posted 13 Nov 2007 in Volume 10 Issue 6

Leveraged finance in South Africa

By Lionel Shawe, director, Deneys Reitz, and Steven Gamble, director, Africa Legal

SOUTH AFRICA has seen the emergence of sophisticated finance techniques in the leveraged finance market. These techniques borrow largely from the international market, but have been customised to deal with local requirements (in particular issues relating to tax, the taking of security, exchange control and financial assistance).
Complex structures in the international leveraged finance market typically involve a bid company (BidCo) being funded directly or indirectly through a holding company structure to acquire a target company (Target) by a combination of sponsor funding, senior debt, mezzanine debt and/or high-yield bonds. Like the international market, sponsors in South Africa use a similar leveraged structure to help them acquire a given Target and maximise their financial returns on exit.
Although the commercial objectives in the South African market are similar to the international market, there are, however, key structural differences that apply to the South African market. These include the following:

1. The sponsor consortium is likely to inject funds in the holding company and BidCo structure by way of equity rather than by way of a combination of equity and subordinated debt. This is due to strict thin capitalisation and exchange control rules that apply under South African law;
2. South Africa does not have an equivalent of the English law security trustee concept and therefore a separate security holding company (Security SPV) is introduced into the structure to replace the traditional security trustee. This structure is reasonably complex and requires a back to back debt guarantee and counter-indemnity arrangement to be introduced into the structure to enable security sharing and to ensure security remains intact following a sell-down or syndication of any debt. All security is channelled through the Security SPV;
3. Subordinated debt is subordinated to senior debt by way of structural and contractual subordination;
4. Leveraged finance transactions in South Africa often commence with an initial bridge facility made available to BidCo to assist it to acquire the Target. Because of certain tax benefits and the financial assistance position referred to above, the next step taken is usually for the Target to sell its assets to a newly-established company (New OpCo), which is a subsidiary of BidCo. The New OpCo then acquires the assets of the Target and finances the acquisition by way of direct take-out facilities. The proceeds of sale received by the Target are then hived-up by way of dividends or other shareholder distributions to enable BidCo to repay its bridge debt. Note that at the time of writing this article certain amendments have been proposed to South African income-tax legislation, which may have an impact on this structure;
5. Mezzanine debt is usually funded at an intermediate level within the holding company structure, although this may depend on the type of debt instrument used to fund the acquisition. Interestingly, high-yield debt is usually funded at the New OpCo level to help achieve maximum tax deductibility of interest. This raises certain important intercreditor and pricing issues for the financing parties;
6. South African law prohibits financial assistance (direct or indirect) from being given by the Target or its subsidiaries incorporated in South Africa. There is currently no equivalent of a whitewash procedure available to South Africa companies, although at the time of writing this article, a new whitewash procedure is expected to become law by the end of 2007.
7. In recent large public-to-private leveraged transactions, institutional shareholders and fund managers that hold shares in the Target have insisted on being offered a reinvestment option in the private entity. This has resulted in complex reinvestment structures that often require a listed instrument to enable compliance with investment mandates.
8. Black economic empowerment (BEE) is an important aspect of leveraged transactions. Relatively complex structures have been used to fund the stakes of BEE shareholders. Funding is often provided by the sponsors or through re-investment of the BEE shareholders’ proceeds from the sale of its shares in the Target.

Even though the development of the leveraged finance market in South Africa is relatively recent by international standards, the last four years has seen the rapid rise of sophisticated structures including the leveraged acquisitions of Alexander Forbes, Edcon, Primedia, Peermont Global and Gold Reef Resorts. Moreover, the South African legal market increasingly offers a platform upon which to launch pan-African transactions. Certain pioneering firms, like Deneys Reitz, intend to capitalise on this and have expanded their legal capacity to include English solicitors - for example, Deneys Reitz’s award-winning Africa Legal division.