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The ‘fund’amentals of Section 12J investing

The investment pool is growing.

Over the past five years, Section 12J funds have become increasingly popular tax shielding mechanisms for taxpayers, given the possibility of significantly reducing their capital gains tax or income tax due before February 28. With the progression of the investment class, taxpayers and financial advisors are in a more informed position to assess the returns generated by individual funds.

The performance results from these funds will have a significant positive impact on the Section 12J market as Section 12J funds which don’t have the basic investment fundamentals, such as reasonable performance fees or an adequate pipeline of investments prior to raising funding, will need to rethink their business models or they will soon find themselves losing significant market share due to competing funds outperforming their returns.

Alexander Babich the founder of wealth management firm Alexander Babich & Associates says:

“In earlier years, taxpayers had very few Section 12J investment options and investors often found themselves in investments which were more focused on the tax saving and without nearly enough emphasis on the investment case. Fortunately, this year’s Section 12J investors are in a position to review a much larger pool of investments and request fund fact sheets from the fund managers in order to determine whether the Section 12J fund has performed in line with expectations during 2019.”

Information contained in the fund fact sheet, such as whether the net asset value per share has increased or decreased, will be a clear indication as to whether the Section 12J funds are achieving the targeted returns. In addition, the percentage of capital the fund manager has re-invested will be a further indication of whether the fund is positioned to generate a meaningful return in the future.”

In order to ensure that an investor’s next Section 12J investment has the basic fundamentals to position the fund to generate positive returns, in line with marketed expectations, investors should confirm that the following investment fundamentals are in place and if not, they should look for an alternative Section 12J investment:

Reasonable fees

Fees charged during and at the end of the investment term can erode returns significantly. On close inspection, investors may discover that performance fees are much higher due to fees being charged on “capital at risk”.

For example, if an investor invests R100, and receives a tax refund of R45, the investor’s “capital at risk” will be R55 (R100-R45 = R55) as the investor’s original investment is reduced by R45 through the tax refund. In this instance, the fund manager would earn a performance fee on any amount above the investor’s capital amount of R55.

If one ran a simple calculation in a scenario where an investor invests R100 and the investment grows to R120 over 5 years, the capital at risk performance fee would be R13 which amounts to an alarming 65% of the investor’s profits.

For most Section 12J investments, the fair approach is to charge a performance fee on any amount above the original investment amount (termed “gross capital performance fees”). Using the above scenario, the gross capital performance fee would be R4 which is only 20% of the investor’s profits.

Investment/deployment rate

It is unlikely that investors will achieve the advertised targeted return if their capital is not invested within a reasonable period (6 to 12 months). Failure to do so results in a “cash drag” and consequently low returns and potentially a longer investment term than expected, due to the investment taking longer to generate the anticipated returns.

Investors should enquire what percentage of the capital under management has actually been invested by the fund manager with special emphasis on the percentage of capital raised in the last year that has been re-invested. Should the percentage of non-deployed capital be high, investors may soon realise that the fund’s performance will be low.

Clear and effective exit mechanisms

Section 12J investments are private equity in nature and unless the fund manager has a clear and effective exit strategy, it’s likely that investors will be invested for longer than the anticipated investment term. The consequence is that the tax benefit associated with the Section 12J investment is spread out over a longer period of time, resulting in a lower effective tax benefit per year.

The above sense checks will place an investor in a far better position to make an informed investment decision. Surprisingly, a large number of Section 12J funds lack these fundamentals, including some which have attracted significant capital. Given the wide variety of Section 12J investments in the market, investors can easily filter their next Section 12J investment, by requesting a fund fact sheet and by requesting information needed to determine whether the above fundamentals are present.

Although Section 12J investments are an excellent investment option for many taxpayers, Alexander Babich rightly states that “taxpayers should seek advice before investing and without a thorough independent comparison and evaluation done by an experienced advisor, investors may find themselves making a poor investment decision. As deputy chairman of SAIFAA (South African Independent Advisors Association) we encourage our independent advisors to use a 26 point due diligence questionnaire. I personally often even inspect the actual underlying assets before recommending any 12J investment”.

Jonty Sacks is a partner at Jaltech Fund Managers.

The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.

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The 100% upfront tax deduction is certainly attractive (especially at the top 45% marginal tax bracket), but yes, the investment case should still remain the primary objective….i.e. what returns can one expect, and over what period(?)

My understanding with S12J investments is the issue of liquidity…..you can’t always sell when you choose to exit. Many S12J has plenty of “T’s & C’s” which you have to read and accept. (…perhaps this issue will be reduced as take-up broadens)

S12J reminds me a bit of the Regulation 28 funds…..there’s a tax incentive, but with a caveat: your money goes back into the local (hi-risk) SA economy.

These investments need to stack up without taking into account the tax benefit. In my experience, as they are non standard investments the Ts&Cs vary from company to company and can vary within different offerings from the same company too. So it’s hard work investing… and then to SEE the returns they tell you about is also tough.

Good marketing based on the tax deduction – they always assume you’re a top tax payer – but not much else other than smoke and mirrors.

So expect a rash of ‘marketing’ in the dash to the end of the tax year…

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