The South African private equity industry is well established
and, by emerging market standards, sophisticated. According to the
South African Venture Capital Association (Savca), in 2003 the
industry had more than R41 billion ($6.5 billion) under management
in private equity investments. In terms of size relative to gross
domestic product, the local industry compares favourably with those
in most European countries.
The industry does not have a specifically designated regulator
or its own industry-specific legislation. Applicable legislation
includes the South African Companies Act, the Collective Investment
Schemes Act, the Competition Act and the Income Tax Act.
Black economic empowerment
One of the main deal drivers in South Africa in recent years has
been the empowerment of black South Africans. 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 regarding 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, 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 challenge in structuring a BEE deal usually lies in
overcoming problems associated with lack of funding and access to
funding on the part of BEE investors. As relevant industry
regulators are becoming more focused on ensuring sustainable,
genuine broad-based empowerment, it is becoming increasingly
important to use structures that are widely accepted and to avoid
structures that are perceived as superficial fronting
arrangements.
Traditionally, the big private equity players in the local
market have been dominated by white ownership and many of them have
recently aligned themselves, or are in the process of aligning
themselves, with black-owned investment groups. However, the
challenge of establishing mutually beneficial funding arrangements
remains a pivotal aspect of most BEE transactions. Most BEE deals
involve the use of hybrid funding mechanisms, including vendor
finance, debt finance and equity investment.
Establishing 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 big players in the local market. A number of
successful independent funds also operate in South Africa, most of
which favour investment at a later stage.
Institutional investors, such as insurance companies and pension
funds, have traditionally been reluctant to invest in private
equity, although they appear to have shown greater appetite for
private equity investment in recent years. Retirement funds are,
however, prevented from making large private equity investments by
local legislation, which requires them to maintain asset diversity
and prevents them from investing more than 5% of their total
portfolio in unlisted entities.
A number of institutions have also established collective
investment schemes, which operate as a fund of funds and specialize
in private equity investments. These collective investment schemes
are typically aimed at individual investors who have traditionally
been excluded from participating in the private equity market
because of the high entry levels specified by independent funds.
According to Savca, these funds are responsible for about 6% of all
private equity investments in South Africa.
The type of entity used for fund formation varies, depending on
whether the fund is a captive fund or independent fund. Captive
funds are usually housed in locally incorporated companies or
trusts, while independent funds are often housed in partnerships.
South Africa has a residence-based, as opposed to a source-based,
taxation system and local companies have a flat tax rate of 30% and
pay secondary tax on companies (STC) of 12.5% on dividends
declared, resulting in an effective tax rate of 38%. Trusts, on the
other hand, are taxed at a flat rate of 40%. Ordinarily, the income
of vesting trusts is taxed in the hands of the beneficiaries, while
the income of discretionary trusts is taxed in the hands of the
trust. Although partners in a partnership are required to submit
joint tax returns, they are taxed individually and a partnership
has no existence as a taxable entity apart from the individual
partners.
Target entities are typically locally incorporated private
companies. These companies may have between one and 50 members (or
more, if such members are employees) and are required in terms of
the South African Companies Act to incorporate provisions in their
articles of association restricting the transfer of their shares.
Such provisions are usually of a general nature and may be as broad
as to allow the directors of the company the discretion to refuse a
particular share transfer.
Investment forms and structuring
As in Europe and the US, common forms of private equity
investment include management buyouts, management buy-ins and
recapitalizations. According to Savca, most private equity funding
in South Africa has historically gone towards later-stage
investments, buyouts and replacement capital.
South Africa has a well-developed banking and financial services
sector and a multiplicity of funding options is available for
leveraged buyouts, the most commonly used options for large
transactions being loans involving senior and junior debt classes
and mezzanine finance. The use of redeemable preference shares is
also a popular method of injecting the required funds.
Financial assistance for acquisition of own shares
prohibited
One statutory provision to consider when structuring any
financial package is section 38 of the Companies Act. Section 38
prohibits a company from providing financial assistance for the
purpose of, or in connection with, the purchase of, or subscription
for, the company's own shares or the shares of its holding company.
There are certain limited exemptions from the application of
section 38, such as exemptions in respect of employee share
incentive-schemes and in respect of share buy-backs.
Companies may not grant any form of security over their assets,
or issue any suretyship or guarantee, or otherwise provide
financial assistance in connection with the acquisition of their
own issued shares or the shares of their holding company. Holding
companies are, however, not prohibited from providing financial
assistance for the purposes of, or in connection with the purchase
of, or subscription for, shares in a subsidiary company. In
addition to voiding a prohibited transaction, a contravention of
section 38 constitutes a criminal offence. As is evident, the
impact of section 38 is far ranging, and it is vital to ensure that
any acquisition finance package does not fall foul of its
provisions.
Sale of shares v sale of business
In any management buyout, one decision is whether the
transaction will be structured as a sale of shares (usually also
involving a sale of shareholders' claims) or a sale of the
underlying business/business assets. Aside from the tax
implications, the big advantage of a sale of business/business
assets is that the buyer is able to cherry-pick the assets it
wants, without assuming unwanted liabilities. Conversely, in a sale
of shares the seller acquires the entity that owns the entire
underlying business, including its liabilities. Sales of shares are
more often used in circumstances where it would be difficult or
impractical (usually in terms of cost and/or timing) to transfer
the assets out of the target company, for example, if the target
company holds a valuable licence/permit or a contract that cannot
be assigned. Given that a purchaser of shares is at a greater risk
of inheriting unwanted liabilities than a purchaser of a business,
a sale of shares often involves a more detailed set of warranties
(covenants) than a sale of business. The negotiation of these
warranties often proves to be a sticking point in any sale
transaction and contributes to the illiquidity of a private equity
investment.
When structuring a transaction as a sale of business, three
statutory provisions must be considered: section 197 of the Labour
Relations Act; section 11(1)(e) of the Value-added Tax (VAT) Act;
and section 34 of the Insolvency Act. Section 197 in essence
provides that, if a business is transferred as a going concern, the
employees of the business are automatically transferred along with
the business, unless the relevant parties (including the employees
or their representatives) agree otherwise. The effect of section
197 is that, unless otherwise agreed, when a business is
transferred as a going concern the buyer will step into the shoes
of the seller vis a vis the employees of that business and full
credit must be given to the accrued rights and employment history
of the transferred employees. Section 11(1)(e) provides that, if a
business is transferred as a going concern, that transfer will
attract VAT at 0%, if certain requirements are complied with.
Section 34 of the Insolvency Act provides that when a business is
transferred, judgment creditors of the seller will be able to
execute against the transferred assets for a period of up to six
months after the date of transfer, unless the required legal
notices are published. So it is usually in a purchaser's best
interests to ensure that sale of business notices are published as
required in terms of section 34. Where this proves to be
impractical, the purchaser usually has to make do with an
appropriately worded indemnity from the seller.
Other legal considerations
The Securities Regulation Code on Mergers and Take-overs (the
Code) also comes into play in some large private equity
transactions. The Code applies where an affected transaction
occurs and where the target company is a public company (whether
listed or not) or a private company with more than 10 members and
shareholders funds (including claims on loan account) in excess of
R5 million (around $800,000). An affected transaction occurs
where the acquirer (acting individually or in concert with others)
acquires all of the shares of a class, or acquires more than 35% of
the voting rights of a company, or (if the acquirer already holds
between 35% and 50% of the voting rights) acquires more than 5% of
the voting rights in any 12-month period, or where a large part of
the target company's undertaking or assets is sold. The application
of the Code means that certain formalities and rules of fair play
would have to be observed and, in certain circumstances, may
involve an offer to minority shareholders. It is possible to apply
to the regulator, the Securities Regulation Panel, for exemption
from the application of the Code.
Tax structuring plays a large role in private equity
transactions in South Africa. Tax considerations include: the form
of investment enterprise to be used; the possibility of a taxable
recoupment arising in a sale of business transaction; the
deductibility of interest where debt-funding is used; the
re-characterization (for tax purposes) of equity as debt where
preference share funding is used in certain circumstances; and,
generally, capital gains tax (CGT) consequences. Consideration
should also be given to ensuring efficient transaction structuring
so as to minimize transfer and stamp duties, which may be
substantial in large transactions. Special tax exemptions
(including CGT and transfer duty exemptions) apply to
share-for-share transactions and intra-group transactions.
In larger private equity transactions, it might also be
necessary to notify and obtain consent from the competition
authorities in terms of the Competition Act before any merger is
implemented, provided that the required transaction thresholds are
met.
Foreign investment in, and disinvestment from, South Africa is
subject to certain exchange control restrictions, but the exchange
control regime is being relaxed.
Disinvestment and exit strategy
As in other jurisdictions, private equity investors in the South
African market usually receive their return through a sale or
merger, an initial public offering (IPO) or a recapitalization.
Historically, there have been few exits, particularly IPOs, 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 because 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 realized 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 an across-the-board no-warranties policy. The
challenge to legal counsel often lies in facilitating a compromise
that both parties are willing to accept.
Author
biographies
David Pinnock
Cliffe Dekker Inc
David Pinnock is a director of Cliffe Dekker Inc. He is an LLB
graduate of the University of the Witwatersrand, South Africa (SA).
He joined Cliffe Dekker in January 1997 as a candidate attorney and
became a partner in March 2002.
Pinnock's areas of specialization are: mergers, acquisitions and
takeovers; formation and initial structuring of new business
entities; and general commercial drafting. His experience
includes:advising non-resident clients on investment and operations
in SA; drafting and registering the prospectus for the public offer
of shares of a company listing in the UK to SA residents; advising
various clients in setting up operations in the US, Europe and
Australia; and advising clients on SA exchange control regulation
and
practice.
Ryan Butler
Cliffe Dekker Inc
Ryan Butler is a senior associate at Cliffe Dekker. He is an LLB
graduate of the University of the Witwatersrand, South Africa (SA).
He joined Cliffe Dekker as a candidate attorney in January 1998 and
will be admitted as a partner in March 2005.
Butler's specialization areas are: corporate finance and banking
law; financial markets law; and general commercial law. His
experience includes acting as member of the team advising a large
LSE-listed platinum producer in a black economic empowerment
transaction with a value of around R4.5 billion ($785 million);
acting for the private equity division of a SA financial services
company in restructuring certain of its offshore holdings; acting
for an SA bank in drafting, negotiating and finalizing
documentation for a R200 million loan and a R140 million
subscription for preference shares.
Cliffe Dekker Inc
1 Protea Place
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Sandton
South Africa
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Benmore 2010
South Africa
Tel: +27 11 290 7000
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www.cliffedekker.com