The South African private equity industry is well established and, by emerging market standards, is relatively sophisticated. According to the South African Venture Capital Association (SAVCA), at last count in 2003, the industry had more than R41 billion (around US$6.5 billion) under management in private equity investments and, 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 major 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 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 time frames.
The rapid proliferation of empowerment legislation, coupled with looming empowerment deadlines and the need to achieve empowerment targets timeously, 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 which have found prior acceptance and to avoid structures which have come to be perceived as superficial "fronting" arrangements.
Traditionally, the major 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 key aspect of most BEE transactions. 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.
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 major private equity investments in terms of local legislation, which requires them inter alia 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, as a fund of funds, which operate and specialise 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 due to the very high entry levels specified by independent funds. According to SAVCA, at last count these funds were responsible for about 6% of all private equity investments in South Africa.
The type of entity used for fund formation varies, depending on factors such as whether the fund is a captive fund or independent fund. Captive funds are usually housed in locally incorporated companies or trusts, whilst 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, whilst 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 1 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 United States, common forms of private equity investment include management buy-outs, management buy-ins and recapitalisations. According to SAVCA, the majority of private equity funding in South Africa has historically gone towards later stage investments, buy-outs and replacement capital.
South Africa has a very well developed banking and financial services sector and there is a multiplicity of funding options available for leveraged buy-outs, the most commonly used options for major 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 of the most important statutory provisions to consider when structuring any financial package, is section 38 of the Companies Act. Section 38 prohibits the provision of financial assistance by a company for the purpose of or in connection with the purchase of, or subscription for, that 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.
To fall within the prohibition, the relevant company must provide "financial assistance", for the purposes of or in connection with the purchase of, or subscription for, that company’s own shares or the shares of its holding company. Companies may not therefore 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 versus Sale of Business
In any management buy-out, an important 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 major 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 which owns the entire underlying business, including its liabilities. Sales of shares are therefore 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 where the target company holds a valuable licence/permit or a contract which 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 major sticking point in any sale transaction and is one of factors which contribute to the illiquidity of a private equity investment.
When structuring a transaction as a sale of business, three particularly important statutory provisions must be considered, namely: 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 where 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 zero percent, 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 following the date of transfer, unless the required legal notices are published. It is therefore normally 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 major 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 ten members and shareholders funds (including claims on loan account) in excess of R5 million (around US$ 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/s already hold/s between 35% and 50% of the voting rights) acquires more than 5% of the voting rights in any 12 month period, or where there is a sale of the major part of the target company’s undertaking or assets. 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 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 of business transaction; the deductibility of interest where debt-funding is used; 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. Consideration should also be given to ensuring efficient transaction structuring so as to minimise transfer and stamp duties, which may be substantial in major transactions.
It is important to note that there are special tax exemptions (including CGT and transfer duty exemptions) applicable to share-for-share transactions and intra-group transactions.
In larger private equity transactions, it may also become 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.
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 return through a sale or merger, an initial public offering (IPO) or a recapitalisation. 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 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 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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.