Private Equity 2024 Comparisons

Global inflationary pressures and a sluggish South African economy put pressure on deal activity in 2023 and this continued into early 2024 with added political uncertainty ahead of the national elections which took place in May 2024. However, the recent formation of a Government of National Unity has generally been viewed as a positive outcome which has been welcomed by the markets and it is hoped that this will trigger a resurgence in deal activity across the country.

Opportunities remain in the infrastructure and energy sectors where there is a need for the private sector to fill the gap left as a result of the deterioration of public services and government infrastructure. 

Restructuring transactions to avert business distress and unlock value have been prevalent in the South African market of late. Divesting of non-core assets to streamline operations and reduce debt burdens has increased.

There is also a programmatic approach to M&A with companies systematically and regularly engaging in M&A as a core part of their growth strategy. These entities are consistently pursuing a series of smaller to mid-sized acquisitions over time, instead of relying on occasional large, transformative deals.

Higher global interest rates together with a weaker local currency continue to place pressure on the South African private equity market (most notably in relation to those funds which are required to account to their investors in foreign currencies).

Proposed Relaxation of Exchange Control Regulations

In an effort to encourage high-growth private equity funds to establish offshore entities from a domestic base, it is proposed that authorised dealers should be empowered to process requests by South African private equity funds that are licensed with the Financial Sector Conduct Authority (FSCA) to invest offshore up to ZAR5 billion per applicant company per calendar year in line with the outward foreign direct investment policy, without prior approval from the Financial Surveillance Department.

Companies Amendment Bills

The first and second Companies Amendment Bills of 2023 were passed by the National Council of Provinces (NCOP) in March 2024 and are currently awaiting assent by the President. The most contentious provisions pertain to the new remuneration disclosure requirements for both private and public companies. Highlighted amendments include: (i) public and state-owned companies should be starting to prepare for the structuring of binding remuneration policies, alignment of remuneration reporting and pay gap disclosures and new social and ethics committee requirements; (ii) private companies with ten or more direct or indirect shareholders that are contemplating an affected transaction should be readying themselves for the potential of additional regulatory scrutiny of their deals by the Takeover Regulation Panel; (iii) all companies should be giving thought to the alternative dispute resolution mechanisms that they have agreed to in their corporate documents and whether or not these are still appropriate considering proposed amendments; and (iv) corporates should be cognisant that their annual financial statements and any disclosures included in their financials, director and officer remuneration or otherwise, will soon become public information.

The Conduct of Financial Institutions (COFI) Bill

The COFI Bill is an overarching regulatory framework that was meant to have been promulgated in 2023 but will now most likely be promulgated in 2024. The conduct requirements of financial institutions are currently regulated by a number of financial sector laws and guidelines. As part of the regulatory reform of South Africa’s financial sector, the COFI Bill proposes to streamline the conduct requirements for financial institutions that are presently found in a number of different financial sector laws. In this regard, the COFI Bill will repeal some statutes in the financial regulatory space, while amending others.

Currently, private equity funds that are structured as limited liability partnerships are not regulated (as a product) and generally do not require registration in order to be promoted or offered in South Africa. Regulation of private equity funds is generally indirect through the regulation of the respective fund managers, who may be required to be licensed as financial services providers in terms of the Financial Advisory and Intermediary Services Act 37 of 2002, depending on their investment activities or roles.

When the COFI Bill is adopted into law, private equity funds will be regulated and licensable. The licensing obligation in relation to the offering of private equity funds will be placed on their managers.

The Primary Regulators and Regulatory Issues Relevant to Private Equity Funds

In South Africa, the legal structure of private equity funds can take various forms, the most common being that of limited liability partnerships (known as en commandite partnerships). En commandite partnerships are a popular structure because they are relatively flexible, they are not (currently) directly regulated under law, and the contractual agreements utilised by the partnership remain private.

The Financial Advisory and Intermediary Services Act, No 37 of 2002 (FAIS)

Fund managers are required to have the requisite financial advisory licence pursuant to FAIS.

Regulation 28 of the Pension Funds Act, 1956

To the extent that a pension fund is invested into a private equity fund, the private equity fund will need to comply with additional reporting obligations in order to enable the investing pension fund to comply with its obligations under the Pension Funds Act.

The Collective Investment Schemes Control Act, 2002 (CISCA)

CISCA regulates collective investment schemes, prescribes ongoing obligations for such schemes and places the same under the regulatory oversight of the Financial Sector Conduct Authority (FSCA). CISCA does not formally regulate private equity structures as there is no formal private equity dispensation provided for in the CISCA framework. However, a private equity fund may constitute a “collective investment scheme” depending on how it pools its funds.

The COFI Bill

See 2.1 Impact of Legal Developments on Funds and Transactions in relation to the COFI Bill.

Primary Regulators and Regulatory Issues Relevant to Private Equity Transactions

Private M&A activity is mainly regulated in terms of the Companies Act 71 of 2008 (the “Companies Act”), under which a number of transactions require the consideration of the Takeover Regulation Panel subject to the takeover regulations issued in terms of the Companies Act.

Listed M&A deals are regulated by the Companies Act as well as the Johannesburg Stock Exchange (JSE) through the JSE Listings Requirements.

Foreign investments or any form of externalisation of funds by South Africa resident investors are generally subject to exchange control regulations prescribed by the South African Reserve Bank (SARB), and any such transactions will require the authorisation of the Financial Surveillance Department of the SARB.

Competition law authorities established under the Competition Act 89 of 1998 have significant powers in respect of M&A activity and are responsible for investigating, approving or prohibiting mergers. Proposed mergers that are above the prescribed thresholds are subject to mandatory merger notifications prior to the implementation of such mergers.

The competition law authorities consider both competition law and public interest factors in determining whether a proposed transaction is capable of justification. Competition and public interest factors carry equal weight in the analysis conducted by the competition authorities. The competition analysis determines whether a merger substantially prevents or lessens competition, whilst the public interest analysis considers the impact of a proposed transaction on certain specified public interest grounds. Amongst these public interest grounds are the effect that a proposed transaction will have on the promotion of a greater spread of ownership by historically disadvantaged South Africans and workers in firms in the market, as well as on employment. The former has seen an increase in conditional merger approvals, with the establishment of employee share ownership schemes being a prominent theme. Preventing merger-specific job losses continues to remain an imperative of the competition authorities.

Depending on the sector in which the target operates, additional regulatory approvals may be required.

Sovereign Wealth Investors

There is no distinction in the way that national security (or other) regulators assess financial investors depending on whether or not they are sovereign wealth investors.

EU FSR Regime Relevant for Transactions in South Africa

The new EU FSR regime has not had a material impact on South African private equity funds.

Anti-bribery, Sanctions and ESG Compliance

Draft amendments to the Money Laundering and Terrorist Financing Control Regulations have been published for public comment. The amendments include provisions related to reporting thresholds (international cash transactions exceeding ZAR25,000 must be reported to the Financial Intelligence Centre (FIC)), required information for cash or negotiable instruments conveyance reports, and designation of authorised recipients of such reports. Failure to declare transactions may potentially result in criminal conviction or hefty fines. These amendments aim to bolster protocols against money-laundering, enhance the FIC’s ability to detect suspicious transactions, and facilitate South Africa’s removal from the grey list.

One of the key recommendations of the Zondo Commission of Enquiry into State Capture was the introduction of an offence related to the failure to report corruption. This recommendation has now been implemented via the introduction of Section 34A of the Prevention and Combatting of Corrupt Activities Act. In terms of the new Section 34A, a member of the private sector or any state-owned entity will be guilty of an offence if a person associated with that company or state-owned entity offers or gives a prohibited gratification to obtain or retain business or an advantage in the conduct of business for that company or state-owned entity. 

In addition to the legislative changes set out above, these topics are increasingly relevant in M&A transactions. There is also increased sensitivity around sanctions and/or possible sanctions, given the stance adopted by the South African government towards Russia and the conflict in the Ukraine.

Red flag, or “exceptions only”, legal due diligence is the most common form of due diligence in South Africa. In unilateral transactions, due diligence is run by the purchaser, whereas auction processes typically involve a vendor due diligence which is then supplemented by purchaser top-up due diligence. Black box and clean team arrangements are common for transactions involving trade buyers.

Apart from business-specific issues, due diligence is also typically conducted in relation to restrictions on transfer and general regulatory compliance (including environmental, data protection and anti-bribery and corruption laws).

Vendor due diligence is common for private equity sellers in the context of auction processes. These will ordinarily be red flag, or “exceptions only”, vendor due diligence reports. In auction sales it would be typical for sell-side advisers to provide bidders with an initial “teaser” document. Bidders that sign up to a non-disclosure agreement are then provided with a more detailed information memorandum, and bidders that have provided attractive non-binding offers are then provided with vendor due diligence reports (which typically cover legal, financial and tax but can also include environmental vendor due diligence, depending on the nature of the target asset).

Buyers typically conduct top-up and/or confirmatory due diligence in relation to vendor due diligence reports or legal fact books and are granted access to the virtual data room for this purpose.

Reliance on vendor due diligence reports by the successful buyers is common.

Most private equity deals are typically concluded via private treaty sale and purchase agreements. The terms of the transaction do not differ materially between privately negotiated deals and auction sales, save to note that in auction sales the transaction agreements are usually more favourable to the seller (depending on the extent of competition involved in the auction process).

In most instances, the private equity fund will incorporate a ring-fenced acquisition vehicle and it is less common for the private equity fund itself to be the direct buyer of the asset. Typically, the fund manager is heavily involved in the negotiation of the buy- and sell-side transaction agreements.

Depending on the size of the transaction, private equity deals are typically funded through a combination of senior third-party debt and funds committed by the private equity fund. Given a number of factors, including: (i) higher interest rates affecting cost of debt; and (ii) local elections in South Africa, there has been lower deal flow in the South African market in the last 12 months.

Established and well-known private equity houses are rarely asked to provide equity commitment letters from their investors but, depending on the nature and size of the transaction, these are sometimes used in order to provide contractual certainty. Similarly, it is not common to require certain debt funds at signing from such private equity houses. Where comfort is required (for the reasons mentioned in relation to equity commitment letters) debt commitment letters from the lender are sometimes used. In other instances, advisers to the fund are asked to confirm that the drawdown arrangements in the fund agreements are binding and that there are sufficient undrawn commitments available to fund the equity portion of the purchase price.

Whether a transaction is for a majority or minority stake will be entirely dependent on the acquisition strategy and investment mandate of the relevant private equity fund.

Consortiums are relatively common, especially in larger transactions where the private equity fund requires additional investors in order to obtain the desired stake in the target company or where the private equity fund does not have sufficient remaining commitments from its existing investors.

The composition of the consortium will depend on the nature of the transaction. Whilst corporate investors do sometimes participate in consortiums, this is less common than participation by existing investors and/or other private equity funds. Where the consortium comprises a private equity fund and one or more of its existing investors, then existing investors are often willing to accept a passive stake. Third-party co-investors will typically require a degree of positive or negative control depending on the size of their stake.

Consideration Structure

Most transactions are priced either using a locked-box or completion accounts mechanism. Fixed-price transactions are not common, as there is generally a prolonged period between the signing of the documents and the closing of a transaction due to various regulatory approvals being required, with the associated need for an adjustment mechanism.

Deferred Consideration

Earn-out arrangements and deferred consideration are fairly common in South African M&A transactions. Rollover structures are less common but are sometimes implemented where members of the management team are sellers.

Transactions involving a private equity seller often result in some form of deferred consideration in order to avoid formal escrow arrangements and allow purchasers to set off any warranty or indemnity claims against the deferred consideration. Although the authors note that set-off of warranty and indemnity claims will also be dependent on whether or not warranty and indemnity insurance has been obtained in relation to the transaction.

Private equity sellers are typically hesitant to provide any form of security against downward adjustments to the purchase price or leakage payments beyond the typical contractual obligations contained in the transaction agreements. However, most deals are structured on the basis that only a downward price adjustment is anticipated.

Private equity buyers are able to provide security to sellers through confirmation of their total commitments over and above the initial purchase price.

Interest is commonly charged on the purchase price. In addition, (reverse) interest will generally be charged on leakage at the same rate that interest is charged on the purchase price so that the purchaser will be placed in the position they would have been in had the leakage not occurred.

It is common for both locked-box and competition accounts pricing mechanisms to have bespoke dispute resolution mechanisms. Parties will generally prefer an expert (for example, a corporate finance house or independent auditor) to consider disputes relating to the pricing aspects of a transaction rather than for same to be regulated in terms of the general dispute resolution mechanism. Expert determination mechanisms are generally used for consideration structures as they provide clear-cut guidelines on how an expert will be invited by the parties to address any differences they may have in respect of the determination of the purchase price.

Prior to appointing an expert, parties will often try to address the dispute between themselves and only refer the particular matters they may have failed to reach agreement on for the expert’s determination.

In addition to the mandatory regulatory conditions – including exchange control approvals, takeover regulation approvals, antitrust approvals and other industry-specific regulations which may be applicable to a particular transaction – private equity transactions are often also subject to other conditions, such as the procurement of acquisition finance, third-party consents as well as shareholder approvals and waiver of pre-emptive and other analogous rights (although both sellers and buyers will typically seek to limit the number of conditions in any transaction).

Whilst material adverse change/effect clauses were not previously common in South Africa, there has been a significant increase in the use of material adverse change/effect provisions in transactions since 2020, as parties seek to bridge the uncertainty that was created by the COVID-19 pandemic as well as other aspects beyond a party’s control that may impact a transaction or a target business.

It is not common for private equity buyers to accept “hell or high water” undertakings in relation to regulatory conditions in the transaction documents (whether in respect of merger control and/or foreign investment regulatory conditions).

Whilst the concerns are less pronounced in relation to foreign investment regulatory conditions, in so far as merger controls are concerned, the competition authorities are required to assess mergers with reference to both competition and public interest effects and the Competition Act makes provision for the Minister of Trade, Industry and Competition (the “Minister”) to intervene and make representations in merger proceedings on specific matters of public interest. The public interest assessment includes:

• whether a merger is likely to impact employment;
• its effect on local industrial sectors;
• the ability of small and medium-sized enterprises, or firms owned and controlled by historically disadvantaged persons (HDPs), to participate within the market;
• the competitiveness of national industries in global markets; and/or
• the spread of ownership, and in particular, ownership in a firm by HDPs or workers.

The broad public interest criteria empowers the competition authorities to impose a range of conditions, which has had a significant effect on a number of mergers involving foreign acquiring firms. Private equity buyers are therefore often unwilling to accept “hell or high water” undertakings given the uncertainty regarding the extent or nature of the conditions which may be imposed by regulatory authorities.

There has been limited engagement, in the context of South African deals, with the EU FSR regime.

In general, break fees are not common in private equity transactions which don’t involve listed entities. However, it is not uncommon to see a break fee in favour of the buyer in a preliminary term sheet (any such break fee often falls away in the formal transaction agreements).

Break fees are more common in public M&A deals and where the target is subject to the Takeover Regulations. Even though the amount and terms of a break fee are decided by contractual negotiation between the parties, the Takeover Regulation Panel has published a guideline advising that it will allow for payment of a break fee not exceeding 1% of the offer. Therefore, transactions which require approval from the Takeover Regulation Panel will need to comply with the above-mentioned guideline.

As noted in 6.4 Conditionality in Acquisition Documentation, South Africa has recently seen the increased use of material adverse change provisions which allow a buyer to terminate an agreement prior to completion. These provisions typically only allow for termination based on an actual material adverse change to the target’s business (termination of the agreement is typically not a remedy in relation to material adverse changes in the market or general economic conditions). Outside of a material adverse change provision, termination is usually limited to termination pre-completion of the transaction for a material breach of the transaction agreement which is either incapable of remedy or is not remedied within a certain period of time.

A typical longstop date would depend on the nature and extent of the conditions and the complexity of the transaction. Where regulatory approvals are required (especially merger controls), the longstop date will typically occur between four and six months after the date on which the transaction documents are signed.

Risk allocation is always heavily negotiated and is dependent on the nature of the business, the level of due diligence, the composition of the seller(s) and pricing. As such, risk allocation is largely transaction specific.

Sellers are typically protected through a combination of limitations on their liability. These primarily include (i) financial limitations (overall liability caps, basket thresholds and minimum claim thresholds), and (ii) time limitations for the institution of warranty and indemnity claims.

Warranties Provided by Private Equity Sellers

Private equity sellers in South Africa are typically open to providing warranties on exit. However, this depends on their percentage stake in the target company, and their involvement in the day-to-day operations of the target company. Generally, their appetite is decreasing in the context of the growing warranty and indemnity insurance market in South Africa. To elaborate, a private equity seller which held a passive and/or minority stake may refuse to provide operational warranties. These warranties are typically limited both from a financial and timing perspective (as detailed in 6.8 Allocation of Risk).

Warranties Provided by the Management Team

A management team will typically provide warranties (including operational warranties) where the management team is exiting alongside the private equity seller. A standalone management warranty deed or agreement is uncommon, although being used more frequently in the context of warranty and indemnity insurance. Where the management team is reinvesting into the target alongside the buyer and/or will continue to operate the business post-closing of the transaction, the buyer will always be reluctant to claim from its management team and will often give management assurances in this respect.

Management liability is subject to the same limitations as applied to all warranty claims and will typically be proportionate to their equity stake (usually a minority stake).

Disclosure of the Data Room

Whether a buyer is willing to accept the full disclosure of the data room will usually depend on the extent of the due diligence undertaken by the buyer and the contents and organisation of the data room. Disclosure is usually subject to the concept of “fair disclosure”.

Typical Limitations of Liability

Limitations of liability are the subject of negotiation and are somewhat transaction specific. Generally, however, the following ranges of limitations on liability are seen in private equity deals:

• de minimis of between 0.1% and 1% (although generally on the lower end of the spectrum);
• a tipping basket between 1% and 2.5%;
• the aggregate cap on claims differentiates between different categories of warranties, where typically:
1.  fundamental warranties will be capped at 100% of the purchase price; and
2. business warranties will be capped at between 10% and 30% of the purchase price (although there may be specific categories of business warranties which have a separate, higher cap – eg, anti-bribery and anti-corruption, environmental or tax warranties); and
• the time period for bringing claims in respect of business warranties ranges between 18 and 36 months, while the time period for bringing claims in respect of fundamental warranties and tax warranties ranges between five and seven years.

Specific indemnities are limited to specific risks identified during the due diligence exercises as well as in respect of any taxation payable by the target business prior to the implementation of the transaction.

Warranty and indemnity insurance has gained traction in the South African market and is attractive to private equity sellers in terms of allowing for a clean exit. Such insurance can also cover tax matters (subject to certain exclusions – eg, transfer pricing). However, the authors’ experience is that insurers are becoming more exhaustive in their underwriting processes, which has resulted in an increased number of exclusions from the warranty and indemnity (W&I) cover and increased costs associated with insured deals. As a result, this has limited the growth of W&I insurance as an effective tool for private equity sellers. That being said, there has been an increase in the use of W&I in the South African market in the last 12 months. The authors also note that insurers in the South African and African markets have indicated a greater appetite for more extensive cover for these jurisdictions, which may be driving the increase.

Whilst escrow provisions are quite common in private M&A transactions, they are rarely used in private equity transactions.

Formal court litigation is not common due to the lengthy court processes in South Africa. It is quite standard for transaction agreements to contain provisions in terms of which the parties submit to arbitration to resolve any disputes arising in respect of the transaction agreements. Arbitration proceedings are most common in relation to W&I claims.

Disputes in relation to consideration mechanics and earn-outs are typically determined by experts in terms of the specific expert determination processes set out in the transaction agreements.

There has been an increase in the number of delistings from the JSE in recent years, and an increase in delistings of small cap stocks is anticipated going forward.

In terms of Section 122 of the Companies Act, a person must notify a “regulated company” within three business days following that person’s acquisition of a beneficial interest in sufficient securities of a class issued by that company, such that, as a result of the acquisition, the person holds a beneficial interest in securities amounting to 5%, 10%, 15%, or any further whole multiple of 5%, of the issued securities of that class.

South Africa has a mandatory offer threshold of 35%. If a person, acting alone or in concert with other persons (“concert parties”), has acquired a beneficial interest in any voting securities issued by a “regulated company” and the concert parties are now, as a result of the acquisition, able to exercise more than 35% of the voting rights attaching to the securities of that company, the concert parties must make a mandatory offer to acquire all the shares of the other shareholders of the company.

According to Section 123 of the Companies Act, if a person acting alone has, or two or more related or interrelated persons acting in concert have, acquired a beneficial interest in voting rights attached to shares of a regulated company, and before that acquisition such persons jointly were not able to exercise more than 35% of all the voting rights attached to the securities of that company but, as a result of the acquisition, now exercise more than 35% of all the voting rights attached to the securities, the persons in whom more than 35% of the voting rights attached to the securities of the company now vest must give notice to the holders of the remaining shares within one business day of the acquisition. This notice must include a statement: (i) that they are in a position to exercise at least the prescribed percentage of all the voting rights attached to securities of that regulated company; and (ii) offering to acquire any remaining securities in accordance with the Companies Act and the Takeover Regulations.

Cash transactions are most commonly used as consideration. Share-for-share transactions are typically limited to internal group restructurings.

Common conditions include the procurement of regulatory approvals including competition law approval, Takeover Regulation Panel approval, exchange control approval and other industry-specific approvals, as well as any other approvals that may be required from the shareholders.

Conditions that are in the control of or dependent on the subjective judgment of an offeror or the directors are not allowed, and conditions must be objectively determinable. An offer conditional on the bidder obtaining financing is not permitted as the offer circular, which must be issued by the board of directors to the shareholders following receipt of the offer, must contain a written statement that an unconditional and irrevocable guarantee has been issued by a South African-registered bank or that a third party has confirmed that sufficient cash is held in escrow in favour of the shareholders to meet any payment obligations of a bidder arising from the offer.

Parties can agree to break fees, match rights, exclusivity arrangements and non-solicitation provisions, and such provisions are not uncommon. The breach of exclusivity arrangements, for instance, may lead to break fee payments in favour of the offeror, subject to a maximum cap of 1% of the offer as prescribed by the Takeover Regulation Panel. There are no caps applicable to reverse break fees, but these are not common in the South African context.

A majority acquisition would typically provide a buyer with the ability to control the board. Minority shareholders can seek additional protections through board representation and reserved matters. 

The Companies Act sets the threshold for special resolutions at 75% and ordinary resolutions at more than 50%. However, the memorandum of incorporation of a company may amend these thresholds, provided that there is always a 10% margin between ordinary and special resolutions.

To squeeze out minorities requires a general offer coupled with a squeeze-out. An offeror can make a general offer to shareholders of a company to acquire their shares. Each shareholder is free to accept or reject the offer, but if the offer is accepted by the holders of at least 90% of all the issued shares (other than those held by the offeror), the holders of the remaining shares can be compelled to sell their shares, pursuant to the “squeeze-out” provisions in Section 124 of the Companies Act.

It is common for an offeror to seek and obtain irrevocable commitments to tender or vote by principal shareholders of the target company. The Takeover Regulation Panel has published guidance to the effect that an offeror may approach five or fewer shareholders, each of whom holds 5% or more of the target’s issued shares, subject to confidentiality requirements and compliance with insider trading rules. A Takeover Regulation Panel dispensation may be sought to approach the top five shareholders who hold less than 5%, or to approach more than five shareholders.

Negotiations are typically undertaken no more than two to four business days prior to the announcement of an offer. This is because key shareholders are precluded from trading shares in the target company whilst they have inside information regarding a potential offer.

Key shareholders may provide irrevocable undertakings to accept a tender offer or to vote in favour of a scheme; the undertakings may be more or less qualified (“hard” or “soft”). Alternatively, they may provide letters of support for an offer, rather than an irrevocable undertaking. The undertakings sometimes provide an out if a better offer is made. The announcement of an offer must contain details of any irrevocable undertakings obtained from key shareholders in respect of the offer.

Equity incentivisation of the management team is common practice, and it occurs either through direct equity incentives or notional equity arrangements.

The management stake will vary from deal to deal, but it is usually a small minority stake (5%–15%), often with a ratchet up to a higher percentage if targets are met on exit by the private equity shareholder.

Sweet equity is relatively common in South Africa, especially in the context of start-ups and private companies. In private equity funds, investors may structure deals where they offer sweet equity to key management personnel or founders as part of the investment terms. This can help ensure that those leading the company are motivated to achieve successful outcomes.

Where management cannot fund their participation, the target or the private equity shareholder will often fund their participation through vendor finance arrangements. In this regard, dividends declared to the management shares will be used to settle the purchase price for the management shares. In such instances, management may not enjoy the full economic benefit of their shares until such time as the purchase price has been settled in full. Use of preferred instruments is not uncommon, particularly in instances where management’s participation has been funded by persons other than management. Such instruments may not have rights to dividends and other rights until the purchase price for the management shares is settled.

Preferred instruments are also common in ratchet incentives.

In South Africa, preferred instruments in such arrangements can take various forms, including preferred shares, convertible instruments and/or preferred participation rights.

Vesting Provisions

Vesting provisions are sometimes seen, particularly where management’s stake is subject to a ratchet mechanism. In this context, vesting usually refers to the entitlement date of the respective awards.

Leaver Provisions

Most leaver provisions provide for a deemed offer of management’s shares to the company or other shareholders upon the occurrence of specific events. These events would include leaving the employ of the company on good terms (also referred to as “good leaver events”), leaving the employ of the company on problematic terms (also referred to as “bad leaver events”), breaching certain key agreements and various insolvency triggers. The price for such deemed offer shares may, subject to tax aspects (as discussed below), be subject to a discount in certain instances (particularly for bad leaver events).

Management’s shares are also often subject to a specific lock-in period. After that period, management can then fully enjoy the economic benefits of their shareholding (subject to having repaid any vendor financing).

In addition, there might be a restriction on who the shares can be transferred to, be it to another management team member or someone who is not deemed a competitor of the company.

Tax – Section 8C

In determining a taxpayer’s income, Section 8C of the Income Tax Act, 58 of 1962 takes into consideration any gains or losses made upon the vesting of an equity instrument acquired pursuant to that taxpayer’s employment with a company or them holding the office of a director of that company.

In practice, Section 8C applies more commonly to restricted equity instruments; ie, equity instruments that cannot be freely disposed of by the taxpayer (often the management shareholders) at market value and/or equity instruments, ownership of which can be forfeited at a consideration which is below the market value (as defined) if the taxpayer (also management) fails to remain in the employ of the company for a specific period. When such instruments vest, the excess of the market value of such shares as at the date on which they vest over the purchase price of such shares may be taxable as income and subject to employees’ tax. In instances where management did not pay for such shares, the entire market value for the shares may be taxable.

Section 8C therefore plays an important role when considering management’s tax consequences while balancing leaver triggers, values and other provisions.

It is common practice for management shareholders to agree to non-compete and non-solicitation covenants and restrictions; however, whilst parties generally reach agreement on these matters easily, developments in South African labour and related laws have over the years made it difficult to enforce these provisions.

Such covenants must therefore always be balanced against (i) a manager’s constitutional right to freedom of trade, occupation and profession; and (ii) public policy considerations and public interest.

The law unfortunately does not prescribe the specific public policy considerations that must be taken into account, nor does it define what constitutes public interests. Nevertheless, in negotiating for non-compete and non-solicitation covenants, the covenants must not be so wide as to impede on one’s right to freedom of trade, occupation and profession, and the covenants must prescribe a specific territory within which the restrained manager may not operate, industrial practices the manager may not undertake and a reasonable period during which the covenants will be effective.

Certain of these restrictions would ordinarily be contained in the equity package, whilst others will be in the employment contract.

Minority protection for manager shareholders (where the private equity fund holds the majority stake) is always transaction specific, but it is common for management shareholders to enjoy veto rights in respect of key issues, such as the procurement of debt above certain levels, amendments to the structure of an entity, amendments to the nature of the target business and amendments to key constitutional documents. This will generally be applicable where the management shares have been fully paid for.

Anti-dilution protections for management who hold a minority stake are not common but can be negotiated in the context of specific concerns (eg, dilution in terms of shareholder funding).

Private equity funds will generally structure transactions with their exit in mind and relevant governing documents will cater for this. In that regard, there will be very limited, if any, management influence over, or restriction on the exit of the private equity fund. At best, management will have tag-along rights to sell their stake alongside the private equity fund, whilst the private equity fund will have a drag-along right to force management to sell their shares if necessary. It is not uncommon for the private equity fund to have a call option to acquire management shares at an agreed price prior to their exit. In any event, management typically undertakes to support an exit whether they retain their stake or sell alongside the private equity fund.

If a Private Equity Fund Holds a Majority Stake

Where a private equity fund holds a majority stake, control will be exercised through board appointment rights (and subcommittees, where relevant) which will effectively entitle the fund to control the board. Additional protections may be provided through shareholder approval requirements (also referred to as reserved matters), most notably in relation to issues where directors nominated by the private equity shareholder may be conflicted in terms of their fiduciary duties to the company.

By virtue of its board representation (coupled with confirmation that said directors can disclose such information to its nominating shareholder), it would get access to various information and insight into the portfolio company.

If a Private Equity Fund Holds a Minority Stake

Private equity fund shareholders generally negotiate for control rights (in the form of either reserved matters at an appropriate threshold which would include them in the vote, or in terms of a specific veto vote) in respect of key company decisions (typically including limiting borrowings, key personal changes, acquisitions/disposals of material aspects and related-party transactions). These key decisions also sometimes include deciding on company budgets, strategy and business plans. However, this always has to be balanced against competition law considerations as same could be construed as an acquisition of control of the relevant company which may create the need for antitrust filings and approvals.

Board appointment rights (and subcommittees, where relevant) are also common. However, voting would generally be linked to shareholding of the nominating shareholder (as opposed to one vote per director) so would not necessarily afford control.

Information rights would be solidified in the shareholders’ agreement to ensure that, in addition to information that they are entitled to in law, any specific reports, information or documents are provided on request or at agreed intervals. This will be driven by the private equity fund’s reporting obligations to its investors, which may include specific ESG or other information and timelines.

The South African Companies Act 71 of 2008 does provide for the piercing of the corporate veil and enables courts to lift the protection afforded to directors and shareholders by virtue of a company being a separate juristic personality.

Case law generally prescribes that the corporate veil may be pierced where there is proof of dishonesty, fraud or improper conduct in respect of a company’s affairs, such that it may be appropriate to consider any such conduct as that of a director or shareholder and not necessarily of the company, even though it has a separate legal persona.

Management teams are increasingly looking to take up a bigger stake when their private equity-backed investors exit.

The typical holding period in South Africa is usually three to seven years, but this has been extended from seven to ten in more recent years (primarily as a result of COVID-19).

Most exits are still conducted by way of secondary buyouts to other private equity firms or private sale to other companies. Dual- and triple-track exits are not common in South Africa, but do occur on occasion.

While the expectation of investors in private equity funds are still that they would, at the end of the term, share in the returns of realising all underlying investments, continuation funds are gaining popularity in Africa and Southern Africa. This option allows the investor to maximise their investment if the time is not right to exit, but roll-over or re-invest in the continuation fund while still holding onto a specific investment.

Drag and tag rights in South Africa are quite typical.

The ability to drag other shareholders can often have a minimum internal rate of return or times money back requirement attaching to it, or can be afforded to a majority private equity shareholder in light of its exit requirements, and private equity shareholders often negotiate for drag-along rights in private equity transactions. However, it is not common to see drag-along rights enforced without co-operation from the other shareholder(s).

A drag threshold will usually be 50%.

Tag-along rights do not typically have a threshold in the same way as drag-along rights; they are often given to specific minority investors.

Management teams may have specific obligations or undertakings to reinvest in the company alongside the new purchasers, even if they have tag-along rights.

Institutional co-investors may also negotiate different thresholds or conditions for drag and tag rights depending on their level of involvement and the terms of their investment and control.

There is no mandatory lock-up period, and lock-up periods are negotiable (if applicable in the context). A lock-up period would, however, generally be shorter for a private equity fund investor than the management team who may hold shares.

Where a shareholder holds a substantial shareholding in a listed entity, it is not unusual for such a shareholder to conclude a relationship agreement with the company in terms of which such shareholder may get preferential treatment, including the ability to nominate persons for appointment to the board of directors, and there may be an agreement on how the shareholder can dispose of its shares.

Private equity fund shareholders also usually get a preferential exit right on IPOs. Furthermore, it is important to manage the valuation and timing of an IPO during the process.