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In previous chapters I had examined the existing literature on transition economies (see. Chapter 2) categorizing transition economies in terms of the speed of the transition process and in terms of the mode of the transition. In the chapter, it was posited amongst other things that the new institutional framework the transition creates allows for the development of a new entrepreneurial activities and a new entrepreneurial class. In chapter 5, I then went on to show using the South African case, how organisations within the private sector can play an important role in establishing market type institutional environment which may facilitate the emergence of new business activities.
Nonetheless, the growth of business activities in transition economies face two challenges (Karsai et al., 1997; Wright et al., 1999; Filatotchev et al., 1996). First, firms in transition economies face the issue of finance, as the previous unsecured loans which were provided by the central government of these economies were no longer available post the transformation; as the extension of credit to individuals and organisations were transferred from government's monobanks to a new set of financial institutions, the banks. And as these new financial institutions gave out loans cautiously to individuals and organisations an equity gap emerged due to the variance between the demand and the supply of capital to entrepreneurs. The equity gap that emerged as a result of this created a funding crisis because entrepreneurs lacked the necessary collateral to secure the funds they needed. This was the case in South Africa as many South Africans (mostly the previously disadvantaged black South Africans) had no economic record that could allow them secure the needed capital. Second, organisations faced the problem that was associated with corporate governance. Corporate governance is the system by which companies are directed and controlled and it involves holding board of directors accountable for the interests of all contracted stakeholders of the company, such as shareholders, employees, suppliers and customers (Rossouw et al., 2002)
These problems are inter - related, as an access to external finance is imperative for effective governance and effective governance is a prerequisite for an easy access to external finance (Karsai et al., 1997). This dual problem of access to external finance and adequate corporate governance principles can be addressed by the introduction of active investors such as venture capitalists (Karsai et al., 1997; Filaltotchev et al., 1997). Venture capitalists' unique style of financing helps to solve the problem associated with the finance for entrepreneurs as they bring equity finance into their portfolio companies. In terms of corporate governance, the presence of venture capitalists as outsider investors with significant equity stakes in their portfolio firms provides a significant influence on the management of the firm (Sapeinza et al., 2000; Sapeinza and Gutpa, 1994). Furthermore, ....
For the purpose of this research on a transitioning economy, I employ Karsai et al's (1998) definition of venture capital. Their definition of venture capital encompasses more than just the classical early stage investment opportunities. Even as Avnimelech and Teubal (2006) argue that the definition of venture capital based on early stage investing only is a narrow definition of venture capital. They argue that, later stage investment opportunities such as specialist portfolio investment in small companies, provision of subsequent rounds of development capital for later stage of business expansion and financing of management buyout or buy - ins (Klonowski, 2005) be included in a broad definition of venture capital definition across countries.
Although scholars traditionally separate venture capital investing from later stage private equity investing, a broader definition of venture capital which includes all firms of the venture capital industry (early or later stage investing) helps provide a comprehensive description of the emergence of the venture capital industry/private equity industry (Bygrave and Timmons, 1992; Karsai et al., 1998). Therefore, this chapter which is on the evolution of the venture capital industry in South Africa uses the term "venture capital" to refer to both venture capital/private equity investment activities as a whole.
South Africa's socio - economic transition and its economic stabilisation post the transition, that is, the transition from apartheid to democracy, has provided a strong foundation for the expansion of the country's financial services industry. The young venture capital industry has played an instrumental role in the development of the post apartheid South African economy, as the industry provides access to capital to entrepreneurs who might have faced difficulties in attracting capital during the apartheid years.
The success of many countries economic development has been associated with their respective individuals levels of their venture capital industry (Jengs and Wells, 2000; Wright et al., 2005). For instance, figures show that in the US, companies backed by venture capitalists' employ over 12.5 million people (Bruton et al., 2005). In addition, many multi national companies such as Intel, Microsoft, Apple and Starbucks may not have existed or grown to the level which they are today without the help venture capital funding (Bruton et al., 2005; Gompers and Lerner, 2001). However, the development of a venture capital industry in these countries involves a combination of variables, which includes the size of the technology sector (Avimelech and Teubal, 2006), the existence of an active financial market (Black and Gibson,1998 ) and government incentives (Lawton, 2002, Murray, 1995; Megginson, 2004; Lerner, 1999). Since the early 1990s, the South African venture capital industry has grown and evolved over the past few years. Nonetheless, the industry's growth is not immune to the challenges that have a growing industry in a political transition economy.
The aim of the chapter is to investigate the emergence of South Africa's venture capital industry along the 3 epochs described in chapter 4, the methodology chapter of this thesis. This is done with a motivation of understanding the institutional issues might have driven or restrained the growth and development of the industry and to determine to what extent these factors might have had a bearing on further evolutionary process within the industry. The chapter also shows the role played by the South African state in the emergence of the venture capital/private industry in South Africa. Besides, it has been argued that the emergence and development of a venture capital industry follows a co - evolutionary pattern (Avinimelech and Teubal, 2006; Dossani and Kenney, 2002) in which the growth of the industry is influenced by the interactions between factors affecting the general cultural, legal, and institutional environment (Dossani and Kenney, 2002; Avimelech and Teubal, 2006). For instance, Dossani and Kenney (2002) show how the emergence and the development of the venture capital industry in India followed a co - evolutionary process in which the young industry's growth was highly dependent on the evolution of the government and its institutions. Furthermore, Avimelech and Teubal (2006) showed how Israel's venture capital industry evolved along side with evolving high - tech industry in Israel. Thus, examining the evolution of the South Africa venture capital industry helps us understand the co - evolutionary pattern of the development of this unique industry along side with the emeregnce of the South African state. Furthermore, studying the development of a venture capital industry can help scholars to identify how the value added services venture capitalists provide to their evolved (Avimelech and Teubal, 2006) in transition economies.
However, prior to this, the chapter examines the literature on the evolution of a venture capital industry as this helps depict the emergence of the South African venture capital industry as a unique evolutionary story. Along with the interview experts presented, the industry demography which is derived from the industry association body, SAVCA is also presented, other data presented in this chapter are archival data from the reserve bank of South Africa and a from previous refereed academic research. It is envisaged that SAVCA's data would be reliable and unbiased as the data is complied by an independent body.
Thus, the remainder of the chapter is structured as follows: Section 6.2 examines the literature on the evolution and emergence of venture capital industries within countries. However, the section does not attempt to review the whole literature on the evolution of venture capital industries across borders as this has been adequately carried out by Wright et al., (2005). Nonetheless, the section presents the necessary institutional components that may facilitate the growth of venture capital in any country, especially transition economies. Section 6.3 presents the literature on the life cycle of venture capital industries distinguishing from the life cycle of a venture capital firm. While an analysis of the emergence of a South African venture capital industry within 3 periods - end of apartheid; Mandela government; Mbeki government - is presented in section 6.4. Section 6.5 examines specific South African legislations that have had huge impact on the growth of the industry, while a conclusion is drawn in section 6.6.
The Evolution of a Venture Capital Industry: General Overview
Multiple theoretical lenses (e.g. institutional theory, population ecology) have been used to investigate the emergence of venture capital industries in many countries across diverse academic streams (e.g. finance, management, entrepreneurship). Findings from these studies have increased the body of knowledge on how venture capital firms in countries emerge and the necessary institutional requirements that facilitates an emergence of venture capital industry in countries. For instance, from an institutional theoretical perspective, arguments have been that for venture capital industry to emerge in any country an active stock market would be present (Black and Gilson, 1998; Jengs and Wells, 2000) as this provides an exit mechanism for venture capital firms. Furthermore, Cumming and Johan (2007) posit that a legal institutional environment strongly influence the amount of capital available for venture capital/private equity investment, as they argue that, the presence of regulatory control and disclosure of venture capital/private investments helps to increase the amount of capital allocated to private equity firms by institutional investors. Similarly, Wright et al., (1992) investigating factors necessary for later stage venture capital investment, i.e. management buy - outs and buy - ins, posit that institutional infrastructures creates buy out opportunities and can facilitate the growth of the later stage venture capital industry. Institutions are of great importance to the growth of a venture capital industry in any country as they shape venture capital emergence and explain the differences in venture capital behaviour across countries (Bruton et al., 2005). From a population ecology theoretical lens, Manigart (1994) present empirical evidence to show that the growth of venture capital firms in neighbouring countries have a positive effect on the growth of venture capital firms in any country.
However, asides from the institutional environment and the influence from neighbouring venture capital markets, other elements are required before a venture capital industry can spring up in any country. For an active industry to emerge in a country, three important elements are required (Karaömerlioglu and Jacobbson, 2000). They are: an institutional environment that would enhance the growth of a venture capital industry, favourable government legislations and incentives from the government, the competence of the venture capital firms. First, as earlier mentioned the institutional set - up of the environment in which the industry is embedded is an important determinant of the emergence of a venture capital industry. Since institutions provide the blueprint for all organisational activities (North, 1990), thus, the institutional environment of a country can influence the emergence and the evolution of the venture capital industry in a number substantive ways (Bruton and Ahlstrom, 2003). For a venture capital industry to thrive, market type economic institutions are required. Market type institutions such as a well defined regulatory framework that provides legal protection to all stakeholders of companies (La Porta et al., 1998; 2000). As a strong legal investor protection is associated with effective corporate governance principles (Bruton et al., 2005; La Porta et al., 2000), which is also a requirement for a venture capital industry to emerge. Also, the growth of developed venture capital industry is dependent on an active capital market (Black and Gilson, 1998, Jengs and Wells, 2000; Megginson, 2004) as this provides the most lucrative exit mechanism, the IPO mechanism, for venture capital firms to exit from their portfolio companies. The impact of this regulatory difference can have a major impact on the nature for exit for VC - backed firms.
Another major requirement for an emergence of a venture capital industry is the government legislations and incentives the state provide to venture capital firms in order to encourage the industry's growth and development. As with many countries, government legislations have been a key catalyst that provided a spring board for the growth and the emergence of an active venture capital industry. For instance, Avimelech and Teubal (2006) argued that the Israeli government's program, the Yozma program, was the event that triggered the emergence of a venture capital industry in Israel. "The Israeli government created a government - funded organisation Yozma, [which was] meant to encourage venture capital in Israel. Yozma received $100million from the Israeli government" (Dossani and Kenney 2002:5) for venture capital investing. In a similar manner, the Swedish government created 2 large investment companies, Atle and Bure, in order to spur venture capital activities in the country (Isaksson et al., 2004). For the venture capital industry in the US, the government's lowering of the top personal income tax rate on realised capital gains from 35 to 28 percent in 1978, and its adoption of the Prudent Man Rule in 1979 which allowed further allocations from pension funds managers to venture capital investing were arguably the major catalyst for the growth and the development of the industry (Megginson, 2004). Thus, government legislations form an important element that may bring about the growth of a venture capital industry in any country.
The third element is the competence of the venture capital firm - that is, the amount of the value added services venture capital can provide to their portfolio firms. In addition to the capital provided to entrepreneurs, venture capital firms also provide some "competence capital" which is the value added services they provide to their portfolio companies (Timmons and Bygrave, 1986). These value added services that venture capital firms provide is a principal distinguishing factor between the venture capital industries other fund providers such as banks. The value added could come in from the networking assistantship, supportive roles or strategic assistantship (Gorman and Sahlam, 1990; Sapienza et al., 1996; Sapienza 1992; Sapienza and Timmons, 1989). The extent to which venture capital firms can provide these services to their portfolio companies and the extent which these services increases the potential success of these organisations is directly related to the growth of a venture capital industry as fund seekers would rather seek capital from venture capital firms would provided other services that can increase their firm value than seeking finance form organisations such as banks who provide debt finance only.
A principal reason for the venture capital involvement with their portfolio firms through the value added service they provide is to improve the profitability outcome of the firm and to enhance a co - operation between the entrepreneurs and the fund providers (Knocknaert et al., 2006). The extent of venture capital firms' involvement with their portfolio companies varies from venture capitalists to venture capitalists, depending on the performance of the portfolio company, the stage of investment and the experience of the venture capital firm (Macmillian et al., 1988).
In addition, when compared with venture capitalists in the West, the nature of the value added services rendered by venture capitalists differs from venture capitalists in the transition economies (Bruton et al., 2004). Bruton and Ahlstom (2003) posit that this difference is because there is a low managerial sophistication in transition economies. Furthermore, with an examination of the venture capital in transition economy, China, Bruton and Ahlstrom (2003) posit that the differences in cognitive culture institutions of countries allow for differences in the value added services provided by venture capitalists between countries as venture capital firms operating in transition economies cultural perceptions of entrepreneurs in that country.
In sum, market type institutional environment; favourable government legislations and incentives; the competence of venture capital via the nature of their value added are elements that facilitate the emergence, growth and development of a venture capital industry.
The Life Cycle of a Venture Capital Industry In Transition Economies
The evolution of the emerging industries especially in transition economies follows a life cycle pattern (Jargic 2003; Klonowski 2005). The life cycle model documents that emerging industries growth rate follows a distinctive pattern of an initial exponential growth rate, below a sharp decline which precedes the natural state of the industry (Klepper and Graddy, 1990). During the growth stages of the new industry, the small number of firms and the limited amount of production encourages new entrants into the industry (Jovanovic and MacDonald, 1994) as the industry still as enough carrying capacity and resources to accommodate new entrants. However, at some point new industries reach a phase in which the industry growth stabilizes and some firms within the industry are selected out. This stability point is triggered by 'chance events' and other exogenous factors that restrict the number of new entrants and the growth rate of firms already in the industry (Klepper and Graddy, 1990). Using the venture capital industry, Manigart (1994) also present similar findings to show that evolution paths of the venture capital industry in three countries, Netherlands, France and the UK, follow evolutionary pattern described in which she showed that when the number of firms in an emerging industry is low, the industry experiences an increased founding rate. However, as size of the industry increases, the fight for limited resources reduces the founding rate of new firms in that industry.
The evolution path for an emerging venture capital industry follows a 5 stage model (Avinimeclech and Teubal, 2006) while Klonowski (2006) propose a 3 stage model for the evolution pathway of an emerging venture capital industry. Avimelech and Teubal (2006) five stage model comprises of: background conditions, pre - emergence, emergence, crisis and restructuring, and consolidation. The first and second stages of Avimelech and Tuebal's venture capital life cycle model creates the precondition necessary (such as the enabling institutional environment) for the emergence of a venture capital industry. The crisis and restructuring stage allows for the smoothing of the industry as non - performing venture capital firms are selected out this allowing for an industry consolidation in stage 5. Similarly, Klonowski's (2005) three - stage venture capital life cycle model of: Development, Expansion and Correction - argues that after initial development and expansion of the venture capital industry, a correction phase occurs in which the amount of the capital raised declines sharply as the investment opportunities within the industry declines. Nonetheless, as with most new industries, it usually takes time for new venture capital industry to enter into the correction (Klonowski, 2005; Klepper and Graddy, 1990) or the crisis and restructuring (Avinimelech and Teubal, 2006) phase. This length of time is known as the learning period (Karaömerlioglu and Jacobbson, 2000). Baldwin (1969) defines the learning period for emerging industries as a period where the industry's production cost of goods and services is higher than the equivalent cost of importing such goods and services. The learning period cost is usually incurred at the early years of the industries, however, there is a gradual reduction of this cost as the new industry grows (Jacobbson, 1993). The length of the learning period varies from industry to industry (Klepper and Graddy, 1990), ranging between 2 to 50 years (Aldrich and Fiol, 2005). For a service industry like the venture capital industry, the learning period could be defined as a period in which the young industry fights for legitimacy, a period where professional behaviour is formed and is generally accepted. It is also a period where allows for the formation of a venture capital association that would represent the industry.
Scholars have suggested a number of criteria for measuring the growth and the development level of emerging venture capital industries. Karaömerlioglu and Jacobbson (2000) suggested that the size of the venture capital industry (in terms of the total cumulative funds raised for investments); the diversity of the country (in terms of the number of the firms covering all stages of venture capital financing) and the competence of the venture capital firms as the techniques to be used to measure the maturity of the venture capital industry. Murray (1995) posits that the actual and the potential growth of venture capital can be measured in terms of the total investments committed by the venture capitalists to portfolio companies and by the amount of external finance raised for future investment activity by the industry. However, the 3 most used measures for analysing the growth of a venture capital are: the number of the venture capital companies, the number of professionals in the industry and the amount under management (Bruton et al., 2004). The preceding section maps out the evolution of the venture capital industry along the 3 periods described in the methodology chapter.
The Evolution of South Africa's Venture Capital Industry:
Unlike many countries' venture capital emergence stories, where government initiatives were the initiating triggers for the growth and the development of a venture capital industry; the emergence of the venture capital industry in South Africa was somewhat different. The South African venture capital industry emerged as a result of the many disinvestment the country faced by many multinationals companies during this period.
These multinational corporations faced with an increasing pressure from the home citizens who questioned their continued existence in an apartheid South Africa where human rights violation was at an apogee. Their citizens argued the multinationals continued existence in South Africa signified an indirect support to the apartheid state. The government and the citizens of multinationals companies operating in South Africa argued for a disinvestment by the multinationals away from South Africa. As they argued that such economic sanction via the withdrawal of trade operation from South Africa would put pressure on the apartheid led South African government that might bring about socio - political change in the form of ending apartheid (Malone and Gooding, 1997; Lansing and Kuruvilla, 1998).
With these disinvestments, multinationals sold off their stake either to white South African investors or to their local management, all at discounts as their buyers could not afford to buy at the companies' intrinsic value. For instance, Barclays Bank in November 1984 withdrew 40% of its investments by selling it off to their staff for R166 million rather than its original value of R200million, a discount of 17% (Jenkins, 1990). Also, General Motors sold its interest to Delta Motor Corporation (Malone and Gooding, 1997). These transactions represent one of the industry first quasi private equity investments. However, other organisations such as Eastman Kodak disinvested completely, withdrawing all its physical assets from South Africa.
The South African economy suffered immensely during this period as it was the period in which apartheid was still entrenched the socio - political system of the South African state. The country experienced diverse disinvestments, withdrawal of loans by international financial institutions which had a negative effect on the South African economy (see Table 6.1). For instance, Table 6.2 below shows South Africa's outstanding with major financial institutions as at 1985, this shows the extent to which the South African economy was on foreign capital for their economic development. And with this non extension of these loans after 1985, the South African economy collapsed.
The Comprehensive Anti - Apartheid Act passed by the US in 1986 played an instrumental role on the demise of apartheid as it not only limit US trade with South Africa, the law instigated negotiations with the ruling apartheid South Africa state and the previously regarded terrorist group, the ANC. The legislation stated that:
The United States shall encourage the ANC to:
- Suspend terrorist activities so that negotiations with the government of South will be possible
- The US shall encourage the ANC to make Known their commitment to free and democratic post - apartheid South Africa.
- The US shall encourage the ANC to re - examine their ties to the South African Communist party
- The United States government will support negotiations between the representatives of all communities in the South Africa and the South African government agrees to enter into negotiations without preconditions, abandons unprovoked violence against its opponents, commits itself to free and democratic post - apartheid South Africa, and the ANC refuses to participate or to 1) abandon unproved violence, or 2) to commit themselves to free and democratic post - apartheid South during such negotiations, then the United States will support negotiations that do not include the ANC. (The Helms Amendement,1984 Sections 102 - 311, in Redden, 1988)
This legislation changed the socio political landscape of the South African state, as the legislation gave international legitimacy to the ANC party, it would be no longer seen as a terrorist movement by the US and the international community if it was willing to enter into negotiations for transition with the ruling apartheid government. Also, in order to avoid further economic sanctions, the ruling apartheid government was compelled to enter to negotiations with their long term enemies. These institutional events via negotiations, disinvestments, transition and transformation created the institutional background that paved way for a development of a venture capital industry in South Africa.
Specifically, with respect to the venture capital during this period, its investment activity was low. The South African venture capital industry had not been established, and only one capital venture capital/private equity firm, Ethos private equity which was established in 1984 was in existence. This is rather strange considering that a market type institution such as a viable capital market (the Johannesburg Stock Market); well defined corporate governance principles were entrenched in the regulatory structure that govern business practices (Rossow et al., 2002). Nonetheless, only one venture capital/ private equity form was registered during this period. One intuitive argument for the low number venture capital firms during this epoch was that although a market type institutional environment that might have facilitated the emergence, growth and development of a venture capital industry was in place in South Africa, the political uncertainty that the country faced restricted investors (both local and foreign investors) to commit their monies to venture capital investment in South Africa. On the issue of raising funds, my respondent at Ethos stated this about Fund 1, their first fund which was raised in 1984:
"We are on our 5th fund. Our 1st fund was off a bank's balance sheet, it was a captive fund and our fund 2 started in 1992 that was a third party fund. Fund 3 was a 1996 fund and that was the first fund with non - resident investors, US investors and 1998 we raised fund 4. The fund in 96 was about 760 million rand, fund four was 1998 vintage and that was about 2.4 billion rand. In that one, we had about 50% foreign investors. In fund 3, in the previous fund we had about 38% foreign investors. Then we raised fund 5 in 2005, that was 5.5 billion and we have approximately 75% foreign investors".
This statement does not only show the huge increase in the amount of capital committed over time as the transition process began. Interestingly, it also shows the change in source of finance committed to venture capital firms over time in South Africa. Only after the political transition process was fully under way, in which Mr. Mandela had spent two years of his 5 year term in office, only then did foreign investors began to show interest in the South Africa venture capital/private equity market. Thus, suggesting that the market of a market type institutional environment is not enough to lure investors to commit capital to venture capital firms into transition economy. Rather, for investors to be interested in the venture capital industry in transition economies, market type institutions must be in place, but also the political environment of the country must be seen as been stable.
In 1991, Brait private equity joined the private equity space in South Africa. This also suggests that with the release of Nelson Mandela in 1990 and the negotiations that began almost immediately after between the opposing political parties signified a birth of a new political South Africa which instilled business confidence that allow for the emergence of a venture capital industry.
This second period represents ANC's first tenure with governmental power. In the eyes of the private sector the Mandela government was a government with a reconciliation mandate. It was also a government that was meant to establish the economic policies of the ANC party. During this period the economy of the South African state improved (see, Table 6.3); economically, this was the period in which the ANC government changed its policy on the role of the state from a RDP policy to the GEAR economic policy. It had changed its policy from that of a socialist state through the nationalisation of firms back to the known market type economic policy as it embarked on privatisation of many SOEs. This privatisation strategy was arguably adopted from the White Paper released by the ruling apartheid party in 1987, the White Paper on Privatisation and Restructuring, which the previously ruling party had attempted to embark upon but failed because of the immense pressure from the ANC and its allies who had argued that it was a plot by the National Party to deny the ANC party the "family jewel" by the time they came into power (Jerome, 2004).
The Mandela led ANC government was not able to achieve much in the area of the privatisation of SOEs as it fought criticisms from the business corporate and the trade unions. On the one hand, the trade unions like COSATU kicked against the 'restructuring of assets programme' (as the government did not call it privatisation in order to avert possible industrial actions) as they argued that the restructuring was against the RDP economic policy which was the platform on which the ANC based its socialist economic policies. On the other hand, the business corporate criticised the government on the slow pace of the privatisation programme. The ANC party responded with a statement which stated that:
The ANC is convinced and satisfied that the government programme of restructuring state assets is proceeding with the ambit the of the ANC policy as adopted in the Reconstruction and Development Programme and elucidated in numerous other documents.
As the movements, we have found nothing untoward in the restructuring programme by the government. Its focus and objectives are within the parameters of the ANC economic policy. (www.anc.co.za assessed on
In February 18, 1995, the National Framework Agreement (NFA) was setup under the National Economic Development and Labour Council (NEDLAC) to address the issue of restructuring, the committee comprising representatives from the government, the labour and the corporate agreed that:
The initiative to restructure state assets is part of the process of implementing RDP. Government has concretised some of these objectives in its so called "six pack" programme namely: belt tightening: reprioritisation of state expenditure; restructuring of state assets and enterprises; restructuring of the public service; building new inter - governmental relations; developing an internal monitoring capacity for the above programmes.
The purpose of restructuring state assets is to re - orientate and (e)inhance the public sector's ability to meet the challenges and requirements identified by the RDP. In this context, it is the role which the enterprise can play in achieving transformation and transition goals as set out in the RDP which should inform decision - making. This requires new structures, new mandates and change management. (www.nedlac.co.za assessed on
During this period, many venture capital/private equity firms were established with an increased size of funds committed to the industry. However, no statistical data is available to support this but the establishment of a venture capital association in 1998 arguably showed that there was a considerable increase in the size of venture capital firms during this period. SAVCA was primarily established to lobby government in order to promote regulations that would enhance a further growth of the industry. SAVCA objectives include some of the following:
- Promote the venture capital and private equity profession in Southern Africa
- Represent the profession at the national and international level
- Develop and stimulate professional and transactional venture capital and private equity investments throughout Southern Africa
- Collect information from markets and from members
- Provide the relevant authorities with proposals for improvement in the corporate, fiscal and legal environment for venture capital and private equity in Southern Africa
- Maintain ethical and professional standard
On the establishment of SAVA, the respondent from SAVCA stated that:
SAVCA ""was primarily built of a need that this industry was starting to grow..., and it needed an industry body to represent its interest. The objectives all set up on our website is primarily to lobby, represent the industry, do research on the industry and try to think about the future of the industry and where should it be going and the likes. [The industry has] grown to today 65 full members, managing just on 86 billion Rand of capital and 30 associate members which are service providers, consultants etc stakeholders such as incubators, lawyers accountants and the likes".
This statement and the objectives that was culled from SAVCA's websites on the issue of 'lobbying' seems to be the association's initiative of gaining legitimacy for the venture capital firms with the South African government in order to allow the government enact laws that would allow for a further growth and development if the industry. Also, with the establishment of SAVCA in 1998, one can arguably say that the learning period for the industry was period 1, prior to the formation of SAVCA, in which the industry's norms and practices were yet to be established.
This period represents another phase of South Africa's political transition with the election of Mr. Thabo Mbeki (the former South African Vice President) as the new South African president who recently as the South African president in 2008, few months before the end of his second term in office
The Mbeki government was face with two major responsibilities (Southall, 2007) - the responsibilities of restructuring and transformation. With the GEAR economic policy, the Mbeki government canvassed for a restructuring program of state owned enterprises (SOE) as a necessary tool for an economic growth, an increase in foreign investments and as a source of funds for the country to repay its international debt (Gumede, 2005). The ANC government had inherited over 300 SOEs which employed over 300,000 South Africans (Southall, 2007). Nonetheless, SOEs were dominated by 4 organisations - Transnet, Denel, Telkom, and Eskom - which controlled about 91% of the estimated total assets of the 30 largest SOEs and provided 86% of their turnover and 94% of the net income and employed 77% of their employees (Financial Mail 26.06. 99 in Southall 2007).
However, although the Mbeki government argued otherwise, its restructuring program was more or less a partial privatisation program. The South African government in its document released by the Ministry of Public Enterprises titled "An Accelerated Agenda Towards the Restructuring of State Owned Enterprises" stated that:
"In summary, [the] Government's policy with regard to state owned enterprises is more properly referred to as a restructuring programme and not in the more simplistic terms of privatisation. The programme was and remains designed around a multiple array of strategies, or mixes of options, that are designed to ensure the maximisation of shareholder interests defined in economic, social and development terms. Thus restructuring refers to [a] matrix of options that include the redesign of business management principles within enterprises, the attraction of strategic equity partnerships, the disinvestment of equity either in whole or in part where appropriate and the employment of various immediate turnaround initiatives" (pg. 4)
One argument for the change of name from "privatisation" to "restructuring" was to pacify the trade unions like COSATU who saw a privatisation by the government to connote mass retrenchment. For instance, at the beginning of the privatisation plan in 1996, COSATU had threatened a one - day anti privatisation strike. The government went on with its privatisation programme in 1999, for instance, 20% of South African Airways was sold to Swissair for R1.4 billion.
On the issue of transformation, the government transformation agenda centred around two objectives (Southall, 2007). 1) to increase the number of black South African employed in SOEs 2) to increase the amount of procurement contracts awarded to black business ventures and enterprises. With the staffing objective the Mbeki government achieved this by appointing black South Africans to middle level and senior level positions within the SOEs. For instance, table 6.1 shows the current composition of the executives of the 4 largest SOEs in South Africa. This raised tensions among white South Africans who argued that free market principles was being jeopardised for the issue of political correctness (Southall 2007: 211). Also on the issue of procurement, the Mbeki government was criticised for the issue of empowering black South Africans to conflict with profitability. However, the government maintained that previous NP government; the apartheid government had also used state parastatals to empower Afrikaners in the past (Southall, 2007).
With respect to the growth and the development of the South African venture capital industry during this period, the industry experienced an increased growth: in terms of the amount of funds committed by investors for venture capital/private equity investing; in the number of venture capital firms and in the number of professionals within the industry.
Figure 6.1 above clearly maps on this growth terms of the increased in funds under management by the venture capital/private equity firms. The industry experienced an increase from R35.9 billion in 2001 to R103.1 billion in 2008, an annualised increase of 121.88%. This invariably increased the number of venture capital/private equity deals. One the issue of change within the industry, 2 interview respondents commented that the industry has experienced an increased in the amounts of funds committed for venture capital investing by investors, as one mentioned that:
"I think the change is [in] the weight of capital .... We [now] have the weight of capital to hold in many cases majority or controlling positions in very large companies. Back in those early days, we were doing small buyouts, still in most cases holding majority but they were small investments. So really that has been the real quantum leap in the growth of the industry".
The other respondent mentioned:
"Ok, a number of things [have changed], let us break this down. In terms of funds raising, obviously funds have increased significantly to 86billion (figures as at year end 2007), you've seen the graphs and where they go. The profile of the people or institutions providing capital has changed somewhat. Initially, [there was] a lot of local capital, then a lot of international capital and now[there is] a kind of balancing act in terms of that, so you know [from] all funds raised, some 25% is South African capital, 34% is US, 27 is UK and then some other you know Canada, Asia etc".
In addition to the increase in funds under management by venture capitalists, the second respondent also commented on changes in the source of funds that has occurred over the years. During this epoch, especially, with the economic stability that the Mbeki government provided to the private sector, the South African venture capital industry experienced an increased in interest shown towards the industry by foreign investors, especially investors from the US and the UK, the topmost venture capital/private equity industries in the world. However, as at 2008 no known foreign venture capital firm was in operation in South Africa.
The industry also experienced growth in the number of professionals within the industry. For instance, in 2001, "the number of professionals grew to 322 from 294 in 2000" (SAVCA Annual Report, 2001:10). With respect to the number of venture capital firms, the industry has under gone a sizeable increase in number from 34 firms in 2000 to 74 firms as at March 2009 (see figure 6.2). These firms consist of captive venture capital firms, government venture capital firms and independents that usually exist within a venture capital industry. The primarily difference in this categorization is the of venture capital firms is their source of funds. For captive venture capital firms, they are subsidiaries of financial institutions like banks, while capital for government venture capital is firms provided by the state. Independent venture capital firms managed funds for their limited partners while they act as general partners for the funds they managed (Megginson, 2004).
Table 6.1 below presents the funds under management for this epoch in the proportion of classes of venture capital firms in South Africa. One interesting thing about the table is that since 2002, captive venture capital firms in South Africa seem to control about half of the total funds under management. However, many of these firms who have subsidiaries of South African banks manage their funds off their bank balance sheet.
Like with many venture capital industries round the world the venture capital industry in South Africa is predominately focused on later stage investing (see table 6.2). While on the exit mechanism for venture capital firms, although the country has an active capital market in place, firms in the industry seem to be generally geared towards exiting through trade sale and lately sale to another private equity firm (see table 6.3).
The South African Government Legislations and its effect on the Growth of a Venture Capital Industry in South Africa
As earlier mentioned, favourable governmental legislations is key to the success of any venture capital industry in any economy. As these legislations lay institutional frameworks and provide industry incentive that may facilitate the growth and development of an emerging industry. For the emerging venture capital industry in South Africa, three government legislations have had an impacting influence on the growth of the industry. They are: the Exchange Control legislations, the Regulation 28 of the Pension Act of 1991, the Broad Based Economic Empowerment Act of 2003.
The South African state introduced the exchange control regulation in 1961 during the thick years of the apartheid in order to "check a deterioration of [the] capital account balance of payments" (South African Reserve Bank, 2001) which was caused by the huge amount of disinvestments the South African economy experienced. Among other things, the exchange control regulated the repatriation of capital away from South Africa as a parallel exchange rate system for the Rand was introduced. Companies were only allowed to repatriate funds at the "financial rand" rate which was a 40% discount to the commercial rate (Levy, 1990). However, although the South African government has since relaxed this regulation with the abolition of the financial rand rate, nonetheless, the current exchange control laws still monitors the flow of funds in and out of the South African economy.
At present, outward investment for a South African individual outside the Southern African Common (CMA) (i.e. Lesotho, Namibia, South Africa, and Swaziland) is restricted to 2 million Rand. While for companies seeking outward investments which exceeds R50 million per calendar year must seek approval from the Department of Financial Surveillance. Other bureaucratic procedures for outward investments by South African firms include the submission of:
- Full details of the longer term monetary benefits to be derived by the Republic (i.e. South Africa) on continuous basis, substantiated by cash flow forecasts.
- A pro forma balance sheet of the offshore entity reflecting the financial position immediately prior to and after the investment from the Republic.
- The proposed financial structure of the entity to be acquired or to be established.
- Where applicable, an estimate of the annual running expenses of the offshore entity (South African Reserve Bank).
The way this regulation affects the venture capital in South Africa is on the issue of the internationalisation of local venture capital firms investing outside Southern Africa as the red tape that comes with investing aboard limits venture capital firms deal structuring outside the region. The region also limits the possibility of an international exit as the government maintains that at least a 50% stake most must be maintained with international subsidiaries at any point in time. A respondent mentioned on the issue of exchange control and how it affects in the industry that:
"In essence what is says is that exchange control doesn't allow what they [the government] refer to as a loop structure. Where [a] South African Entity cannot hold shares in a company that is offshore that holds assets in South Africa. So what happens is that when a VC fund looks to exits or get into global type of market which is where the bigger type of returns are made..., [the exchange control laws] leads to premature [international] exits by VC fund managers.
Another informant criticising the existence of the legislation and its effect on the venture capital industry, especially venture capital international exit mentioned that:
"... so exits are hugely affected by exchange control. We are not allowed to hold..., if we held an offshore entity, it had to be more than 50%..., and the kind of exit we are talking about we would hold 5% - 10% of the offshore entity and we are just not allowed to do that, you've got to repatriate [thus] we leaving much on the table. [When you] eventually get to the reserve bank [for documentation]. You [are] paying lawyers and you paying bankers a lot of money to work the process for you, not only that it takes time. Now if you are a US pharmaceutical company and you have a choice of three compounds, three paid compounds, one that happens to be South African, one Israeli and one French. You like the South African one and you go for that first. But now this is taking months, you say guys you know really I'm not gonna get that one, its not worth it. So it really does impact exit in a big way, that's pure exchange control".
One said vehemently:
"You know South Africans is one of the very few countries in the world who have exchange control, it bizarre, everything else we've modernized, in some aspects we are ahead of the developed world but we still have exchange, and no one is giving me a good reason for it. No one has given me a good reason why we still have it.... It one of Trevor Manuel's big failing that he didn't get rid of it and don't ask me why he is keeping it, I've never heard a good reason for keeping it, never"
The regulation 28 of the Pension of Act of 1991 is another legislation that has influenced the growth of the venture capital industry in South Africa. The limits the amounts of exposure pension fund managers have to "alternative business". At the moment, "no more than 15% may be invested in a large capitalisation listed equity, and 10% in any single other equity.
How this regulation affects the venture capital industry is that, with the present threshold, the amount that can be committed for venture capitalists investments is limited to only 10% of their pension. An increase in this threshold would increase the total amount of funds pension fund managers can commit to venture capital investing. As one venture capitalist said:
"... I don't know the precise numbers but I know that they are huge, that [the] pension fund industry has x billion/trillion under management. Take [an extra] 5% of that ..., so its even [an] impediment at the macro level."
The third legislation that has influenced the growth and the development of the venture capital industry in South Africa has been the Black Economic Empowerment (BEE) program. The BEE scheme which is aimed at fostering the emergence of a black capital class, requires that by 2014 organisations within the private sector should have handed between 25 - 50% of their ownership to black South Africans (Iheduru, 2008). The program itself has promoted the passage of important measures such as the Employment Equity Act of 1998 and the Promotion of Equality and Prevention of Unfair Discrimination Act of 2000 in law. These legislations have imposed important obligation upon organisations to make their workplace demographically representative (Southall, 2007). However, the government had to start to the implementation of its BEE principles with the SOEs as it lacked the power to mandate the private sector to embrace this legislation (Iheduru, 2008) which the private sector saw as a bid to revive some form of state socialism under a free market environment and since BEE was easier to pursue with the state SOEs (Southall, 2007) the government started its BEE program with them.
Under the BEE Act No. 53 of 2003, BEE is defined as:
- increasing the number if black people that manage, own and control enterprises and productive assets;
- facilitating ownership and managing of enterprises and productive assets communities, workers, cooperatives and other collective enterprises;
- human resource and skills development;
- achieving equitable representation in all occupational categories and levels in the workplace;
- preferential procurement; and
- investments in enterprises that are owned or managed by black people ( Department of Trade and Industry, South Africa, 2004)
To monitor the compliance of BEE by organisations, the government enacted A BEE code of Good Practice and an Empowerment Scorecard in 2004 on which it allocates BEE points to organisations based on their ownership composition, skills development for black South Africans, preferential procurement, enterprise development and residual development (BEE Act, 2003). This is caused what Iheduru (2008:343) calls a "cascading effect", in which all organisations with direct or indirect relations with the government have embraced the BEE program as BEE beneficiaries from SOE activities also demand BEE compliance from their own customers as well. Iherduru (2008:343) noted that "having a good BEE score becomes almost as necessary as having a business card." However, initially the private sector the not embrace the idea of a BEE program as they termed it as "sin tax" (Iheduru 2008) even as the black South Africans lacked adequate capital to purchase equity from the private sector. Nonetheless, the South African government used state power to coercive organisation conformity with respect to the BEE agenda. For instance, the energy and mining sector were told to either embrace the BEE program or face economic liberalisation and the removal of government protection and government subsidies.
On how the BEE program as influenced the growth and development of a venture capital/private equity industry in South Africa, the BEE program as influenced the amount of capital committed by the government for venture capital/private equity investments, as the government would not fund any company that is not BEE complaint. A respondent noted:
I'll tell you the way it affects me or the way its affects our company. Because biovenutures is the only source for funding for biotech the only other source is government. There you've got small to people three people company who pre revenue and because you go to government for money they say you need a BEE partner and you need black partners. I mean it's a lack of understanding again of the business, the nature of the business, and just where BEE plays a role. Even one of our companies that is now profitable, they say why hasn't this company got a local partner because they are selling to the local hospitals need a BEE plan.
The way BEE deals are done is you come along you like the company so you, we want to be part of this company you can add value, you are a genuine business person, you want to be part of it, you not just like an outside person. But you don't have money you don't have that kind of money needed to buy a stake in the company. So you go to a bank and a bank lends you money to buy into the business you pay the money back by the business paying dividends to you and then you paying the bank. Biotechs paying dividends? It doesn't happen. So the only way to actually get black players in is to actually give up shareholding. But then you've built a business, and we are investors we got to give our money back.., its not even our money. So that's the problem with trying to enforce BEE to a sector like ours.
Now the act doesn't do that, the act says very clearly, if this is a small business that doesn't fall within the act or if it's a business of this size it only needs to look at two or three components of the Act, it doesn't need to look at all of it. So Act itself is fine but it's the people applying the act, its these idiots in governments, some of whom where there yesterday. You sit with these government funders, if you say you are applying for government funding therefore you have to do this. And I'm like look at the Act, this Act is fine you know it's the application. And its because the people who work in these organizations have no business experience and don't really understand what its like, they don't know how big deals are done, you know the assume you know, that you coming along you pay and that's all
At the micro level, the codes of good practice in relation to the venture capital/private equity industry contain four requirements before venture capital portfolio firms can be required to as a black empowered firm. The conditions are:
- More than 50% of any exercisable voting rights associated with the equity instruments through which the private equity fund manager holds rights of ownership must be held by black people
- More than 50% of the profits made by the private equity fund manager after realising any investment made by it, must by written agreement, accrue to black people
- The private equity fund manager must be a BEE - owned company, as defined in the BEE Codes
- Over a 10 - year period, the private equity fund must have more 50% of the value of funds invested, invested in black - owned enterprises that have at least 25% direct ownership
Private equity firms that have portfolio companies who meet these requirements enjoy some preferential treatment from the government. As one respondent commented:
"Specifically, in the private equity space, people say that because you, if you are a private equity fund that meets those four criteria, you might get some type of discount on concluding transactions and the likes. Well, that's probably true, if you are a fund manager that doesn't met those credentials, 9 out of 10 big transactions that are concluded have some type of BEE continuum into it anyway"
This chapter investigated the evolution of the venture capital industry in a transition economy, South Africa. Findings from the chapter shows that the emergence of the venture capital industry in South Africa is somewhat different as the disinvestments the country experienced during the twilight years of apartheid was the event that triggered an emergence of the industry. Also, it was also argued from the chapter that in addition to a market type institutional environment, for venture capital to thrive in any country the country should be seen as politically stable, only then would investors will be willing to commit funds for venture capital investing. Furthermore, the chapter also has shown how some legislation by the South African government has influenced the growth of the industry. One interesting theme that emanated from this joint evolution story is the need for legitimacy both by the government and the venture capital industry which would be discussed in the next chapter, chapter 7.
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