True test for BEE players as the going gets tough 
 6 August 2009

The mantra of the can-do entrepreneur during tough times is "never let a good recession go to waste". A similar philosophy may soon come into play among black economic empowerment (BEE) players who are confident they have developed robust models that are fit for purpose in all business conditions.

Our first recession in 17 years is already claiming casualties. It would be unrealistic to expect BEE companies to remain immune. Some may fail; others will entrench their positions and continue to add value to their partners and the national economy. This raises two questions: which BEE models are vulnerable? And which have a degree of recession-proofing?

Clues are provided by the “Asian contagion” of 1997 when share values tumbled across emerging markets, including SA. The market slide was an early warning to BEE companies that cycles turn and deal structures based solely on upside assumptions are seriously flawed.

Experience at a BEE entity such as the Mineworkers Investment Company (MIC) illuminates both the challenges and opportunities.

MIC 's investment strategy of the mid-90s was tilted toward listed equities — for apparently solid reasons. You can touch more lives by becoming the BEE partner of big listed groups while listing criteria ensure transparency and full reporting. However, if JSE shares are your only “currency” you accept a high degree of market risk. This risk multiplies when lock-in clauses apply.

At MIC, a salutary lesson was provided by a partnership with a listed diversified services group. MIC entered the transaction at an average share price of R6,30. Values rose steadily, peaking around R24 per share. Then the market turned. Other investors were able to realise value. We could not.

Profit-taking would have been prudent for MIC and its beneficiaries anywhere above the R13 mark. Lock-ins prevented even limited profit-taking. Values were well below our R6,30 entry level before we could exit the arrangement. Losses in other listed investments also had a material impact on the MIC balance sheet as market weakness persisted.

The conclusion? Over-reliance on equity upside, overcommitment to listed partners, and overdependence on dividend income create unacceptable levels of business risk, especially when lock-in clauses uniquely prejudice the BEE investor.

Those were the BEE lessons for the “class of 1997”. BEE models that failed to respond are today at great risk of failure, in my view.

What of the companies that learnt the lessons and adapted?

The biggest international financial crisis in 80 years will stress-test numerous institutions, not just BEE entities. Thankfully, a number of robust BEE companies have emerged. For example, long- term sustainability is an obsession at MIC, leading to a threefold strategy characterised by diversification on multiple levels, demonstrable value-add through hands-on involvement and the courage to say “No”.

MIC retains an exposure to the listed environment, but this is complemented by exposure to unlisted investees. Sector diversification is desirable, too, but diversification of income streams warrants particular attention.

When corporate earnings dip, so do dividends; and they might stop entirely, as we 've seen recently. Therefore, dividends can usefully be complemented by fee- income and preference share arrangements that are unaffected by equity volatility. Fees are only payable for tangible services that lend themselves to precise measurement by the investee company.

In other words, performance- based income (or value unlocked through performance-linked share options) can only be derived by hands-on involvement in day-by- day transformation and the achievement of targets. The hands-on BEE contributor not only derives a good income, but great satisfaction. You take pride in the training and development of workers, supervisors and managers. Another nonfinancial reward is the chance to watch the beneficiaries of enterprise development establish themselves.

The ability to conclude a good deal is important; so is the ability to walk away from a bad one. The cultural and philosophical fit between BEE investor and investee has to be good if long-term value is to be derived. If the investee is looking simply for a passive provider of minimum BEE requirements then a credible empowerment company has to walk away. Long-term credibility is compromised by any other response.

The ability to say “No” also applies to the nuts and bolts of deal- making with a serious would-be partner with a genuine commitment to BEE. Having a place at the boardroom table is not enough; you need a voice at the table. An investor with an equity stake of less than 26% has little control. At 26% and above, you at least exert “negative control” as you can block boardroom decisions you regard as ill-considered, a power bestowed by the Companies Act. It therefore makes sense to strive for a meaningful stake.

Alternatively, you can reach a special shareholder’s agreement allowing special powers below the key 26% level. Lock-in clauses might still be applied, but you can negotiate special provisions and warranties to protect your position in the event of market volatility.

A credible player known for delivering value-enhancing empowerment gains has a strong negotiating position when issues like this are on the table.

These are also the players who won’t “waste” the recession. They’ll learn its lessons, emerge stronger than before and drive continuing empowerment as SA bounces back and starts growing again.

Nkuna, www.businessday.co.za