The new amendment to the codes of good practice for broad-based black economic empowerment (BEE) was published on October 11, 2013 and will come into force on October 14 this year. It will bring clarity to the treatment of investments made by the private equity industry and create opportunities for black-owned private equity fund managers for BEE purposes.
Previously, the BEE treatment of investments by the private equity industry was muddied by inconsistencies between the interpretive guide published by the Department of Trade and Industry in 2007 and the earlier codes of good practice, which led to a number of private equity fund set-ups being put on hold.
The amendment largely mirrors the interpretive guide and, as the codes of good practice take precedence over the guide, the new amendment is needed to ensure that the codes of good practice give effect to what was already contained in the guide.
The aim of the new amendment is to breathe life into the already growing black fund management industry. Unlike the position previously under the codes of good practice, the new amendment will ensure that private equity fund managers rather than the funds themselves are targeted by the relevant regulations.
Under the new amendment, portfolio companies will be entitled to regard all of the shares held by a private equity fund as being held by black people (as defined by BEE legislation) if:
n At least 51 percent of any of the votes held by that fund’s private equity fund manager in the underlying portfolio company are held by black persons;
n at least 51 percent of the private equity fund’s executive management and senior management is made up of black people;
n at least 51 percent of the profits made by the private equity fund manager after realising any investment made by it must by written agreement accrue to black people, and
n the fund manager is a company owned by black people.
The private equity fund manager is further required to seek to invest a proportion of the value of its funds under management in companies that have at least a 25 percent black shareholding (using the flow-through principles) which is to be applied from October 14 this year or from the time a new fund is set up (if set up after October 14).
This requirement will initially be a relatively modest 5 percent of the value of its funds under management in the first year, which will increase year after year until it will eventually reach 51 percent of the value of its funds under management by the ninth year.
The private equity fund manager can also facilitate the direct black shareholding at the time it makes an investment in the portfolio company. The position is simpler for funds that are fully invested prior to October 11, 2014 since there is no requirement for these funds to invest in companies with direct black shareholders provided they satisfy the other criteria referred to in the paragraphs above.
Black fund managers have historically faced the challenge of entering an industry that places great emphasis on past track record, which itself acts as a bar to new entrants (including black entrants) and has therefore made historical imbalances particularly difficult to overcome.
The new amendment provides impetus for companies to seek investment from funds managed by black fund managers so that the portfolio company is able to benefit from an improved BEE rating. It will also mean that black companies with at least a 25 percent direct black shareholding should on average find it easier to attract private equity investment than at present.
That said, black fund managers have already succeeded in overcoming many challenges. A survey conducted by KPMG and the SA Venture Capital and Private Equity Association, published in June last year in respect of the 2012 calendar year, found that the South African fund management industry as a whole grew at a compound annual growth rate of 11.6 percent (excluding undrawn commitments) between 1999 and 2012 to a figure of R126 billion in funds under management as at December 31, 2012. Of this, 75 percent of funds under management (or R94.6bn) was managed by black, black-empowered or black-influenced companies.
This already represents a significant increase of approximately 60 percent from 2007, when only R58.9bn worth of funds under management was managed by black, black-empowered or black-influenced companies. The new amendment will no doubt help to strengthen this growing trend.
It is expected that the private equity industry will not only play a role with regard to investing more funding in black businesses but that it will also help to create jobs for black people (particularly in the ownership and management of portfolio companies) and develop skills as know-how is transferred by the private equity investors to the portfolio companies.
While the new amendment will help to encourage new black entrants to the fund management industry, its treatment of BEE is slightly at odds with the BEE treatment of other entities, such as companies and may lead to new kinds of fronting practices.
While the BEE legislation as a whole ensures that, for example, in respect of companies, the majority of the profits of the company must accrue to black investors if black ownership is to be achieved, this is not necessarily the case with the private equity industry.
By regulating the manager rather than the fund, the majority of capital invested in the fund may be invested by white investors, and yet this capital will be treated as “black” for the purposes of BEE if the fund manager satisfies the relevant criteria, notwithstanding that most of the profits of the fund would accrue to the white investors in the fund.
Although the rationale behind this regulatory approach makes sense because black fund managers should not be penalised for managing any investor’s capital (whether white, black or foreign), it remains to be seen whether fronting practices will develop where bogus funds enter into arrangements with black managers on irregular terms specifically to “blackwash” capital invested by white investors.
Private equity investors and fund managers have already begun to consider how to restructure to benefit from this welcome change and private companies which are looking for private equity investment have also begun to consider how to capitalise on this opportunity to improve their BEE ratings.
* Dylan Cunard is a director at Werksmans Attorneys.