Black Economic Empowerment Contracts and Risk Incentives

47 Pages Posted: 11 Dec 2018 Last revised: 3 Dec 2019

See all articles by Thomas McWalter

Thomas McWalter

University of Cape Town (UCT); University of Johannesburg

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance

Date Written: November 27, 2019

Abstract

After the fall of apartheid in South Africa, Black Economic Empowerment emerged as a central policy, aimed at redressing the imbalances of the past by fairly transferring financial and economic resources to the majority of its citizens. Corporations voluntarily conduct Black Economic Empowerment deals in response to these regulatory constraints, which are designed to provide firms with incentives to draw in previously disadvantaged citizens. These deals use financial contracts and structures to dramatically alter the profile of the investor base of the firm, thereby enabling new investors to immediately participate as contingent shareholders, without the need for them to provide much initial capital. The magnitude of these deals not only significantly alters the capital structure of the firm but also affects investment opportunities. We develop a dynamic model of corporate structure, in which the claims held by all participants in a deal are carefully valued under a second-best policy, established by the original shareholders of the firm. The model allows us to trade off the benefits of doing a deal against the costs. We demonstrate that the regulations have succeeded in bringing in new investors. We also show, however, that the structure of these deals induces wrong-way risk, resulting in shareholders becoming risk-averse. The implications of these regulations, which attempt to broaden participation in financial markets, are fully explored.

Keywords: Government Policy and Regulation, Ownership Structure, Capital Structure, Wrong-way Risk, Risk Taking

JEL Classification: G320, G380, L51

Suggested Citation

McWalter, Thomas and Ritchken, Peter H., Black Economic Empowerment Contracts and Risk Incentives (November 27, 2019). Available at SSRN: https://ssrn.com/abstract=3287384 or http://dx.doi.org/10.2139/ssrn.3287384

Thomas McWalter

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

University of Johannesburg ( email )

PO Box 524
Auckland Park
Johannesburg, Gauteng 2006
South Africa

Peter H. Ritchken (Contact Author)

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3849 (Phone)
216-368-4776 (Fax)

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