Sophisticated fronting is the smart guy’s trick

Investment bankers’ deals have been keeping the crown jewels in white hands for decades

THIS week, the Department of Trade and Industry held a conference to discuss the illicit practice of “fronting” in broad-based BEE transactions.

“Fronting” refers to a deliberate circumvention of broadbased BEE whereby an entity claims BEE credentials by misrepresenting facts. In short, it is lying about one’s BEE credentials.

Its most common practice is having black people registered as shareholders and directors but with no beneficial ownership of their equity and no say in running the company.

In a typical broad-based BEE fronting deal, the economic benefits of the purported ownership or directorships would flow disproportionately to the black people, if at all, and the lion’s share would be pocketed by their white counterparts.

Over the years, we have seen many reports of cases in which domestic workers and gardeners discovered they were BEE partners of their unscrupulous white “masters”.

These have never been investigated and prosecuted. Well, until now.

Recent amendments to the Broad-Based BEE Act make “knowingly engaging in a fronting practice” a criminal offence, the penalty for which is a fine, or up to 10 years’ imprisonment, or both.

In addition, a person convicted of fronting will be disqualified from doing business with any organ of state for 10 years.

The “domestic worker” cases are the obvious ones, and it’s easy to see the injustice and accept that those who engage in such practices should indeed be jailed and never be allowed to do business with the state, or anyone else for that matter.

However, the truth is that fronting has been happening for many years, in a much more sophisticated manner and by much more sophisticated people than some scruffy, khaki-wearing “master” hoodwinking his unsuspecting gardener.

In the late ’90s and early 2000s, every major South African company was under tremendous pressure to do a BEE deal. CEOs and chairmen had accepted there was no way to stop or even slow down the government’s transformation agenda. To prosper in the new South Africa, one had to introduce broad-based black shareholding.

But there was a problem. These companies were worth billions, and “selling” 26% to black people with no money, on commercial terms, appeared near impossible. The popular view was that markets and shareholders would hate it, because whichever way you looked at it, a BEE deal would be dilutionary.

So these billion-rand companies had to think of ways to tick the BEE box without giving away the crown jewels. They had to appease a Pretoria that was unwavering on economic transformation, but they also had to retain the support of Stellenbosch and Cape Town, the capital cities of South African asset managers.

A number of CEOs at the time would call BEE “giving away value to black people”. Of course, this was never said in public, with every major company CEO singing the praises of BEE and how it was the “right thing to do”. The truth is that many resented it and worked hard to devise ways to be seen to be doing the right thing without really doing it. TOUGH LINE: Trade and Industry Minister Rob Davies. His department is promising to act on BEE fronting

Enter the investment bankers — in those days the smartest guys in the room with their double-cuff shirts and Porsche 911s. Their job was to come up with structures that looked like bona fide BEE deals with minimal value leakage for white shareholders and, where there was a gap, an opportunity to profit from this BEE thing.

As you can imagine, most of the mergers and acquisitions at this time involved BEE deals, and lots of effort went into devising BEE schemes that could be sold to clients. Hundreds of millions of rands in fees were earned by lawyers and bankers for designing and implementing structures for the optimal BEE deal for their clients.

One of the popular schemes was the special purpose vehicle structure. It had two variations.

The first was to introduce black shareholders, through a special purpose vehicle, at the level of the mother company. The white company’s shareholders would “lend” the black shareholders funds to acquire the shares. The black sharehold- ers would cede their dividends to service the loan and interest and, at some point, the share price would have increased so much that a partial sale of the shares would settle the original loan plus interest.

The upside was that the BEE shareholders were the rightful owners of the equity at the mother company level on day one. Tick. The downside was that the equity was obviously encumbered, and the settlement of the debt depended on a consistently growing dividend income that outpaced the interest charge and, of course, also a flourishing share price.

As we now know, many such structures fell apart mainly because the shares didn’t perform as anticipated, dividends were not consistent and, as investment bankers say, the deals eventually went “under water”. The second SPV variation involved setting up a new company. This was initially a shell that issued 26% shareholding to the BEE shareholders at no cost, with the balance of the shares owned by the white mother company.

The “newco” would then be the official BEE company of the group. The original mother company, or crown jewel, would remain 100% white-owned and the BEE company, with its 26% black shareholding, would be the vehicle used for all government-related business.

One could recognise the products of these BEE deals by their names — often some mixture of the mother company’s name and some African verb, like “siyaya”, “siyakhula” or “ses’fikile”.

This was a great deal for the white company. It got to do a BEE deal and got a cool black name without giving away any share of the mother company. The white company didn’t have to fund the BEE shareholders or wait for them to raise capital to conclude the deal. Best of all, the group had a new subsidiary, with politically correct credentials and an incentivised team dedicated to securing government business.

The white companies didn’t stop there. They would often charge the BEE company a man- agement fee for back-office services — financial management, sales and marketing support, rent and so on — and this would often be a percentage of the revenue generated by the BEE company, which further reduced its margins from whatever government business it secured.

The white companies also recognised they had to sustain the facade that the BEE deal was a group-wide transaction. There had to be a link of sorts between the mother company, which remained lily-white-owned, and the BEE company.

To achieve this, the mother company would appoint to its board the key person in the BEE consortium, who was often a politician or struggle stalwart.

His job, other than ticking the box of being a black director, would be to report to the main board all the “business development and stakeholder management” tasks being carried out by the BEE company on behalf of the group — further entrenching the facade that a group-wide BEE deal had been concluded.

He would earn board fees, the status of being on a listed company board, in return for protecting the group’s interests with the government and regulators. We never called this a front; we called it a partnership.

As I mentioned, in a typical broad-based BEE fronting deal, economic benefits attached to the purported ownership or directorships would disproportionately flow to black people, if at all, and the lion’s share would be pocketed by their white counterparts.

The reality is that the mother company never transformed. Instead, it pocketed most of the economic value created by the toil of the black shareholders in the BEE company. So how was this not fronting? Khumalo is chief investment officer of MSG Afrika Group and presents “Power Business” on Power 98.7 at 5pm, Mondays to Thursdays

The white company got a BEE deal and a cool black name