Category Investments

Taking stock of section 12J funds as the end draws near

18 June 2021 Renier de Wit, Managing Director of Gaia Fund Managers
Renier de Wit, Managing Director of Gaia Fund Managers

Renier de Wit, Managing Director of Gaia Fund Managers

As the section 12J tax dispensation draws to a close at the end of June, Renier de Wit, investment specialist, takes stock on how it contributed to South Africa’s investment landscape and how these fund managers can support the country’s developmental needs.

Traditionally, private equity was an alternative asset class only available to large institutional investors, such as retirement funds or the super-wealthy. When the South African Government introduced the Section 12J tax dispensation 12 years ago, it opened this market for retail investors, too. It also ensured a large capital base developed for the funding of small, medium and micro enterprises (SMME).

With more than R10 billion in investments flowing to section 12J venture capital companies since the dispensation’s inception, the foundation for a ‘new’, accessible asset class has been laid. From 1 July this year, Section 12J venture capital companies will be forced to close to new business under the tax dispensation. However, there are private equity fund managers, such as Gaia, that will continue providing alternative investment opportunities to investors.

This is significant: the basis of investment management – whether for institutional or retail clients – boils down to diversification. Investors must spread their investment risk over various uncorrelated asset classes. When market shocks – such as the worldwide sell-off of stocks during March 2020 – hit investments, a portion of an investor’s portfolio will behave differently to the general investment market. This could have positive and negative effects but as we have seen through the Covid-19 pandemic, many of these alternative investments delivered a robust performance, retaining their values and, in some cases, even benefiting through the chaos.

As the tax dispensation reaches its demise, private equity managers will need to adjust how they market their funds. In the past, the tax deductibility of section 12J funds was an alluring way to get wealthy investors’ attention. Now, this asset class must be marketed on its own. The benefits – both the uncorrelated nature of returns and the sustainability of income generation – should take centre stage when targeting potential investors. Those Section 12J funds that were established with longevity in mind can easily stand on their own after the tax dispensation has lapsed.

The question is: how can section 12J funds contribute to economic growth in South Africa after the tax-deduction benefit lapses? Given the government’s proposed changes to the prudential investment allocations in terms of Regulation 28 of the Pension Fund Act, the importance of infrastructure investment was placed squarely in the middle of South Africa’s developmental objectives. Private equity funds will continue to contribute to this aim.

This poses another important question. Are the managers of private equity funds, especially those geared towards infrastructure investment, sufficiently skilled to analyse potential projects and deploy capital to them? There are enough young analysts who want to get involved in private equity as an asset class. That said, South Africa lags behind the rest of the world in terms of a large skills pool when it comes to infrastructure investment. By way of example, retirement funds in developed markets have been investing in this asset class since the 1960s. In South Africa, the largest investable projects are those linked to the Renewable Energy Independent Power Producer Procurement Programme (REIPPPP), launched a little more than a decade ago. According to the government’s IPP Office, the REIPPPP attracted R209.7 billion in committed funding during the first seven rounds of bidding for renewable power projects. Of this, R41.8 billion came from abroad. If considered against the scale of South African retirement funds – R2.2 trillion according to the Reserve Bank by the end of December – there remains huge scope for this asset class to grow.

Aside from infrastructure spending, South Africa desperately needs its SMME sector to expand rapidly and employ more people. The formal SMME sector, if supported sufficiently with funding and guidance, could play an important role in reducing the country’s unacceptably large pool of unemployed people. The section 12J funds gave access to funding for start-up businesses as well as working capital support to those in critical growth phases.

It has been proven globally that if a country wants to grow its economy, reduce unemployment and radically address income inequality, it must support its SMMEs. According to the 2019 Global Competitiveness Index, compiled annually by the World Economic Forum, South Africa ranked dismally at 96th out of 141 nations when measured for the effectiveness of financing small and medium enterprises. This is dire for a country where the aspirations of school and university leavers are trampled when they cannot find employment. There is no shortage of entrepreneurs in South Africa. However, there is an enormous shortage of formal SMMEs with the business sector skewed towards large companies. Not only will a surge of formal SMMEs benefit job creation and economic growth, but it will also address income inequality, declining tax revenues and skill shortages.

On 30 June, when the section 12J tax dispensation ends, investors will get the opportunity to discern between those managers who disproportionately relied on the tax incentive to attract capital and those with a proven track record of efficient and appropriate capital allocation. Private equity and infrastructure funds with their underlying assets fit the government’s drive for bigger participation by the private sector in this asset class. Although new capital in private equity funds would not attract the tax discount, investors will get an uncorrelated investment that supports the country’s drive to address domestic investment and economic growth.


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