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Empowerment deals

under the spotlight

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Shiraaz Abdullah

Global Equity Analyst

The dismantling of Sasol’s Inzalo B-BBEE scheme after it failed to deliver to its investors has placed empowerment deals, especially those in the resources sector, under the spotlight once again. Debt-financed schemes appear to benefit no one – not the participants and certainly not the diluted shareholders. The answer may lie in a new empowerment structure with which Sasol wants to replace the embattled Inzalo project – but this may also have unforeseen consequences.

Broad-based black economic empowerment (B-BBEE) is part and parcel of doing business in South Africa. The principles behind the legislation are admirable but unfortunately effective administration and implementation have been lacking. This is especially disadvantageous to mining companies, where any investor knows that generating profits is like riding a roller coaster – great excitement is followed by fear, and you’re always left with a strange feeling in your stomach.

FUNDING THE PURCHASE

Granting shares to individuals, especially employees, can be a great way to align interests for all stakeholders – but there’ll always be difficulties if the employees don’t have the capital to fund the purchase. The way companies have addressed this challenge has been to set up a structure that borrows funds from a bank in order to buy shares for the B-BBEE scheme.

So how does it work? Shares are usually issued to B-BBEE shareholders at a discount. For example, a share trading at R10 will be issued to the scheme at R9. The company in question is therefore providing an incentive for the scheme participants to be locked in for a lengthy period. This dilutes the ownership of all other shareholders who aren’t part of the scheme.

This initial dilution can be illustrated as follows:

  • Company X has 100 shares that trade at R10 each – it is therefore worth R1 000 (ignoring debt).
  • The company issues 30 more shares at R9 each to a B-BBEE scheme.
  • We now have 130 shares and total equity of (100xR10) + (30xR9) = R1 270.
  • This equates to a share price of R9.77.
  • Ordinary shareholders have therefore lost ~2.5% of value.

Over the lock-in period, companies pay dividends to the B-BBEE structure in order to pay down interest costs on the borrowed capital. This may create a conflict of interest for management when it comes to allocating capital. There are times when a mining company should definitely be conserving cash and not be issuing a dividend, but then the B-BBEE scheme may potentially collapse – this leads to suboptimal decisions being made. Therefore, over time, the share price must rise more than the interest costs due on the borrowed capital.

To illustrate:

  • Assume I borrow R100 to buy a share for R100, and the interest cost is 10%.
  • At year end, I owe the bank R110.
  • The company pays a R5 dividend, and the share price is R115.
  • I sell the share for R115, keep the dividend and walk away from a successful scheme with R10 in my pocket.

COMMODITY PRICE SWINGS

B-BBEE schemes run over longer periods of time (around 10 years), so the example above would be a reasonable assumption for most companies. It’s a much trickier situation with resource companies, however, as their share prices are exposed to commodity price swings. A case in point is Sasol’s failed Inzalo empowerment project, launched in 2008 as the biggest B-BBEE deal in South Africa at the time. It will now come to an end next year without accruing any benefit to its participants.

In fact, Sasol’s paltry share price performance – resulting from oil price fluctuations over which the company has no control – means that when the shares are sold at the close of the scheme, ordinary shareholders are going to be responsible for paying down the debt that was loaned to buy the shares. And then the company will have to start all over again – in terms of the new Mining Charter, another scheme must now be initiated.

But yet another scheme will just mean further dilution, with no guarantee of any real benefits for those it aims to empower. How can deals of this nature – in a sector dependent on commodity prices – ensure that the redistribution envisaged by the government’s B-BBEE policy is in fact realised?

A VIABLE SOLUTION?

The answer may lie in the new, R21 billion empowerment scheme Sasol has proposed to replace Inzalo when it’s terminated. Under the Khanyisa scheme, the company will sell a portion of the Sasol SA business to eligible employees and outside shareholders, and will itself take on the role of the bank, through vendor finance.

When the scheme matures, the participants will retain their B-BBEE ownership by exchanging Khanyisa shares for B-BBEE Sasol shares. These shares already exist (ticker: SOLBE1) and are equal to ordinary Sasol shares. So to prevent the dilution that takes place each time a new empowerment scheme is initiated (every 10 years, or sooner if it’s heavily indebted), a new class of share is likely to be created that can be traded only by previously disadvantaged South Africans. This sounds like a viable solution – but it may of course also have unforeseen consequences that will only come to light in years to come.

From an investment perspective, it’s important to remember that while moves around empowerment deals tend to have a negative impact on a company’s share price (Sasol fell by around 7% the day after the Inzalo/Khanyisa announcement), they also create opportunity. South African exposed mining shares may become cheap even after accounting for policy decisions – and we would then consider buying them. Also, capital flowing away from South African mining may well create investment opportunities elsewhere.

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