The global economic meltdown of recent years has turned the financial environment on its head, I don’t expect anyone reading this to disagree with that. However, as the well-spoken Sir Winston Churchill would remind us: “Difficulties mastered are opportunities won,” which stirs us to explore ways in which the current economic climate can be utilised to generate sustainable growth. One such opportunity is private equity, which has become quite a buzzword in the global financial space over the years. Private equity funds like the US based Blackstone Group have sailed very well through the waves of economic turmoil over the last few years.
The copybook private equity deal can be illustrated by the following example of the ideal leveraged buy-out transaction, obtained from David Carey and John E. Morris’s highly recommended book “King of Capital”:
Company X generates R1 million of cash annually and Company A is interested to buy Company X for R10 million. If Company A were to buy Company X using its own cash, it would earn a 10% return on its investment on an annual basis. Not bad, but considering the risk involved this would be a relatively low-yield return. However, Company A can opt to only use R1 million of its own cash and R9 million borrowed from a bank or other funder. As security for the loan from the bank Company A cedes and pledges to the bank the Company X shares to be acquired and pays interest of R600 000 per year using Company X’s proceeds to repay the loan to the bank. After paying the interest, Company X is left with R400 000 generated per year. Company A has then effectively acquired an income bearing asset by investing R1 million of its own money and earning R400 000 returns per year on such investment, constituting an annual return of 40% on its capital investment. Hence the label “leveraged buyout.” The ideal company to acquire, is therefore one that looks likely to produce enough cash to cover the interest on the debt needed to acquire the company.
In this article, we intend to discuss some of the most fundamental legal considerations in structuring a private equity fund between third party South African resident investors (excluding strictly regulated investors such as pension funds, collective investment schemes and other financial institutions as defined in the Financial Services Board Act, 1990, as these will require more rigorous regulatory measures to be complied with) and South African fund managers.
Private companies are usually not preferred as investment vehicles for private equity funds, as it can be quite a daunting task to create a capital structure in a company that is flexible enough to accommodate the goals of a private equity fund. For instance, the shareholders of a company usually contribute capital to a company in proportion to their shareholding, which is not ideal if investors intend to reserve the discretion as to whether they intend to invest in a particular opportunity or not. As discussed below, flexibility in the structure applied is key to ensuring that the fund is positioned to act on the opportunities presented to it by fund managers.
The most common private equity fund structures in South Africa are investment clubs, bewind trusts and limited liability partnerships (also called en commandite partnerships). Further details on these options are as follows:
i) Investment clubs
Investment clubs have only in recent years become more popular in South Africa. These may be seen as vehicles by which investment opportunities are presented in a closed environment, rather than being an investment vehicle in its own right. The basic framework in this case, is that fund managers would source suitable investment opportunities for the club, which opportunities may then be invested in by the members of the club at their discretion. The club members may include high-net-worth individuals or other entities, which pay annual membership fees to fund managers. The membership fees are applied to fund the fund managers who quit their day jobs to actively look for investment opportunities. Members do not make any capital commitments toward the club, subject to the rules of the club, unless they opt to participate in a particular opportunity. The rules of the club should record the type of investment vehicle to be used when investments are made by club members, the options are discussed below.
ii) Bewind trusts
Those readers that are familiar with the concept of trusts under South African law will understand this quite easily. The trusts used on a day-to-day basis in South African business and estate planning are mostly discretionary trusts. In these trusts, the trustees obtain ownership of trust assets, but only in a fiduciary capacity (which means they own and manage assets for the benefit of the beneficiaries). Bewind trusts are different in the sense that the trustees merely hold and manage assets on behalf of the beneficiaries. Therefore, ownership of trust property remains vested in the beneficiaries and never in the trustees.
These trusts are created by means of trust deeds and are subject to the regulatory control of the Master of the High Court in the same manner as discretionary “family trusts”. From a private equity perspective, the fund managers will be the trustees of such a trust, administrating the trust property (shares and claims in investee companies) for the benefit of the pool of investors, as beneficiaries. In this scenario the trust will have certain rules that apply to provide a discretionary framework for fund managers (trustees) to guide the private equity activity in accordance with the investors’ risk appetite and other financial considerations.
It is of course possible to form an investment club as indicated above, which is presented with investment opportunities by the fund managers. The investing club members are then plugged into the trust structure once they decide to act on a particular investment opportunity. Such club members will then become the beneficiary of the trust, created to pursue the particular opportunity. The benefit of this structure is that the beneficiaries may be ring-fenced to be exposed to certain investment opportunities only. As indicated above, “club members” need not commit any capital unless they want to act on a specific investment opportunity.
iii) Limited liability partnerships
Limited liability partnerships are more common in the private equity world and are created like any other partnership, except for the requirement that the parties must expressly agree to form such partnership. The fund managers (called general partners in this context) manage the funds of the partnership and are the public face of the partnership. The investors are called en commandite or “silent” partners, contributing capital to the partnership to enable the general partners to invest in opportunities in terms of the partnership agreement. The silent partners’ limited liability lies therein that their liability to creditors is limited to their investment in the partnership and nothing more. The general partners’ liability to creditors is, however, not limited in this manner. The silent partners are therefore mostly on the background and share in the profit or loss of the trust in proportion to their respective capital contributions to the partnership.
The type of vehicle chosen depends on numerous factors, including the track record of the fund managers, investors’ appetite for risk and as always, the relevant tax considerations. Eventually the parties should ensure that a structure is implemented that protects investors optimally, whilst still enjoying enough flexibility to enable investors to get involved in suitable investment opportunities in their discretion.
“Opportunity comes like a snail, and once it has passed you it changes into a fleet rabbit and is gone.” ~ Arthur Brisbane