Smart investing: 12J and renewable tax incentives deliver effective 21%pa

It took a while for the market to warm up to the SA government’s section 12J tax incentive designed to encourage private investment into the small business sector. But with private sector innovation now having sucked in billions, the State has decided to cap the maximum investment per taxpayer – and is reconsidering whether to renew the incentive when it expires in 2021. As you can image, not all 12J companies are equal. But in former hedge fund heavyweight Kevin Shames’s Bright Light Solar, we’ve uncovered the industry’s lowest cost supplier tailored to double up on both the 12J allowance and the extra incentive available for Renewable Energy investments. The result: an astonishing effective return of 21% a year for the six year term of the investment (min R100,000; max R2.5m per taxpayer). In this in-depth interview, Shames explains the inner working of one of the most appealing investments currently available in South Africa. For more information click here. – Alec Hogg

This special podcast is brought to you by Bright Light Solar VCC and it’s really a warm welcome to Kevin Shames. We go back a long time to the days when you listed a hedge fund on the Johannesburg Stock Exchange. Mercury Alpha Capital if I remember correctly.

That’s right. Alec that was in 1999.

Goodness and what have you been doing since then?

I’ve been very involved in the hedge fund industry. I was chairman of the hedge fund industry association that was called “the South African Hedge Fund Association” and then became known as AIMA. I was very fortunate to be appointed an international board member of AIMA which I thoroughly enjoyed – I did a lot of work with the regulators in South Africa in terms of getting hedge funds regulated – and then I moved out of the hedge fund industry and now I’m involved in a very exciting sector which is a Section 12 J Company and we are focused on providing alternative energy solutions.

Don’t we just need it for the amount of loadshedding we’ve been having. 12J was an initiative by the government to try and stimulate investment. What was the thinking here and how successful has it been?

The thinking behind it was primarily to provide investment into small and medium enterprise with the express intention of creating employment – as we all know we so desperately need in South Africa – and it was recognised that employment is created primarily through small and medium enterprise. What was estimated was that the cost of creating jobs – through SME’s – was far lower than through the public sector or even through public funding institutions who would then assist in creating employment.

So the 12J offered tax incentives to normal taxpayers to try and fund this?

Exactly. Any South African taxpayer has an opportunity to leverage this opportunity provided through the Income Tax Act which includes individual taxpayers, companies and trusts. The incentive is that you get to deduct 100% of the investment that you make, into an approved section 12 company against your taxable income in the year in which you invest.

That means that effectively the tax man is giving you a rebate – depending how much your tax rate is – if say 28%, then on R1m investment, R280,000 is paid for by the taxman. Am I getting that right?

Exactly and if you’re a marginal taxpayer at a 45% percent tax rate, then you are effectively getting a 45% contribution from national treasury into your investment.

How popular have 12J’s been?

It’s been fantastically popular. In the beginning of the initial draft of Section 12J was largely unusable, there were lots of complexities that made it very unattractive. Industry then got together and lobbied national treasury to make it a more attractive proposition which then happened. Since then, there has been a massive growth in the region of about 150 Section 12J companies and as far as I’m aware, about R6bn has been invested into section 12J companies so far.

And presumably created a lot of jobs, which was the intention.

So that’s one of the things that the 12J industry is doing, it’s trying to provide national treasury with employment statistics because there is a sunset clause which means that this investment opportunity will no longer continue after June 2021. There is a lobby movement to try and get it extended and as part of that, what we’re doing is showing National Treasury how many jobs both direct and indirect have been created and what the cost of those jobs are.

When you say “we” is that your company “Bright Light”?

We are one of the 12J’s, we are a member of the section 12 J industry association, it’s a self-regulating body that has been set up to provide national treasury with enough information to be able to make the right decision as to whether they should extend the sunset clause beyond June 2021.

So the name tells us that you’re in the solar or renewable industry – Bright Light Solar – what exactly is it that you’re honing in on?

What we’ve been doing to date is primarily targeting gated estates – mainly sectional title, body corporates and homeowners associations – and providing them with rooftop solar solutions which give them the opportunity of substantially cutting their electricity bills by capturing energy from the sun during daylight hours. At the moment battery technology is still quite expensive so we aren’t active in the energy storage space, but what we’re targeting is daytime electricity consumption and we design, install, insure and maintain the entire system and then sell the electricity to the customer at a reasonably substantial discount to what they’re currently paying to their local utility.

So you work through body corporates?

That’s our primary target market. We have done shopping centres, we’ve done some industrial buildings, some commercial buildings but our primary target market is the gated residential estates.

And how successful has it been?

It’s been fantastically successful and growing. Funny enough, with the kind of loadshedding that we are experiencing at the moment, every wave of loadshedding leads to a huge increase in the number of people applying to us to install solar into the gated estates.

And how much does it cost the body corporate itself or for the people living in a gated estate?

The beauty of what we’re doing is that it costs them absolutely nothing. The way we do that is that we raise capital through the section 12J Investment opportunity and we use their capital to invest in the solar installations for our customers. We then sell the electricity to them – from these installations – and we use that electricity revenue to pay back to our investors in the form of dividends.

Let me just understand this. Because there’s a tax incentive called a 12J, you can use that incentive to get people to invest more easily into your company Bright Light Solar, you then take the capital and do a deal with the body corporate, put in solar installations – don’t charge them anything for that – and charge them for the electricity that they draw down at a discount to the price they would pay from Eskom.

That’s exactly right. Those discounts sometimes – depending on the area in which the gated estate is – can be very substantial and as a result we are getting a great amount of interest in people coming to us asking us to install these into their estates.

Where would there be resistance? I suppose it depends how pretty the solar installation looks like – the aesthetics – that’s the only thing I can see that would be negative for a gated community.

Exactly. I think aesthetics historically has been a problem. Funny enough what we are starting to see now, is that the optics of being green is actually becoming very attractive. What used to be an aesthetically displeasing installation – having these solar panels on your roof – is now becoming pleasing because people want to be seen to be green. I think people are also anti-utility because there’s just so much anger towards Eskom – the loadshedding, the amount of corruption, the constant price increases – people actually are finding it very attractive to say “I’m rejecting what is currently being proposed” and this is the alternative that we are all embracing.

Kevin, I also understand that the government is trying to promote investment in renewables. Do you guys get a benefit from that as well? Does the renewables also kick in?

That’s such a great point and it’s a huge benefit which all renewable 12J companies have. The investor gets 100% deduction – in terms of what capital they are contributing into the section 12J – the company that actually owns the solar installation (referred to in section 12J as a qualifying company) – the qualifying company gets another 100% deduction in terms of what’s called Section 12B, which is an accelerated wear and tear allowance, specifically for renewable energy projects. It’s like a Verimark advert, not only do you get a 100% deduction on your capital investment, but wait there’s more, because the company also gets 100% tax deduction and that benefit flows back to the investor through increased internal rates of return. In other words, the returns that those investors are getting out of the kind of investment that we offer.

So what are they getting? What are those returns?

The returns – if an investor exits at the beginning of year 6 – are being forecast to the investor, who will get a 21% after tax. I just want to qualify that, it’s after tax, after fees, after dividend tax, that is net in his hands. So it’s not a 21% per annum calculation. Because the investor gets a 45% tax deduction upfront in year zero and then gets dividends that grow over time and then sells his investment back to us at the beginning of year 6, those cash flows equate to a 21% after tax return.

Annual, per annum?

It’s an effective annual return. Yes.

So for every year in the next 6 years effectively, the return that that investment will generate is 21%.

Correct and that’s not exposing the investor to any market risk, to exchange rate risk, to interest rate risk. What we’ve tried to do is to try and take the venture out of venture capital and the beauty is that we’re using old technology solar photovoltaic, which was invented in 1977. So this is not new technology. We’re using old technology, we’re using the advantage of Section 12J and we’re using the benefits of competing with the utility who are charging extremely high rates for electricity. When we combine those factors , we’re able to provide investors with this incredibly attractive 21% after tax.

It’s just amazing how the private sector will come up with ideas if you have an inefficient state body – they don’t get more inefficient it seems at the moment than Eskom – so government is almost funding all of this, or certainly promoting it through the renewable energy allowances in the 12J’s?

They are. There is definitely a promotion from governments. Just before Jeff Radebe left as Minister of Energy earlier this year, he raised the limit from 1 megawatt up to 10 megawatts – in terms of what the potential allowable size of a solar PV installation could be – that would be on the commercial side, but on the residential side there’s pretty much no cap. Your only cap is your limitation on roof space.

But are you getting lots of people wanting to invest in this? You’ve got a prospectus which will be in the market in February presumably that’s to coincide with the tax year.

Yes our prospectus hopefully will be ready in about the next 10 days. It will be publicly available from the beginning of January and we are going to market looking to raise quite a lot of capital to invest in this. First of all because the returns are so attractive and second of all because the need is there to be able to provide these alternative energy solutions to our customers.

Is there demand from body corporates?

We’ve actually crossed a milestone today where we’ve just done our 1,000 proposal to potential clients. That gives you an idea of the kind of interest that’s being shown by our existing client base and from people who are approaching us and saying “you haven’t contacted us please will you come and give us a proposal”.

And the fees how much are you going to take?

The fees are very interesting in the 12J space. One of the biggest criticisms of Section 12J companies, are that the fees are very high. Some of our competitors are charging fees on clients tax savings, so are you getting a 45% tax saving and many of the 12J companies are charging fees on those tax savings. The one caveat to investors, is anyone that looks at a 12J investment, you need to be really aware of what the fees are being charged and how they levy. You need to ask the tough questions as to why the fees are charged in the way that they are. Is there a hurdle rate. Is there a performance fee, is there a fee based on assets under management? Is there a capital raising fee? These are all questions that are really important that investors understand and are willing to ask before they part with their money so that there aren’t any surprises after the fact. From a Bright Light point of view, what we’ve decided to do is to be the lowest cost section 12J provider in the industry and as a result we don’t charge any capital raising fee. We don’t charge a fee on assets under management, we don’t charge a fee on clients tax saving, all we do is charge a 17.5% performance fee based on the net income in the underlying qualifying companies. So we don’t even charge 1c of fee at the venture capital level, because it’s a tax inefficient structure – it’s a little bit complex to explain that in a few minutes here – but what we do is we charge our fee at the underlying operating company level to ensure the maximum tax benefit to the investor.

After that fee people are getting effectively 21%.

Correct. Yeah.

And is there a limit on how much people can invest? A minimum and maximum?

So that is the change that came in the Tax Law Amendment Act in October this year – all investments after October 2019 – the limit is R2.5m per individual or Trust investor in the current tax year, R5m for a corporate investor. So a company can can invest up to R5m, an individual or trust up to R2.5m and our minimum is R100,000.

Okay. And you are going to be having your prospectus out in the marketplace beginning of the new year.

That’s it.

And in that you’ve covered all the legalities, it’s really a smart idea, how did you stumble onto this?

We looked at the 12J opportunity and then we’ve partnered with a company called Sectional Title Solutions who’ve got brilliant access into the gated estate community. The two of us together have taken this product to their client base – the demand was always there and it was just really getting the economics right – and when you combine that tax saving with the continued increases in utility prices that we’ve all experienced, it’s actually quite an easy solution. We can provide these amazing returns, we can actually get paid as managers and the customer can get substantial savings so it’s really a win win solution.

Kevin Shames is with Bright Light Solar and this special Podcast was brought to you by Bright Light Solar. Click here for more information.