Making the most when investing in 12J companies
The Treasury’s Section 12J tax incentive ensures SA receives investment across most sectors — but choose your 12J company wisely
Given the current state of the South African economy, the Treasury’s Section 12J tax incentive is arguably one of the few incentives ensuring the country receives investment across most sectors, particularly sectors that have a large impact on job creation, such as mining, agriculture and tourism.
Given the enormous interest from South Africans to invest in Section 12J venture capital companies (12J companies), more than 120 have already been formed. Over the years, 12J companies and investors have often been guilty of focusing too much attention on the tax savings associated with Section 12J and not nearly enough attention as to what these 12J companies are investing in.
Not only is the underlying investment an important consideration for investors so, too, are the softer issues, such as whether the 12J companies are managing to re-invest an investor’s capital and whether the fees charged for identifying and managing the funds are justifiable.
There are a number of key factors investors must consider before investing in 12J companies.
Fees: net capital vs gross capital
Along with other fees, 12J companies generally charge investors a performance fee, which is based on funds returned to investors. However, on closer inspection, a large portion of the market’s 12J companies look to earn a performance fee on a portion of the investor’s original capital amount. This is referred to as earning a performance fee on net capital.
In other words, if an investor invests R1m and receives a tax refund of R450,000, many 12J companies believe it is acceptable to levy a fee on any amount above the net capital amount of the difference of R550,000.
In order to incentivise 12J companies to perform, investors should first consider investing in those that charge a performance fee on funds returned above the investor’s original investment amount (gross capital amount) as opposed to investing in 12J companies that charge a performance fee on just the investor’s original investment.
12J companies have an obligation to re-invest investor’s capital as soon as possible to allow investors’ funds to generate a return. Given the investment restrictions associated with Section 12J, 12J companies have realised that identifying an investment that is compliant with the section and yields the returns anticipated by investors is not an easy feat.
As a consequence, a large portion of Section 12J capital has not been invested in the economy as there are a number of 12J companies that have failed to re-invest investors’ capital. This is ultimately to the detriment of their investors. Therefore, before investing, investors must inquire with the 12J company as to what percentage of capital under management has actually been invested.
High- vs low-risk investments
Investors should avoid being blindsided by the attractive upfront tax deduction and should focus time and effort into understanding the investment strategy of the 12J companies under consideration.
If the investor is looking for high returns, there are riskier 12J companies that invest in pure venture capital investments. If the investor is looking for capital preservation, there are property-backed hospitality assets offering stable returns.
Lastly, if the investor is looking for exposure to established businesses, there are 12J companies investing in private equity.
Investors should invest in a 12J company that meets their risk profile and should not be driven to invest purely for the tax benefit.
Management and board
Investors must pay special attention to who is managing the investor’s funds. The management team will ultimately be responsible for the performance of the investor’s investment. In addition, the board or (at the very least) the investment committee must be independent as this will ensure there are no conflicts of interest when investments are made.
Investors should research the management team and board members to be confident that their funds are in safe hands.
Investors have very limited options when looking to exit a 12J company. They can either find a buyer for their shares or hope that the 12J company has sufficient liquidity to purchase the shares from the investor.
Investors should look to invest in 12J companies that have a clear and realistic exit strategy. Examples of these include disposing of all investments after five years, or listing on an exchange, such as ZAR X, which will create more liquidity on the secondary market.
There are a number of excellent 12J companies to invest in, all offering significantly different investment strategies, fees, returns, many of which are run by pioneers of their industry.
This sentiment has been shared by the South African taxpayers, who have invested more than R3bn within the past few years, with a projected total investment for the 2019 financial year end close to R2.5bn. This will bring the total anticipated funds under management in the region of R5.5bn. These investments should not only result in significant returns to investors but will lead to economic growth and job creation.
• Sacks is a partner at Jaltech.