A Q&A guide to private equity law in Germany.
This Q&A is part of the PLC multi-jurisdictional guide to private equity. It gives a structured overview of the key practical issues including, the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.
To compare answers across multiple jurisdictions, visit the Private Equity Country Q&A tool. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.
The statistics contained in this chapter are based on information provided by the German Private Equity and Venture Capital Association (Bundesverband Deutscher Kapitalbeteiligungsgesellschaften) (BVK) in its 2010 statistics (see box, Private equity/venture capital association) in BVK Annual Statistics 2010.
The sources of private equity funding are:
Banks (55.5%).
Industry (18.2%).
Funds of funds (6.8%).
Private investors (6.2%).
Insurance companies (3.3%).
Public sector (2.9%).
Family offices (1.9%).
Trusts (1.6%).
Unknown (1.5%).
Other asset managers (1.1%).
Foundations (0.6%).
Capital gains for re-investments (0.4%).
After an almost complete collapse of the private equity market in 2009, as a result of the financial and economic crisis, investment began to rise sharply and sustainably in 2010. Since then the German private equity market has gained a lot of stability. In 2010 investments in Germany increased by 59% to EUR4.44 billion (as at 1 November 2011, US$1 was about EUR0.7). Approximately 1,300 companies (mostly small and medium-sized) are currently financed with private equity.
However, as of Autumn 2011, German markets are again jeopardised by macroeconomic circumstances, particularly the high indebtedness of certain countries within the Eurozone.
Fundraising was down in 2009 and 2010 due to a sceptical market environment. In 2010 EUR0.93 billion new funds were raised, 13% below the weak result of the previous year (EUR1.07 billion). For the last two years, therefore, German private equity firms raised the same amounts as in 1996. In 2010 capital raised from institutional and private investors through independent fund-raising increased slightly to EUR0.75 billion (up from EUR0.68 billion in 2009).
In 2010 funds were raised for:
Buyouts (40%).
Early stage investment (17%).
Later stage investment (16%).
Venture capital (unknown) (5%).
Growth (22%).
After a decline to EUR2.78 billion in 2009, EUR4.44 billion was invested in 2010. Buyouts were the most common investment in 2009 and 2010. EUR2.52 billion was invested in buyouts in 2010, which was a more than 50% increase on 2009, which can be primarily explained by the growth in size of investments.
In 2009 many transactions failed because of:
Cautious banking policies.
Diverging valuation opinions between buyers and sellers.
Uncertain business forecasts.
There were fewer transaction failures in 2010.
The distribution of investments by stage in 2010 was (BVK Annual Statistics 2010):
Buyouts (MBOs, MBIs and LBOs) (57%).
Growth (18%).
Replacement (10%).
Seed and start-up capital (8%).
Later stage venture (6%).
The distribution of investments in 2010 by sector was:
Industrial products and services (34.2%).
New technologies (for example, information technology or communications) (22.6%).
Life sciences (12.5%).
Consumer goods and retail (11.4%).
Financial services (9%).
Energy and environment (5.1%).
Chemicals, materials and services (2.8%).
Logistics (1.8%).
Real estate (0.2%)
Unknown (0.4%).
Exits totalled EUR2.75 billion in 2010 and increased by almost 30% from the 2009 level of EUR2.1 billion. The following exit routes were used in 2010:
Public offerings (29.2%).
Write-offs (23.4%).
Sales to other investors (secondary buyouts) (18.3%).
Trade sales (13.9%).
Repayments of silent participations and shareholder loans (9%).
Management buybacks (4.8%).
Sales to financial institutions (0.9%).
Divestments by other means (0.7%).
The regulatory framework for private equity funds will change dramatically with Directive 2011/61/EU on alternative investment fund managers (AIFM Directive), which came into effect on 21 July 2011 and must be implemented domestically by 22 July 2013. The AIFM Directive creates considerable administrative burdens for market participants, including in particular:
Licence requirements for managers.
Internal organisation and risk management requirements, which include:
conduct rules; and
reporting requirements.
Capital maintenance rules for managers.
Depositary requirements.
The AIFM Directive will introduce a passport option, enabling alternative investment fund managers (AIFMs) to raise and manage funds on a cross border basis in other EU countries (passport option), provided that the fund is marketed only to professional clients as defined under the MiFID. It is uncertain whether this will boost business as the AIFM Directive imposes also heavy regulatory requirements to be met by the AIFMs.
Managers of private equity funds are only subject to the registration requirement and excluded from most of the other requirements if they do not manage assets worth more than either (AIFM Directive):
EUR100 million (including assets acquired through use of leverage).
EUR500 million when the portfolio only includes unleveraged funds with no redemption rights within five years following the date of initial investment.
However, EU member states are free to foresee stricter rules.
AIFMs falling within the scope of the AIFM Directive (or opting in) are subject to authorisation and supervision. They can market units or shares of their managed AIF across the EU based on a passport, provided that the marketing is only addressed to professional clients as defined under the MiFID. In this context, marketing means a direct or indirect offering at the initiative of the AIFM of units or shares to investors domiciled or with a registered office in the EU.
In addition, the Commission published its Proposal for a Regulation on European Venture Capital Funds, which suggests an optional uniform regulatory regime of qualifying venture capital funds called the European Venture Capital Fund (EVCF). If approved and adapted, managers of EVCFs would be allowed to raise funds freely across the EU from professional clients within the meaning of MiFID as well as certain high net worth individuals. The regulation would only apply to EVCFs managing assets of less than EUR500 million only. All EVCFs would have to invest at least 70% of their aggregate capital contributions and uncalled committed capitals in equity and quasi-equity instruments of unlisted SMEs only.
Additionally, the Reforming the Laws on Intermediaries for Financial Investments and on Investment Products Act (Gesetz zur Novellierung des Finanzanlagenvermittler- und Vermögensanlagenrechts) was published in the Federal Law Gazette on 12 December 2011 after passing the German parliament (Bundestag) and the Federal Council (Bundesrat). The most important parts of the act will enter into force on 1 June 2012.
Under this new act, interests in closed-ended funds will qualify as financial instruments and may in certain circumstances trigger the application of the German Banking Act (Kreditwesengesetz) (KWG) and the German Securities Trading Act (Wertpapierhandelsgesetz) (WpHG) in the context of marketing the fund.
It is currently unclear how the new act will work with the national implementation of the AIFM Directive.
There are no specific tax incentive schemes in Germany. However, there are certain rules that apply where a company is not listed.
According to the 2012 revised rule, a foreign company that receives a payment subject to German withholding tax will be entitled to (full or partial) withholding tax relief under the respective double tax treaty or the Directive 90/435/EEC on the taxation of parent companies and subsidiaries (Parent-Subsidiary Directive) or Directive 2003/49/EC on interest and royalty payments (Interest and Royalty Directive) if either:
The company is owned by shareholders that would be entitled to a corresponding benefit under a tax treaty or an EU directive if they received the income directly.
The foreign company's gross receipts in the relevant year are generated from its own genuine business activities.
If the foreign company fails both tests, the company would be entitled to withholding tax relief only if it meets both of the following tests:
Business purpose test. There are economic or other relevant (that is, non-tax) reasons for the interposition of the foreign company in relation to the receipts.
Substance test. The foreign company has adequate business substance to engage in its trade or business and participates in general commerce.
This rule was amended by the Economic Stimulus Bill (Wachstumsbeschleunigungsgesetz) (ESB), effective since 1 January 2010. Any tax losses (current or carried forward) are generally forfeited entirely where more than 50% of the shares in a company are transferred directly or indirectly. If more than 25% but not more than 50% of the shares in a company are transferred, the tax losses are denied pro rata. However, the ESB provides that tax losses are not forfeited where they are covered by taxable German built-in gains in the target companies' business assets.
The domestic legal structure most commonly used as a vehicle for private equity funds is a limited partnership (Kommanditgesellschaft) (KG), with a private limited company (Gesellschaft mit beschränkter Haftung) (GmbH) as its general partner and the investors as limited partners (GmbH & Co KG). Sometimes companies, such as GmbHs, public limited companies (Aktiengesellschaft) (AG) or partnerships limited by shares (Kommanditgesellschaft auf Aktien) (KGaA) are used.
If a domestic fund entity is used, the tax consequences depend on whether or not the fund entity is fiscally transparent.
Unless it is deemed to be a commercial partnership, a GmbH & Co KG qualifies as a fiscally transparent fund entity for:
Corporation tax.
Trade tax.
GmbH & Co KGs are not considered to have a permanent establishment based on the circular issued by the German Federal Ministry of Finance (Bundesfinanzministerium) (BMF) on 16 April 2010.
To avoid treatment as a commercial partnership, GmbH & Co KGs must:
Be managed (wholly or partly) by one or more of the limited partners.
Not hold an interest in a commercial partnership unless the investment is made indirectly through a corporation.
Qualify under the guidelines provided by the BMF in its statement of 16 December 2003 (PE Decree). These guidelines deal with the tax treatment of private equity and venture capital funds and the distinction between commercial and non-commercial partnerships. Non-commercial partnerships must usually:
not have external funding (except for limited short-term bridging loans);
not have security provisions over its portfolio companies' liabilities;
not have an organisational structure beyond what might be expected of a large, privately held estate;
use the fund's expertise only for trading on its own account;
only administer and realise investments for its own account;
not have short-term holdings (that is, holdings of under three to five years);
not reinvest sales proceeds, except as cover for investors' capital initially used to pay management fees. Up to 20% of the fund's capital can be reinvested as additional capital in companies in which the fund already holds an investment;
not be actively involved in the management of companies in which the fund has invested.
German tax resident investors with non-commercial interests in a transparent fund entity are subject to tax on the capital gains generated both:
At fund level by means of the sale of the shares in a portfolio company.
Through the sale of their partnership interest in the fund entity.
If the private investor's indirect participation is lower than 1% in a portfolio company at each point in time during a five-year period before the sale, the capital gain is taxed at a rate of 26.375%.
Properly structured non-German investors are only subject to tax if their indirect interest in a portfolio company amounts to 1% or more of the nominal capital in the portfolio company.
Corporations, such as GmbHs or AGs, are not fiscally transparent and are subject to trade tax and corporation tax, regardless of their shareholders. The following rules also apply:
Dividends received, and capital gains derived from the disposal of a shareholding in a portfolio company, are 95% exempt from corporation tax, unless:
the fund entity has acquired the shareholding in the portfolio company to generate a short-term trading profit; or
the acquiring company is a mere holding company (without any functions).
Dividends are only 95% exempt for trade tax purposes if the fund entity holds at least 15% of the portfolio company's nominal capital from the beginning of the assessment period.
Non-German portfolio companies must not receive more than 10% of their gross income from specific types of controlled foreign corporation (CFC) income.
In case of any European portfolio company, the 95% trade tax exemption only requires a 10% participation and provides no CFC income limitation.
Dividend withholding tax and potential relief under a tax treaty or an EU Directive must be considered.
No withholding tax on payments is imposed in Germany where the payment is viewed as a return of capital for tax purposes rather than a dividend.
Since 2009, German tax resident investors holding qualifying interests are subject to tax on their capital gains at a flat rate of 26.375% if they do not hold 1% or more in the nominal capital of the fund corporation.
The BMF issued two circulars on the flat tax regime on 22 December 2009 and 16 November 2010, which provide further guidance.
Foreign investors' tax treatment in Germany depends on the comparison of the foreign structure's legal form with its domestic equivalent. Foreign limited partnerships are usually considered tax transparent if they meet the PE Decree's requirements.
The BMF provided more guidance on 16 April 2010 in a circular on the treatment of partnerships with inbound and outbound structures under double tax treaties.
If a foreign structure is not recognised as tax transparent, a tax transparent partnership can be used as parallel vehicle (see Question 7, Transparent entities).
Sometimes fund initiators seeking to create funds that are not transparent under foreign tax laws can be subject to the complex provisions of the Foreign Tax Act (Außensteuergesetz) or the Investment Tax Act (Investmentsteuergesetz), which apply to resident taxpayers who invest in a non-transparent foreign fund.
The main investment objective of private equity funds is to create a healthy return on investments. This is commonly measured by internal rate of return (IRR) multiples and cash-on-cash figures.
Investors typically aim to achieve an overall fund return of 20% to 25% IRR per year through favourable exits by sale or initial public offering (IPO) after three to five years.
However, lower investment gearings are unfavourable to these return objectives and during the global financial crisis when exits were difficult to achieve, typical holding periods for investments extended from five to seven years. The average life of a fund ranges from eight to 12 years.
Investors can have additional objectives, such as access to:
Individuals.
Management expertise and resources.
New technical developments.
Business ideas.
Popular private equity fund structures (see Question 6) do not usually require authorisation although certain regulatory requirements will be introduced under the AIFM Directive (see Question 4).
However, the public offering of interests, units and shares in private equity funds requires the registration and approval of a prospectus by the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) (BaFin). Exemptions apply to private placements if the units in a private equity fund qualify as either:
Interests (for example, interests in closed-ended funds) within the meaning of the German Sales Prospectus Act (Wertpapier-Verkaufsprospektgesetz) (VerkProspG), where there is an exemption from prospectus requirements if:
the minimum commitment per investor amounts to at least EUR200,000; or
the offer is addressed to professional investors only.
Shares in AGs or KGaAs within the meaning of the German Securities Sales Prospectus Act (Wertpapierprospektgesetz) (WpPG); in which case either:
the offer must be addressed to qualified investors; or
the minimum investment per investor is at least EUR50,000.
Additionally, private funds organised under the German Associated Companies Act (Gesetz über Unternehmensbeteiligungsgesellschaften) (UBGG) are subject to certain investment limitations and reporting requirements. They also benefit from certain tax advantages (see Question 11, Regulation).
Private equity funds do not usually qualify as domestic investment funds under the German Investment Act (Investmentgesetz) (InvG). Investment funds within the meaning of the InvG are collective investment undertakings, which provide for redemption rights (open ended) and invest according to the principle of risk diversification in certain assets listed in the InvG.
Participations are a permitted asset under the InvG. However, a fund cannot qualify as an investment fund under the InvG if it either:
Invests more than 20% of the value of the fund in unlisted participations.
Is closed-ended (that is, it has no redemption rights) and not subject to investment supervision.
A private equity fund can be publicly certified as an associated company (Unternehmensbeteiligungsgesellschaft) (UBG), which has certain tax and financing advantages (see Question 10). However, UBGs are not common in practice because the UBGG generally prohibits the acquisition of control of a portfolio company by the UBG.
Under the German Venture Capital Act (Wagniskapitalbeteiligungsgesetz) (WKBG), venture capital funds can invest in unlisted capital companies (Kapitalgesellschaften) with registered and administrative office within a European Economic Area (EEA) member state which both:
Have a share capital of less than EUR20 million.
Were incorporated no more than ten years before the investment date by the venture capital firm.
However, the WKBG is too limited in scope to work practically for a venture capital fund, so no venture capital firms have done so. The European Commission decided on 30 September 2009 that the exemption of venture capital companies from trade tax pursuant to the WKBG is incompatible with the common market and must be implemented (Decision 2010/13/EC on aid scheme No C2/09 which Germany intends to grant to modernise the general conditions for capital investments). Therefore, the WKBG is no longer applied. National laws implementing the AIFM Directive will provide a completely new regulatory environment for fund managers from July 2013 (see Question 4).
Private equity companies do not usually qualify as domestic investment companies (see above, Regulation).
There are no specific restrictions on investors in private equity funds. However, certain civil law restrictions protect the assets of minors (persons younger than 18 years).
In addition, insurance regulations require that a German institutional investor (including as insurance companies and pension funds) is able to transfer its interest in the private equity fund without the consent of the general partner. German insurance companies and pension funds can only invest in OECD based fund vehicles. The fund cannot employ leverage. Short term borrowing is permitted but must be limited to 10% of the value of the fund. The fund must provide annual reports for each accounting period, which must be prepared and audited in accordance with the rules for capital companies.
There are no general statutory or other limits on:
Maximum or minimum investment periods.
Investment amounts or transfers.
However, to take advantage of tax transparencies under the PE Decree, the funds must hold their investments for three to five years (see Question 7, Transparent entities).
The principal instrument governing the relationship between the investor and the fund is either:
The fund's partnership agreement if it is a limited partnership.
The company's articles of association (articles) if it is a company.
Investors typically seek:
A predefined, clear investment concept and strategy with restrictions on the types of investments which can be made by the fund, so they can assess and mitigate the investment risk.
Sufficient control rights.
Adequate exit possibilities.
No, or capped, payment obligations.
Contractual restrictions on other activities by the fund managers. (These are not usually available when investing in listed funds.)
Some of the contractual clauses through which investors seek protection include:
Key man clauses. These require certain named executives to devote a minimum amount of time to the fund.
Hurdle rates. These set minimum targets a fund must achieve before the partners or managers can receive an increased interest in the proceeds of the fund.
Carried interest. These limit managers' right to a share of gains without having to contribute capital to the fund.
Clawbacks. These limit the managers' share of fund distributions.
Escrow arrangements. These empower an independent trusted third party to receive and distribute funds.
Removal of general partner clauses.
Investor advisory board seats.
Conflicts of interest rules.
Default clauses.
Private equity funds take equity interests (ordinary shares and/or preference shares) and mezzanine interests (if any) in portfolio companies.
Mezzanine interests can be split into:
Equity interests. Equity interests are:
usufruct rights (Genussrechte), which entitle the holder to earnings and/or capital gains;
silent participations giving contractual participation in the portfolio company's assets, participation in capital gains and losses, and corresponding control and governance rights (atypische stille Beteiligung).
Hybrid interests. Hybrid interests include warrants or convertible bonds (Wandel- und Optionsanleihen), which are bonds with the right to subscribe for shares attached.
Debt interests. Debt interests are shareholder loans (with or without an equity kicker) and silent participations, which confer no participation in capital gains or losses. They only have limited control rights (typische stille Beteiligung).
Mezzanine interests confer more limited participation in the risks and benefits of an investment than equity interests. Mezzanine interests rank behind senior debt but take priority over equity interests. Expenses for debt mezzanine can be tax deductible, in which case interest barrier regulations (see Question 22) can also apply. Equity holders and mezzanine finance providers who do not participate in the equity have diverging interests. However, an equity kicker can be used to align these interests to some extent.
Partnerships. Admissions of new limited partners and transfers of interests require the consent of the limited partners. However, under the partnership agreement, this requirement can be excluded, modified or consent can be granted in advance.
Companies. The transfer of shares in an AG and a GmbH can be restricted, for example, by adding consent requirements to the company's constitutional documents. Commonly applied transfer restrictions include requirements for prior consent from the:
Company.
Shareholders' meeting and/or the shareholders.
Supervisory board.
Other voluntary boards (for example, advisory boards or shareholder committees).
Shares in a GmbH can only be transferred in notarised form. Shares in AGs and GmbHs can only be issued for a contribution equal to their par value. Currently, the minimum par value is EUR1 for an AG and a GmbH.
Competitive processes have become the industry standard, even in the mid-cap sector. There are no specific rules for this procedure. However, if the target company is a listed AG or KGaA with its corporate seat in Germany, the German Takeover Act (Wertpapierübernahmegesetz) (WpÜG) applies. Distressed companies are generally not suitable for auction.
Public to private transactions are cumbersome and not common in Germany. Despite the introduction of a mandatory legal framework for public takeovers in 2002 (through the WpÜG), the complexity of public to private transactions is often considered disproportionate to the commercial benefits received by the investor.
In 2002 the Federal Court of Justice stipulated the following basic and fundamental conditions for a (voluntary) de-listing:
The general shareholders' assembly must resolve the de-listing with a simple majority.
The company or the main shareholder must submit a public offer to acquire the outstanding shares from the remaining shareholders as compensation for the delisting.
Minority shareholders can be inclined to oppose this measure, and can try to make a profit out of this situation. If the investor holds, or has acquired by way of a takeover offer, at least 95% of the shares, they can initiate a squeeze-out procedure under the WpÜG or the German Stock Corporation Act (Aktiengesetz) (AktG). The squeeze-out under the AktG is currently the more popular form.
A third squeeze-out route has just been introduced through a change of the German Transformation Act (Umwandlungsgesetz). This allows an entity holding at least 90% of the shares in another company to squeeze out the minority shareholders through an upstream-merger (that is, a merger by which the subsidiary is merged on the parent).
The principal documents are:
Acquisition documents. The principal acquisition documents are one or more share and/or asset purchase agreement(s). In multi-jurisdictional buyouts, there is often a master purchase agreement and local transfer agreements, which follow the legal requirements of the local jurisdictions.
Equity documents. The principal equity documents are:
shareholders' agreement entered into between the shareholders of the acquisition vehicle (NewCo);
articles of NewCo;
bye-laws (Geschäftsordnungen) for the management of NewCo;
partnership agreement, if the managers are pooled in a separate investment vehicle, usually in the form of a KG (see Question 6);
managers' service agreements; and
shareholder loan agreements or similar instruments (such as preferred equity certificates) entered into between NewCo and its shareholders.
Debt documents. The principal debt documents are:
senior facility agreements;
mezzanine facility agreements (if any);
inter-creditor agreements (if any);
security documents granting security over the shares and assets of NewCo and the target(s); and
security trust agreements (if any), under which the security trustee is required to hold certain types of security on behalf of the lenders and to execute the security in its own name (but on the lenders' account).
Private equity funds usually request comprehensive protection from sellers and managers through warranties and indemnities, which cover all relevant aspects of the portfolio company (including the legal, tax and financial situation).
It is common for sellers to enter into covenants restricting the business' operation between signing and closing, and non-compete obligations following closing. Restrictive covenants are used to conserve the status of the target (in particular, to prevent cash leakage) as of the annual accounts date (known as a locked box). These covenants are sought especially if purchase price adjustments are not based on closing date accounts.
During the global financial crisis, buyers placed a strong emphasis on the target's net cash at closing for valuation and for liquidity reasons. Locked boxes became less acceptable and earn-out clauses became more important. This enabled the deferral of the purchase price and allowed sellers to participate in the targets' future earnings. Earn-outs help to bridge the gap between the seller's price expectations and the buyer's valuation, but carry a higher risk of purchase price disputes after closing. These gaps are typical when the target's future earnings are unpredictable. Once the markets stabilised, locked box mechanisms became more popular.
Portfolio company managers owe fiduciary duties (Treuepflichten) (for example, confidentiality and non-compete duties) to the company. Generally, the managers must act in the best interests of the company (the company's interests are not always identical to the shareholders' interests, and the interests of other parties, such as employees, must also be taken into account).
While managers have a constitutional right of freedom of choice and to exercise professionalism, which generally allows them to conduct an MBO, they must not violate any of the company's prevailing interests, even if they conflict with their own interests. For example, the managers must inform the competent body of the company (such as the shareholders' meeting, the supervisory board (Aufsichtsrat) or a competent shareholders' committee (Beirat), if any) before they enter into negotiations with potential investors in relation to an MBO.
Restrictive covenants, including non-compete, non-solicitation and confidentiality covenants, both contractual and post-contractual, are usually imposed on the management in their individual service contracts, and frequently in the shareholders' agreement. The employment terms are tied into the incentive structure (good leaver or bad leaver provisions) agreed with the managers as shareholders of NewCo. In addition to their contractual terms, managers must abide by their fiduciary duties (see Question 20).
The private equity fund in a buyout is typically the majority shareholder of the NewCo used for the acquisition of the portfolio company. Therefore, private equity funds usually control the NewCo and the portfolio company's managers (who are appointed as managing directors of NewCo), which means they indirectly control the portfolio company and its subsidiaries on the shareholder level.
A NewCo is commonly structured as a GmbH. The shareholders in a GmbH can instruct the managing directors to take (or refrain from taking) certain measures and can remove the managing directors at any time.
It is common for the NewCo's management and its subsidiaries to be bound by procedural rules making certain measures subject to the prior consent of the shareholders' meeting or the shareholders' committee (if any).
A German GmbH's (and AG's) articles must be filed with the commercial register. These are publicly available. Companies, therefore, usually do not give protective measures in the articles themselves, unless required to by law, so these provisions are inserted into the shareholders' agreement instead.
Rules of procedure can be deemed to be a general instruction to the managers by the shareholders' meeting or committee. Therefore, they do not need to be made part of NewCo's articles to bind managers. The rules of procedure are often attached to the shareholders' agreement.
Although debt financiers are rare, all-equity transactions are common. Where debt financing is available, usually only up to 50% of the financing is currently provided by debt. Debt-to-equity ratios of 1:1 are common and senior debt is structured through term loans and working capital facilities. It is likely that sponsors will seek to recapitalise their investments as soon as the finance markets are more open to LBO financings.
At present there is only limited room for mezzanine financing in buyouts. Lenders can price senior debt highly with interest rates varying between different types of mezzanine products. While standard products are offered at rates of around 8%, mezzanine financing for more risk-oriented transaction structures (such as buyouts) are often priced at rates of at least 10%. At least 50% of the investment must currently be made as equity. Second lien finance (debt finance, which in terms of risk and return ranks between senior debt and mezzanine) is no longer relevant.
Mezzanine finance is usually structured as a junior loan, although other forms of mezzanine finance (see Question 15) are used, such as:
Vendor loans.
Silent participations.
Usufruct rights.
Bonds (including high-yield bonds in mega deals).
Recent trends include:
Vendor loans have been used widely to bridge the gap between buyer funding abilities and seller price expectations. These are often coupled with earn-outs (see Question 19).
Equity mezzanine instruments are more common (see Question 15).
German thin capitalisation rules have been replaced by interest capping rules (Zinsschranke), effective from 1 January 2008.
The interest capping rules limit the tax deductibility of (net) interest expenses for taxable businesses in Germany. Interest deductibility is capped at 30% of the taxable earnings before interest, taxes, depreciation and amortisation (taxable EBITDA) of the relevant business, and the rules apply to all (short- and long-term) interest payments to shareholders and third parties. However, the interest capping rules do not apply if the net interest expense (interest expense less interest income) does not exceed EUR3 million (escape clause 1). Moreover, the interest deduction is not limited, if the ratio of the adjusted equity to total assets of the business does not fall short by more than 2% of the equity-to-assets ratio at a consolidated accounts level (escape clause 2).
Escape clause 2 does not apply to corporations that form part of a concern if more than 10% of the net interest expense is paid to either:
Corporate shareholders that directly or indirectly hold a greater than 25% stake.
Affiliates of shareholders or third persons that have recourse against the shareholders or affiliates, provided the loan on which the interest is paid is shown in the consolidated accounts.
Non-deductible interest is carried forward indefinitely, but may be lost in corporate restructurings or the transfer of partnership interests.
Businesses are able to build up an EBITDA carry forward in business years where 30% of the taxable EBITDA exceeds the net interest expense. The EBITDA carry forward can then be used in the following five business years if the net interest expense exceed 30% of the taxable EBITDA in a business year and, therefore, the interest capping rules, in principle, would apply.
In case the interest capping rule does not apply, interest expense (gross not net) is only deductible at 75% for trade tax purposes.
Debt providers typically protect their investments by taking security over the shares and assets of NewCo, the portfolio company and its subsidiaries. NewCo's assets are usually limited to:
The shares in the portfolio company.
Rights under the acquisition agreement, in particular any compensation claims under the warranties and indemnities.
The portfolio company and its subsidiaries commonly grant the following kinds of security:
Real property charges.
Security assignment of chattels.
Security assignment of receivables.
Security assignment of intellectual property rights.
Share pledges.
Bank account pledges.
Guarantees.
Contractual subordination between shareholder loans and other debt finance is set out in the senior loan agreement and the mezzanine loan agreement. Priority of senior lenders over the mezzanine lenders and other creditors is provided for in the inter-creditor agreement. Structural subordination between certain types of debt providers can also be created by a multi-layer acquisition structure.
An AG cannot provide any loans or security to assist the purchase of its shares.
A GmbH cannot grant any benefits to its shareholders which would result in the book value of its net assets falling below its registered share capital figure (capital maintenance rules). This excludes payments in cash or in kind and the granting of security with respect to loans, which shareholders have received from third parties. The minimum registered share capital is EUR25,000.
When a GmbH makes a loan to a shareholder, the claim for repayment is taken into account when calculating the net book value, provided the value of the claim is not impaired. The managing directors must monitor the value and must immediately call back funds if there are indications the claim is impaired.
There are no exemptions for AGs in the context of a buyout.
Capital maintenance rules do not apply to shareholders with whom the GmbH has entered into a domination or profit pooling agreement. Managing directors of a GmbH can be liable for granting unlawful benefits to shareholders and shareholders can be liable for stripping the company of its assets or liquidity, or causing its insolvency. As a consequence, it is common for lenders to accept limitations on security being granted by the target company.
The order of priority in insolvency proceedings is regulated by the Insolvency Code (Insolvenzordnung). Debt providers are generally given priority over equity holders. This applies to claims for the repayment of shareholder loans, which are subordinated below external debt providers' claims.
There is no longer any distinction made between equity replacing and general shareholder loans. The insolvency administrator is entitled to deny any repayment of a shareholder loan which was granted in the year preceding the application for the commencement of insolvency proceedings.
Generally, debt providers are insolvency creditors. At best they receive a quota of their claim (if anything at all) ahead of equity holders. However, if debt providers have secured preferential rights over certain assets based on a contract or a collateralisation agreement, they can have priority over other creditors (for example, company employees or unsecured insolvency creditors).
Creditors can agree to voluntarily subordinate (Rangrücktritt) their claims to other claims, including those of equity holders. Debtor, creditors, and insolvency administrator (after commencement of insolvency proceedings), can also agree on a plan to reorganise and recapitalise the company.
Debt holders can achieve equity appreciation through conversion features. Equity appreciation through conversion features is easier to structure if the debtor is an AG (as opposed to a GmbH or a GmbH & Co KG). An AG can set aside a specific portion of its share capital to service holders of convertible bonds' equity appreciation rights.
Equity appreciation rights granted by other entities are usually structured as shareholder loans with warrants attached. However, these warrants are not convertible features. They grant an option to acquire equity as well as the right to payment under the loan. The shares required to service these options are usually delivered by shareholders. If the option is exercised, the transferring shareholder is compensated for any capital loss (which can arise if the purchase price of the option shares is lower than their fair market value).
In AGs and GmbHs, subject to the consent of a qualified shareholders' majority, it is possible to create authorised capital (genehmigtes Kapital) under which a debt holder can be issued new shares as payment for a debt as a contribution in kind (Sacheinlage). The right to trigger this conversion of debt into equity can be contractually entrenched.
There are three types of management incentives that can be used separately or together:
Variable salary components. Managers' service agreements can provide for a variable payment dependent on the portfolio company's performance and/or the individual performance of the relevant manager. These payments can be related to key financial figures such as EBITDA or the economic value added. They can also be related to the fair market value of the portfolio company. For tax purposes, payments are treated as manager's income and as an expense of the portfolio company.
Equity options. Managers can be granted equity appreciation rights (share options) in the form of warrants or convertible bonds (see Question 27).
Equity participations. Managers are often granted indirect or direct equity participations in their portfolio company, which is sometimes referred to as the management participation program or management equity program (MEP).
No specific tax reliefs or incentives are granted to portfolio company managers.
There is a modest tax relief, limited up to an annual amount of EUR360, for employees who receive shares from their employer at a discount, which depends on certain requirements (for example, that all employees employed for at least one year are entitled to receive such shares).
There are various restrictions on payments by a portfolio company to its investors including corporate, tax and regulatory aspects.
The applicable restrictions vary depending on the legal form of the company:
An AG is prohibited from making any payments to its shareholders other than regular dividend payments, which may only be paid out of the statutory annual surplus.
A more lenient regime applies to a GmbH, which may make payments to its shareholders provided that the book value of the net assets of the company does not fall below the figure of its registered share capital. In addition, shareholders are liable for damages if they cause the company's statutory insolvency by extracting cash from the company against prudent business judgement.
Payments to shareholders can be made as dividends or return of capital. Whether payment is regarded as a dividend or as a return of capital for tax purposes depends on the sourcing. Dividends can only be distributed from statutory profits. A return of capital does not attract German withholding tax, which is currently 26.375%, and does not lead to taxable income at the level of the shareholder.
Interest payments and all other payments to shareholders must meet the arm's length test, which means they must be in line with the terms and conditions third parties would agree. Any excess payments are viewed as a constructive dividend and attract withholding tax.
Distributions to the fund are prohibited if they occur within 24 months after acquiring control of the portfolio company and are either (AIFM Directive):
Made when, at the end of the last financial year, the net assets are (or, following the distribution, would become) lower than the amount of the subscribed capital plus reserves which cannot legally be distributed.
In excess of the profits at the end of the last financial year plus any profits brought forward and sums drawn from reserves available for this purpose, less any losses brought forward and sums placed to reserve in accordance with the law or the statutes.
The most commonly used forms of exit are:
Trade sales.
IPOs. (Although currently, IPOs only play a small role.)
Secondary buyouts.
Trade sales and secondary buyouts usually allow an immediate complete exit, whereas IPOs do not. IPOs are vulnerable to events that have an adverse effect on market sentiment, even if they have no direct relation to the company. However, in favourable periods, IPOs can produce high returns. Additional gains can be made when the share price picks up following listing, which means trade buyers are willing to pay a strategic premium.
The two most common forms of exit for unsuccessful/distressed companies are:
Sale to financial investors specialising in turnaround situations and restructuring.
Management acquisition of the company. They will attempt a turnaround using their first-hand knowledge of the target.
Since management has first hand knowledge of the target, management acquisitions can be smoother, quicker and less disruptive to the business than sales to financial investors. However, the seller must aim to ensure that management does not take advantage of their first hand knowledge to the seller's detriment. In particular, management may be tempted to emphasise the negative aspects of the target's status. Therefore, sellers should seek to protect their interests through anti-embarrassment (quick flip) clauses. These allocate a portion of the consideration received by the management in a follow-on sale of the target, which is in excess of the purchase price paid by the management to the seller.
Status. The BVK is a non-governmental organisation.
Membership. Currently, 217 investment companies are corporate members of the BVK.
Principal activities. The BVK is responsible for:
The development of public awareness of private equity.
The improvement of the framework for private equity in Germany.
The BVK is the major organisation for the German private equity industry and for the representatives of foreign private equity/venture capital funds operating in Germany. It co-operates with other private equity institutions internationally.
T +49 69 24 70 47 19
F +49 69 24 70 47 35
E jan.wildberger@pplaw.com
W www.pplaw.com
Qualified. Germany 1998; England and Wales, 2001
Areas of practice. Private equity; M&A; restructuring.
Recent transactions
T +49 69 24 70 47 16
F +49 69 24 70 47 15
E patricia.volhard@pplaw.com
W www.pplaw.com
Qualified. Germany, 1999; France, 2000
Areas of practice. Fund formation; regulatory.
Recent transactions
T +49 69 24 70 47 12
F +49 69 24 70 47 35
E pia.dorfmueller@pplaw.com
W www.pplaw.com
Qualified. Germany, 2003
Areas of practice. International tax structuring; M&A; finance structures; European holding companies; German inbound, in particular, from the US; German outbound.
Recent transactions
T +49 69 24 70 47 16
F +49 69 24 70 47 15
E jin-hyuk.jang@pplaw.com
W www.pplaw.com
Qualified. Germany, 2010
Areas of practice. Fund formation; regulatory.
