This country-specific Q&A provides an overview to private equity laws and regulations that may occur 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/practice-areas/private-equity/
What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?
Based on recent public data, the value of private equity sponsored investments in Germany increased from EUR 21.1 billion (July 2016 to June 2017) to EUR 24.7 billion (July 2017 to June 2018). In the first half year 2018, the number of private equity sponsored deals remained stable amounting to 96 compared to 97 in the first half year 2017 whereby the transaction value significantly rose in the same time period from a total value of EUR 5.3 billion (first half year 2017) to a total value of EUR 10.7 billion (first half year 2018).
Given the overall amount of 314 published M&A transactions in the first half year 2018 in Germany, of which 96 transactions involved a PE sponsor as buyer or seller, approximately 30 % of all published M&A transactions in Germany involved financial sponsors.
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?
Financial sponsors need to achieve a clean exit which allows them to upstream a clearly defined amount of proceeds from the transaction to their investors. The clean exit approach is important for both the purchase price mechanics and the warranty and indemnity coverage given by sellers. Most exits from financial sponsors are structured on a ‘locked-box’ basis with an effective date prior to signing and no purchase price adjustments or earn-out mechanisms. Also, in most sponsor deals, the buyer receives very limited fundamental warranties (i.e. authority, capacity and title) with the optionality for the buyer to take out a W&I insurance for operating warranties. We hardly see any forms of indemnity being offered unless there is a tax indemnity the sole recourse for which is against a W&I insurance policy.
The time limitations for all other claims are very short - we have recently also seen a "no survival of claims" (i.e. with regard to covenants and other obligations under the transaction documents) concept following the closing which has been imported from the US.
On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?
The process for effecting the transfer of the shares depends on the type of the relevant target entity, i.e. private or publically listed stock corporation (Aktiengesellschaft) or limited liability company (Gesellschaft mit beschränkter Haftung).
As for a publically listed stock corporation, the takeover of a target company whose shares are listed in Germany is primarily governed by the German Securities Takeover Act. The German Securities Takeover Act provides for a formal takeover procedure and sets a strict timetable in which the bidder and the target have to publish certain documents, inter alia, an offer to all shareholders to acquire their shares in the target company.
Shares in a private German stock corporation, in principle, can be freely transferred. To the extent that share certificates are issued, the transfer is subject to the regulations under applicable securities laws. If no share certificate is issued, the shares can be transferred by assignment of the shares. However, in case of registered shares, the transfer of the shares requires an agreement between seller and purchaser by way of endorsement.
Shares in a German limited liability company are validly acquired by the execution of a share purchase agreement notarized by a German notary.
Generally, a transfer of shares is exempt from German VAT (unless seller opts for VAT which is very uncommon for share deals). If the sold entity owns German real property (or rights treated as real property under German civil law), such transfer may trigger German real estate transfer tax depending on the purchaser’s acquiring structure and this is a cost that is borne by the purchaser.
How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?
Sponsors usually provide the seller with equity commitments and certain funds debt commitment letters prior to signing. The equity commitment letters are usually structured as an irrevocable commitment given by the fund to the acquisition vehicle pursuant to which the financial sponsor commits itself to invest certain funds in the acquisition vehicle. The equity commitment letter is usually issued solely for the benefit of the purchasing entity but may be enforced by the seller on its behalf against the relevant fund entity. In the event that the German target is a limited liability company, the equity commitment letter should be notarized together with the share purchase agreement in order to be fully enforceable.
How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?
Locked-box structures are currently the most common approach in German M&A transactions. There are obviously a number of key benefits to using a locked box concept, the most obvious being that it gives certainty of price for both the buyer and seller at the time of signing the deal which is also the reason why a locked-box is clearly favour by financial sponsor sellers. However, a locked-box concept is also commonplace now among strategic sellers as locked-box share purchase agreements are considerably less complex and in auction processes the bids of the different bidders are much easier to compare. Also, a locked-box prevents the lengthy process of preparing, reviewing and potentially disputing the final price adjustment derived from completing accounts and does not tie up the target's management prior to signing with providing the necessary data for the different line items in relation to the adjustment items in completion accounts.
What are the typical methods and constructs of how risk is allocated between a buyer and seller?
The current market for sale terms is very seller friendly.
The most important risk allocation method is the locked-box itself which passes all economic risks and rewards following the effective date to the buyer. The effective date will be based on a historic balance sheet date which has been diligenced by the purchaser. The Seller is usually expected to provide fundamental warranties following such date. All operating issues are either not covered in the share purchase agreement at all or have primary recourse as against a W&I insurance policy. In the most competitive auction processes where there is a compressed timetable, we have seen instances of buyers signing share purchase agreements with no protection (outside of vendor due diligence and some buyer due diligence) and obtained W&I insurance coverage between signing and closing following a comprehensive confirmatory due diligence exercise. We do not see any closing conditions except for regulatory approvals (i.e. no bring-down, no MAC) in which case most transaction documents contain either a strict hell or high water clause for the merger clearance or a corresponding contractual penalty/break fee.
How prevalent is the use of W&I insurance in your transactions?
The use of W&I insurance has become an essential element of private equity M&A transactions in Germany. Historically, financial sponsor purchasers have used W&I insurance in auction processes in order to limit potential seller exposure and thus making their offer more attractive. In recent years, W&I insurance has also become more popular in transactions involving corporate sellers and it is therefore fair to say that at least 60% of all M&A transactions (and certainly almost all of these involving a financial sponsor) are now subject to W&I insurance. Given the competition and supply in the W&I insurance market, insurance policies have also moved from providing an insurance solution to operating warranties only to also covering title warranties, specific tax insurance and zero seller liability structures (i.e. no skin in the game by the Seller) without incurring substantial additional premiums.
How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?
Historically, we have not seen many sponsor driven public deals in Germany which was probably also a result of the common misperception that public deals in Germany are complex and burdensome. However, in the last twelve months we have seen several major public takeovers in Germany which were initiated by financial sponsors (e.g. Stada/Bain, Cinven, GFK/KKR) and we clearly see a strong tendency that sponsors are reviewing much more actively public deal opportunities. We would therefore expect more sponsor public takeovers in the future. The infrastructure market is booming in Germany with many sponsors looking actively at targets. We have seen several recent landmark infrastructure deals (e.g. Techem, Scandlines, Inexio, Tank & Rast) and we expect this to continue as more financial sponsors invest in assets with longer hold periods.
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?
An M&A transaction involving a German target company may be subject to review under the German Foreign Trade Ordinance (Außenwirtschaftsverordnung). The German Federal Ministry of Economics and Energy (Bundesministerium für Wirtschaft und Energie - "BMWi") is entitled to review any transaction provided that a non-EU person acquires (directly or indirectly) at least 25% of the voting rights in a domestic company. The review considers whether the respective acquisition poses a threat to the public order or security of the Federal Republic of Germany. The investment control procedure applies in principle to all sectors and regardless of the size of the companies involved in the acquisition (so-called cross sector review). Special rules apply to the acquisitions of certain defence and IT security companies (so-called sector-specific review).
For the purposes of a cross-sector review, it is sufficient if the German company is only acquired as part of an international Group that has been acquired by a non-EU person or if the non-EU person only indirectly acquires the respective stake in a German company through another EU-company. However, a notification of the BMWi is only required in case the German target company is active in the field of critical infrastructure. Since the BMWi is entitled to conduct a review even without having been notified officially and to issue orders or prohibit the transaction, parties to an M&A transaction that might fall in the scope of the German Foreign Trade Ordinance tend to notify the BMWi and to apply for a clearance certificate on a voluntary basis. As a result, clearance under the German foreign investment control regime is now frequently introduced as a condition precedent to closing in most share purchase agreements with a foreign purchaser acquiring, directly or indirectly a domestic company.
This is in particular true since recent developments have shown that the BMWi, since the amendment of the German Foreign Trade Ordinance in July 2017, takes a closer look to foreign investments. In July 2018, for the first time ever, the German government used its veto right to prevent a transaction based on the grounds of the German investment control procedures. In light of these recent developments, a further tightening of the German foreign investment control process is currently being discussed by the German government and it is expected that the threshold of 25% of the voting rights acquired by a non-EU acquirer will be lowered by 10% to 15%. However, changes to the German Foreign Trade Ordinance are still being discussed and private equity clients should be aware that a lower threshold may become effective to the end of the year.
How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?
The antitrust risks are usually shifted to the buyer as most transaction documents contain either a strict hell or high water clause for the merger clearance or a corresponding contractual penalty (whether by way of fixed amount or contractual damages) if the merger clearance cannot be 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?
There’s been a significant increase in the number of minority investments by financial sponsors over the last few years and we expect this to continue. We have seen many different capital structures from pure common equity investments with certain control rights for the operating business as well as a preferred equity or debt-like structure with limited governance rights (more akin to debt securities) but with the ability to participate in equity returns (e.g. through warrants, equity kickers or within the capital rights of the securities themselves).
How are management incentive schemes typically structured?
Most management incentive schemes are structured on an equity or equity-like basis granting the managers indirect equity interests in the target company, usually pooled in a management company at a higher level of the acquisition structure above the debt financing. Such a structure provides the management an indirect equity participation in the target company which facilitates the administration of the incentive scheme as well as the participation of new managers in the incentive scheme or the retirement of former managers. Non-equity incentive schemes are less common but seen in smaller deals or in programs with many participants in which the equity structure is too burdensome. Non-equity schemes have a broad range from bonuses, phantom stocks to cash settled options programs.
Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
If the management incentive scheme provides for a subscription by management to equity (or equity-like) instruments, beneficial capital gains tax treatment for income deriving from such instruments can be achieved under German tax law, if the individual has acquired beneficial ownership in the shares (e.g. participation in profits and losses; full administrative rights (esp. voting rights); notwithstanding vesting, ownership in the underlying assets cannot be arbitrarily withdrawn by sponsor etc.). The current capital gains tax rate is approx. 26.375 % (plus church tax if applicable) if a manager holds less than 1 % in equity or approx. 28.5 % (plus church tax if applicable) if the manager holds at least 1 % in equity. No capital gains tax treatment can be achieved if a program merely ‘mimics’ an equity participation (such as a phantom share program) or where share options are issued. Income from such programs would be usually qualified as wage income, subject to wage tax withholding, i.e. personal tax rate, which is currently up to approx. 47.5 % (plus church tax if applicable).
Are senior managers subject to non-competes and if so what is the general duration?
The managing directors service agreements and the employment agreements of key employees usually provide for non-compete restrictions including a post-contractual non-compete obligation for twelve to twenty four months following termination of the service or employment agreement. Pursuant to German law, post-contractual non-compete obligations are only enforceable if an additional compensation is paid for the term of the post-contractual non-compete obligation which depends on the impact of the non-compete agreement on the managing director. As a general rule, the compensation for the post-contractual non-compete should equal a minimum amount of 50% of the last contractual earnings of the managing director or key employee.
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?
With regard to the management of the target companies, in case of a German limited liability company, rules of procedures are often implemented, linking management decisions above certain thresholds to the approval of supervisory or advisory boards or the shareholders’ meeting. These corporate bodies are usually implemented through the articles of association and are dominated by representatives of the financial sponsor and thus the sponsor has control over material business decisions. In addition thereto, shareholders can instruct management of a German limited liability company with a simple shareholders’ resolution. Where the target company is a German stock corporation, there is no right to directly instruct the management of the company and there is less flexibility with regard to the corporate governance structure, the financial sponsor as majority shareholder can use its influence on the appointment of supervisory board members and management board members to control material business decisions.
In view of equity participations held by management, financial sponsors typically aim to have the controlling voting rights under any structure. Therefore, financial sponsors will limit the management's influence as equity holder to a minimum which can be done by establishing an indirect investment structure for the management participation program. The respective pooling vehicles established by the financial sponsor for the investment structure are solely managed and represented by an entity held by the respective financial sponsor in order to ensure that a financial sponsor has control over the investment.
Is it common to use management pooling vehicles where there are a large number of employee shareholders?
In the event a large number of employees are participating in the management incentive schemes, a limited partnership is usually used as a management pooling vehicle as these can be controlled via the general partner which is held or controlled by the majority shareholder. In general, as management of such equity participation programs and vehicles becomes more complex and complicated, the more managers and employees are involved, investors usually try to limit the number of participant and implement exit bonus schemes or phantom entitlements for additional employees.
What are the most commonly used debt finance capital structures across small, medium and large financings?
Small-cap deals have traditionally seen the greatest variety of structures. Aside from a particular focus on German particularities, a frequent capital structure in small-cap deals is a senior bank financing with a mezzanine financing provided by a debt fund.
In the mid-cap range there has been a strong competition between traditional banks offering senior financing and debt funds offering unitranche financings (see also the discussion of debt funds below).
For large acquisitions sponsors have frequently relied on a mixture of both term loan facilities in the London market and New York senior secured (or unsecured) notes. The split between these instruments depended primarily on investors’ demand at the time and so was different from deal to deal. Some deals have even seen complex structures combining both term loan facilities, senior secured notes and senior unsecured notes. Sponsors on large deals have also been able to push for intercreditor agreements providing for extensive hollow tranches, giving the sponsor a variety of possibilities to bring in new (senior or subordinated) financing (facilities or notes) into the capital structure.
Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?
German corporate law provides for two different financial assistance regimes depending on the type of the relevant entity – private limited companies (GmbH) or public stock corporations (AG, SE).
Public stock corporations (AG, SE) are generally restricted from supporting any stock holder’s acquisition of stock in such stock corporation. It is the general view in the German legal market that this restriction also applies to any form of upstream credit support –upstream guarantees or upstream security – by a target stock corporation for the acquisition financing. Guarantees and asset security are therefore typically granted only subject to a contractual limitation that such guarantee or security may not be enforced to the extent prohibited by corporate law. While this limitation is generally accepted by lenders in the German market, the contractual limitation may significantly reduce the amount enforceable under the guarantee or security (possibly even to zero).
Both private limited companies (GmbH) and public stock corporations (AG, SE) are additionally restricted from making distributions to their relevant share or stock holders to the extent such distribution would affect the relevant company’s share capital. It is generally accepted in the German legal market that these restrictions will also apply to any form of upstream credit support – upstream guarantees or upstream security – for an acquisition financing. Accordingly, the contractual limitations discussed above generally apply as well.
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?
Due to currently generally sponsor and borrower friendly market conditions, sponsors have in many cases been able to suggest their own sponsor precedent – mostly based on the Loan Market Association’s suggested form but reflecting specific drafting relevant to that sponsor’s investment and business strategies. It is typically agreed already in the term sheet that the agreed terms should be reflected in the sponsor’s precedent and the credit agreement would frequently be prepared by the sponsor’s counsel on that transaction. The level of negotiation on the draft credit agreement depends on whether the lender has completed recent deals with that sponsor (in which case the terms from the recent deal are often treated as agreed) or whether there is no such recent deal (in which case the draft is subject to more lengthy negotiations).
What have been the key areas of negotiation between borrowers and lenders in the last two years?
Aside from the obvious commercial points for negotiation, sponsors have been pushing for more favourable terms in certain key aspects of the credit agreements:
Credit agreements have generally tended to have only a covenant lite protection (with no protection for term loan lenders and springing financial covenants for revolving lenders only). In the same context, cure rights for financial covenants are almost always EBITDA cures, where the cure amount does not decrease the borrower’s debt but increases borrower’s EBITDA (giving any cure a commercially significantly greater effect). Calculation of EBITDA has frequently taken into account cost savings and synergies from acquisitions (or other initiatives), in many cases even on an uncapped basis. Especially on larger deals the credit agreements many times incorporated a New York notes style covenant section.
Many credit agreements allow the incurrence of additional debt subject only to a financial ratio test and in any case allowing for a certain “freebie” amount which can be incurred at all times. Lastly, credit agreements have been increasingly tightened with respect to assignments and transfers which can be made without the borrower’s consent, particularly with respect to assignments/transfers to competitors or loan-to-own investors.
Have you seen an increase or use of private equity credit funds as sources of debt capital?
The most notable shift in German sponsor driven mid-cap financings over the past years has been the increasing success of debt funds as one of the main sources of acquisition financing with figures of up to 50% of German mid-cap deals funded by debt funds. While earlier years have seen many unitranche financings provided by debt funds only, structures have continuously evolved into first-out/second-out structures featuring a built-in revolving facility, typically provided by a bank, and thus significantly lowering the overall margin for the unitranche product. Debt funds have also underwritten increasing ticket sizes (> EUR 250m) and even covenant lite unitranche structures for very strong credits.