This country-specific Q&A provides an overview of the legal framework and key issues surrounding Private Equity in Germany.
This Q&A is part of the global guide to Private Equity.
For a full list of jurisdictional Q&As visit http://www.inhouselawyer.co.uk/index.php/practice-areas/private-equity-2nd-edition/
What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?
The German M&A market is stabilising after record highs in 2017 and 2018. According to recent EY reports , private equity sponsored investments in Germany decreased from 242 (July 2017 to June 2018) to 229 (July 2018 to June 2019). The value of these transactions also decreased from EUR 25.0 billion (July 2017 to June 2018) to EUR 14.2 billion (July 2018 to June 2019). Despite the surge in transactions in 2018, where the value of primary PE investments increased from EUR 2.4 billion to EUR 5.5 billion, the overall decline was primarily driven by the lack of multi-billion Euro transactions. Acquisitions by strategic investors increased by 20% in second half year 2018, to 298 transactions, who are achieving their growth targets largely through acquisitions and the willingness to pay higher premiums.
What are the main differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in your jurisdiction?
Many financial sponsor exits are achieved through a locked-box structure. This is because it provides an effective date agreed prior to signing and no earn out mechanisms or other purchase price adjustments. This allows for a clean exit with clearly defined proceeds delivered to investors. In addition, the buyer generally receives very limited essential warranties (authority, capacity and title) in financial sponsor backed deals, and obtains W&I insurance for operating warranties. Broad indemnities are uncommon with the exception of tax indemnity, the sole recourse of which is against a W&I insurance policy, or certain identified risks, such as environmental, known litigation, etc. There are also short time limitations for all claims.
On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?
The share transfer requirements are determined by the legal nature of the target entity, whether a private or publically listed stock corporation (Aktiengesellschaft) or limited liability company (Gesellschaft mit beschränkter Haftung) or certain forms of partnerships (Personengesellschaften).
The German Securities Takeover Act (WpÜG) governs publically listed stock corporations and provides an official takeover procedure requiring the buyer and seller to publish relevant transaction documents. This includes an offer to acquire all shareholdings in the target company, within a narrow time frame. In principle, shares in a private German stock corporation are easily transferrable. If share certificates are issued, the transfer is subject to applicable securities laws. If not, transfers are generally made by way of assignment. Registered share transfers require an agreement between the seller and buyer by way of endorsement. German limited liability company shares are transferred upon execution of a share purchase agreement that requires notarisation by a German notary. Generally, share transfers are VAT exempt unless the seller selects otherwise, albeit very uncommon for share deals. If the target entity owns German real property, or by German law is treated as real property, real estate transfer tax provisions may come into force. This depends on the buyer's acquisition structure and is a cost typically assumed by the buyer.
How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?
Prior to signing, the seller is generally provided with equity and debt commitment letters by the financial sponsor. Equity commitment letters are typically structured as an irrevocable commitment by the fund to the special purpose vehicle to invest funds in the special purpose vehicle. It is often solely for the benefit of the purchasing entity, however, it may be enforced by the seller on behalf of the purchasing entity against the relevant financial sponsor.
How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?
Currently, the locked-box structure is the most common pricing structure in the German M&A market. A key benefit and reason it is preferred by financial sponsor sellers is certainty of price at the time of signing. A locked-box structure is also widely used by strategic sellers as it is far less complex and bids received in the auction process are easier to compare. The structure assists to avoid disputes regarding the final price adjustment as it provides the necessary data regarding the adjustment items in the relevant financial statements. In case of an adjustment, sellers tend to seek interest on the purchase price, however, no interest is actually charged for leakage of value to the seller as it is treated as a purchase price reduction.
What are the typical methods and constructs of how risk is allocated between a buyer and seller?
The focus of German private equity investors is to achieve a clean exit. As such, the locked-box structure is used as an important risk allocation technique by fixing the purchase price at signing. This aims to shift all risk after the effective date to the buyer. The effective date on which the fixed price is based is usually a historical balance sheet date for which audited accounts exist. Given the current sellers' market, private equity buyers often accept purchase agreements with few warranties and in some cases, none at all. Sellers may provide limited fundamental warranties (title, authority, no insolvency) but seek to minimise operational warranties (including financial statements and compliance). As such, buyers typically request comprehensive due diligence information and may attempt to use management participation schemes, including management warranties, as additional security. Private equity buyers usually arrange W&I insurance, with zero seller liability except for fundamental warranties, to cover their exposure. The scope of operational warranties depends on the nature and size of the target entity and W&I insurance. Costs of W&I insurance are usually assumed by the buyer.
Closing conditions, such as a Material Adverse Change clause, are uncommon, except for regulatory approvals, whereas private equity buyers are sometimes willing to accept strict hell or high water clauses for merger clearance and a corresponding contractual penalty/break fee.
How prevalent is the use of W&I insurance in your transactions?
Today, the use of W&I insurance is crucial to German private equity transactions and is an established tool for the majority of deals. In previous years, financial sponsor buyers used W&I insurance to increase the appeal of their offer by limiting potential seller exposure. Given the growth in use and competition in the W&I insurance market, W&I insurance policies have evolved from purely insurance to include operating warranties (title warranties, specific tax insurance, zero seller liability structures) without significantly increasing premiums. As such, contractual mechanisms to ensure feasible remedies for the buyer, including partial purchase price retention, escrow models or bank guarantees, are now less relevant as they only apply to breach of fundamental warranties, which in itself is unlikely.
How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?
While public to private deals in Germany are more uncommon in comparison to other jurisdictions, it is mostly driven by the misguided belief that they are overly complex and burdensome. However, Germany does have a large percentage of prominent companies that are not listed (Mittelstand) and therefore, unlike the USA or UK, reduces the pool of potential public targets.
In the current market, financial sponsors are actively considering public deal opportunities with the expectation that financial sponsor public takeovers will continue to rise. There are a number of major deals in the pipeline including KKR being granted approval in November 2019 to purchase over 40% in Axel Springer, which would make KKR the largest shareholder, and to privatise the company. The attempt of Blackstone and Hellman & Friedman to acquire Scout24 was not successful though.
Infrastructure deals are also expected to increase due to the current boom in the sector and as financial sponsors are purchasing assets with prolonged investment periods. Recent infrastructure deals included the acquisition of stakes in targets such as Currenta, the Chemical parks of Bayer, and FlixMobility GmbH, a German-based provider of bus and railway transportation services.
Outside of anti-trust and heavily regulated sectors, are there any foreign investment controls or other governmental consents which are typically required to be made by financial sponsors?
If a German company is an acquisition target, there are two types of investment control procedures that it may be subject to under the German Foreign Trade Ordinance (Außenwirtschaftsverordnung). Firstly, a cross sector review which in principle, applies to all sectors. The German Federal Ministry of Economics and Energy (Bundesministerium für Wirtschaft und Energie, BMWi) has the right to review and prohibit any transaction where a foreign investor (any person or legal entity with direct or indirect ownership from outside the EU) acquires at least 25% of the voting rights in a German company, or (since 2018) 10% if the investment involves critical infrastructure. The review considers whether the acquisition endangers public order or security of the Federal Republic of Germany. Secondly, a sector specific review targets potential investments in industries that are considered significant for national security purposes (defence and IT security technology sectors). The BMWi's prior consent is required if foreign investors intend to acquire 10% or more of the voting rights in the relevant German company.
For a cross sector review, it is sufficient if a German company is acquired as part of an international group that is itself acquired by a foreign investor or if the foreign investor indirectly acquires the share in a German company through another EU-company. The BMWi may conduct a review without being officially notified and issue orders or prohibit the transaction. Parties to a transaction that may fall within the review scope, can notify the BMWi and voluntarily apply for a clearance certificate. As such, many share purchase agreements include clearance under the German foreign investment control regime as a closing condition. This is especially the case since the tightening of the German foreign investment control regime in 2018 and the impending adoption of the EU Regulation establishing a European screening mechanism for foreign direct investment due to become fully adopted on 11 October 2020 which may further tighten the rules.
How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?
Antitrust risks are often shifted to the buyer due to strict hell or high water clauses regarding merger control conditions or a corresponding contractual penalty (fixed amount or contractual damages) if the merger clearance is not obtained.
Have you seen an increase in the number of minority investments undertaken by financial sponsors and are they typically structured as equity investments with certain minority protections or as debt-like investments with rights to participate in the equity upside?
The rise in minority investments by financial sponsors has meant that diverse transaction and capital structures are being created to suit the particular requirements of each deal. Such structures include pure common equity investments with control rights over the operating business, preferred equity or debt-like structures with limited governance rights which are more analogous to debt securities but have the potential to receive equity returns (warrants, equity kickers, capital rights of actual securities).
How are management incentive schemes typically structured?
In Germany, management incentive schemes are common and are typically structured on an equity basis, granting management direct or indirect equity interests. Indirect equity interests in the target company are generally pooled in a management company above the debt financing entities and acquisition entity which facilitates the administration of the incentive scheme including involvement of new managers or the departure of former managers. This structure enables management to hold an indirect equity share in the target entity.
Non-equity incentive schemes are used infrequently, however are more common in smaller deals or schemes with a large number of participants with an onerous equity structure. These types of schemes cover a broad spectrum of incentives including option programs, bonuses or phantom stocks.
Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
In general, management remuneration qualifies as employment income that is subject to wage withholding taxes at the manager's personal tax rate, which currently is up to approx. 47.5% (plus, if applicable, church tax and social security charges). By contrast, management incentive schemes can be structured in a way that the manager receives capital gains instead of employment income. Capital gains are not subject to wage withholding tax and preferential tax rates apply (rates vary between 26.375% to 28.5% plus church tax, if applicable, depending on the size of the managers participation). In order for a manager to achieve this preferential treatment, he or she must become the beneficial owner of the relevant shares or other equity instruments. This requires, inter alia, that the manager participates in profits and losses of the shares, has full administrative rights (particularly voting rights) and that, notwithstanding vesting, the ownership in the underlying shares or other equity instruments cannot be arbitrarily withdrawn by the sponsor. Capital gains tax treatment is generally not available if an incentive scheme simply imitates an equity participation (e.g. in case of phantom stocks); it is also not available for stock option plans.
Are senior managers subject to non-competes and if so what is the general duration?
The most common restrictive covenant in managing directors service agreements and employment contracts is a non-compete obligation. The time period for such a covenant is usually one to two years after termination of the agreement. Terms beyond two years are generally unenforceable. Under German law, a compensation for the compliance with the obligation is required in order for a post-contractual non-compete obligation to be enforceable. The amount depends on the impact of the obligation on the managing director. Generally, compensation for the post-contractual non-compete for managing directors should be equivalent to a minimum of 50% of the last base salary; for regular employees it must be 50% of the entire contractual earnings (incl. bonus payments and other benefits).
How does a financial sponsor typically ensure it has control over material business decisions made by the portfolio company and what are the typical documents used to regulate the governance of the portfolio company?
The articles of association of German limited liability companies often allow the adoption of rules of procedure that require the approval of supervisory or advisory boards or the shareholders’ meeting for management decisions above a particular threshold and the relevant corporate bodies are dominated by representatives of the financial sponsor. This provides the financial sponsor with the desired level of control over material business decisions. Furthermore, shareholders can use a shareholder's resolution as a mechanism to instruct management. If the target company is a German stock corporation, there is no right to directly instruct management, reducing flexibility of the influence over corporate governance. However, as majority shareholder, the financial sponsor is to a certain extent able to utilise its influence on the composition of the supervisory board and (thereby indirectly) on the management board members to control material business decisions.
Is it common to use management pooling vehicles where there are a large number of employee shareholders?
Financial sponsors aim to obtain controlling voting rights and minimise management's influence. This can be achieved by establishing a management incentive scheme through a management pooling vehicle, particularly if a large number of employees participate. The pooling vehicle is then generally controlled and managed by an entity held by the financial sponsor. Where management incentive programs and vehicles become more complex, the more managers and employees are involved, financial sponsors seek to limit the number of participants and offer additional incentives such as exit bonuses.
What are the most commonly used debt finance capital structures across small, medium and large capital financings?
Traditionally, small cap deals are financed through loans from traditional commercial banks, including local savings banks, such as the Sparkassen. As such, these deals are mostly driven by the regional (and often long-term) relationships and remain mostly club-style without syndication strategies.
In mid-cap deals, there remains heavy competition between debt funds and the syndicated senior lending market including national and international players. Over the last two to three years, debt funds have significantly increased their market share in such market segment by offering straight forward super senior /senior unitranche financing structures, often teaming up with commercial banks buying into the super senior revolving facility tranche. Such financings often allow for increased flexibility, including grower basket concepts, uncommitted incremental facilities and permission of envisaged buy-and-build strategies.
Large cap deals are still widely dominated by syndicated senior financings. Debt funds are not yet in a position to compete as they do in the mid-cap segment, however are aiming to increase their current market share, including relating to transactions with debt volumes in excess of EUR 200 million. An alternative large-cap financing solution also includes high yield bonds, however this form of financing is commonly used by strategic investors from the strong German corporate segment whereas combined bank/bond financings remain an option also for private equity investors.
Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?
German corporate law does not include financing assistance legislation in a sense comparable to other jurisdictions such as the UK but provides capital maintenance schemes to protect the relevant directors from personal civil and criminal liability. The relevant applicable scheme depends on the entity involved, whether a private limited company (GmbH) or a public stock corporation (AG, SE). It is generally prohibited for a public stock corporation (AG, SE) to support any stock holder’s acquisition of stock in such entity. In addition, private limited companies (GmbH) and public stock corporations (AG, SE) may not make distributions to their relevant share or stock holders so far as the distribution affects the company’s registered share capital. It is generally accepted in the German legal market that these restrictions also apply to any form of upstream credit support, whether upstream guarantees or security, for acquisition financing. As a result, guarantees and asset securities are typically granted subject to a contractual limitation providing that the guarantee or security may be unenforceable to the extent it is prohibited by corporate law. While this limitation is generally accepted by lenders, the contractual limitation may significantly reduce the amount enforceable under the guarantee or security, potentially in its entirety.
For a typical financing, is there a standard form of credit agreement used which is then negotiated and typically how material is the level of negotiation?
With current market conditions favouring sponsors and borrowers, they often propose their own precedent, primarily based on the recommended Loan Market Association form whilst reflecting specific points regarding the relevant investment and business strategies. It is often provided in the term sheet that the agreed terms are reflected in the sponsor’s precedent and the credit agreement for the transaction is to be prepared by the sponsor’s counsel. The extent to which the draft credit agreement is negotiated depends on whether the lender and sponsor have completed recent deals together, which may result in the terms from the recent deal being treated as agreed, or if there is no recent deal, the draft being subject to potentially extensive negotiations.
What have been the key areas of negotiation between borrowers and lenders in the last two years?
Financial sponsors are insisting on more favourable terms in credit agreements, including higher leverage levels and more relaxed loan terms such as grower baskets, a reduced number of restrictions and more flexible permissions relating to disposals, acquisitions and other key commercial parameters. In particular, covenant lite / covenant lose credit agreements provide reduced risk alert protection for term loan lenders and springing financial covenants for revolving lenders only. Similarly, cure rights for financial covenants are primarily EBITDA cures to increase the borrower's EBITDA rather than decrease their debt. Thus, providing a significantly enhanced commercial outcome.
The EBITDA calculation often accounts for cost savings and synergies from acquisitions (or other initiatives), even on an uncapped basis. Especially in large deals, credit agreements are regularly incorporated into a New York notes style covenant section.
Many credit agreements allow for additional debt, subject to a financial ratio test and often for a specified amount that can be incurred at all times. Assignments and transfers under credit agreements are increasingly tightened to occur only with the borrower’s consent, excluding transfers to competitors or loan-to-own investors from the onset.
Have you seen an increase or use of private equity credit funds as sources of debt capital?
In recent years, a prominent shift in particular in sponsor lead mid-cap financings is the rise of debt funds, which have become a main source of leveraged / acquisition finance. As a consequence thereof, market players previously only recognized as private equity investors have entered into the market with own debt financing departments, often accompanied by office openings in German financial centers. Fund raising volumes continue to rise significantly and the availability of enormous dry powder has significantly lowered the overall margin for unitranche financings. Debt funds have also started to underwrite increasing ticket sizes (> EUR 200 million) in the German market.