THE ART OF BEE TRANSACTION FINANCING – BY EZRA DAVIDS AND ASHLEIGH HALE
The major activities in mergers and acquisitions in South Africa have taken place recently in the black economic empowerment (BEE) sphere. BEE is a central part of the South African government’s economic transformation strategy which aims to increase the number of black people that manage, own and control the local economy. South African business accordingly has to achieve the BEE ownership and control targets that have been incorporated in BEE legislation and related BEE industry-specific charters and scorecards. The sectors most affected to date have been mining and resources, financial services and ICT.
Capitalists without capitalThe main challenge facing black investors and the sustainability of a BEE deal is the lack of access to capital by black investors. The cost of third party finance for black investors only exacerbates this. This has been instrumental in shaping the way BEE deals have been financed and structured.
The early structuresDuring the first wave of BEE transactions in the late 1990s, black investors were typically funded by third parties utilising special purpose vehicles (SPVs). The BEE investor would be issued with 100% of the SPV’s ordinary shares at nominal value and the SPV would be capitalised through the issue of redeemable preference shares to a financial institution. The capital would then be used by the SPV to acquire the relevant equity for the black investor. Dividend income received from the equity investment would be used by the SPV to pay the preference dividends and to redeem the preference shares at the end of their term.
Very few of the BEE transactions undertaken during this period have been successful. This was due partly to market conditions and partly to the nature of the transaction structure. Volatile markets, the 1998 market crash and the high interest rate environment in South Africa at the time meant that dividend receipts on the equity investment were not sufficient to service the preference share funding obligations. As a result, many of the underlying equity investments reverted to financial institutions when repayment obligations could not be met.
The new structuresIn the new wave of BEE deals the problem of access to capital has been addressed through innovative financing structures. These structures are elaborate and complex, generally involving a combination of debt, equity and hybrid instruments (such as deferred shares, options and preference shares), together with various legs and multiple parties (special purpose vehicles, community and employee share trusts, etc.). The acquisition of equity tends also tends to be vendor-financed, although other more conventional methods of funding involving third party financing may be used.
Deferred shares, preference shares, options…Many of the new structures facilitate the transfer of equity to black investors through the creation of deferred shares. This class of shares typically gives the black investor the same voting rights as an ordinary shareholder on date of issue (thereby meeting the control requirements of the BEE scorecards), but the right to receive dividends in respect of the shares is deferred until the company has achieved a level of growth in earnings that can be attributed to the contribution of the black investor.
Preference shares are still very popular funding instruments. Standard Bank and Liberty Life in the largest BEE deals announced to date, intend funding their transactions through the issue of preference shares to wholly owned subsidiaries. The subsidiaries will then acquire a certain percentage of ordinary shares from the shareholders of Standard Bank and Liberty in terms of a scheme of arrangement. The equity in these subsidiaries will then be transferred to various BEE investors and employees at a nominal value.
ABSA Bank intends using options to transfer of 10% of its equity to black shareholders. ABSA will issue a number of redeemable preference shares to a BEE company at par value. The redeemable preference shares will each have an option attached to them entitling the BEE company to subscribe for 1 ABSA ordinary share at a pre-determined strike price. When and if the options are exercised, the redeemable preference shares will be redeemed at their par value.
Sustainability?The new structures are neither perfect nor without their challenges. The complexity of the new structures has meant that the parties involved are often at risk of contravening the company law prohibition on a company giving any type of financial assistance related to the purchase of or subscription for its shares, or shares in its holding company. The parties are also at risk of incurring substantial upfront and future tax costs.
It seems that no amount of financial or legal engineering can overcome the lack of access to capital by black investors. The jury is still out as the whether or not the new wave of BEE transactions can be successful and sustainable in the long-term.EZRA DAVIDS / ASHLEIGH HALE18 AUGUST 2004