THERE are numerous designs for black economic empowerment (BEE) participation, but they tend to be variations on two basic themes — buying shares in an existing company or establishing a new company, leveraged to facilitate the entry of black partners.

The share purchase option is becoming a rarity. The leveraged NewCo platform has become increasingly popular over the past five years and could eventually hold total sway.

A discussion of the pros and cons of the two designs explains the trend to new, BEE-friendly company formation.

In the first structure, the shareholders of ABC sell a 25% stake to black partner BeeCo. The deal may be sweetened through vendor finance or a discounted valuation on the company. The BEE consortium pays for equity with debt (usually a preference share loan).

On the face of it, higher company earnings in recent years and strong dividend streams seem to suggest that returns will be sufficient to service debt. However, buoyant earnings push up valuations, lifting the price of entry.

Unfortunately, experience shows that it is difficult to keep dividends fat enough for long enough to service interest and pay back the loan. Serial refinancing is needed.

Meanwhile, the major shareholder may become restive. Constantly pumping cash out of the business as dividends depletes the funds available for investment in new capacity and product development. It may also impede a business’s ability to spend heavily in training and fast-tracking of HDI employees, creating potential for conflict between different sets of BEE beneficiaries.

The structure has the advantage of simplicity but it is inefficient and banks generally do not advance loans to fund the purchase of shares in a private company. If things go wrong, they stand last in line to collect their debt. Furthermore, some would-be BEE owners are hesitant to take on large personal liabilities.

Smarter gearing can lead to the same result — a 25% equity sale — on a more sustainable basis. But a less onerous alternative is available.

In the second model the business of ABC, which is valued at R100m, is sold to NewCo, a structure created to enable BeeCo’s easier entry.

A bank provides R50m in senior debt (secured by company assets and cash flows). BeeCo pays in R12,5m (25% of the unfunded portion of the transaction). The owners of ABC (Pty) Ltd therefore receive R62,5m in cash and retain a stake worth R37,5m in NewCo.

Cash flow from the business (not from individuals) services the bank debt of R50m. When all arrangements are concluded and all debts are cleared, the original owner has 75% of a company that has been strengthened by its new BEE profile. Black partners own the remainder.

This approach brings an efficient, well-established leveraged buy-out structure to the realms of BEE ownership.

The BEE owners may have taken personal loans to generate their R12,5m stake, but the loan is for only half the amount required under the initial model. Because the black owners sit with only half the debt they might have taken on (eg they have leveraged their investment), their returns as 25% equity owners are sufficient to retain a significant shareholding in the NewCo. The majority shareholder receives R62,5m versus the R25m he would have received under a share sale.

The bank is comfortable with the arrangement as its loan is secured. It is now first in line for repayment in the event that the business fails.

The share purchase structure does not always fail, but it is almost impossible to execute unless the BEE investor has substantial unencumbered assets. It also often leads to the reversal of the BEE deal in the event that the dividend flow is insufficient to meet the loan payments.

The private business owner also feels frustrated, may enter into talks at different times with various black partners, none of whom can afford to pay cash for a 25% stake and who find it difficult to obtain a loan or find repayment levels too onerous.

Discussions fall flat and the owner becomes disillusioned with BEE talks that always stall when he says “show me your money”. The NewCo alternative offers a solution that more private companies are starting to explore.

Homann is director of corporate and structured finance service provider Spirit Capital.