Equity

What is equity?

Equity financing is where the government provides capital and takes an ownership interest in an entity in anticipation of future returns (via dividends and/or capital returns). The company can be either a private sector business or a government-owned business. The entity must be outside the general government sector.

When should I use equity?

There are a number of considerations to be balanced in determining the most appropriate non-grant financing option (or blend of options). Government financing should generally only be sought when all other sources of capital have been exhausted.

Equity investment is most commonly used to address a market gap where there is a high level of financial risk. A gap can exist where there is a financing shortfall from other parties or where there are risks that the private sector is unwilling to accept and where the government is seeking the ability to influence the strategic delivery of policy objectives. If ownership is not an objective of the investment, other commercial financing or funding mechanisms may be more appropriate. Royalties, revenue or profit sharing and super profits tests stapled to financing are all mechanisms which can be used to share upside instead of using equity. As set out in the 3 Step Commercial Assessment Toolkit, there are several considerations in balancing the risks and benefits of equity. Other financing or contractual options may achieve similar policy objectives with lower long-term investment risk and should therefore be considered before equity.

Equity investments generally offer more control (depending on the size of the ownership share and conditions of shareholder agreements) but less certain financial returns, usually expected well into the future. Equity typically ties up government capital for longer than other financing mechanisms such as loans. Equity is also generally more complex and takes longer to administer than other financing or funding options. Departments implementing equity require longer term and appropriately skilled resources for ongoing management. See further guidance on Q&A – Equity investments.

Characteristics of equity

Accounting and budget classification and reporting of equity

Accounting Standards require equity to be classified on the basis of its economic substance, rather than its legal form. This means that regardless of what legal documents state, equity must continue to meet certain accounting tests to be classified as equity. To be treated as equity for budget accounting purposes, the expected return on capital must be at least equal to the long-term inflation rate and there should be a reasonable expectation that the investment will be recovered. More information on recognition in Budget aggregates is available here. If the returns are expected to be less than the estimated long-term inflation rate at the time the investment is made, some or all of the payment will be treated as a grant expense. The amount treated as grant expense will depend on the expected level of return, relative to the investment. For guidance further guidance on rate of return, contact InvestmentFramework@finance.gov.au.

Implementing equity investments

A key step in implementing an equity investment is to ensure a fit-for-purpose equity agreement is executed by the appropriate parties. An equity agreement can be used to formalise the Commonwealth’s equity arrangement with a company and may include shareholder agreements, share purchase agreements and equity subscription agreements.

Equity implementation checklist

Entities should consider the following prior to implementing equity:

• Given the level of risk, is equity the most appropriate financing option to achieve government’s policy objectives? Other options should first be considered prior to equity.
  • What other financing options, such as loans, have been considered and why were they not considered appropriate to achieve government’s policy objectives?
  • Is ownership a strategic objective of government’s investment?
  • What are the risk levers that should inform equity terms and the provision of equity?
  • What is the appropriate risk premium to apply to the rate of return?
  • After adjusting the rate of return to factor in risk, is the risk taken through the investment worth the expected return?
• Assessment of risk and opportunity, including legal, financial and market due diligence assessment.
  • Assessment of cash-flow forecasts annually over the life of the investment, including forecast development capital costs, operational costs, operational revenues, borrowing costs, dividends, estimated terminal value and internal rate of return. A detailed cash-flow based on financial model should be developed for investment analysis purposes.
• Assessment of confidence around:
  • Project/program development and operational costs
  • Operational revenues
  • Borrowing costs
  • Methods of estimating value
  • Commonwealth return (via distributions and/or divestment)
• Stress-test a range of downside scenarios, which may include:
  • Forecast earnings not eventuating as a result of less demand
  • Project development and/or operational costs increase
  • Interest rate/borrowing cost changes
  • Project takes longer to construct/delays in earnings commencing
  • Worse case market/industry specific scenarios (“black swan” events).
• An exit strategy, including a divestment plan. In developing the divestment plan, entities should consider:
  • The policy objectives for the proposed investment
  • Appropriate timing for divestment
  • Market conditions, including investment interest
  • Phasing divestment to limit market disruption.

Entities should assess the likelihood of downside scenarios eventuating prior to implementing equity. For example, if a downside scenario is identified but is highly remote and the risks can be managed, it may be of little concern. However, if a small project is assessed to have likely cost overruns, it will be more concerning. Refer to the relevant Estimates Memoranda for further information on the financial risk of equity. For guidance on sourcing this information contact investmentframework@finance.gov.au.

The Guidance for Financial Modelling toolkit provides further guidance on minimum information requirements to support the business case, assist in budget costings and enable assessment of accounting and budget aggregate treatments.

Shareholder Departments should ensure entities receiving equity avoid holding large, unused cash reserves.
This requires due diligence from the Accountable Authority of the agency responsible to ensure the frequency and calculation used to determine equity drawdowns is fit-for-purpose.

If appropriate, does your agency have the skills and resources to draft legal and governance documents internally? Entities should consider engaging legal expertise in developing legal and governance documents.
Do you have the resources and capacity to administer and oversee the drawdown process? The Legal and Governance Training and Financial Analysis Training provides comprehensive training to APS staff.

Equity Subscription Agreement considerations

Equity Subscription Agreements are contracts where government agrees to purchase equity directly from a company. The agreement specifies the details and conditions of the share purchase.

The Equity Subscription Agreement should consider:

• What the equity is to be used for
• The maximum amount of equity subscription
• How equity is drawn down – cash forecasts needs (as opposed to accrual) is imperative to ensure the solvency of the entity
• How equity draw downs are to be calculated
• Seniority of equity i.e., preference, ordinary shares or other classes of shares 
• Interactions with legislation, other corporate and any project documentation (i.e. Statement of Expectations, Commercial Freedoms Framework, Investment Mandate or investment guidelines (where relevant), project deed, company constitution and enabling legislation)
• The frequency and type of reporting on the project
• Developing a Budget appropriation process for the Portfolio Department – for example, agencies should not commit to an equity drawdown schedule without sufficient appropriations to cover the payments
• Corporate operational budget ratification
• Distribution policy
• Restructuring and/or divestment policies
• Debt strategy
• Change of scope that may impact the existing arrangement, including any adjustments in the event of a project timetable or cost variation
• If not dealt with elsewhere, restrictions on issue of shares to, or borrowing by the company from, other persons without the Commonwealth’s consent.

Suggested process for arranging equity drawdowns for Shareholder Departments:

Equity drawdown process

The equity drawdown process consists of four stages, followed by two post-payment actions.

1. Submit a request

The entity submits a written request to the relevant shareholder department or departments. The request must include the equity drawdown calculation and appropriate cash flow forecasts.

2. Review the request

The shareholder department reviews the request, seeks clarification where required and confirms that the request is appropriately documented.

3. Arrange payment

The Portfolio CFO Group requests payment and advises the entity’s CFO Group when the payment will be made.

4. Receive payment and issue shares

The entity receives the payment and, in exchange, issues a share certificate.

Post-payment actions

Following payment:

• the portfolio department arranges for the relevant documents to be tabled in both Houses of Parliament as soon as practicable, in accordance with section 72 of the Public Governance, Performance and Accountability Act 2013
• the entity updates its share register and notifies the Australian Securities and Investments Commission of the change, as required.

Ongoing Equity Management

Entities should consider appropriate ongoing oversight and governance arrangements for the proposed equity investment. 

Within the Commonwealth equity is generally managed through shareholder oversight functions, such as those that are established for GBEs or through Specialist Investment Vehicles (SIVs). If the government’s shareholder ownership is greater than 50 per cent, the company may be prescribed as a Government Business Enterprise (GBE). For GBEs, equity is managed by the respective shareholder departments, in line with the  Government Business Enterprises (GBEs) (RMG 126) . 

Further reporting and financial requirements are outlined in the PGPA Act. Minority equity investments are usually provided through SIVs, which have dual objectives to achieve a financial return and respective policy objectives that make them best placed to manage these investments. Shareholder departments should ensure that robust oversight arrangements are in place regardless of the body responsible for management. 

Corporate governance

Prior to entering into an equity investment, entities should consider appropriate mechanisms for ongoing corporate governance. A company’s board of directors is responsible for operational oversight and strategic direction. For non-GBE equity, it may be reasonable to receive a board position in return for the equity position. If appropriate, government should ensure it is represented by an experienced director on the board of the company that is receiving equity. This will assist in ensuring government’s objectives for the investment are considered within corporate decision making. In appointing a board member, entities should consider the following:  

• What are the government’s strategic objectives for the equity investment? 
  • What are the relevant skills and areas/sectors of expertise specific to the investment and the broader operations of the company? 
• How large is the government’s investment/portion of shareholding? 
• Do candidates have an appropriate balance of qualifications, experience and skills (such as commerce, finance, accounting, law, marketing, workplace relations, management, public sector relations and other skills relevant to the specific investment)?  
• Do candidates have any real or perceived conflicts of interest and if so, can they be appropriately managed? 
• What ongoing internal processes are appropriate for board appointments?
  • How long will board positions stand once appointed?
  • Who is the appropriate decision-maker to determine board appointments?
  • What briefing processes are appropriate to ensure decision-makers are appropriately informed about candidates prior to making an appointment? 

Reporting requirements

As a part of active investment oversight, entities should ensure that the business has appropriate reporting requirements and timeframes (for example, corporate plans, annual reports, quarterly reports, equity subscription reports). Entities should consider the GBE guidelines RMG 126 as best practice in relation to minimum requirements and timetables for reporting. 

The company’s corporate plan should set out the government’s financial and performance expectations for the company. Shareholder departments should establish appropriate internal processes and capability to provide feedback to align reporting with government expectations and review reporting. Teams should be established with appropriate expertise to support this function (including financial analysis, policy expertise and legal).

Government usually holds equity with joint shareholders i.e. the Minister for Finance and the portfolio minister. Shareholder departments should ensure that Shareholder Ministers are appropriately informed about reporting, including raising any concerns in relation to government’s investment. Entities may wish to develop a briefing template to assist teams in considering relevant factors within the reports.

Financial and Performance Governance

In reviewing and assessing reporting with respect to financial and policy performance, shareholder departments should consider the following:

• Are there any concerns apparent within reporting in relation to the company’s financial health?
• Are there any substantial changes within the company that create new risks or worsens existing risks for the Government’s investment?
• Are there any changes that will affect the expected return or timeframe in which Commonwealth will make this return?
• Has the company established KPIs within corporate plans and are the chosen KPIs appropriately set? Entities should routinely assess if KPIs are realistic and achievable for future business cycles.
• Has the company provided appropriate financial forecasts to support the Government Budget processes?

If the government decides to sell shares, entities should assess the final return on investment based on the sale value.