Clout of Africa
13 March 2006
The South African private equity industry is well established and, by emerging market standards, relatively sophisticated. The market is growing at speed and playing a key role in shaping both the financial services landscape and the wider economy.
Not only is the industry beginning to attract major international investors - such as the recent investment of R5.4bn (£495m) made by CCMP Asia, formerly JPMorgan Asia, in its acquisition of Waco Industries - but it is also being driven to a large extent by the need for the empowerment of historically disadvantaged South Africans.
Black economic empowerment
Black economic empowerment (BEE) legislation, such as the Broad-Based Black Economic Empowerment Act and various industry-specific empowerment charters (effectively agreements between government and sectors of the economy), such as the charters in place in respect of the mining industry, the oil and petrochemical industry and the financial services industry, have placed substantial empowerment requirements on local businesses. These requirements, which generally include equity/asset ownership, employment and procurement requirements and targets, are often linked to specific timeframes.
The rapid proliferation of empowerment legislation, coupled with looming empowerment deadlines and the need to achieve empowerment targets within a set timescale, has precipitated a flurry of empowerment-related deals. In today's market, when companies seek private equity capital, they often want a BEE investor and many recently concluded private equity deals have had a BEE flavour.
The major challenge in structuring a BEE deal usually lies in overcoming problems associated with lack of funding and access thereto on the part of BEE investors. As relevant industry regulators are becoming more focused on ensuring sustainable, genuine broad-based empowerment, it is also becoming increasingly important to use structures that have found prior acceptance and to avoid those which have come to be perceived as superficial 'fronting' arrangements.
Nowadays, most major BEE deals involve the use of hybrid funding mechanisms, including vendor finance, debt finance and equity investment.
Establishment of funds
The captive funds of South Africa's larger banks, as well as the captive funds and private equity investment portfolios of government-backed agencies such as the Industrial Development Corporation (IDC), are significant players in the local market. There are also a number of successful independent funds operating in South Africa, most of which favour later-stage investment.
The type of entity used for fund formation varies, depending on factors such as whether the fund is a captive or an independent. Captive funds are usually housed in locally incorporated companies or trusts, while independent funds are often in partnerships. In South Africa, which has a residence-based taxation system, local companies have a flat tax rate of 30 per cent and pay secondary tax on companies (STC) of 12.5 per cent on dividends declared, resulting in an effective tax rate of 38 per cent. Trusts are taxed at a flat rate of 40 per cent. Partners in a partnership are taxed individually.
Investment forms and structuring
As in Europe and the US, common forms of private equity investment include management buyouts (MBOs), management buyins and recapitalisations. The majority of private equity funding in South Africa has historically gone towards later-stage investments, MBOs and replacement capital.
South Africa has a well-developed banking and financial services sector and there is a multiplicity of funding options available for leveraged buyouts (LBOs), the most commonly used options being loans involving senior and junior debt and mezzanine finance. The use of quasi-debt instruments, such as redeemable preference shares, is also a popular method of injecting the required funds.
The South African Securities Regulation Panel regulates mergers and takeovers and usually comes into play in major private equity transactions, including those where the target company is a public company (whether listed or not). In addition, the rules of the Johannesburg Stock Exchange (JSE) are relevant to the large number of private equity transactions which take place in respect of listed entities.
Tax structuring plays an important role in private equity transactions in South Africa. Important tax considerations include: the form of investment enterprise to be used; the possibility of a taxable recoupment arising in a sale or business transaction; the deductibility of interest; the re-characterisation (for tax purposes) of equity as debt where preference share funding is used in certain circumstances; and, generally, capital gains tax (CGT) consequences.
It is usually also necessary to notify and obtain consent from the competition authorities in terms of the Competition Act before any 'merger' is implemented.
It should also be noted that foreign investment in, and disinvestment from, South Africa is subject to certain exchange control restrictions. The exchange control regime is currently in the process of being relaxed.
Disinvestment and exit strategy
As in other jurisdictions, private equity investors in the South African market usually receive their returns through sales or mergers, IPOs or recapitalisations. Historically, the number of exits, particularly IPOs, has been quite low in comparison with the number of investments made, although this must be viewed against the backdrop of a generally low number of IPOs in recent years. The recent formation by the JSE Securities Exchange of a new junior capital market, known as ‘Alt X’, has met with moderate success to date, but it is still too early to tell if Alt X will lead to a substantial increase in IPO activity.
The fairly poor liquidity of private equity investments in South Africa is largely attributable to the fact that there is no ready market for such investments and it is often difficult to match the expectations of a willing buyer with those of a willing seller. Due diligence investigations go a long way towards providing potential buyers with comfort, but buyers often want the seller to stand behind the investment being realised by providing a comprehensive set of warranties. On the other hand, sellers are usually reluctant to provide warranties, with some sellers (particularly independent funds) adopting across-the-board 'no warranty' policies. The challenge for legal counsels often lies in facilitating a compromise that both parties are willing to accept.
Chris Ewing is chairman and Ryan Butler a director at Cliffe Dekker