Private equity in Germany: market and regulatory overview
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.
The statistics in this article are taken from the German Private Equity and Venture Capital Association (Bundesverband Deutscher Kapitalbeteiligungsgesellschaften) (BVK) Annual Statistics 2012 (see box, Private equity/venture capital association).
The sources of private equity funding are:
Fund of funds (14.9%).
Pension funds (14.8%).
Family offices (9.6%).
Other asset managers (8.7%).
Insurance companies (7.3%).
Public sector (7.2%).
Private investors (1.9%).
Private equity manager (GPs) (0.3%).
After a weak start, the German private equity market regained at the end of 2012. Economic development and the government's alleviating measures relating to the debt crisis will be groundbreaking for 2013. Private equity is established as a solid part of German corporate financing. The demand will remain high and the investment results should be comparable with 2012.
In 2012, funds were raised for (BVK Annual Statistics 2012):
Early stage investment (7.6%).
Venture capital (unknown) (3.9%).
Later stage investment (2.8%).
Buyouts were the most common investment in 2012. EUR4.54 billion was invested in buyouts (down from EUR4.78 billion in 2011). This is a decrease of less than 5% compared to the 2011 investments.
Venture capital investments (seed, start-up and later-stage venture capital) achieved EUR0.52 billion (down from EUR 0.72 in 2011). This is a decrease of less than 27.5% compared to the 2011 investments.
The distribution of investments by stage in 2012 was (BVK Annual Statistics 2012):
Venture capital (seed, start-up and later stage venture capital) (61.0%).
Replacement capital (1.2%).
Exits totalled EUR2.71 billion in 2012, a decrease of almost 50% from the 2011 level of EUR5.35 billion. The following exit routes where used in 2012 (BVK Annual Statistics 2012):
Sales to other investors (secondary buyouts) (27.4%).
Trade Sales (24.9%).
Devestments stock exchange (24.3%).
Management buy-backs (2.5%).
Repayments of shareholder loans (1.0%).
Sales to financial institutions (0.3%).
The regulatory framework for private equity funds will change dramatically under 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. In Germany, the AIFM Directive will be implemented in the Capital Investment Act (Kapitalanlagegesetzbuch) (KAGB). The KAGB is intended to replace the currently applicable German Investment Act (Investmentgesetz), which is generally only applicable to open-ended investment funds invested in specific assets in accordance with the principle of risk diversification. The KAGB will become the legal framework for all future German fund structures (including closed-ended funds). The KAGB will create considerable administrative burdens for market participants, including in particular:
Licence requirements for managers.
Internal organisation and risk management requirements, which include:
conduct rules; and
Capital maintenance rules for managers.
In addition, alternative investment fund managers (AIFMs) will be able 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 Directive 2004/39/EC on markets in financial instruments (MiFID). The KAGB will also treat semi-professional investors in the same way as professional clients. Semi-professional investors are defined as either:
Investors who commit to invest at least EUR200,000 and who can prove their necessary expertise, experience and market knowledge with respect to the investment.
Staff members of the AIFM that have influence on the risk profile of the AIFM or the alternative investment fund (AIF), that assume control functions or have a comparable status, and members of the board of directors of the externally managed AIF.
Investors who commit to invest at least EUR10 million.
It is uncertain whether this will boost business, as the KAGB also imposes product requirements to be met at the fund level by AIFMs.
German managers of private equity funds are only subject to the registration requirement and excluded from most of the other requirements if only professional or semi-professional investors are invested in the AIFs and do not manage assets worth more than either:
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.
The Capital Investment Act (KAGB) also provides a lighter regulatory regime for EU sub-threshold AIFMs. These sub-threshold managers can market to professional and semi-professional investors in Germany on a cross-border basis provided that all of the following apply:
They are registered as a sub-threshold AIFM in their home member state.
Marketing of AIF managed by sub-threshold AIFMs is allowed under the rules of the home member state and is not subject to stricter requirements than those under the KAGB.
The sub-threshold AIFM has notified the intended marketing to the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) (BaFin).
European Venture Capital Fund Regulation
On 25 April 2013, the Regulation on European Venture Capital Funds was published in the Official Journal of the European Union. It suggests an optional uniform regulatory regime for qualifying venture capital funds (European Venture Capital Funds (EuVECAs)). Managers of EuVECAs will be allowed to raise funds freely across the EU from both:
Professional clients within the meaning of MiFID.
Certain high net worth individuals.
The regulation only applies to managers managing assets of less than EUR500 million. All EuVECAs would have to dedicate at least 70% of their aggregate capital contributions and uncalled committed capitals to investments in unlisted small and medium enterprises (SMEs) that issue equity and quasi-equity instruments. An EuVECA can invest in another EuVECA if the target fund itself invests not more than 10% of its aggregate capital contributions and uncalled committed capital in other EuVECAs.
Investment Products Act
On 1 June 2012, the German Investment Products Act (Vermögensanlagengesetz) (VermAnlG) came into force. It replaced the German Sales Prospectus Act (Wertpapier-Verkaufsprospektgesetz). Under the VermAnlG, interests in closed-ended funds 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.
Tax incentive schemes
There are no specific tax incentive schemes. However, there are certain rules that are particularly relevant for private equity investments.
Capital gains tax exemption
A capital gain triggered by the sale of shares in a corporation by a corporation is nearly exempt from German corporate income tax and trade tax (section 8b, Corporate Income Tax Act (Körperschaftsteuergesetz) (CITA)). Only 5% of the capital gain is treated as non-deductible business expenses. Therefore, effectively 5% of the capital gains are subject to corporate income tax and trade tax. As a result, the effective tax rate on capital gains is only about 1.5%. This regime applies to:
PE funds that are qualified for German tax purposes as non-transparent entities.
The investor corporation, if the fund is qualified as transparent.
There are certain exemptions to this rule, but they are not relevant to private equity investments.
In addition, a non-transparent fund or an investor corporation in a transparent fund can seek the protection of an applicable double tax treaty, depending on both the:
Place of residency of the fund and the investor.
Fund's legal form.
If the investor in a transparent fund is an individual, 40% of the capital gains are tax exempt, resulting in an effective tax rate of about 28.5%. In certain circumstances, a flat rate of 26.4% on the capital gains may be applicable. Double tax treaty protection is more relevant for foreign individual investors.
The carried interest of the managers of a private equity fund is generally both:
Qualified as taxable income from a commercial activity.
Subject to full income tax up to 47.5%.
Carry is subject to a special regime if both the:
Private equity fund is deemed to be a transparent asset-managing entity (not a business).
Managers' entitlement to the carry is subject to the investors having received full repayment of their capital.
Under this special regime, 40% of the carry is tax exempt (similar to capital gains). The effective tax rate is up to about 28.5%.
German change of control rule/loss carry forwards
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 (section 8c, CITA). 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 law provides that tax losses are not forfeited to the extent 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). Companies such as GmbHs, public limited companies (Aktiengesellschaft) (AG) or partnerships limited by shares (Kommanditgesellschaft auf Aktien) (KGaA) are sometimes used.
New German closed-ended AIFs must be set up as a closed-ended Investment-KG or an Investment-AG with fixed capital (Capital Investment Act (KAGB)). Transitional rules will apply to certain AIFs and their managers established before 22 July 2013.
If a domestic fund entity is used, the tax consequences depend on whether or not the fund entity is tax transparent.
Unless it is deemed to be a commercial partnership, a GmbH & Co KG qualifies as a tax transparent fund entity for:
Corporate income tax.
These non-commercial GmbH & Co KGs are not considered to have a permanent establishment in Germany (see the circular issued by the German Federal Ministry of Finance (Bundesfinanzministerium) (BMF) on 16 April 2010).
To avoid treatment as a commercial partnership, a 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 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 throughout a five-year period before the sale, the capital gain is taxed at a fixed rate of 26.4%.
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. Depending on their place of residency and their legal structure, they can seek protection under a double tax treaty.
Corporate fund entities, such as GmbHs or AGs, are not fiscally transparent and are subject to corporate income tax and trade 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 corporate income tax, unless the:
fund entity has acquired the shareholding in the portfolio company to generate a short-term trading profit; or
acquiring company is a mere holding company (without any functions).
Dividends received by the corporate fund entity are subject to corporate income tax and trade tax, if the shareholder holds no more than 10% of the portfolio company's share capital at the beginning of the calendar year. If the fund acquires a stake of 10% or more during a calendar year, this is deemed to have been acquired at the beginning of the year. This rule was introduced in 2013 and may in particular influence the taxation of recaps.
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. For non-German portfolio companies, this is also subject to the following requirements:
they must not receive more than 10% of their gross income from specific types of passive income;
in the case of a European portfolio company, the 95% trade tax exemption only requires a 10% participation and provides no passive income limitation.
Dividend withholding tax and potential relief under a tax treaty or Directive 90/435/EEC on the taxation of parent companies and subsidiaries (Parent-Subsidiary Directive).
must be considered, when the fund passes its proceeds to its investors (see Question 30).
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 distribution of gains (dividend). However, the taxpayer cannot choose the order of use and accrued gains are deemed to be distributed before paid-in capital.
Since 2009, German tax resident investors holding qualifying interests are subject to tax on their capital gains at a flat rate of 26.4% if they do not hold 1% or more in the nominal capital of the fund corporation.
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 a parallel vehicle (see Question 7, Transparent entities).
Fund initiators seeking to create funds that are not transparent under foreign tax laws may 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:
Management expertise and resources.
New technical developments.
Fund regulation and licensing
Popular private equity fund structures (see Question 6) do not usually require authorisation, although certain regulatory requirements will be introduced under the Capital Investment Act (KAGB) (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 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 Investment Products Act (Vermögensanlagengesetz) (VermAnlG), 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 Securities Sales Prospectus Act (Wertpapierprospektgesetz) (WpPG). In this case either:
the offer must be addressed to qualified investors; or
the minimum investment per investor is at least EUR100,000.
Additionally, private funds organised under the 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).
However, when the KAGB becomes effective from 22 July 2013, the conditions for marketing AIFs will be governed by the KAGB only. The private placements exemptions under the VermAnlG and the WpPG will no longer apply. The KAGB will not differentiate between public and private placements, and any marketing in Germany will require prior notification. However, the KAGB will differentiate between marketing to private investors (that is, any investor that is not a professional or semi-professional investor) and professional and semi-professional investors. Marketing AIFs to private investors will be subject to very strict requirements. For example:
AIFMs must be subject to public regulation for investor protection purposes.
AIFMs must have their registered office in the same country as the AIF.
AIFMs and AIFs must comply with the requirements of the AIFM Directive.
Non-German AIFMs must appoint a representative and a payment agent in Germany.
AIFs must comply with the product rules of the KAGB.
The marketing documents must be translated into German language.
The AIFM Directive provides the marketing provisions that apply to professional and semi-professional investors. During the transitional period until 2015, Germany will allow both:
Third country AIFMs to market EU and third country AIFs (but not German AIFs) to professional and semi-professional investors in Germany.
German and EU AIFM to market third country AIFs to professional and semi-professional investors in Germany.
Exemptions from the marketing rules under the KAGB will only apply to German sub-threshold AIFMs managing AIFs in which exclusively professional and semi-professional investors are invested (see Question 4).
Private equity funds do not usually qualify as domestic investment funds under the 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.
A new regulatory environment for fund managers will exist from July 2013 under the Capital Investment Act (KAGB) (see Question 4). The KAGB also applies to UBGs (in addition to the current regime).
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 fund's value. The fund must provide annual reports for each accounting period, which must be prepared and audited in accordance with the rules for capital companies.
Interests in Spezial-AIF can only be held by professional and semi-professional investors.
There are no general statutory or other limits on:
Maximum or minimum investment periods.
Investment amounts or transfers.
However, to take advantage of being treated as a non-business partnership 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.
Interests in portfolio companies
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).
Advantages and disadvantages
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:
Shareholders' meeting and/or the shareholders.
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 de-listing.
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 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).
Warranties and indemnities
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).
Covenants and purchase price adjustments
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)) 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 either in:
Their individual service contracts.
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 comply with 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). This 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. Therefore, companies do not usually give protective measures in the articles themselves, unless required to by law. 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:
Bonds (including high-yield bonds in mega deals).
Recent trends include:
Rules limiting the deductibility of interest
Interest capping rules. 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).
To corporations that are not part of a concern (escape clause 2) if not 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.
To entities that are part of a concern or group, 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 3). Escape clause 3 does not apply if any of the group members pays more than 10% of its net interest expenses for a shareholder financing (see above).
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 exceeds 30% of the taxable EBITDA in a business year (and the interest capping rules would therefore, in principle, apply).
Trade tax. If the interest capping rules do not apply (see above, Interest capping rules), gross interest expense exceeding EUR100,000 is only deductible at 75% for trade tax purposes.
Arm's length principle. Interest payments to shareholders or related persons which are not at arm's length are requalified for tax purposes as hidden dividends. If this is the case, the interest is not tax deductible and withholding tax will be triggered.
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.
Bank account pledges.
Contractual and structural mechanisms
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. Shareholders can be liable for stripping the company of its assets or liquidity, or causing its insolvency. Therefore, 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 can both:
Deny any repayment of a shareholder loan.
Reclaim any shareholder loan amount which was repaid 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. The 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.
This conversion can cause tax problems in distressed companies. If the loan that is converted into equity does not have face value at the moment of conversion, the difference between the market value of the loan and its nominal value is qualified as taxable gain. This gain may be set off with loss carry forwards from previous years. However, this set-off is subject to minimum German taxation. Therefore, 40% of taxable gains exceeding EUR1 million cannot be set off with loss carry forwards, even if sufficient loss carry forwards would be available. In an urgent restructuring, additional tax relief may be available on this gain.
Portfolio company management
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 (stock 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).
In addition, there is an indirect tax relief, as capital gains derived from equity participations are subject to a more favourable tax regime than ordinary income (which is subject to a tax rate of up to 47.5%). Only 60% of the capital gains derived by individuals are taxable, which results in an effective tax rate of up to 28.5%. A flat tax rate of 26.4% applies to shareholdings below 1%.
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 its 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 the 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 accrued profits. A return of capital does not attract German withholding tax, which is currently 26.4%, 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.
German anti-treaty/directive shopping rule
A foreign company that receives a payment subject to German withholding tax is entitled to (full or partial) withholding tax relief under either:
The respective double tax treaty.
The Parent-Subsidiary Directive.
Directive 2003/49/EC on interest and royalty payments (Interest and Royalty Directive).
However, this relief is subject to the anti-treaty/directive shopping rule (section 50d, paragraph 3, German Income Tax Act (ITA)). Under this, a foreign company is only entitled to the relief if either:
It 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.
Its gross receipts in the relevant year are generated from its own genuine business activities.
If the foreign company fails both tests, it is only entitled to withholding tax relief if it meets both of the following tests:
Business purpose test. There are economic or other relevant (that is, non-tax) reasons for the foreign company's receipt of the relevant payment.
Substance test. The foreign company has adequate business substance to engage in its trade or business, and participates in general commerce.
From 22 July 2013, distributions to the fund are prohibited if they occur within 24 months after acquiring control of the portfolio company and are either (AIFM Directive and Capital Investment Act (KAGB)):
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.
Forms of exit
The most commonly used forms of exit are:
IPOs (although IPOs only play a small role).
Advantages and disadvantages
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.
Forms of exit
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.
Advantages and disadvantages
Since management has direct 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.
Private equity/venture capital association
German Private Equity and Venture Capital Association (Bundesverband Deutscher Kapitalbeteiligungsgesellschaften) (BVK)
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.
Published guidelines. The BVK publishes the BVK-Yearbook, BVK-Directory and various other private equity related publications.
Information sources. The BVK collates its information through extensive surveys among its members (and a few non-members).
Description. Official Journal of the European Union - Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.
Description. Official Journal of the European Union - Regulation (EU) No 345/2013 of the European Parliament and of the Council of 17 April 2013 on European venture capital funds.
Description. Official website of the German Federal Parliament (Bundestag) - draft of the German AIFM Directive implementation act (including the German Capital Investment Act (Kapitalanlagegesetzbuch) (KAGB)).
P+P Pöllath + Partners
Professional qualifications. Germany, Rechtsanwalt, 1998; England and Wales, 2001
Areas of practice. Private equity; M&A; restructuring.
- Advised Quadriga Capital on their buyout of Lapp Insulators.
- Advised the management team on the buyout of CABB by Bridgepoint from Axa Private Equity.
- Advised Deutsche Beteiligungs AG on their exit of Heim & Haus.
P+P Pöllath + Partners
Professional qualifications. Germany, Rechtsanwalt, 1999; France, avocat à la Cour, 2000
Areas of practice. Fund formation; regulatory.
- Advising EVCA and BVK in the AIFM-D legislative process.
- ECE: Structuring of PE Real Estate Fund (Shopping Centres).
- MCap: Structuring mezzanine fund M Cap Finance Mittelstandsfonds GmbH & Co. KG with Deutsche Bank as cornerstone investor.
- First State Investments (UK): First State European Diversified Infrastructure Fund FCP-SIF.
P+P Pöllath + Partners
Professional qualifications. Germany, Attorney-at-law 1994, Germany, Tax adviser 1998
Areas of practice. Corporate taxation, corporate law, M&A, restructuring.
Non-professional qualifications. Law Examination, Free State of Bavaria; Business Administration, Ludwig-Maximilians-University, Munich.
- Advised Odewald Private Equity by the acquisition of Oberberg-Kliniken and the add-on-acquisition of SOMNIA-Kliniken;
- Advised Stargate Capital by its exit of Gehring Technologies;
- Advised Primondo Specialty Group with its sales of Hess Natur to Capvis;
- Advised Odewald KMU PE on their buy-out of Media Central.
Languages. English, German.
Professional associations/memberships. Vice President of the tax commission at Union Internationale des Avocats (UIA); member of IFA Germany; Deutsche Steuerjuristische Gesellschaft e.V., Arbeitsgemeinschaft der Fachanwälte für Steuerrecht e.V.; Munich Bar Association; Bavarian Tax Advisory Chamber.
Publications. Ongoing blogs in Handelsblatt-Online. Recent publications:
- Side-step merger without issuing new shares – Tax implications, Finanz-Rundschau 2008, p 160 – 165 (together with Helder Schnittker).
- German CFC-Rules after Cadbury Schweppes, Actualités DFJ 2007, p 54 – 56 (together with Herta Weisser).
- The sub-participant as notional shareholder of a GmbH, GmbH-Rundschau 2006, p 910 - 919.
P+P Pöllath + Partners
Professional qualifications. Germany, Rechtsanwalt, 2010
Areas of practice. Fund formation; regulatory.