DealMakers - Q3 2020
A BEE deal pandemic?
Many an article has been written about the “unprecedented times” we are facing and the “murky uncharted waters” of the global and local economy. Naturally, the COVID-19 pandemic has had a devastating impact on the South African economy, which was already wounded, and has also affected the local deal-making landscape in various ways. One such affected area is BEE transactions within the listed environment.
Using the JSE All Share Index as a proxy for the health of corporate South Africa (excluding Naspers and more recently Prosus), listed companies have experienced downward pressure, which has been exacerbated by the COVID-19 pandemic. The Bloomberg graph below shows the performance of the JSE All Share Index (in blue) vs the JSE All Share Index excluding Naspers and Prosus (in amber), reflecting a decline of 8.9% and 25.4% respectively from their respective highs.
As depicted by the amber graph, the expectation of limited short-to-medium-term growth has caused company valuations to lower across the board. Given that the majority of BEE transactions are structured on the premise of the underlying company’s share price appreciating over time, it is reasonable to assume that a large number of BEE transactions may now find themselves underwater.
There are various ways to structure BEE transactions, but typically, given that the BEE participants often do not have funding (or sufficient funding), these deals are either vendor funded or third party funded (with the underlying share forming the security for the loan). With the current economic climate, on the back of years of declining growth, and South Africa’s credit downgrade to junk status and arguable economic mismanagement morphing all together into the derating of share prices, both types of transactions are facing tough times with potential covenant breaches. Coupled with the drop in share price value, “dividend postponements” or “dividend cuts” add extra pressure on BEE parties who rely on dividend cash flows to pay back the outstanding debt and interest payments, both for vendor-funded and third party-funded BEE deals.
For third party-funded deals, banks have to make a decision whether or not to call on the security provided, which may include a guarantee from the issuing company. There may be a bit more pressure in third party-funded BEE deals vs vendor-funded transactions, as banks will look to stem losses, whereas vendor-funded transactions have more flexibility to restructure. The only saving grace has been that, for the time being, banks have not panicked as this would destroy their security further. However, it remains a precarious situation and banks will not remain patient forever. Furthermore, companies who have implemented vendor-funded deals are at major risk of losing their black ownership if they unwind the deal (which was a key part of the reason for implementing the BEE transaction in the first place).
A key area of concern for companies where BEE deals are currently underwater is that their BEE status may be impacted. If a company fails to score at least 40% of the available net value points on the BEE scorecard, the company automatically drops a BEE level even though it may have scored well across all the other priority elements on the scorecard. The question then begs, will we see a flux of BEE restructurings in the South African listed environment? And is it the right time to do so?
City Lodge has recently completed a R1,2bn rights offer, of which c.R774m was used to settle the remaining third party debt which was issued to fund the original BEE deal (guaranteed by City Lodge). Given the wind down of its current BEE deal, City Lodge will aim to do a new BEE deal, as it requires a BEE rating of at least level 4 in order to provide the company with 100% procurement recognition in the tourism sector. As many companies rely on their BEE recognition status, we may see more restructurings as now, in these COVID-19 times, it is more important than before to be best positioned to compete. However, going forward, companies may be hesitant to conclude BEE deals where guarantees are required, unless they are very dependent on BEE points.
Despite all of these negatives, now may be an opportune time for BEE restructurings, and even more so for participants of first-time BEE deals. Given the derating in valuations, it may provide an opportunity for companies who have not yet done a BEE transaction to do so and, in the process, provide a good entry point for BEE investors to create value (economic flow through), thereby securing the important net value points. Restructuring existing BEE deals will, however, be a bitter pill to swallow for investors who have been enduring below par returns, having to carry the further dilutionary effects (IFRS 2 accounting charges and shares in issue) of a new/restructured BEE transaction at a low share price.
An interesting factor that seems to be discarded is that underwater BEE deals still have value, as the optionality of future growth still exists. Naturally, this value may still be realised but, given the current environment, economic outlook and COVID-19 uncertainty, this may be difficult to achieve in the short-to-medium term. Nonetheless, when calculating a company’s annual BEE scorecard, the value implicit in the optionality seems not to be considered, which may imply that, from a BEE scorecard perspective, a bird in the hand, whether negative or positive, is better than two in the bush.
Watch this space.
Human is a Corporate Financier at PSG Capital