Investing In South African Growth Companies: Challenges And Opportunities Created By An Evolving Legal Environment

As South Africa aims to rebuild its economy, it faces not only the same economic challenges that are faced by other countries around the world, but the Government's looming fiscal deficit that existed even before COVID-19 has had South African taxpayers on edge for some time. It also didn't help when Moody’s Investors Service cut South Africa’s credit rating below investment grade earlier this year at the height of South Africa's COVID-19 crisis, citing “continuing deterioration in fiscal strength and structurally very weak growth”.

It should be noted that even while the government under Cyril Ramaphosa since his election in 2018 has been far from perfect, there has been some progress in rooting out the legacy of corruption of the previous regime that had the country in its stronghold for close to a decade. We've also seen various initiatives to stimulate investment in a slow economy, particularly in the private investment market. This article therefore aims to give a bird's eye view of the lay of the land in the South African private investment space, focusing on some of the key challenges, the initiatives that have been taken to solve them and the opportunities that exist in a post-COVID-19 landscape.

Constraints

Inward investment by offshore private equity and venture capital funds provides crucial support to the domestic private investment industry. This investment activity has made some progress in recent years but has had notable constraints as described briefly below.

Exchange Control Regulations

Every transaction in which a South African resident natural or juristic person transacts with a non-South African natural or juristic person (non-resident) results in the flow of funds or capital assets of South Africa being subject to South African Exchange Control Regulations. The objective of this regulatory environment is to control the flow of capital into and out of South Africa and ultimately to limit the export of capital by residents, driven by the mandate of the South African Reserve Bank (SARB) to maintain control over South Africa’s balance of payments (BoP). The legislation underpinning these regulations has been in effect since the outbreak of the first world war in 1939 and the Exchange Control Regulations, of 1961 (the Regulations) were initially aimed at stabilising the South African BoP in volatile economic conditions and had limited scope and application. However, as the nature of economic activity evolved, the SARB's mandate became more complex and the Regulations evolved as a result.

The position today is that the administration of exchange control in South Africa is performed by the SARB's Financial Surveillance Department (FSD), with some scope given to local banks acting as "authorised dealers" to be the "hands and feet" of the SARB to some degree.   

In the last decade, the most noteworthy Regulations that we've seen having an effect on inward investment and multinational structures are, firstly, the requirement that the sale of any capital assets by a South African resident to a non-resident requires SARB approval through an extensive process that can severely hamper the momentum of a sale of local assets such as intellectual property. The second major challenge has been the restriction on structures commonly referred to as "loop structures". These structures are formed when South African residents own shares in non-resident companies that own shares in a South African resident company. The friction caused by the Regulations when, for example, intellectual property is sold by a South African resident company to a non-resident acquirer, can mean that an offshore acquirer will look elsewhere to acquire intellectual property, especially in an industry where time is of the essence. The loop structure restrictions have also provided some very burdensome structuring challenges for multinational businesses, often resulting in overly complex structures that affect the long-term investability of these enterprises.

Regulation 28 of the Pension Funds Act

The domestic private equity industry in South Africa has shown steady progress over the last decade as the importance of private investment activity has largely been demonstrated by job creation statistics in one of the most economically imbalanced countries in the world. One of the historical challenges for private equity funds in South Africa has been the limited access to capital from retirement funds as investors in private equity funds. Regulation 28 is issued under the South African Pension Funds Act and limits the extent to which retirement funds may invest in certain asset classes. The obvious aim of this regulation is a sensible one: to protect members' retirement value by limiting exposure to more risky and less diversified asset classes. However, this has historically meant that local private equity funds have had limited access to capital and that institutional investors have been constrained in optimising their investment portfolios.

Lack of access to capital by early-stage companies

Early stage start-up companies have difficulty raising seed funding, especially in their pre-revenue phase. While this is the case in most countries, in the South African landscape this is arguably even more pronounced as the venture capital funds are predominantly mandated to invest in post-revenue companies that are in a position to scale. This leaves a big gap for capital raising activity in the early stages, unlike countries like the United States where pre-revenue investment by investment funds are more common. This regime means that early-stage companies are dependent on what the industry commonly refer to as "friends, fools and family" capital for quite some time before investment funds will be interested. In a country where the "friends, fools and family" environment might be able to support the development activity for some, it is often an insurmountable challenge for founders from communities historically disadvantaged by economic exclusion during the Apartheid era.

According to recent statistics referenced by the South African Venture Capital Association (SAVCA being the association for both private equity and venture capital funds in South Africa)  small and medium enterprises in South Africa represent more than 98 per cent of businesses, employ more than half of the country’s workforce, and are responsible for a quarter of private sector job growth. This emphasises the important role that investment in early stage companies will play in the country's economic recovery.

Initiatives And Opportunities

Relaxation on some Exchange Control Regulations

In recent years, some of the most restrictive Exchange Control Regulations have been relaxed to cater for a more nuanced cross-border investment environment to provide multinational companies with more flexible and sustainable long-term structuring goals. For example, the prohibition on loop structures has been relaxed through a series of amendments and updates, from a position of outright restriction to the current position effective from 4 January 2021 where the restrictions on loop structures have been abolished and have been substituted with certain reporting requirements that have to be fulfilled by the relevant companies to a local South African bank (reporting the loop structure immediately after it has been formed and some additional ongoing financial reporting requirements in respect of the companies in question). These relaxations are welcomed and will no doubt support the legitimate structuring goals of multinational businesses involving South Africans.

Regulation 28: changes on the cards

SAVCA published a position paper in June this year, which was reiterated in October, that the current provisions of Regulation 28 should be amended to  gradually increasing the allocation threshold to private equity funds from 10 per cent to 15 per cent and to separate hedge funds and private equity funds as separate asset classes, each with their own allocation cap. This would be a move away from the current limitations which combine hedge funds and private equity funds under the same umbrella and impose a 15 per cent cap on this combined asset class with a limit of 10 per cent on private equity investments within that combined asset class. These proposed changes are largely supported by the investment industry and could be a very timely boost for private equity funds' contribution to a growing economy.

Initiatives to bolster early stage investment activity

To overcome the friction in early stage fundraising activity, the local entrepreneur ecosystem has adopted some innovative funding avenues for early stage companies, such as the launching of the first African equity crowdfunding platform in 2017, the emergence of fundraising through blockchain based instruments, and a more structured and coherent network of angel investors formed by high net worth individuals investing in early stage companies. While these initiatives have certainly filled some gaps, they have realistically not, to date, made the impact needed to fill all the funding gaps in the early stage investment industry. The start-up industry has been boosted by various incubators and accelerators that also make a substantive contribution to systematically building an ecosystem that enables economic growth in this respect.

The Government has also played a big role in stimulating venture capital investment by South African taxpayers, most notably through the implementation of a tax incentive regime in terms of Section 12J of the South African Income Tax Act, which enables South African tax residents (individuals and companies) to deduct their investments into venture capital companies (i.e. companies that invest in certain qualifying investee companies) from their taxable income. This incentive was initially very limited in its application, so much so that even though it was started in 2009, there were only 10 active venture capital companies by 2014. There have been some desperately needed changes to the incentive over the years which have, according to main role players in the industry, led to over ZAR9.3 billion of taxpayers’ funds having been invested in small and medium enterprises through Section 12J approved venture capital companies, creating over 10,000 new jobs in the process. The only unfortunate fact is that South African taxpayers have a limited window period to make use of this incentive which expires in June 2021. Given the slow initial uptake and the current need for stimulating investment, the hope is that there will be an extension to this window period. It remains to be seen whether the fiscus will take this route considering its own budgeting constraints that need to be balanced carefully.

SG Laubscher
SG specialises in Private Equity, Venture Capital and M&A transactional work; international corporate structuring; private equity and venture capital fund structuring.