Part 10 – Transferring ownership in private capital markets is tough

Photo by Tommy Lisbin on Unsplash

Photo by Tommy Lisbin on Unsplash

Before we discuss the various ways of structuring BEE ownership deals, it’s worth looking at why deals suck.

This article discusses the generic problems of transacting in private-capital markets (which covers 99.99% of the SA economy); the next article discusses BEE related issues in addition to these private-capital market problems.

Transacting in private-capital markets is tough:

Those who studied corporate finance at university learned the rules of the game for investing in, and raising money for, large companies that operate in public capital markets. These are the companies who raise capital by issuing shares that trade on highly-regulated exchanges and include the largest companies that are able to issue their owns bonds. When one thinks of PE multiples, buying shares, selling shares and your retirement portfolio, this is the domain.

The problem with this lens on financial markets is that in South Africa, only about 500 companies are big enough to be listed on our exchanges. There are probably another thousand or so subsidiaries of these companies, and there are about two thousand companies in private-equity portfolios (who get a lot of their funding from pension funds, so they’re indirectly funded by public capital markets). That’s the maximum scope of the public capital markets.

The other 99.99% of South African companies operate in private capital markets, where buying and selling shares comes with a lot more risk.

The table below contrasts public and private capital markets.

 Public Capital MarketsPrivate Capital Markets
Information:Symmetrical, transparentAsymmetrical, Opaque
Liquidity:High: instant transfers of minority interestsLow: long-term planning of exits/entry required
Asset allocation:EfficientInefficient
Regulation:RegulatedMainly non-regulated
Exchange:Continual buy/sell. Continous pricingHighly infrequent exchange. Point-in-time, negotiated valuation
Cost of Capital:LowHigh
Owner diversification:HighLow
Holding period:Short (seconds)Very long (years)
Transaction costs:LowHigh
PE ratio:±15x±3x

Private capital markets are very different:

From the investor perspective, it is very difficult to buy shares in private companies and even more difficult to sell them – investors often hold their shares for many years more than they planned or want. The price must be negotiated each time (there is no ready market price, so bespoke valuations are required, and the final price is often only determined after months of negotiations and at expense to the parties). Both buyers and sellers incur significant search and transaction costs. There is far less regulation or oversight and limited investor protection. Information about a company’s performance is typically delayed, at point-in-time, opaque – and sometimes manipulated. The existing shareholders may be wanting a partner who’ll be there through thick and thin, rather than an anonymous and emotionally unavailable investor. Lastly, the other shareholders are often also management – so there is no ethos separating ownership and control and governance can be very weak. Still want to buy shares in a private company?

All of this leads to additional investor risk, which means that average prices paid for earnings are far lower than in public markets (typically by as about 70%).

Why some companies never sell:

Research in the EU around the SME market (i.e. ‘privately-held’ companies) found that the typical business raised money/transferred shares about once every 12 years. i.e. most privately-held companies very rarely sell any shares or even the whole business (vs. several hundred times a minute in liquid listed companies).

One of the reasons for this is that with private-company valuations in the 2-5 PE range, the owner of a business looks at either selling a business (or share thereof) for say, 2x profits or he just holds onto the business for another 2 years and gets all those earnings plus those still to come too. With low valuations the hassle of selling shares to 3rd party is often not perceived to be worth the upside. The converse is true too – the prospective buyer of shares in a privately-held company might get a cheap price coming in but will also find themselves largely unable to unlock any value when they eventually want to sell. Thus, it’s unsurprising that the biggest drivers of transactions in private capital markets are factors outside of the business itself – typically the illness/death/incapacity of a shareholder, divorce, other major life changes, or the owner having reached a position from which they want to retire.

It’s against this backdrop that BEE ownership deals in SA must be concluded; these add further challenges to this space. We’ll cover BEE specific issues in our next article in this series.

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