If alternative funding models used in most empowerment deals are not found, South Africa could, at worst, be headed for its own sub-prime crisis or at best fail to achieve its empowerment targets, say experts.
Ajay Lalu, a partner at BEE consulting firm Bravura Consulting, is outspoken about the inherent weakness of empowerment funding models, particularly models requiring the creation of special purpose vehicles (SPVs).
In a recent article Lalu said that these deals entail the creation of an SPV that is injected with cash by a funding party. The SPV will own shares in the participating company, while the funding party owns preference shares in the SPV as security against the debt.
According to Ernst & Young about 90% of all BEE deals on the JSE involving third parties still use an SPV approach.
”Banks will say it’s not a sub-prime issue because of the security arrangements they have in place,” he told the Mail & Guardian.
”Technically this is correct as banks don’t have large exposure because of the security arrangements inherent in these transactions. Companies often provide security against the empowerment loan and the shares themselves are used as collateral.”
But ”in reality” there is ”systemic risk” in the financial system, said Lalu, as market volatility of the kind we are currently seeing, means shares perform poorly and banks’ security no longer remains intact.
This could see the lending institutions asking the participating companies to cash up. Companies will have to use their cash reserves in these instances, which will result in further declines in their share price.
Ultimately banks, pension funds and insurers who invest in equities could see an impairment in their assets, creating a downward spiral in asset values.
”Potentially we are sitting on South Africa’s sub-prime crisis,” he said.
Lalu is calling for a serious discussion between the private sector, lending institutions, empowerment companies and the government to re-evaluate how BEE transactions are funded and investigate whether government’s BEE ownership objectives will be met.
Parallels with the US?
Opinion is divided about the level of risk that major empowerment deals face but similarities between BEE deals and the way the US sub-prime mortgage crisis originated are bluntly apparent.
In the case of the sub-prime market credit was issued to risky homebuyers, on the assumption that US housing prices would always do well, and that sub-prime buyers would be able to pay off their debt as a result.
In the case of BEE participants in deals incur massive debt to take part-ownership of companies, with shares almost always used as collateral against that debt. As with the sub-prime saga it is assumed that share prices will continue to increase and the debt can be paid off over time.
Under ordinary circumstances this is not a problem. But in the current market the value of those assets, and the bank’s security against those debts, are plummeting.
Houses in some parts of the US are going for as little a $6 000, while our JSE has seen trillions of rand wiped off its value in the wake of global market turmoil.
Steven Hawes, a researcher at empowerment rating agency Empowerdex, said there are parallels between the way sub-prime mortgage deals and BEE deals are structured but questions whether the ”fallout” will be similar.
Although deals between funders and SPVs may need to be renegotiated, it’s unlikely that banks will pull out entirely as share-cover transactions are viewed as long-term investments, many of them structured over seven to 10 years, he said.
Hawes also pointed out that banks have been prudent and taken ”a good deal of security” when structuring share-cover transactions.
”Most banks have taken into account a 30% decrease in share prices. Their debt-cover ratios are good enough to withstand a considerable drop.”
What’s the cost?
Although banks may not collapse what could happen is that BEE deals, particularly those nearing the end of their life, could unwind, with BEE participants owning far less of participating companies than was intended.
Dave Thayser, director of Ernst & Young’s transaction advisory services said the most vulnerable schemes are those with the largest gap between the price at which the deals were done and the current share price, in industries where, as a result of the global economic slowdown it could take a long time for the underlying share price to recover.
”The chief executive of a listed company we have worked with that entered into a BEE transaction in 2007 for 25% of the company’s equity believes that at the close-out of the scheme the conversion factor will be 70%. In other words, the notional equity percentage of 25% will convert into 17.5% of actual equity [for BEE participants].
”If that is the actual outcome it is likely to be one of the more successful schemes.”
The implications of this, said Thayser, is that the country’s empowerment targets will not be met solely through these schemes.
”The ownership targets will be met only if the pillars of the BEE codes other than ownership, such as employment equity, operate effectively in transforming the economy.”
”The shortfall will then potentially be made up by previously disadvantaged individuals investing their savings in the share market. Given current market conditions, that situation may be a little way off.”
Bee under pressure
A few companies are reassessing their empowerment deals:
- MTN: In February MTN announced that it would delay the implementation of its new BEE deal, which was due to take place early this year.
The company issued a statement saying that, in light of the constraints in the financial markets, it was not in the best interests of the company to carry out the transaction as planned.
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BARLOWORLD: In August last year Barloworld opted to reprice its BEE initiative from R102.87 to R83.31 a share, saying the re-pricing would encourage the sustainability of the transaction.
The R2.4-billion deal was later found to be ”under water” but the company’s chief executive, Clive Thomson, maintained that the group was not overly concerned as it could top up the funding if the share price dropped to a certain level.
- SASOL: Sasol’s 2008 empowerment deal saw shares sold to the public, under options including a cash purchase at R366 a share, and a funded option whereby the price of the shares was discounted and the difference was lent to buyers through the company. The scheme has a lock-in period of up to 10 years. Under the funded options the intention is that outstanding debt on the shares be paid out of the sale of shares required to meet the debt at the end of the lock-in period.
The shares, however, have declined in value to about R290, leaving the transaction well under water. Although there is still time for the market to make a substantial recovery, the shares need to grow at healthy rates for participants to meet debt requirements and for the company to retain its black ownership targets.
- SUPER GROUP: Transport and logistics group Super Group has seen a share price drop of 94% from 2004 when it sold 25.1% of itself to empowerment partner Peu Group.
By the end of last year ratings agency Fitch had downgraded the Super Group several times, citing reservations about its liquidity. The company has since asked shareholders for additional funding and has planned a R1-billion rights offer to help reorganise its debt.
- MVELAPHANDA RESOURCES: Mvelaphanda’s decision to dismantle itself was viewed as a setback for BEE but Mvela’s spokesperson, James Wellsted, said the decision was a strategic one ”not driven by a financial crisis or any perceived debt burden” but by the JSE’s requirement that it end its pyramid structure by August. It also needed to fund the Booysendal platinum project.
On March 16 Mvela announced that it had refinanced the R2-billion mezzanine debt associated with its investment in Gold Fields. The next day the firm’s R4.1-billion BEE deal with Gold Fields matured and the company exercised its right to exchange its shares in Gold Fields South Africa’s GFI Mining South Africa for ordinary shares in Gold Fields Limited.
Chief executive Pine Pienaar said refinancing the mezzanine debt would allow the firm to optimise the value of its Gold Fields investment at the appropriate time. — Faranaaz Parker and Lynley Donnelly
