Challenges in Funding for Black Businesses in Mining and Petroleum Sectors

1. Presentation to the Portfolio Committee on Minerals and Energy on the problems and difficulties that black businesses encounter when looking for funding, particularly in the Mining and Petroleum sectors 2 April 2003

2. 1. Introduction • The purpose of this document is to set out a number of the key issues that are faced by black economic empowerment (“BEE”) companies in seeking funding for transactions in specifically the Mining and Petroleum sectors. • It is key to note that, although a number of BEE companies have developed into major companies with significant investments in a range of sectors, there are generally few BEE companies that have to date generated sufficient cash resources to allow them to make significant investments without assistance from funding institutions. •  In addition, a significant proportion of the wealth of many of the leading black high net-worth people in the country is attributable to the shares that they own in the empowerment companies that they manage or control. In many cases such shares are not particularly liquid or capable of being used by the individuals as security to raise significant sums of cash to finance another investment. • The key implication of the issues above is that there are not many BEE companies that can finance, without the involvement of third party financiers, a material investment in some of the large companies in the sector. Similarly, it is not likely that major established empowerment individuals will easily be able to use as security the equity that they own in the companies that they are associated with to finance a separate investment in another company, particularly where that investment is one that will not necessarily allow them to have control and/or operational involvement. • It is however important to note that the issues faced by BEE companies in seeking financing for transactions will differ depending on whether they require funding to finance their participation in a specific project, or whether they are looking to acquire a direct equity interest in an established company. This document discusses a number of the relevant issues in both instances.

3. 2. Accessing funding for specific projects • The minerals and energy sector, more than any other sector, lends itself to project based financing because of the nature of the assets involved. • On the basis that in most instances a particular project will have a specified level of expected cash flows, it is generally possible to structure a transaction where the financing is secured against the cash flows that are expected to be generated by the asset or project. • This form of financing generally helps to facilitate BEE because the BEE company can finance its equity participation in a project at significantly lower rates. • In addition to creating direct access to the underlying cash flows of the project, investing directly in a project also facilitates the use of vendor financing by the established company that participates alongside the BEE entity in the project.

4. 3. Accessing funding to secure a direct interest in established companies Limited opportunities for “pure” vendor financing • Whereas it is relatively straight-forward for a company to provide financial assistance to a BEE company to secure equity participation in a project, it is less straight-forward to do so, due to S38 of the Companies Act, where the equity participation by the BEE company is intended to be in the company itself. • There are however fewer legal impediments to such financial assistance where the established company is providing assistance to a BEE company to acquire an interest in one of its subsidiaries • Successful financing of BEE transactions in recent years has tended to require significant facilitation and funding from the underlying investment company in order to be successful, incorporating measures such as significant discounts to fair market value, gearing up of the underlying entity to reduce the size of the required investment, offering put options against the holding company or guarantees to the BEE entity or its financier, and other vendor financing arrangements. • Limited pool of available capital for financing BEE transactions • Retirement fund managers such as Old Mutual Investment Managers, Sanlam Development Fund and others were the key financiers behind the initial wave of BEE funding. Since the shortcomings of the SPV model were exposed in the market downturn at the end of the 1990’s, these institutions have not played a significant role in assisting BEE companies to acquire interests in listed entities, preferring to focus, if at all, on financing direct private equity investments in BEE companies. • Key players in the BEE financing arena at present include the IDC and the PIC. It is important to note, however, that these entities are required, in terms of their current mandates, to provide BEE financing on commercial terms, in particular with regard to issues such as pricing of the underlying investment, co-investment by and risk sharing with the BEE entity, and mechanisms to exit at the end of the investment period.

5. 3. Accessing funding to secure a direct interest in established companies Rates of return required by BEE financiers • Traditional financiers, such as the large pension fund managers, historically required significant returns for providing funding for empowerment transactions. These returns have generally been based on the prime rate, with an average premium of up to 10% above prime (“the hurdle rate”) together with a share of the equity returns generated by the investment above the hurdle rate. In a number of instances financiers received up to 90% of equity returns above the hurdle rate. Financiers justified these financing rates on the basis that they were effectively taking equity risk on debt funding that they were providing while the BEE companies effectively took no risk. • In the SPV model, dividends received from the underlying investment were generally not sufficient to cover even the interest on debt. Interest was accordingly ‘rolled-up’ over the period of the financing, thus increasing the amount that needed to be repaid to such a level that the share prices of the underlying investments needed to significantly outperform the market before BEE companies had any opportunity to generate any value for themselves from the investment. It is for this reason that, in many cases, a BEE entity acquiring a 25% interest in a company at a point in time could end up with less than 5% at the end of the investment period. Exit mechanism and investment horizon • All funding structures require a mechanism to be built-in to allow the financier, and possibly the BEE partner, to exit from the structure in the medium term. To date this has resulted in funders of BEE transactions taking direct control of some of the ordinary shares in the underlying investment at the end of the funding period, with the intention of disposing of the shares to recover their capital and interest. In circumstances where the underlying shares are not listed it has been a requirement to either commit to a listing in the medium term or consent to a trade sale of some description to allow the financier to exit. • Financiers of BEE transactions have to date generally not been willing to consider financing periods in excess of 5 years. Although institutions such as the IDC have recently indicated a willingness to consider providing equity funding for BEE transactions for periods of up to 7 years, this sort of time scale has created a challenge for many established companies requiring a BEE partner for the long-term.

6. 3. Accessing funding to secure a direct interest in established companies Pricing • To facilitate the financing of BEE transactions, funders generally require the shares in the underlying investments to be acquired at significant discounts to ruling market prices in order to compensate them for the lack of liquidity and the requirement to give up some value to the BEE entity. This is complicated by the fact that many of the entities in the sector are large companies where a 25% interest can be worth in excess of several billion rand. In addition, such companies, many of which are directly or indirectly listed on foreign bourses, are sensitive to creating an impression among their investors that they are selling off their South African assets at a significant discount to fair market value. Risk Sharing • Most BEE funding structures generally required little or no capital contribution from BEE partners and ring-fenced the funding, effectively insulating the BEE partner from any downside risk on the investment. Funders therefore bore the bulk of the risk on the investment, with only the shares in the underlying investment as security for the funding. • Current structures that are being adopted by entities such as the IDC have generally required BEE parties to contribute at least 10% (with at least 2,5% required to be in cash terms) of the capital to be invested in the underlying investment. This requirement for a cash contribution has however still posed a challenge to many BEE companies with limited access to their own cash resources – particularly where they are contemplating investments in some of the larger companies in the sector.

7. 4. Other relevant issues Control • In early BEE transactions BEE companies typically acquired minority interests in established companies, with limited ability to materially influence the strategic direction of the company. In addition, investments by BEE companies tended to be via broad-based consortia that limited the ability of BEE companies to exercise effective control over the underlying investment, as there was often no clear controlling or lead shareholder in the consortium.There is currently increasing pressure for BEE companies, and particularly established BEE companies, to focus on investments where they can exercise some measure of control, or at least significant influence, over the underlying investment company to allow them, to the extent possible, to control the cash flows of the underlying investment company. There is also an increasing trend for established BEE companies to either invest alone or to create consortia where they have clear control over the strategic decision making of the consortium. Operational involvement • As discussed above, many of the first BEE investments were minority investments where the BEE companies were not able or not incentivised to become involved at an operational level in the underlying investment. In addition, a key feature of the SPV method of financing was that the funding on each investment was ring-fenced and accordingly BEE companies had no downside risk on the investments that they made. BEE companies were therefore incentivised to conclude as many investments as possible, with little incentive to focus on any particular sector or industry or to focus on adding value to any one underlying investment company.BEE companies, and particularly established BEE companies, are under increasing pressure from funders and the markets in general to focus on particular companies or sectors, principally to facilitate operational involvement in and add value to the underlying company.

8. 5. Recommendations • Provide increased assistance from government controlled financial institutions to facilitate BEE financing, including • guarantees to facilitate funding of BEE transactions provided by the private sector; • venture capital funds to provide risk capital to black entrepreneurs who have limited access to cash resources; • increased investment periods beyond the current 5-7 year period; and • less onerous rates of return. • There may be scope for Government to consider reviewing the Companies Act, and particularly s38, to allow a company to provide financial assistance to a BEE entity acquiring its shares. The wider impact of such an amendment on the South African business environment in general would however need to be considered. • Encourage established BEE companies to assist emerging entrepreneurs entering the sector in terms of: issues such as: • technical skills to evaluate projects; and • financial assistance in structuring transactions and raising funding.