In recent weeks there has been much public debate regarding the news that Saudi Arabian Military Industries (SAMI) is in talks with the South African government to take up a stake in Denel SOC, the state-owned defence company.

African Defence Review can exclusively report though that South Africa was the recipient of a similar overture from Qatar in 2017, in which the sheikhdom offered Denel SOC a US$350 million five-year loan facility, to be converted to future equity in the company. This offer expired in April and it’s unclear whether Qatar remains interested.

Therefore to properly evaluate the future options for Denel it is important to understand the context of both the Saudi and Qatari overtures, Denel’s own future prospects, and the deadly serious ethical and financial implications of each course of action.

What is clear is that any decision taken by the South African government with regard to Denel is going to have negative consequences, some terrible, and not all will be offset by an upside; so the South African government can only determine which of those choices is the least damaging. There are no easy options left.

These events are driven by two unrelated but coincidental developments: The severe liquidity & debt crisis caused by state capture & mismanagement facing state-owned enterprises like Denel, and the ambitious industrialisation programmes of Saudi Arabia & Qatar. The first has made the South African state open to outside investment in its SOEs and placed it under time pressure to get deals concluded, while the second has turned the two Gulf powerhouses into investors willing to spend billions of dollars in a relatively short space to time to acquire industrial capabilities.

Although Denel had been steadily increasing its profit levels over the years, going from R41 million in after-tax profit in FY 2011/12 to R395 million in FY 2015/16, it had not yet managed to achieve a steady net cash inflow and it remained heavily reliant on issuing a series of Domestic Medium Term Notes (DMTN) to fund its ongoing cash needs. By 2017 Denel’s total issued outstanding debt, mostly DMTNs, stood at R3.7 billion, of which R1.85 billion was guaranteed by the South African government. Once it became public that Denel was caught up in the ‘State Capture’ scandal and was deeply involved with the notorious Gupta family via both its partnership with VR Laser and its highly dubious investment in Denel Asia, amongst other questionable management decisions, private lenders began to refuse to buy the company’s debt notes unless they were fully guaranteed by government. Yet South Africa’s National Treasury was unable to provide further guarantees beyond a once-off R580 million in December 2017. Since then, Denel’s liquidity situation has declined so badly that it has been unable to pay suppliers (and thus deliver orders), had to short-pay senior managers & engineers in September, and may not be able to pay salaries this month.

Qatar and Saudi Arabia are locked in a bitter rivalry at present, though both have embarked on similar and ambitious industrialisation programmes designed to turn them into fully-developed countries with diversified economies that aren’t reliant on oil or gas revenues. Qatar has termed its economic plan ‘Qatar National Vision 2030’, and Saudi Arabia’s plan is termed ‘Vision 2030’, each including a goal of creating a viable indigenous defence industry. To this end, early this year Qatar created Barzan Holdings as a subsidiary of the Ministry of Defence and Saudi Arabia created Saudi Arabian Military Industries as a subsidiary of the Saudi Public Investment Fund. Both Barzan and SAMI have the mandate of forming partnerships, joint ventures, and equity investments with defence companies around the world in order to transfer technology and set up local manufacturing and R&D facilities, along with the financial backing to make the transactions profitable for the foreign companies involved, and both have already begun local manufacturing of a number of systems as a result of those agreements.

According to Denel spokesperson Pamela Malinda, in 2017 the government of Qatar approached Denel to discuss the possibility of providing loan funding and of acquiring an equity stake. This was followed by the signing of a formal Memorandum of Understanding in October 2017 by representatives from Qatar, Denel, and the South African government, based on the following conditions provided to us by Denel:

US$350 million loan facility for a five year term which Denel could draw down on as as-needed basis. Six month exclusivity period to conclude the loan agreement Confidentiality clause. The desire of Qatar’s government to obtain an equity ownership stake in Denel SOC, though specifying that this would require a separate approval process beyond Denel’s board. Provision for the loan agreement to be concluded with Denel itself if the equity ownership could not be approved. Provision for the loan agreement to be repaid via a future conversion into equity in Denel SOC if approval was achieved.

However the loan itself was contingent on the securing of unspecified guarantees from the South African government, which for unspecified reasons could not be secured before the negotiating period lapsed. Questions posed to the Department of Public Enterprises on this subject went unanswered.

It’s unclear whether Qatar is still interested in further negotiations over Denel, or whether any discussions took place after April.

The United Arab Emirates has been mentioned as another possible suitor for Denel, but there are no indications that its interest has gone any further than small extensions to the joint venture between Tawazun and Denel Dynamics.

During President Ramaphosa’s visit to Saudi Arabia in July this year both countries discussed the possibility of a US$10 billion Saudi investment programme in South Africa, primarily in the energy sector. Some analysts have speculated that this may also include equity stakes in other debt-laden SOEs like Eskom, the national energy provider. Those discussions also involved various options for SAMI to partner with South African defence companies, including a potential equity stake in Denel SOC and/or some of its subsidiaries. Notably this has formed part of discussions and agreements for the Saudi government to invest US$ 10 billion in South Africa, which some analysts have speculated may include equity stakes in other debt-laden SOEs like Eskom, the national energy provider.

ADR spoke to Dr Andreas Schwer, CEO of SAMI, on the sidelines of last month’s Africa Aerospace & Defence exhibition in Tshwane, about his company’s proposals. In the interview Schwer stated that SAMI had been given the goal of by 2030 being amongst the top 25 largest defence firms, supplying more than 50% of Saudi Arabia’s security procurement needs (up from less than 5% today), directly employing more than 40 000 people, and contributing US$3.7 billion to the kingdom’s GDP.

To achieve this SAMI has consolidated all other Saudi state-owned defence companies under its umbrella and has begun pursuing strategic partnerships with major defence companies, including Boeing, Lockheed-Martin, and Rosoboronexport. According to Schwer, who was in South Africa to hold talks with local private defence companies and ministerial representatives, SAMI is particularly but not exclusively interested in partnering with companies that could provide missile, ammunition, and optoelectronic technology. In terms of Denel, Schwer said that SAMI was seeking both an equity stake in the holding company, Denel SOC, as well as stakes in one or more of its subsidiaries, but said that it had been approaching all South African defence companies, including Paramount Group, about partnerships.

In return, SAMI’s incentive to its strategic partners is a combination of long-term investment, sustained R&D funding, and the promise of guaranteed exclusive contracts from the Saudi state for decades to come. Schwer claimed that SAMI’s offer was aimed at creating a beneficial situation for both sides, where technology, manufacturing facilities, and skills would not be taken out of the country but would instead be mirrored in both South Africa and Saudi Arabia along with substantial R&D funding invested in the product portfolios of the South African firms that partnered with them. He made it clear that in return technology sharing was non-negotiable, and that it was SAMI’s strong preference to wrap up talks with South African firms, including Denel, by the end of the year.

Schwer would not be drawn on how much SAMI is willing to pay for its stakes in Denel and the South African government has not been willing to comment on the record. A highly-placed advisor who wished to remain anonymous claimed that a figure of US$ 1 billion (R14.2 billion) was said to have been discussed, but was unable to provide further detail, nor whether this quoted amount was for an equity stake or an intellectual property-sharing partnership.

In fact most of the parameters of the negotiations remain unclear, especially with regard to the sizes of the equity stakes at both Group and subsidiary level and the intended timing. While it’s likely that the South African government would wish to retain controlling ownership in Denel SOC, at least via a golden share, the same may not be true of all of its divisions and subsidiaries and there remains the possibility of a majority takeover that results in a structure similar to that of Rheinmetall Denel Munitions or Hensoldt Optronics, in which Denel holds minority stakes. In either case, an investment of R14.2 billion will have a transformative effect on Denel, allowing it to recover from its crisis and expand its product portfolio by completing a number of presently-moribund projects and concepts and upgrading existing systems.

Of course before any deals are concluded, either with Denel or with any other South African defence firm, there are a number of legal and administrative steps to clear. First, any shareholding that SAMI takes up in South African defence companies will have to be approved by the Chief Directorate Conventional Arms Control (CDCAC) and its parent body the National Conventional Arms Control Committee (NCACC), via both internal vetting in terms of the National Conventional Arms Control Act and through the approval of Defence Intelligence, Armscor, the SAPS, the State Security Agency, and various national departments.

The CDCAC and NCACC will have to determine whether Saudi Arabia’s actions in Yemen, which have drawn widespread criticism for alleged human rights violations, and its recent murder of Washington Post journalist Jamal Khashoggi are sufficient conditions as per the National Conventional Arms Control Act to deny any arms sales to the country or shareholding in South African firms. This may not be a straightforward decision, as while some elements of Section 15’s Guiding principles and criteria in the Act would appear to be disqualifying, those criteria are judged as a total set and include the principle that a recipient country has the right to self defence, and not all armament types would be seen as directly usable for violations in Yemen.

In addition any transfer or sale of intellectual property outside of South Africa will have to be cleared by the Department of Defence (DoD), primarily Defence Intelligence and Armscor. It has long been rumoured that the DoD was responsible for blocking a proposed investment into Denel Dynamics by the European missile company MBDA in the mid-2000s via this mechanism.

At the same time, the South African government will have to weigh these decisions against the probability of Denel surviving in its present form should outside investment be lost or rejected. The damage caused by state capture and mismanagement is substantial, the harm caused by the company’s months-long liquidity crisis on top of that may be catastrophic. For over a year Denel has been unable to pay most suppliers, which has resulted in the shutdown of a number of its production lines and a failure to deliver on orders and other commitments. As a result the company is failing to bring in new revenue, has suffered penalties for non-delivery, and may have lost some contracts in their entirety. Just how much of an impact this has all had will only be known in part once the company’s 2017/18 Annual Report is released to Parliament, yet Denel is now almost a month late in submitting it.

It is entirely possible that, given the damage done and the inability of the South African government to commit further funds to stabilise Denel and other SOEs, if foreign investment is rejected Denel will default; and enter an uncontrolled downward spiral after which it might be liquidated at the cost of thousands of high-skill jobs and critical strategic capabilities. The impact on the rest of the country’s high-tech industry if that happened would be devastating and the South African National Defence Force (SANDF) would see the cost of supporting a number of its key systems, especially workhorse aircraft like the C-130BZ transport and Oryx helicopter, escalate to the point of making them unaffordable to continue operating.

This is what makes these negotiations such a delicate balancing act for the South African government. It cannot dismiss the poor human rights record of the Saudi government, not only because it creates reputational and legal risks for any country too-tightly aligned to the kingdom if that human rights record deteriorates further, but because South Africa has a stated desire to pursue a moral foreign policy. Yet against that it must weigh its own difficult position in which it cannot afford the debt that its state-owned companies have accrued, it appears to have no other potential investors lined up to provide funds at this scale, doing nothing and letting the SOEs fail may send the already-fragile South African economy into a tailspin, and rushing a fire sale privatisation process may have negative long-term outcomes. Each of the choices has serious downsides.

It would be a legitimate choice to decide that the risks of associating with Saudi Arabia is too high a cost to pay, even when compared to the cost of SOE failure, but then it’s important that contingency plans be in place to limit the fallout. Similarly, if Saudi investment and SOE shareholding is accepted, South Africa must ensure that its key intellectual property is protected, that it has a long-term sustainability plan beyond Saudi Arabia’s own strategy, and that it has defended itself against the risk of the Saudi government becoming a rogue state.

Whatever path is ultimately taken, and whatever the fate of Denel and other state-owned companies might be, this set of decisions will have a profound effect on South Africa’s foreign policy, economy, and defence industry strategy for years to come. It’s important that they be made as transparently as possible and that both the public and civil society have the chance to weigh in on the debate.