Why do BEE deals fail?

During the weekend I scrolled past a tweet where a lady was explaining why BEE deals don’t work, or better yet, why they are not to the benefit of the BEE Partner. I thought I should elaborate on this, but more on the audit assist side: the view I have on BEE deals.

Truthfully it’s a precursor to a post I’m going to do on IFRS 2 BEE valuations soon.

First, some theory:

The transaction is commonly structured with the BEE Holding Company forming a Special Purpose Vehicle (SPV) which would provide the initial capital in the form of a subscription price.

The SPV raises funding in the form of a loan, through a Third Party Financier and/or directly through the Vendor Company and using the funding, the SPV acquires shares in the Vendor Company.

Consistent with market practice, the transaction is normally financed by the Vendor Company as the BEE Partner usually does not have the required capital amount and as a result, the transaction is valued as a European call option because at the loan’s expiration the BEE Partner has the option to walk away from the debt if dividends received throughout the loan period were not enough to cover the loan balance; thus the BEE Partner has the option to relinquish the shares and walk away or, exercise by retaining the shares by ensuring the loan is paid off.

Why they break down:

See, the deal is structured as an option right and often the equity value quoted in these transactions is way too high

On top of that, the cost of the debt is high as well, more especially in instances where a third-party financer is used via SPV. SPV financing models suck because they’re premised on increasing share prices rather than cash flows, what this means is

Should the economy/ financer face tough times, the dividends earned therefore won’t be enough for the BEE Partner to cover the debt, thus, the whole thing falls apart. The company has benefited a few years of meeting regulatory requirements (BEE) and, the BEE partner walks away with nothing. No ownership. No empowerment.

How do we fix this?

For starters, get rid of third-party financing; banking on the share price to go up then hoping it will cover the cost of debt as well as the capital is the wild west, Vendor Financing is the way rather – which is indeed the route market has been taking lately.

What this means is that Vendor Financing is the appropriate choice; the BEE SPV issues the loan at much lower than bank rates. Even zero.

Lastly buyer and seller need to have truthful conversations about the value of equity, there’s way too much overpricing going on. Get realistic and the BEE Partner will be able to meet the transaction.

That’s all folks.

Talk to me on twitter here.