE transactions to the operations of the target asset and less to the performance of the share price.
Two ownership models have emerged in this new wave: the Newco model, which is facilitated by the transfer of the target enterprise's assets into a new entity, and the dividend flow model, where BEE players lock their dividend income into debt payment.
