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 global 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-guide.

Mark Linington and Gigi Nyanin, Cliffe Dekker Hofmeyr Inc.
Contents

Market overview

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

During 2015, 94.1% of reported fundraising activity was accounted for by independents. Of the total funds raised in 2015:

  • Pension and Endowment Funds were the source of 56.2% of all third-party funds raised during 2015 (2014: 25%).

  • Governments, aid agencies and Development Finance Institutions (DFIs) accounted for 24.4% in 2015 (2014: 57.7%).

  • Private equity fund of funds made up 10.3% of funds raised in 2015 (2014: 4.4%).

Cumulatively, of the funds raised but not yet returned to investors, South Africa was the main source of fundraising (54.7%), ahead of the UK (20.7%) and the US (9.8%).

The industry statistics quoted in this article are sourced from the Southern African Venture Capital and Private Equity Association (SAVCA) Venture Capital and Private Equity Industry Performance Survey of Southern Africa, which covers 2015.

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

There is a notable increase in fundraising by private equity managers: ZAR29 billion was raised in 2015, up from ZAR11.8 billion in 2014 and the highest on record for the industry. The vast majority of this capital was sourced by independent fund managers from third-party investors for late-stage mandates.

The value of investment activity during 2015 reached ZAR10.5 billion (in 2014, ZAR13.9 billion), of which ZAR4.4 billion was for follow-on investments and ZAR6.1 billion for new investments. By value, most of the deal activity was centred on late-stage assets in financial services, retail, infrastructure and manufacturing, reflecting the generalist nature of the Southern African private equity industry.

Black Economic Empowerment (BEE) remains a significant feature and driver of private equity in South Africa. BEE is a statutory policy designed to facilitate greater economic participation for black, historically disadvantaged individuals through the acquisition of equity ownership or management of an investee company (or both).

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

Fundraising

The total of third-party funds raised by the industry in 2015 reached ZAR29 billion, a 145.4% increase from the ZAR11.8 billion reported for 2014.

Independents account for the majority of reported fundraising activity during 2015, accounting for 94.1% of funds raised during the year (in 2014, 85.4%).

Investment

The reported value of private equity investments made during 2015 is ZAR10.5 billion (in 2014, ZAR13.9 billion). The total number of investments increased by 33 to 534 during 2015 (2014: 501).

The overall average investment deal size (new and follow-on transactions) decreased to ZAR19.7 in 2015, from ZAR27.7 million in 2014. The average deal size for new investments decreased to ZAR22.3 million in 2015, from ZAR27.4 million in 2014, while average deal size for follow-on investments decreased to ZAR16.9 million in 2015, from ZAR28.1 million in 2014.

The investments made during 2015 can be classified into the following sectors:

  • Banks, financial services and insurance sectors: 15.9%.

  • Retail sector: 15.7%.

  • Infrastructure sector: 14.2%.

Transactions

The cost of investments into seed and start-up/early-stage entities contributed 14.8% of cumulative unrealised investments at 31 December 2015 (2014: 14.7%). This represented 17.2% of the number of investments at 31 December 2015 (2014: 17.6%), which is indicative of the proportionally smaller transaction values for the early-stage types of deals.

Expansion and development capital, as a proportion of investments made by cost, increased from 33.5% in 2014 to 38.8% in 2015. Replacement capital increased from 20.1% of investments made by cost during 2014 to 28.5% in 2015.

Exits

Disposals in the form of trade sales were the most popular in value terms. By volume, the most popular method of disposal was to management.

Funds returned to investors in 2015 totalled ZAR8.9 billion, a 19.1% decline from the ZAR11 billion returned to investors during 2014.

 

Reform

4. What recent reforms or proposals for reform affect private equity in your jurisdiction?

Exchange control

Private equity funds, that are members of the Southern African Venture Capital and Private Equity Association (SAVCA), mandated to invest into Africa, can now apply to the Financial Surveillance Department (FSD) of the South African Reserve Bank (SARB) for an annual approval to invest into Africa. Applications will also be considered where an unintended loop structure is created, as a result of private equity funds investing into companies in the rest of Africa with a portion of their business in South Africa.

Johannesburg Stock Exchange (JSE) Listing Requirements

The JSE Limited recently introduced new listing requirements permitting the listing of special purpose acquisition companies. Such a company may not carry on any commercial or business operations at the time of its application for a listing, but must acquire assets meeting the qualifying criteria of the main board or the alternative exchange (AltX) of the JSE within 24 months from the date of its listing.

It is anticipated that this type of vehicle may in future be used as an alternative to the more traditional private equity funds structures discussed below.

Black Economic Empowerment (BEE)

BEE is a statutory policy designed to facilitate greater economic participation for black, historically disadvantaged individuals, through the acquisition of equity ownership or management of an investee company (or both). The Broad-Based Black Economic Empowerment Act 2003 provides the general legislative framework for the promotion of BEE, empowering the Minister of Trade and Industry to issue Codes of Good Practice. The approach under these Codes is to measure the contribution of each South African firm to broad-based BEE in accordance with a detailed prescribed scorecard. An important element of this scorecard involves the percentage of the equity shares of a firm held directly or indirectly by black persons.

Accordingly, an important consideration in respect of any investment in a portfolio company by a private equity fund is how the investment (together with co-investments) will affect the BEE score of the portfolio company.

South African Pension funds

The prudential investment limits for pension funds registered under the Pension Funds Act 1956 were amended in 2011 to expressly permit pension funds to invest up to 10% of their assets in private equity funds (with sub-limits of 2.5% per private equity fund and 5% per fund of funds). In terms of the regulatory framework, the Registrar of Pension Funds published conditions for investment in private equity funds (the Conditions) in March 2012 that stipulate requirements for a private equity fund to qualify for investment by a pension fund. The Conditions came into effect in 2012. Although the applicable requirements do not bind private equity funds, pension funds are significant investors and private equity funds therefore have a strong incentive to comply.

Regulation of private equity managers/advisers

Managers/advisers of South African private equity funds must be regulated as financial services providers (FSPs) in terms of the Financial Advisory and Intermediary Services Act 2002. Usually, they are entitled to be licensed as "category I" FSPs, which is a less onerous regulatory regime for non-discretionary managers. However, any managers managing or advising private equity funds, whether domestic or foreign, with South African pension fund investors must hold a "category II" FSP licence. The category II FSP licence is for discretionary asset managers and its more onerous requirements can be problematic for private equity managers. The Financial Services Board (FSB) is currently engaging with industry representatives with a view to introducing a category of FSP specifically tailored for private equity managers. It is unclear when draft regulations will be published.

AIFM Directive

The FSB has entered into co-operation agreements with a number of EU member states under the auspices of Directive 2011/61/EU on alternative investment fund managers (AIFM Directive).

 

Tax incentive schemes

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

Incentive schemes

Tax and exchange control. To encourage the use of South Africa as a springboard for investment into Africa, government has over the past few years made significant changes to the country's tax and exchange control regime. Such changes include various amendments to the tax legislation to prevent the activities of South African investment managers from causing the investments of non-South African investors to be taxed in South Africa.

Venture Capital Company (VCC) regime. The VCC regime is a tax-based scheme designed to encourage individual and corporate investors to invest in a range of smaller, higher-risk start-ups by investing through VCCs.

Overview of the regime. Qualifying investors will invest in approved VCCs in exchange for the issue of Venture Capital Shares and investor certificates. Investors can claim tax deductions in respect of their investments in an approved VCC. The approved VCC will, in turn, invest in qualifying investee companies in exchange for qualifying shares.

Upfront tax relief. VCC investors enjoy an immediate tax deduction equal to 100% of the amount invested with no annual limit or lifetime limit. The tax relief is available provided that the VCC investor subscribes for equity shares, as opposed to buying them second hand from other VCC investors. The VCC scheme only applies to VCC shares acquired on or before 30 June 2021. The VCC investor must support its claim for a tax deduction with a certificate issued by the VCC, stating the amounts invested in the VCC and that the Commissioner for the South African Revenue Service has approved that VCC.

At whom directed

Investor. Any taxpayer qualifies to invest in an approved VCC.

Qualifying investors can claim income tax deductions in respect of the expenditure actually incurred to acquire shares in approved VCCs. Where any loan or credit is used to finance the expenditure in acquiring a venture capital share and remains owing at the end of the year of assessment, the deduction is limited to the amount for which the taxpayer is deemed to be at risk on the last day of the year of assessment. No deduction will be allowed where the taxpayer is a "connected person" to the VCC at or immediately after the acquisition of any venture capital share in that VCC.

A corporate investor is a "connected person" in relation to the VCC if it forms part of the same group of companies as the VCC (50% is used as the threshold for a group) or it holds at least 20% of the equity shares or voting rights in the VCC and no other shareholder holds the majority voting rights in the VCC. If the VCC is held by natural persons and/or trusts, they will only be "connected persons" in relation to the VCC if they individually (or jointly with any "connected person" in relation to themselves) directly or indirectly hold at least 20% of the equity shares or voting rights in the VCC.

Conditions

Investee company. The investee company must meet the following conditions:

  • The investee must be a company.

  • The company must be a resident.

  • The company must not be a controlled group company in relation to a group of companies.

  • The company's tax affairs must be in order.

  • The company must be an unlisted company or a junior mining company (a junior mining company can be listed on the Alternative Exchange Division (AltX) of the JSE Limited).

  • During any year of assessment, the sum of the investment income derived by the company must not exceed 20% of its gross income for that year of assessment.

  • The company must not carry on any of the following impermissible trades:

    • any trade carried on in respect of immoveable property, except trade as a hotel keeper;

    • financial service activities such as banking, insurance, money-lending and hire-purchase financing;

    • provision of financial or advisory services, including legal, tax advisory, stock broking, management consulting, auditing, or accounting;

    • any trade in respect of gambling;

    • any trade in respect of liquor, tobacco products, arms or ammunition; or

    • any trade carried on mainly outside South Africa.

VCC. A company must meet all of the following preliminary requirements to qualify for an approved VCC status for each year of assessment:

  • The company must be a resident.

  • The sole object of the company must be the management of investments in qualifying companies (that is, investees).

  • The company's tax affairs must be in order.

  • The company must be licensed in terms of section 7 of the Financial Advisory and Intermediary Services Act 2002.

The company must satisfy the following requirements by the end of each year of assessment after the expiry of 36 months from the first date of issue of venture capital shares:

  • A minimum of 80% of the expenditure incurred by the VCC to acquire assets must be for qualifying shares, and each investee company, immediately after the issuing of the qualifying shares, must hold assets with a book value not exceeding:

    • ZAR500 million in any junior mining company; or

    • ZAR50 million in any other qualifying company.

  • The expenditure incurred by the VCC to acquire qualifying shares in any one qualifying company must not exceed 20% of any amounts received in respect of the issue of venture capital shares.

 

Fund structuring

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

Private equity funds are mostly structured as fiscally transparent vehicles to avoid the increased taxes associated with investing through companies. This is in the form of en commandite partnerships, vesting trusts or bewind trusts.

An en commandite partnership has two categories of partners, a general (disclosed) partner and the limited (undisclosed) partners. The general partner conducts the business of the partnership and has unlimited liability for the partnership business, whereas the limited partners do not participate in the business of the partnership and their liability is limited to the amount of their aggregate capital contributions to the partnership.

A bewind trust enables the legal ownership of assets to be separated from the enjoyment of the benefits that flow from the assets. The ownership of the underlying trust assets vests in the beneficiaries and the trustees only manage the trust for the benefit of the beneficiaries.

 
7. Are these structures subject to entity level taxation, tax exempt or tax transparent (flow through structures) for domestic and foreign investors?

En commandite partnership

This entity is tax transparent and partners are deemed to be carrying on the trade or business of the partnership.

The income and capital gains received by the partnership are deemed to be received by or accrued by the partners in ratio of their partnership interests. The expenditure is allocated in the same manner. Therefore, the partners are subject to tax in respect of the partnership income and capital gains. They provide investors with limited liability, so that an investor will only be liable to the extent of its capital contributions to the fund.

Bewind trust

Beneficiaries of a bewind trust are owners of the assets held by the trust and are taxed as such.

The trustees only manage the trust for the benefit of such beneficiaries.

They are not subject to cumbersome regulatory oversight and can be established with relative ease.

The income and capital gains received by the trust are deemed to be received by or accrued by the beneficiaries. The expenditure is allocated in the same manner.

 
8. What (if any) structures commonly used for private equity funds in other jurisdictions are regarded in your jurisdiction as being tax inefficient (whether by not being recognised as tax transparent or otherwise)? What alternative structures are typically used in these circumstances?

South African companies are not tax transparent and increase the tax cost for investors, as capital gains tax (CGT) is levied on gains realised by a company at the rate of 22.4%, and dividends withholding tax is levied on dividends declared by a company at the rate of 15%. Private equity funds often prefer routing their investments by way of special purpose investment vehicles incorporated in foreign jurisdictions such as Mauritius.

For funds that have a geographical mandate that is not confined to South Africa, the partnership or company is normally formed in Mauritius in order to avoid the exchange control limitations of investing from South Africa. Where there are South African investors in such a fund, a dual structure is normally used, involving two parallel legal structures that co-invest, one based in South Africa for the South African investors and one based in Mauritius for the non-South African investors.

 

Fund duration and investment objectives

9. What is the average duration of a private equity fund? What are the most common investment objectives of private equity funds?

Duration

The average lifespan per fund is normally between seven to ten years. The lifespan of funds that invest in infrastructure, energy and related sectors tends to be longer.

Investment objectives

The investment objectives of private equity funds are to give long term unlimited equity positions for investors where portfolio companies can be guided to growth, as well as to return attractive yields to investors over the fund's lifecycle.

 

Fund regulation and licensing

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

Managers or advisers of private equity funds must be licensed as financial services providers (FSPs) under the Financial Advisory and Intermediary Services Act 2002. Principals must be approved as representatives of the licensed FSP.

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

Regulation

There is no particular regulatory body to which private equity firms must report nor is there any one body that oversees private equity transactions. There are a number of legislative and regulatory frameworks which private equity funds must be mindful of. These are:

  • Black Economic Empowerment (BEE) policies.

  • The Takeover Regulations (overseen by the Takeover Regulation Panel).

  • Legislation regulating antitrust actions (overseen by the Competition Commission).

  • The Financial Services Board (FSB).

  • The Exchange Control Regulations (overseen by the South African Reserve Bank).

  • For any listed entities, the Johannesburg Stock Exchange (JSE) Listing Requirements (overseen by the JSE).

  • The Companies Act 71 of 2008.

The Collective Investment Schemes Control Act 2002 regulates retail funds. It regulates and controls the administration of collective investment schemes and the promotion of the business of or the solicitation of investments in a collective investment scheme in South Africa.

Exemptions

The FSB has exempted private equity funds that are members of the Southern African Venture Capital and Private Equity Association (SAVCA) from regulation under the Collective Investment Schemes Control Act 45 of 2001 (CISCA), provided that SAVCA members do not market their funds to members of the public.

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

Private equity funds are unregulated and therefore there are no restrictions as to which categories of investor can participate.

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

Private equity funds are unregulated and any limits on maximum or minimum investment periods, amounts or transfers of investments are therefore regulated under the fund's constitutional documents.

 

Investor protection

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

A private equity fund is governed by its constitutional document (that is, a partnership agreement or a trust deed).

Investors typically seek to negotiate the following protections:

  • Investment restrictions, including restrictions on geographic and sector exposure and on borrowing and hedging.

  • Key persons' time commitment.

  • The appointment of an investors' advisory board, which usually regulates conflicts of interest.

  • Restrictions on raising competing/successor funds.

  • General partner removal clauses (for cause and without cause).

  • Clawbacks of carried interest that have been paid in excess of the general partner's entitlement.

  • Reserved matters that require limited partner approval.

 

Interests in portfolio companies

15. What forms of equity and debt interest are commonly taken by a private equity fund in a portfolio company? Are there any restrictions on the issue or transfer of shares by law? Do any withholding taxes or capital gains taxes apply?

Most common form

Private equity transactions are usually funded by equity or debt or a combination of both. Sources of funding generally include other private equity funds, collective investment schemes, wealthy individuals, banks, government or Development Finance Institutions (DFIs) and institutional investors, including pension funds and insurance companies.

The blend of ordinary shares, preference shares and shareholder loans in the capital structure of an investee company depends on a number of factors, including:

  • The legal nature of the investors. For example, if the investors are South African taxpayers the preference would be to invest in ordinary or preference shares, rather than shareholder loans. Interest-bearing shareholder loans would cause the South African taxpaying investors to pay cash tax on interest accrued each year, even though the interest may be accumulated and remain unpaid.

  • The incentives given to the management/founders. The fund often injects disproportionately greater funds in the form of preference shares and shareholder loans. In addition, new managers who are allowed to subscribe for ordinary shares often have insufficient funds to do so. A "thin" layer of ordinary share capital is then injected, in order to make the ordinary shares affordable for the new equity participants.

  • The Black Economic Empowerment (BEE) requirements for the investee company's business. In order to lower the entry cost for the BEE investor, the capital structure could be weighted to debt and preference shares, so that the ordinary shares constitute a "thin" layer of the company's initial capital.

  • Whether or not the investors are exchange control residents. Interest rates levied on loans from foreign shareholders are limited to the prime lending rate and require Authorised Dealer consent. It is possible to levy interest in excess of prime (up to prime plus 3%) although this requires specific consent from the Financial Surveillance department of the South African Reserve Bank (SARB). For this purpose, SARB regards preference shares as debt instruments.

  • Whether or not the investors are foreign tax residents. Thin capitalisation and transfer pricing rules may apply to limit the income tax of interest incurred on foreign shareholder loans.

  • The forecast of earnings before interest, taxes, depreciation and amortisation (EBITDA) of the portfolio company. Where a debt push-down structure is implemented immediately post acquisition, the interest deduction is limited to a percentage of "adjusted taxable income", which approximates EBITDA. The allowable percentage is determined in accordance with a formula which varies with the changes in the repo rate. The allowable percentage is currently 44%.

Restrictions

Shareholders commonly regulate their relationship in a shareholders' agreement, and that agreement often provides for restrictions on the issue or transfer of shares. For example, if a company proposes to issue any shares, each existing shareholder has a right of pre-emption, where a number of shares equal to the voting power of that shareholder's general voting rights must be offered to the shareholder first.

Taxes

Disposal by South African taxpaying investors is generally subject to capital gains tax (CGT).

Non-residents are not subject to CGT on the sale of shares in a South African company, unless the company is a property-rich company (where more than 80% of the value is attributable to immovable property) and the foreign shareholder holds at least 20% of the ordinary shares in the company.

CGT applies to companies at an effective rate of 22.4% and to natural persons at an effective tax rate of 16.4%.

South Africa also imposes withholding tax on dividends, interest and royalties at a rate of 15%.

 

Buyouts

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

Buyouts by way of public auction are common in relation to large portfolio companies and no legislation governs sales by public auction. Outside of the public procurement process, there are no regulations that govern auction processes. In most instances, however, regulations apply to each transaction. For example, to the extent that any offer is governed by the Takeover Regulations, such regulations, and Part B and C of Chapter 5 of the Companies Act 2008, apply to the offer. The Takeover Regulations are mainly intended for public companies but can, in certain instances, apply to private companies.

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

From 2006 to 2008 various buyouts of listed companies were concluded by way of schemes of arrangement. Since then only two public-to-private transactions have been concluded.

 

Principal documentation

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

The main documents which are typically produced in a buyout include:

  • A sale agreement.

  • Resolutions authorising the parties to enter into the transaction.

  • Debt documentation for the third party funding, including the loan agreements for the bridge loan and the long-term debt.

  • Shareholders' agreement for the investing consortium.

  • Insurance policy for the warranties and indemnity insurance (in the case of a secondary transaction).

  • Post-acquisition sale of business agreements to implement the debt push-down structuring.

  • Resolutions to conclude the debt-pushdown asset transfers and distributions.

 

Buyer protection

19. What forms of contractual buyer protection do private equity funds commonly request from sellers and/or management? Are these contractual protections different for buyouts of listed companies (public-to-private transactions)?

Private equity funds request warranties and indemnities from the sellers, including management in their capacity as sellers of equity. In certain instances of high-risk items, indemnities are requested from the sellers, sometimes accompanied by a portion of the sale proceeds being withheld in escrow for a period of time.

An increasing trend is to obtain warranty and indemnity insurance, where the seller is absolved of its exposures to the company.

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

The directors of a company owe fiduciary duties to the company of which they are directors and must acknowledge the interests of all stakeholders in the company, subject to always acting in the best interest of the company.

The Companies Act 2008 (Companies Act) sets out the standards of conduct expected from directors and partially codifies the common law duties of directors. Directors have a duty:

  • To act in the best interests and for the benefit of the company and not in the interests of any other person.

  • To avoid a conflict of interest.

  • Not to exceed their powers.

  • Not to exercise their powers for an improper or collateral purpose.

  • To exercise an unfettered discretion.

  • To act in good faith and promote the best interests of the company.

  • Of skill, care and diligence.

The relevant provisions of the Companies Act specifically include references to alternate directors and also extend the duties and liabilities referred to in those provisions to prescribed officers, board committee members and audit committee members (even if they are not members of the board).

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

Restraint of trade agreements are usually required.

In addition, management's equity participation is often subject to good leaver/bad leaver provisions.

 
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 governance documents?

The shareholders' agreement will normally include undertakings on the part of the portfolio company and the management not to do various things without the consent of the private equity fund. In addition, regular supervision will be effected through the private equity fund's participation in, and monitoring of, the company's board.

 

Debt financing

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

Private equity acquisitions are generally funded by substantial debt, usually as a combination of senior debt, mezzanine debt and equity loans.

Recent trends for bigger transactions are to fund the acquisition with senior debt of three to four times earnings before interest, taxes, depreciation and amortisation (EBITDA). Based on a price of seven times EBITDA, this translates into a gearing level of about 50% in respect of the senior debt.

The senior debt is often a blend of amortising, bullet and working capital facilities and is in some cases provided by a consortium of South African banks, with one bank acting as the facilities agent.

Mezzanine debt is generally not used in the larger private equity transactions. There are a few mezzanine funds in South Africa, which tend to focus on the smaller private equity transactions.

 

Lender protection

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

Security

Senior lenders generally take first-ranking security over all the assets of the borrower and material group companies. In order to facilitate syndication of the debt, a security special purpose vehicle (SPV) is used. The security SPV guarantees the obligations of the borrower and is indemnified by the borrower.

Security is taken over:

  • Immovable property by way of registered mortgage bonds.

  • Specific movable assets by way of a registered special notarial bond.

  • General movable assets by way of a registered general notarial bond.

  • Shares and rights and claims by way of a cession in security.

Contractual and structural mechanisms

A blend of facilities with different ranking in relation to repayment and security is normally achieved by means of structural and contractual subordination, where the senior lenders advance loan funding directly to the operational company and the second-ranking lenders advance loans indirectly through a holding company of the operating company. This includes shareholders loans, where the third party lender typically requires that the holding company pledge the loan claim (against the operating company) as additional security for the senior facilities.

 

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

The board of directors can authorise a company to provide financial assistance by way of a loan, guarantee, provision of security or otherwise for the purpose of, or in connection with the:

  • Subscription of any option or securities, issued or to be issued by the company or a related or inter-related company.

  • Purchase of any securities of the company or a related or inter-related company.

These requirements provide that the board cannot authorise any financial assistance unless:

  • The financial assistance is pursuant to:

    • an employee share scheme that satisfies the requirements of the Companies Act; or

    • a special resolution of shareholders, adopted within the previous two years, which approved such assistance either for the specific recipient, or generally for a category of potential recipients.

  • The board is satisfied that:

    • immediately after providing the financial assistance, the company would satisfy the solvency and liquidity test; and

    • the terms under which the financial assistance is proposed to be given are fair and reasonable to the company.

In addition to these requirements, the board must ensure that any conditions or restrictions with regard to financial assistance set out in the company's memorandum of incorporation have been satisfied. In the context of a buyout, the target must comply with these financial assistance requirements.

To achieve tax deductibility in respect of the borrowing costs, a "debt push-down structure" is normally implemented, which generally entails the following steps:

  • A newly-formed BidCo acquires the shares in the target company, utilising the equity sponsors' funds and a bridge facility from a bank.

  • Immediately post-acquisition, the businesses/going concerns and asset of the operational companies with the target group are transferred to a newly formed, wholly-owned subsidiary of BidCo, funded partially by the injection of the long-term third party debt.

  • The sale proceeds of the intra-group business transfer are distributed to the BidCo and the BidCo settles the bridge facility.

Exemptions

There are no exemptions for financial assistance in relation to private equity transactions.

 

Insolvent liquidation

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

On insolvency, the order of priority is normally:

  • Liquidation costs. The costs of the liquidation must be paid prior to creditors receiving any dividend on their claim.

  • Secured creditors. Secured creditors rank first on insolvency and are paid from the proceeds of the sale of the secured asset. Where a secured creditor's claim is not satisfied in full, the unpaid balance is considered a concurrent claim.

  • Preferent creditors. Preferent creditors are creditors who do not hold security for their claims, but rank above concurrent creditors. They are paid from the proceeds of unencumbered assets in a pre-determined order as set out in the Insolvency Act, 1936. Preferent creditors include employees' remuneration (up to a prescribed amount) and the South African Revenue Service.

  • Concurrent creditors. Concurrent creditors are paid from any proceeds of unencumbered assets that remain after preferent creditors have been paid in full. They are paid in proportion to the amounts owing to them.

 

Equity appreciation

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

The debt holder can acquire warrants or options in respect of the equity of the borrower. These funding features are however seldom used in the larger private equity transactions, where third party debt typically only comprises of senior debt.

In the case of foreign lenders, these equity features are taken into account in determining whether the implied funding rate falls within the rates allowed by the South African Reserve Bank.

 

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?

Managers are normally incentivised by way of equity share participation and ratchet shares. The capital of the investee company is often structured with a "thin" layer of ordinary share capital to make the share acquisition affordable for the managers, otherwise other funding structures are put into place by the equity sponsor to facilitate managements' equity investment, often using a unitised trust. Ratchet shares are generally structured as preference shares, the participation rights of which depend on the exceptional performance of the portfolio company.

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

There are no specific tax reliefs or incentives available to portfolio company managers.

Shares held by employees remain within the employees' tax net to the extent that they are subject to restrictions, such as bad leaver provisions, that result in the employee forfeiting the shares for less than market value.

The tax cost for a manager is greater if the gains are subject to employees' tax (maximum marginal rate of 41%) as opposed to the gains being subject to capital gains tax (maximum capital gains tax (CGT) rate of 16.4%).

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

The directors can make any distribution at any time provided that the:

  • Board of directors has authorised the distribution.

  • Company will satisfy the solvency and liquidity test under the Companies Act immediately after completing the distribution.

 
31. What anti-corruption/anti-bribery protections are typically included in investment documents? What local law penalties apply to fund executives who are directors if the portfolio company or its agents are found guilty under applicable anti-corruption or anti-bribery laws?

Appropriate indemnities are often included in the investment documents to the effect that the sellers have not induced any person to enter into any agreement or arrangement with the company that has involved the payment of any bribe or improper gratification.

Anti-corruption/bribery protections. The Prevention and Combatting of Corrupt Activities Act 2004 (PCCAA) provides for, among others, the strengthening of measures to prevent and combat corruption and corrupt activities and investigative measures in respect of corruption and related corrupt activities.

Section 20 of the PCCAA provides for the offence of being an accessory to or after the offence. A person will be guilty of an offence when that person who, knowing that property or any part of property forms part of any gratification that is the subject of an offence under the PCCAA, directly or indirectly, whether on behalf of himself or any other person, either:

  • Enters into or causes to be entered into any dealing in relation to that property.

  • Uses or causes to be used, holds, receives or conceals that property.

Section 21 of the PCCAA provides that when any person attempts, conspires with any other person or aids, abets, induces, incites, instigates, instructs, commands, counsels or procures another person to commit an offence in terms of the PCCAA, that person will be guilty of an offence.

Penalties. Section 26 of the PCCAA provides for various penalties. A person convicted of any of the abovementioned offences is liable:

  • If a sentence is imposed by a High Court or a Regional Court, to a fine or to imprisonment for a period not exceeding ten years.

  • If a sentence is imposed by a Magistrate's Court, to a fine or to imprisonment for a period not exceeding three years.

Sentences range from three years to a life sentence.

 

Exit strategies

32. 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

Exits are normally in the form of a share and loan disposals.

An asset/going concern sale by the portfolio company, followed by the distribution of the after-tax proceeds, results in a higher tax cost due to the higher capital gains tax (CGT) rate for companies and the dividends tax which is levied on company dividends.

Share sales can be trade sales, listings on the Johannesburg Stock Exchange (JSE), management buyouts and secondary sales to other private equity funds. The exit is often preceded by a refinancing of the funds instruments, such as a refinancing of shareholder loans and/or preference shares.

Advantages and disadvantages

With regard to certain sectors the listed prices are higher than can be achieved in a private sale, and a listing is therefore the preferred exit route. The sellers also give no warranties or indemnities in an IPO. The execution risk and costs of an IPO are however high and the two-month lock-in, whereby the investors must retain at least 30% of their shares for at least 12 months after listing, also delays the exit process.

Management generally prefer to exit by way of a secondary transaction, where they can negotiate better equity participation with the new private equity investor and where they have greater autonomy in the strategic development of the business.

 
33. 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

The senior lenders often exercise their security and take the equity or a portion of it in the distressed portfolio company. This is often followed by the private equity fund re-investing in the portfolio company's equity.

The exit is otherwise in the form of a share and loan disposal in order to preserve the tax loss in the investee company. A sale of assets/going concern followed by a forgiveness of shareholder loans could result in recoupments of income tax deductions claimed by the portfolio company.

Advantages and disadvantages

Where the lenders exercise their security in a cyclical downturn the portfolio company often returns to financial health in the cyclical upturn. Most funds therefore support their portfolio companies by injecting further equity to cure the covenant breaches, and the exit is normally deferred in these circumstances.

 

Private equity/venture capital associations

South African Venture Capital and Private Equity Association (SAVCA)

W www.savca.co.za

Status. SAVCA is a non-governmental organisation.

Membership. Currently, 98 GP members and 53 associate members.

Principal activities. SAVCA is the industry body for the private equity and venture capital industry in South Africa. It is a promoter and advocate for the industry and its members.



Online resources

South African Government website

W www.gov.za/documents

Description. Official website including legislation, government documents and reports. It may be out of date.



Contributor profiles

Mark Linington, Director of Tax and Head of Private Equity Sector Group

Cliffe Dekker Hofmeyr Inc.

T +27 11 562 1667
F +27 11 562 1067
E Mark.Linington@cdhlegal.com
W www.cliffedekkerhofmeyr.com

Professional qualifications. South Africa, Chartered Accountant of South Africa.

Areas of practice. Corporate tax services focused largely on mergers and acquisitions; private equity and venture capital fund formation; private equity portfolio transactions; BEE structuring and cross-border transactions.

Non-professional qualifications. Bachelor of Accounting Sciences in Financial Accounting, University of South Africa; Higher Diploma in Accounting and Higher Diploma in Tax Law, University of Durban Westville

Recent transactions

  • Tax structuring for the formation of private equity funds, including AIIM, Ethos Fund V and Fund VI, Vantage, Pangea, Stockdale Street and Actis, and tax structuring for private equity acquisitions and disposals, including Life Healthcare, Plumblink, Edcon, Alexander Forbes, Actom, Tracker, Moresport, Idwala, Busby, Brandcorp, RTT, Lil-lets, Bluff Meat Supply, Thoroughtec, Morecorp and In2Food.
  • Advising the Curator for African Bank in respect of the formation of a new bank and the restructuring of the ABIL group.
  • Assisting the South African Venture Capital Association with its lobbying efforts with the National Treasury on tax legislation, and drafting the tax submissions for SAVCA and representing SAVCA in its presentations to the standing committee of Finance in Parliament.

Languages. English

Professional associations/memberships. The South African Institute of Chartered Accountants

Gigi Nyanin, Associate, Tax

Cliffe Dekker Hofmeyr Inc.

T +27 11 562 1120
F +27 11 562 1111
E Gigi.Nyanin@cdhlegal.com
W www.cliffedekkerhofmeyr.com

Professional qualifications. South Africa, Attorney.

Areas of practice. Corporate tax services focused largely on mergers and acquisitions, private equity and venture capital fund formation; private equity portfolio transactions; BEE structuring and cross-border transactions.

Non-professional qualifications. LLB Degree and Postgraduate Diploma in Tax Law, University of Johannesburg

Languages. English

Professional associations/memberships. The Law Society of South Africa


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