Private equity in South Africa: market and regulatory overview

A Q&A guide to private equity law in South Africa.

This Q&A is part of the multi-jurisdictional guide to private equity. It gives a structured overview of the key practical issues including, the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.

To compare answers across multiple jurisdictions, visit the Private Equity Country Q&A tool.  For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.

Contents

Market overview

1. How do private equity funds typically obtain their funding?

New funds of ZAR11.1 billion (as at 1 November 2011, US$1 was about ZAR8) were raised in 2010 with 42.4% of this from South African sources. Cumulatively, funds sourced from South Africa represented 39.7% of funds under management. The main non-South African contributors were the United Kingdom and the United States.

The main sources of funds were:

  • Development Finance Institutions (DFIs) (36.7%).

  • Insurance companies (17.4%).

  • Pension and endowment funds (16.3%).

  • Family offices (15.8%) (KPMG and South African Venture Capital & Private Equity Association (SAVCA) Venture Capital and Private Equity Industry Performance Survey of South Africa for 2010) (see box, Private equity/venture capital associations).

 
2. What are the current major trends in the private equity market?

South Africa is positioning itself as the main investment gateway into Africa and many new funds are targeting an investment area that is much broader than South Africa. Africa deal flow is therefore increasing and international funds are increasingly looking to set up a presence in South Africa.

In the local market, deal activity is also increasing following a lack of activity in 2009 and 2010. Third party debt is available at reasonable multiples and the pipelines of many funds are fuller than previously. The new Companies Act, 2008 (Companies Act) (effective 1 May 2011) and aggressive new tax legislation targeting the tax deductibility of interest on borrowed monies, have caused uncertainty. Some deals collapsed or were put on hold pending greater clarity. Generally, the Companies Act is likely to increase deal costs and execution risk and, in the short term, may deter public to private activity (see Questions 22 and 25).

 
3. What has been the level of private equity activity in recent years?

Fundraising

Third party fundraising was low before 2006, reflecting the industry's relatively underdeveloped nature at that time. ZAR14.5 billion was raised in 2006 and ZAR15.4 billion in 2007. This dropped a little to ZAR10.6 billion in 2008, with a dramatic drop to ZAR3.8 billion in 2009.

Activity in 2010 picked up to ZAR11.1 billion. Generally, sponsors found the fundraising environment in the last two years difficult, with DFI's effectively supporting the industry. Recent vintage funds tend to have been smaller and to have taken more time to raise.

Investment

South Africa's early stage market is very underdeveloped and it is difficult to raise funds for this sector. Of the ZAR11.1 billion raised in 2010, only ZAR200 million was for early stage investments. The pattern for preceding years reflects a similar picture.

Business Partners, a specialist risk finance company that specialises in small investments, often in early stage businesses, remained active, undertaking 375 of the 528 investments in the market, with an average deal value of ZAR1.35 million. The average deal size for other investments was ZAR67.9 million.

Transactions

2010 saw a large number of follow-on investments (182 out of 528). Overall the level of activity remained low and there were very few large public to private transactions. Many funds focused on managing their portfolios rather than on new investment, which concentrated on:

  • Infrastructure (34%).

  • Services (20%).

  • Manufacturing (15%).

Of the unrealised investments at 31 December 2010, the categories included:

  • Expansion and development (42%).

  • Replacement capital (11%).

  • Buyouts (17%).

  • Start-ups and early stage (17%).

Exits

The value of funds returned to investors in 2010 was ZAR8.54 billion (excluding the Venfin exit of ZAR8.8 billion). This included:

  • Debt repayment or preference share redemptions of ZAR2.57 billion.

  • Trade sales of ZAR947 million.

  • Sales to other financial institutions of ZAR1.57 billion.

Towards the end of 2010, exit activity increased and some larger deals were completed, including deals through trade sale and initial public offerings (IPOs).

 

Reform

4. Are there any proposals for regulatory or other reforms affecting private equity in your jurisdiction?

The regulatory environment in South Africa has experienced a period of change over the last few years.

Historically, South African funds were formed through a dual fund structure, with international investors accommodated in a fund vehicle established outside South Africa. This was due to uncertainty over:

  • Whether or not a limited partner in a South African fund would, because of its investment in the fund, create a permanent establishment in South Africa.

  • Exchange controls that limit offshore investments by South African funds.

The tax position is now clarified by legislative amendment and the permanent establishment concern no longer exists. An exchange control policy for private equity (PE) funds allows South African funds to obtain upfront approval to invest 100% of their commitments in Africa. The approval is for three years, after which it must be renewed, and approvals are generally qualified by potentially difficult conditions.

As a result of the exchange control policy, dual fund structures are still very much market practice if the fund's investment mandate extends beyond South Africa, Namibia, Lesotho and Swaziland (the Common Monetary Area).

South African pension funds can invest up to 10% of their assets in PE funds, with a 2.5% limit per fund and a 5% limit per fund of funds. The PE fund must obtain a category of financial services licence that most funds do not have and many do not wish to acquire.

PE funds themselves are not regulated. PE fund advisors and managers must be licensed under the Financial Advisory and Intermediary Services Act, 2003 (FAIS Act), which regulates the giving of advice and/or rendering of intermediary services for a wide category of financial products, including unlisted shares.

There is considerable uncertainty in the market over the licence category required by PE fund advisors and the Financial Services Board (FSB) is considering this issue.

 

Tax incentive schemes

5. What tax incentive schemes exist to encourage investment in unlisted companies? At whom are the schemes directed? What conditions must be met?

Incentive schemes

The Venture Capital Company (VCC) initiative is the only specific tax incentive scheme encouraging investment in unlisted companies. Introduced in 2009, this initiative provides tax allowances or deductions to investors for expenditure incurred in acquiring equity shares in the VCC.

At whom directed

The incentive is directed at individuals, listed companies and controlled group companies of listed companies. Individuals can deduct up to ZAR750,000 per investment in the year of assessment in which the VCC qualifying shares are issued, with an aggregate lifetime limit of ZAR2.25 million. A listed company and its controlled group companies are not subject to a limit, but the VCC shares held by that company (or within its group) may not constitute more than 40% of the VCC's equity shares.

Conditions

A VCC must:

  • Have management of investments in qualifying companies as its sole objective.

  • Be unlisted.

  • Be tax resident in South Africa.

  • Not control any qualifying companies in which it holds shares.

The South African Revenue Service (SARS) must approve a company as a VCC and the VCC must submit annual returns to SARS in the prescribed form. Certain minimum qualifying investment expenditure thresholds also apply to VCCs.

Proposed amendments to the VCC incentive have been released which, if implemented, will provide investors an upfront tax deduction of the full amount of the VCC investment. Only the following would qualify for the tax deduction under the proposed amendments:

  • VCC investments in qualifying small business and junior mining companies.

  • Investments in VCCs that form part of a group of companies or are listed on the Johannesburg Stock Exchange (JSE).

 

Fund structuring

6. What legal structure(s) are most commonly used as a vehicle for private equity funds in your jurisdiction?

The preferred vehicle for PE funds is an en commandite partnership, which is equivalent in all material respects to a limited partnership.

Some funds are also formed as bewind trusts, which are specific trusts where the beneficiaries (investors) own the trust's assets and trustees administer them.

 
7. Are these structures taxed, tax exempt or fiscally transparent for domestic and foreign investors?

Limited partnership

Partnerships are tax transparent for South African tax purposes. Each partner is deemed to carry on a trade and the partners are taxed in their personal capacities on their attributable partnership interests.

Foreign partners are only taxed on South African-sourced, or deemed sourced, income and are subject to capital gains tax on:

  • The disposal of immovable property or any interest or right in immovable property in South Africa.

  • Assets of a South African permanent establishment.

Bewind trust

Ownership of the fund assets of a bewind trust resides in the investors' hands, with the trustees merely administering such assets on their behalf. Bewind trusts are therefore fiscally transparent and treated on the same basis as partnerships for tax purposes (see above, Limited partnership).

 
8. What (if any) structures commonly used for private equity funds in other jurisdictions are regarded in your jurisdiction as not being tax transparent (in so far as they invest in companies in your jurisdiction)? What parallel domestic structures are typically used in these circumstances?

Some foreign limited partnerships are treated as companies and are not tax transparent for tax purposes because of foreign regulatory requirements. The tax treatment of these structures is largely dependent on the legal form and relevant entities' jurisdiction.

Vesting trusts and partnerships are commonly used to achieve tax transparency, as the income and capital gains are typically taxed in the beneficiaries' or partners' hands.

 

Investment objectives

9. What are the most common investment objectives of private equity funds?

Most PE funds seek an internal rate of return (IRR) of about 25% over the fund's life. Investment mandates include a geographic area, within which the fund can invest, and typical prudential limits. The limits generally include a restriction on the percentage of the fund that can be invested in any one transaction (usually 20%) and can include sector restrictions in a generalist fund.

Niche funds are becoming more important, focusing primarily on mining, infrastructure and agriculture. In South African funds (as opposed to pan-African funds), investments in listed companies are generally prohibited other than toehold investments (that is, acquisitions of less than 5% of a company's outstanding shares) preceding a public to private transaction. Hostile takeovers are not permitted.

A fund's average life is ten years with the possibility of two one-year extensions at the general partner's discretion.

 

Fund regulation and licensing

10. Do a private equity fund's promoter, principals and manager require licences?

A PE fund's advisor or manager must be licensed under the FAIS Act (see Question 4) and principals must be registered as key persons under that licence. There is no specific regulation for fund promoters except that promoters must have a licence if their activities include giving advice, other than mere factual advice, or arranging investment deals.

A licensed firm must meet certain operational requirements and has ongoing compliance and reporting obligations. Each key person of the firm must provide evidence that he meets the required minimum qualifications and experience and must fulfil continuous professional development requirements.

 
11. Are private equity funds regulated as investment companies or otherwise and, if so, what are the consequences? Are there any exemptions?

Regulation

PE funds are usually structured as partnerships, and sometimes as trusts, and are not regulated as investment companies. There are no specific restrictions on marketing or advertising, except that PE funds must be marketed only to a small group of investors and not offered to the public. A prospectus should include the usual private placement selling legend.

Exemptions

There are no applicable exemptions for PE funds.

 
12. Are there any restrictions on investors in private equity funds?

South African pension funds and financial institutions can invest in PE funds according to their statutorily prescribed prudential limits. Collective investment schemes (mutual funds) cannot invest in unlisted securities and cannot, therefore, invest in unlisted PE funds.

Exchange control regulations determine whether or not residents can invest in PE funds established outside South Africa. Loop structures are prohibited, meaning that residents cannot invest in non-South African funds that invest back into the Common Monetary Area as a general rule.

 
13. Are there any statutory or other limits on maximum or minimum investment periods, amounts or transfers of investments in private equity funds?

There are no limits on maximum or minimum investment periods, amounts or transfers of investments in PE funds.

 

Investor protection

14. How is the relationship between the investor and the fund governed? What protections do investors in the fund typically seek?

The relationship between the investor and the fund is governed primarily by the partnership agreement or trust deed establishing the fund. Subscription agreements tend to be simple but side letters are quite common.

The typical fund terms are based largely on international practice, with the Institutional Limited Partners Association Private Equity Principles being the point of reference. Fund managers can be removed for cause by ordinary resolution and without cause by supermajority. The consequences of removal are usually negotiated on a case-by-case basis.

Key man provisions are standard, with the detailed arrangements being case specific. Most funds contain provisions regulating conflicts of interest between the manager and investors, especially where the manager manages multiple funds.

It is standard practice for investors to sit on an advisory board. The advisory board's functions are in line with international standards and typically include the:

  • Resolution of conflicts of interest.

  • Approval of valuations.

  • Relaxation, within defined limits, of prudential requirements.

In an en commandite partnership (see Question 6) investors cannot participate in the partnership's day-to-day management as they lose their limited liability if they do. There are no safe harbour rules.

 

Interests in portfolio companies

15. What forms of equity and debt interest are commonly taken by a private equity fund in a portfolio company? What are the relative advantages and disadvantages of each? Are there any restrictions on the issue or transfer of shares by law?

Common forms

PE funds usually invest in:

  • A combination of equity, such as ordinary and preference shares.

  • Different categories of shareholder loans, subordinated to the senior debt and having different interest rates, rankings and security arrangements.

Advantages and disadvantages

The advantage of equity is that it gives the holder a degree of direct control over the portfolio company through voting and other share rights, whereas a pure debt instrument generally relies on loan covenants.

The advantages of shareholder loans are that:

  • Any interest incurred used for productive purposes is deductible by the portfolio company in certain circumstances.

  • Interest accruing can be paid to a loan note holder even if the investee has no distributable profits to declare dividends to shareholders.

  • There is greater flexibility when repaying to investors than with other forms of capital.

  • The Companies Act restrictions (see Questions 22 and 25) do not apply to shareholder loan repayment and interest.

Restrictions

Exchange control regulations apply to approvals required from the South Africa Reserve Bank (SARB) or its authorised dealers for the flow of funds in and out of South Africa.

Thin capitalisation rules (which limit the degree of interest deductibility on foreign debt above a certain debt-to-equity threshold for foreign owned companies) are also considered in selecting the optimal debt and equity investment by foreign PE funds.

Share issues are subject to statutory rights of pre-emption unless they are waived by existing shareholders. No pre-emptive rights for the transfer of shares arise as a matter of law but it is common to regulate this in shareholders' agreements.

 

Buyouts

16. Is it common for buyouts of private companies to take place by auction? If so, which legislation and rules apply?

It is common for buyouts of private companies to take place by auction with rules typically set by the seller's investment bank.

If an auction is classified as an affected transaction under the Companies Act, it will be regulated by the Fundamental Transactions and Takeover Regulations under the Companies Act (Takeover Regulations).

 
17. Are buyouts of listed companies (public to private transactions) common? If so, which legislation and rules apply?

Buyouts of listed companies are common and normally achieved through a scheme of arrangement.

Public to private transactions are governed principally by the:

  • Takeover Regulations.

  • JSE Listings Requirements.

  • Companies Act.

  • Securities Services Act 2004 (to be replaced by the Financial Markets Act).

  • Competition Act 1998.

 

Principal documentation

18. What are the principal documents produced in a buyout?

The principal documents in a buyout are the:

  • Sale agreement for a private transaction.

  • Circular for a public to private transaction.

  • Shareholders' agreement regulating the relationship between the PE investor, management and, often, the Black Economic Empowerment (BEE) partner in the business.

  • Memoranda of incorporation (MOI) (being the constitutional documents) of the affected companies.

  • Documents that set out the management incentive structures and the debt facilities' agreements, typically the facility agreement and security package.

 

Buyer protection

19. What forms of contractual buyer protection do private equity funds commonly request from sellers and/or management?

PE funds typically require warranties from the sellers and/or management, although this is not generally possible in public to private transactions.

Depending on the extent of due diligence and the business's particular risk areas, the extent and substance of warranties given in a private transaction varies from basic title warranties to detailed warranties regarding operations, with future performance potentially affecting earn-outs.

Additionally, buyers sometimes seek indemnities, particularly for contingent tax, competition law, environmental and undisclosed liabilities.

A thorough due diligence is essential and contractual restraints of trade put in place for the sellers, management and key employees.

 
20. What non-contractual duties do the portfolio company managers owe and to whom?

Directors are subject to fiduciary duties at common law and statutory duties under the Companies Act. Directors are required to:

  • Act in good faith, for a proper purpose and in the company's interest.

  • Avoid conflicts of interests.

  • Not exceed the company's powers.

  • Exercise an independent discretion.

  • Not disclose or misuse confidential information or information obtained in his capacity as director to gain an advantage for anyone other than, or to cause harm to, the company and its subsidiaries.

  • Account for secret profits.

  • Disclose any personal financial interest in any agreement with or matter relating to the company.

  • Not misappropriate corporate opportunities.

  • Act with a degree of care and skill.

The Companies Act extends a director's liability for breaches of its provisions to any other person who suffers loss or damage as a result of that breach. The Companies Act also allows for persons, acting as a member of a group of affected persons, to bring class actions.

Alternates, prescribed officers and board committee members are also subject to statutory duties under the Companies Act.

 
21. What terms of employment are typically imposed on management by the private equity investor in an MBO?

Existing contracts with managers are automatically transferred with the sale of the business, as a matter of law.

Whether the MBO is a share or business acquisition, these contracts are carefully reviewed during due diligence to determine the provisions that require amending or, where appropriate, contracts that require replacement.

The closing of arrangements with management is usually a condition precedent to a private transaction and progresses in parallel in a public transaction.

PE investors typically require management to be bound by comprehensive restraints of trade and confidentiality undertakings and ensure that notice periods are adequate. Fixed term contracts are also common, taking into account the time line and the need for succession planning.

It is very difficult to terminate employment in South Africa so termination provisions are usually quite limited.

 
22. What measures are commonly used to give a private equity fund a level of management control over the activities of the portfolio company? Are such protections more likely to be given in the shareholders' agreement or company bye-laws?

PE investors typically require a veto right over key matters of a portfolio company and its subsidiaries, especially where the investor does not hold a controlling interest.

Restricted matters, including the appointment and dismissal of the company's key executives, are usually included in the portfolio company's MOI and that of each of its subsidiaries. If there are any inconsistencies between the shareholders' agreement and the MOI, the MOI prevails under the Companies Act.

The voting threshold for all (or certain) special resolutions and/or ordinary resolutions can be increased or reduced under the Companies Act, provided that there is always a margin of at least 10% between the highest established requirement for approval of an ordinary resolution and the lowest established requirement for approval of a special resolution. This is also included in the company's MOI.

It is common for shareholders to agree an approvals' framework that takes effect when the transaction is implemented and to include any amendment to this framework as a restricted matter.

PE investors typically require the:

  • Right to appoint a requisite number of directors to the board, who commonly vote in accordance with the appointing shareholders' shareholding.

  • Necessary quorum protections at board and shareholders' meetings.

The investors typically acquire expanded rights to access information and management in the shareholders' agreement.

 

Debt financing

23. What percentage of finance is typically provided by debt and what form does that debt financing usually take?

PE transactions typically include a combination of third party debt and equity finance. Lenders in the past were willing to advance debt for PE transactions in the ratio of 70:30 debt to equity but following the global economic crisis the ratio reduced to about 50:50. There have been a few transactions in which no debt was advanced.

The tax regime favours the use of debt. Interest paid by portfolio companies on debt is deductible if the debt's proceeds are applied to the business for productive purposes.

The most common forms of debt provided by lenders are term facilities and revolving facilities. Bridge facilities are common for the initial funding of transactions, particularly in public to private transactions, and are often replaced by term facilities soon after the transaction's closing. Portfolio companies are also advanced working capital facilities.

Borrowers issue bonds on the debt capital markets to diversify their sources of funding, among other things. The use of high yield bonds is increasing as they are considered a less difficult way of obtaining debt.

 

Lender protection

24. What forms of protection do debt providers typically use to protect their investments?

Security

Debt providers take security over the portfolio company's and its subsidiaries' assets through, for example, mortgage bonds, security cessions and pledges.

In certain cases debt providers also require:

  • Security over the investors' shares, although this is restrictive for PE funds and often resisted.

  • A guarantee of the portfolio company's performance under the facility granted from the portfolio company's holding company and other group companies.

Contractual and structural mechanisms

In transactions with multiple debt providers, security structures can be set up where a special purpose vehicle (SPV) is established to hold the security on behalf of all the debt providers. The enforcement rights of debt providers against the SPV for the security held are set out in an inter-creditor agreement.

Shareholders must also contractually subordinate their claims against the portfolio company to the debt providers in subordination agreements. Any payments to shareholders for repayment of shareholder loans or distributions are restricted in the debt agreements.

The facilities agreements typically include extensive financial covenants, positive and negative undertakings, warranties and default events.

 

Financial assistance

25. Are there rules preventing a company from giving financial assistance for the purpose of assisting a purchase of shares in the company? If so, how does this affect the ability of a target company in a buyout to give security to lenders? Are there exemptions and, if so, which are most commonly used in the context of private equity transactions?

Rules

Under the Companies Act there are a number of categories of direct and indirect financial assistance that can affect the investment or divestment activities of PE investors. Of particular importance to note is that loans, and guaranteeing or securing any other obligation of financial assistance, to, among others, directors (and persons related to such directors), group companies or any person for the purposes of subscribing for securities in the company is prohibited unless the company shareholders have specifically or generically (to a specified category of recipients) approved the financial assistance by way of a special resolution (75%). In addition, the board of the relevant company is required to satisfy itself that:

  • Immediately after providing the proposed financial assistance, the company will satisfy the solvency and liquidity test set out in the Companies Act.

  • The terms under which the financial assistance is proposed to be given are fair and reasonable to the company (Solvency, Liquidity and Reasonableness Test).

The exemption which is most likely to be relevant to private equity investors and portfolio companies is that financial assistance to certain qualifying employee share schemes is not subject to the above restrictions.

Intra-group loans and guarantees for any purpose are now subject to prior shareholder approval and the Solvency, Liquidity and Reasonableness Test, under the new Companies Act.

PE transactions are typically structured as debt pushdown structures under which, as a preliminary step, the target company's entire issued share capital is acquired. The target group's business is then transferred to a newly established subsidiary of the acquiring company. In this structure, the financial assistance provided by the newly established company is not linked to the acquisition of its shares. However, the above restrictions imposed on intra-group financial assistance apply to intra-group guarantees and security that typically form part of the security package provided to the debt providers.

 

Insolvent liquidation

26. What is the order of priority on insolvent liquidation?

In insolvent liquidations, the claims of debt providers and other creditors have priority over shareholders' claims as follows:

  • Claims of creditors with security, including notarial bonds, over an asset (for the sale proceeds of that asset).

  • Preferent claims including, in order:

    • costs of liquidation and costs of execution;

    • salaries and wages;

    • statutory obligations;

    • taxes;

    • other proved preferent claims.

  • Concurrent claims (claims of ordinary, unsecured creditors).

  • Shareholders.

 

Equity appreciation

27. Can a debt holder achieve equity appreciation through conversion features such as rights, warrants or options?

Debt holders can achieve equity appreciation through:

  • Convertible debt instruments that convert into equity, either automatically or on pre-determined events.

  • Acquiring options to subscribe for shares in settlement of the loan obligation.

 

Portfolio company management

28. What management incentives are most commonly used to encourage portfolio company management to produce healthy income returns and facilitate a successful exit from a private equity transaction?

Executives must be paid market rates and benefits. To ensure their interests are aligned with PE investors' interests, executives are incentivised and retained through a combination of:

  • Bonus plans linked to group performance designed to drive required individual behaviours.

  • Long-term equity incentive arrangements, often subsidised, including good leaver/bad leaver provisions.

  • Vesting provisions that usually affect the pricing at which the executive will exit the plan if he leaves the target group's employment:

    • before the vesting period's expiry; or

    • at any time in circumstances where he is a bad leaver.

  • Ratchet type plans aligning executives and PE investors towards an exit.

Plans are designed to be as beneficial as possible for the executives from a tax perspective and are structured with the aim of getting capital gains tax rather than income tax treatment.

 
29. Are any tax reliefs or incentives available to portfolio company managers investing in their company?

There is no specific tax relief or incentives for portfolio company managers investing in their company.

 
30. Are there any restrictions on dividends, interest payments and other payments by a portfolio company to its investors?

The Companies Act restricts the making of distributions. The term is widely defined to include:

  • Dividends.

  • Consideration for the repurchase of investors' shares.

  • Distribution of property.

It is unlikely to include the repayment of shareholder loans or payment of interest.

A portfolio company cannot make a distribution unless it is under an existing company legal obligation or a court order, or the board of directors has authorised the distribution. The board must be satisfied that the company will meet the solvency and liquidity test under the Companies Act immediately after completing the proposed distribution.

Contractual restrictions on the payment of dividends, interest payments, repayments of shareholder loans and other payments are included in a company's MOI, the shareholders' agreement, and the debt agreements where the transaction was funded with third party finance.

Foreign investors require exchange control approval from SARB's Financial Surveillance Department (FSD), under the Exchange Control Regulations, Orders and Rules of 1961, for:

  • Loans advanced from non-residents to residents if they do not fulfil the specific criteria applicable to inward foreign loans. Preference shares are considered as loans.

  • Dividend distributions to foreign-controlled companies, in certain circumstances.

There are no restrictions on interest payments, provided the required approval has been obtained for the loan facility.

SARS can disallow the charging of excessive interest being treated as a deduction and treat it instead as a dividend declared under the thin capitalisation restrictions of the Income Tax Act 1962. The deduction can be disallowed if the financial assistance is in SARS' opinion excessive in relation to the company's fixed capital. This rule applies if assistance is granted directly or indirectly by a non-resident to any connected person who is a resident.

As a general guideline, SARS does not apply the thin capitalisation provisions where the financial assistance to fixed capital ratio is less than 3:1. This guideline is under review and amendments are expected with effect from 1 April 2012.

 

Exit strategies

31. What forms of exit are typically used to realise a private equity fund's investment in a successful company? What are the relative advantages and disadvantages of each?

Forms of exit

Typical forms of exit used by PE funds to realise investment in a successful portfolio company include:

  • IPOs.

  • Redemptions of preference shares or repayments of shareholder loans.

  • Secondary buyouts.

  • Trade sales.

  • Share buybacks by the portfolio company.

  • Management buyouts (MBOs).

  • Asset sales.

Advantages and disadvantages

IPO. The advantages of an IPO are that it:

  • Provides the portfolio company with additional capital needed to expand.

  • Increases the portfolio company's public profile.

The disadvantages are that:

  • It is usually subject to a lock-in period after listing to limit the adverse effect on the company's share price should the PE fund sell its shares on the open market immediately.

  • The cash realisation is often delayed.

  • The costs associated with listing, and increased governance and transparency requirements, can make an IPO unattractive to the portfolio company's management.

Redemptions of preference shares/repayments of shareholder loans. Redemption is a simple exit method with no significant disadvantages. Equity returns to shareholders are subject to solvency and liquidity requirements.

Secondary buyouts. Secondary buyouts involve selling the portfolio company to another PE fund. The main advantage is the general alignment of operating model between the buyer and the seller as company shareholders.

Trade sales. Trade sales involve selling the portfolio company to another company, usually in the same industry sector. There are no significant disadvantages to this type of sale. If the acquisition is strategically important to the buyer, pricing can be more advantageous, although competition concerns can arise.

Share buybacks by the portfolio company. Share buybacks involve the portfolio company repurchasing some, or all of the PE fund's shares, provided that after the transaction, the portfolio company has at least one ordinary share in issue.

To effect a share buyback, the portfolio company's board of directors must satisfy themselves that the portfolio company will meet the solvency and liquidity requirements under the Companies Act.

If the shares are acquired from a director or a portfolio company's prescribed officer, or a person related to either of them, the buyback must be approved by the portfolio company's shareholders by special resolution.

If the buyback is for more than 5% of the company's issued share capital, among other things, the:

  • Portfolio company's board must obtain an independent report from an independent expert.

  • Unaffected shareholders must approve the buyback by special resolution.

MBOs. MBOs are the most popular divestiture route in recent years and can be structured in various ways, including through a leveraged buyout (LBO) or a share buyback (see above). The advantage is that both the selling and purchasing parties are well-acquainted with the business so an in-depth due diligence is not normally required.

Asset sales. Asset sales involve the sale of assets by the portfolio company and the distribution of sale proceeds to the PE fund as part of a liquidation dividend.

 
32. What forms of exit are typically used to end the private equity fund's investment in an unsuccessful/distressed company? What are the relative advantages and disadvantages of each?

Forms of exit

PE funds generally try and restructure their investments by entering into refinancing or restructuring arrangements with funders. If these are not successful, the forms of exit used include:

  • Selling and realising a loss.

  • Liquidating the investment by a voluntary winding-up.

  • Having the company liquidated, if insolvent.

  • Write-off and trade sale.

A new business rescue procedure has been introduced by the Companies Act. Business rescue aims to rehabilitate financially distressed companies by restructuring debt, liabilities and equity to put the company back on a solvent footing. The process begins by resolution of the company's board, or by court order, and involves appointing a business rescue practitioner to manage the company's affairs and a temporary moratorium on claimants' rights against the company.

Advantages and disadvantages

Business rescue is yet to be used and its effectiveness tested.

 

Private equity/venture capital associations

South African Venture Capital & Private Equity Association (SAVCA)

W www.savca.co.za

Status. SAVCA is a non-profit organisation.

Membership. Members must be actively involved in venture capital or PE investment and must be of good standing in the industry.

Principal activities. The principal activities of SAVCA include:

  • Promoting self-regulation of the PE industry.

  • Lobbying on behalf of the PE industry.

  • Arranging training for staff of its members.

  • Researching the PE industry in South Africa.

African Venture Capital Association (AVCA)

W www.avcanet.com

Status. AVCA is a non-profit entity formed under the laws of Cameroon.

Membership. Full membership is open exclusively to organisational units and persons defined as venture capitalists who can prove substantial activity in the management of equity or quasi-equity financing and whose main objective is long-term capital gains to reward risks.

The main centre of activity and principal investments of members must be located in Africa within a member state or a non-member state, or territories, of the Organisation for African Unity.

Principal activities. The AVCA's principal activities are to:

  • Promote, develop and encourage the PE industry in Africa by providing equity finance to companies with good development potentials.

  • Encourage the promotion, research and analysis of venture capital in Africa and in other countries or territories.

  • Facilitate contact with policy-makers, research institutions, universities, trade associations and other relevant institutions.

  • Encourage the creation, development and use of equity markets appropriate to the needs of venture capital investors and investees.



Contributor details

John Bellew

Webber Wentzel

T +27 11 530 5253
F +27 11 530 6253
E john.bellew@webberwentzel.com
W www.webberwentzel.com

Qualified. South Africa, 1984

Areas of practice. PE and venture capital; mergers and acquisitions; local and international taxation; exchange control; capital markets and acquisition finance.

Recent transactions

  • Representing Kagiso Trust Investments in its merger with Tiso.
  • Involved in the establishment of a number of prominent Africa-focused PE Funds, including African Infrastructure Investment Fund II, Ethos Private Equity Fund VI, Vantage Capital Mezzanine II, ECP Africa Fund III and Pan African Investment Partners II.
  • Representing Bain Capital in its acquisition of Edcon, the largest public to private transaction to date in the South African market.
  • Representing Ethos Private Equity in its successful private takeover of House of Busby.

Sally Hutton

Webber Wentzel

T +27 11 530 5228
F +27 11 530 6228
E sally.hutton@webberwentzel.com
W www.webberwentzel.com

Qualified. South Africa, 1992

Areas of practice. PE transactional work; BEE funding and reorganisations; restructuring and recapitalisation transactions.

Recent transactions

  • Acting for Ethos Private Equity Fund V in a series of transactions which resulted in it and some existing shareholders of Universal Industries Corporation (Universal) acquiring joint control of Universal.
  • Acting for a consortium including Actis, RMB, RMB Ventures and MIC Investment Holdings in the acquisition of Tracker Investment Holdings.
  • Acting for Bain Capital in its acquisition of Edcon.
  • Acting for Ethos Private Equity Fund V in their successful takeovers of Brandcorp and Ti Auto.
  • Acting for the Kagiso Health Consortium in their participation in the Adcock Ingram ZAR1.3 billion Broad-Based BEE (BBBEE) transaction.
  • Acting for the lenders and bondholders in the underwritten recapitalisation and debt restructuring transaction between Super Group and its lenders and bondholders.

Brian Dennehy

Webber Wentzel

T +27 11 530 5215
F +27 11 530 6215
E brian.dennehy@webberwentzel.com
W www.webberwentzel.com

Qualified. South Africa, 2000

Areas of practice. Merger and acquisitions; management incentive plans; corporate tax.

Recent transactions

  • Acting for Vox Telecom in its ZAR500 million buyout and delisting by a consortium comprising the Lereko Metier Capital Growth Fund and Investec Bank (2011).
  • Acting for both Kagiso Trust Investments and Tiso Group in their landmark ZAR13 billion merger transaction (2011).
  • Acting for Wal-Mart Stores in its US$2.4 billion offer for 51% of Massmart Holdings (2011).
  • Acting for RMB Holdings in its ZAR23 billion rationalisation and unbundling of Rand Merchant Insurance Holdings (2011).
  • Acting for FirstRand Bank and Momentum Group in the ZAR30 billion merger of Momentum Group and Metropolitan Holdings and the subsequent unbundling by FirstRand Bank of its shareholding in the merged entity (2010).
  • Acting for MTN Group in its ZAR8.1 billion BBBEE transaction (2010). This has been the largest telecommunications empowerment transaction in South Africa to date.
  • Acting for MTN Group in its proposed merger with Bharti-Airtel (2009).
  • Acting for MTN Group in its ZAR24.4 billion unwind of its 'Newshelf' empowerment structure (2009).

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