/ 11 May 2005

The view from the mezzanine

The importance of black economic empowerment financier Makalani must have whizzed past most newspaper readers when they learned of its imminent launch on the JSE Securities Exchange. The reason is the phrase ''mezzanine financing'', previously a mystery to all but financiers.

The importance of black economic empowerment (BEE) financier Makalani must have whizzed past most newspaper readers when they learned of its imminent launch on the JSE Securities Exchange. The reason is the phrase ”mezzanine financing”, previously a mystery to all but financiers.

This is the focus of Makalani: the middle of the sandwich of finance that appears to have been hard to find before now.

Forget about that for the moment. What is significant is that the Financial Services Charter has, by accident rather than design, created a whole new company dedicated to funding an important slice of BEE transactions and infrastructure investment.

The company will enable financial sector players to earn charter scorecard points. More importantly, though independent, it is backed financially and technically by RMB, and will soon list on the JSE Securities Exchange with a market capitalisation of R2,5-billion — not chicken feed. And this happens in an era where delistings have become more common than listings, welcome proof that BEE can create new companies rather than reshuffle the shares of existing firms.

Investors will now be able to profit directly from the wave of BEE transactions set in motion by the various charters, and the infrastructure investment demanded in the Financial Services Charter in particular.

By signing the charter, financial institutions have committed themselves to making available funding of about R124 billion for BEE deals and ”targeted investments” such as transformational infrastructure (roads, bridges, port facilities and so on), affordable housing, the funding of small, medium and micro enterprises, and emerging agriculture. The R2,5 billion being raised by Makalani is a small percentage of that.

What Makalani will not do is solve the conundrum of financing BEE deals. That is, mismatch of risk: the financier extends loans, which should be safe ”senior debt” to finance the purchase of shares, classed as risky, with no hard assets to attach if things go pear-shaped. Financiers do not want to end up owning shares whose realisable value is less than the value of the loan.

The problem of who takes the risk has been solved in recent deals by the principal or vendor becoming involved in financing all or part of the deal, at some cost to the shareholders of the vendor company.

In a big transaction, such as the FirstRand BEE deal, the share-holders cannot be asked to bear the entire burden of making the deal work, and so third-party financiers are brought in.

The vendor or private equity financiers — who are looking for high returns — can provide the equity financing of the deal, say a third of the total amount needed.

If banks or other third-party financiers do get involved in these deals, they want their pound of flesh (apologies to Shakespeare’s archetypal lender). So for every R10 of shares financed, say, they will want the right to attach R40 worth of shares in the event of the deal going sour. And they will want interest on their money commensurate with the risk.

Hence the banks, including ”development finance institutions” such as the Industrial Development Corporation and the Public Investment Commissioner, will finance part of the BEE deals, but at a fairly hefty cost, which has sometimes been -criticised.

What is left, perhaps the remaining third of the finance needed, is the mezzanine funding — so called because it occupies the tier between the ground floor of debt and the upper storeys of equity investment. Once the need for this finance was identified, the creation of Makalani was the next step.

The structure of the company is fairly complex. Makalani Holdings is not itself a BEE company, since 20 % of its shares will be held by RMB and 80% by other share-holders, including institutional investors and the public.

Unlisted Makalani Management, owned 25 % by BEE entities, will manage Makalani’s funds for a fee. Vusi Mahlangu will be CEO and Sidney Mhlarhi chief investment officer of both the listed company and the management company.

A columnist in a Sunday news-paper suggested this week that BEE money, such as that involved in the big Old Mutual BEE deal, could be better used on infrastructure. Well, the Financial Sector Charter does direct about R25-billion alone toward ”transformational” infrastructure — and Makalani will get a slice of that.

Mezza-what?

Mezzanine financing is one tier of the financing used in what is known as a ”leveraged transaction”, in other words, the kind of transaction that is needed in black economic empowerment (BEE) deals to try and transfer wealth from shareholders to BEE partners who do not have the cash to pay for the shares outright.

Mezzanine financing is a class of debt that fits somewhere between extremely risky equity (shares) and low-risk bank debt. The key to understanding how it works is to envisage bankruptcy of an entity that has been financed by all three. Usually the first in the queue to get its money from the entity being liquidated is the bank: the last in the queue, normally ending up with nothing, is the shareholder. In the middle somewhere are the holders of mezzanine finance.

With the various levels of risk come commensurate reward. On the other hand, if you put your money in the bank or, even more securely, in government bonds, you don’t expect to make a killing.

Mezzanine financing is growing in importance. Paul Roelofse of RMB explains that since interest rates have fallen dramatically, growth has been driven by demand for investments with a higher income yield. To get higher income, investors need to risk a little more. Even perpetual preference shares, a safe bet, offer just over 6 %.

Enter mezzanine finance, and Makalani, to allow the investing public to buy into an instrument with a reasonable income yield that is safer than a share but not as safe as a government bond. Investors in Makalani will be able to buy linked units (debentures and ordinaries) issued at R100 each, with returns of about 10%. — Reg Rumney

Reg Rumney is director of the BusinessMap Foundation