The Pricing of BEE Share Purchase Schemes
by Graeme West and Lydia West, Financial Modelling Agency
Black Economic Empowerment (BEE) transactions are very topical, with companies that have to date failed to put in place meaningful BEE schemes under serious pressure from various interested parties. What is involved is the sale of a stake in the business to suitably qualified partners.
The Broad-Based Black Economic Empowerment Act (2003) was introduced in order to assist in ensuring a more equitable distribution of wealth amongst the people of South Africa. This act defines ‘black people’ and introduces legal mechanisms for their economic upliftment.
The core feature of these transactions is that the seller (vendor company) exchanges company value for BEE credentials. The buyer (BEE partner) provides
- the legal requirement
- avenues to new business, in particular statal and parastatal businesses
- promotion of the vendor company, in particular as a BEE compliant company
- assistance for the vendor company in staffing, affirmative action and its social responsibility programs.
Under most circumstances the designated partner does not have the resources to pay cash for their stake. Thus, structures need to be put in place to facilitate the purchase of the designated stake.
In the earliest stages of BEE these transfers were achieved somewhat cynically, by means of fronting. More or less any transfer of equity would be as a gift, in return for the privilege that the vendor would then enjoy of having a black name on letterheads.
In preparation for the Nedbank and Mutual and Federal BEE transactions, those companies introduced the option for all shareholders to receive dividends in cash or as stock.
The next stage is the vendor financing stage. Typically the structure consists of the following scheme: shares are transferred to the BEE partners by the vendor company at or at about market value. To pay for this, typically a small cash payment (usually 1% to 5%) is made, but the great majority of the payment is set up as debt issued by the BEE partners. The vendor company is the party that buys this debt.
During the debt period the transfer of shares is a legal transfer of ownership; in particular the BEE partner has voting rights.
Over time, the debt rolls up with interest, and rolls down with dividend flows that are received from the shares. At termination, if the share value is higher than the outstanding debt, the BEE partners keep their shares and pay off the outstanding debt, or surrender sufficient shares to pay off the debt. If lower, the BEE partners also surrender their shares, but walk away from the debt.
Thus, what the BEE partner owns is a European call option on the shares with the strike being the level of debt. This option is somewhat exotic because the strike of the otherwise vanilla call option is not known in advance.
Statements made by participants in these schemes can make mildly amusing reading given this understanding. When the vendor company wishes to trumpet the successful creation of a BEE structure, it announces that such-and-such a percentage of the company is now held by black partners. On the other hand, if it is being pressured about a grant which some parties – such as the financial press, for example - are viewing as too generous, then it will brazenly retort that the partner owns precisely nothing until such time as the debt has been paid down. As we now see, neither statement is correct: the truth lies somewhere in between.
In the next stage, institutional financing comes into play. In these cases, real money is needed to facilitate the transaction - for example, minorities may need to be bought out. In this case equity is purchased using financing from banks and other financial institutions. The financial institution structures their asset into a cascade, with senior, mezzanine and equity components. The senior and/or mezzanine tranches receive a spread above typical interest rates in the market, and will enjoy covenants on the equity. The financial institution might buy the senior tranche in its entirety, and will participate in equity upside.
Currently most common is a mix of the vendor and institutional financing models. We are now starting to see a few straight purchases: BEE companies will have enjoyed income from previous transactions that they can use to enter into new trades. This cuts out the institutions who are acting as quite pricey middle men here. We believe that this type of transaction will become more and more common.