General overview

How developed is the private equity market?

The Czech economy has seen a steady growth and the legal environment has been continuously improving.

Previously, numerous investments by local players who became strong in the second wave of coupon-privatization were ended by trade sales in the late nineties and as a result strong foreign strategic investors (from, among others, Germany and Austria) controlled a large part of the traditional industry. The Czech Republic lacked mid-sized and family-run businesses, meaning there were few investment opportunities for PE funds. Between 1998 and 2001, only 15 regional funds were set up, mostly by international players.

But from about 2004 changes set in, driven by the following:

• New technology companies emerged, which needed private equity and venture capital (for example, the anti-virus software Grisoft).
• Family and privately owned businesses realized that their previous strategy did not take adequate account of the development of corporate value, and opened up for investors.
• Strategic investors from the era of privatization reconsidered their strategy and divested parts of their businesses in the CEE region.
• The Czech Consolidation Agency started selling non-performing loan portfolios, providing a possibility for the entry of PE investors into Czech companies by later capitalization of receivables.

The Czech private equity market is still in a stage of development and expansion. The market has seen increasing activity of foreign private equity funds with an investment focus on the central and eastern European region. Acquisition vehicles are typically offshore acquisition vehicles in countries enjoying a favourable tax treatment (for example, The Netherlands). According to statistics published by EVCA in October 2005, a total of €496 million has been raised in 2004 for private equity investments into the CEE region, an increase of 59% compared to 2003. Most funding across the CEE region is sourced from non-domestic investors.

Czech institutional investors are still cautious regarding private equity investments due to a lack of experience with this type of investment in the private equity market. Further, the relevant Czech regulations limit the investment policy of domestic insurance companies and pension funds. Czech companies are only slowly becoming aware of private equity as an alternative financing source of which they can avail with confidence.

To what extent, if any, is there government support for investment in private companies?

The investment incentives granted by the Czech government are mainly aimed at large investments into new businesses. There are two types of incentives – for the manufacturing sector, and for technology centres and strategic services.

For investment incentives for the manufacturing sector, the main eligibility criteria are:

• the minimum investment is Kc200 million ($8.1 million) (or Kc150 or Kc100 million in regions with high unemployment);
• construction of a new production plant or expansion of existing production facilities;
• at least Kc100 million must be covered by the equity of the investor.

The types of incentives provided are corporate tax relief for 10 years, job creation grants, training and re-training grants and land transfer at symbolic prices.

For investment incentives for strategic services and technology centres, projects such as customer contact centres, shared service centres, expert solution centres, software development centres and high-tech repair centres can qualify. Depending on the nature of the project, the investors are obliged to fulfil exactly specified criteria: a certain amount of minimum investment, minimum number of newly created jobs, and financing a certain part of investment with own resources. There are two forms of support – subsidy to business activity and subsidy for training and re-training.

The investment incentives are granted through the Czech investment promotion agency – CzechInvest.

The Czech investment agency, CzechInvest, and the European Investment Fund are considering their support for PE investments by setting aside €10 million for the creation of a fund to top-up private equity investments into Czech start-up and growth companies that would be too small for private equity investment alone. At the time of writing, no official time schedule for disbursement of this fund has been announced; it is believed that the programme is planned for 2006.

How does the general tax regime affect direct investment in private companies?

The standard Czech corporate income tax rate is 26% for 2005 (and 24% for 2006 and following). Tax losses can be carried-forward for a maximum of five years.

Dividend distribution: Taxation of profit distribution (dividends) is generally subject to a 15% Czech withholding tax (regardless of whether the shareholder is an individual or a company). An exemption from the taxation is enabled by the implementation of the EU parent-subsidiary directive. Following that, dividend distributed by a Czech company is tax-free if: (i) the Czech subsidiary is a limited liability company, a joint stock company or a cooperative; (ii) the parent is tax resident in another EU member state; and (iii) the holding period of at least 20% share in the registered capital of the Czech subsidiary exceeds two years (this does not need to be fulfilled at the moment of distribution). Should these criteria not be satisfied, an extensive network of double-taxation treaties might also provide for a reduction in the withholding tax rate (depending on the tax residency of the parent). As a rule, double-tax treaties usually do not lower the withholding tax rate on dividends in case of foreign individuals.

Proceeds from the sale (capital gains): The proceeds from the sale of shares (both in limited liability and joint stock companies) are taxed at the standard corporate income tax rate. In contrast to many other countries, no participation exemption is available for Czech holding companies. As far as foreign holding companies are concerned, most of the double-taxation treaties stipulate that these proceeds may be taxed in the country of tax residency of the seller only (that is, the capital gain would not be taxed in the Czech Republic) – one exceptions is the double-taxation treaty with Germany.

Sale of shares in a limited liability company by an individual is generally exempt after a five-year holding period has elapsed, sale of shares in a joint stock company by an individual is generally exempt after a six-month year holding period.

Taxation in the country of residency of the holding entity has to be addressed separately.

Acquisition loans: Direct expenses incurred in connection with holding of participations, including interest on acquisition loans, are specifically tax non-deductible. Indirect expenses are capped at 5% of the dividend income if the holding company cannot prove a lower amount. To achieve the leverage effect and ensure the tax deductibility of interest on the acquisition loan, creation of a Czech SPV and subsequent merger may be an option to consider.

How are funds formed in your jurisdiction?

There are two categories of fund structures under Czech law:

• private funds (subject to general rules of the Commercial Code); and
• public funds (subject to specific regulation and supervision by regulator).

The main differences between these two categories are the manner and scope of fundraising, and the composition of investors participating in the investment vehicle.

Private funds: Limited partnerships (komanditní spolecnost) are private funds, but are rarely used as a form of fund structure. A limited partnership must have two types of partners: the limited partner and the general partner.

The limited partners are liable up to the unpaid amount of their contribution to the registered capital of the limited partnership (minimum contribution Kc5,000 – about €170 per limited partner).

The general partners are liable for the partnership's obligations with their entire property. They are the statutory body of the partnership and manage its business.

The regulations on limited liability companies apply to the limited partners and the regulations on general commercial partnerships (vos) apply to the limited partnership itself. Where no mandatory provisions of the Commercial Code apply, the rights of the partners may be stipulated by the articles of association.

Public funds: Public funds are regulated by the Act on Collective Investments (CIA), which defines two types of investment funds available under Czech law: (i) a standard fund based on a common EU licence according to the Ucits directive; and (ii) a specialized fund that does not satisfy the necessary legal requirements of the European regulation (that is, different risk allocation, investment in different financial instruments, no buyback of the securities, closed type fund). A specialized fund may be established through the form of an investment fund or a mutual fund (either open or closed). The CIA defines seven types of specialized funds, including private equity funds, stipulating special requirements for each of them. The CIA imposes several restrictions on funds formed under its rules. As these are not mandatory for private equity funds, no private equity fund has been established under the CIA.

The Act on Collective Investments recognizes the following legal structures:

• Investment company (management company, MC). This takes the form of a joint stock company. Its core activity is the creation and management of mutual funds or the management of investment funds. In addition, an MC may perform other activities (for example, managing individual portfolios and investment consulting). One of its activities must always be collective investment. Its licence is granted by the Securities Commission (SC), provided,
  – the MC's seat is in the Czech Republic;
  – the origin of its registered capital is transparent;
  – it has bearer shares;
  – personal and organizational prerequisites exist;
  – its business plan has been submitted;
  – qualified participation in the MC is by persons who are found to be suitable; and
  – leading persons fulfil certain requirements and are approved by the SC, the surplus capital of the MC must be at least €125,000 and it must be maintained throughout its existence. Additional criteria for the surplus capital must also be followed (for example, the surplus capital escalates with the value of the collective investment funds managed by the MC).
• Investment fund (IF). This is a legal entity in the form of a joint stock company with a limited duration (maximum 10 years). This structure is rarely used.
• Common fund (CF). A CF is not a legal entity. The contributions to a CF are collected by an investment company through the issuance of participation certificates. A ST constitutes a property that belongs to all the owners of the participation certificates. Czech law distinguishes between two types of CFs;
  – open, which does not have a limit on the amount of certificates issued. The owners are entitled to sell back the certificates to the CF or investment company; and
  – closed, which exists only for a limited time (maximum 10 years). The participation certificates cannot be sold back. The owner itself must sell them.

Deal structuring

What are the options for structuring an equity investment in your jurisdiction?

Shares in Czech companies may be acquired either through a local or foreign acquisition vehicle or directly; no restrictions exist for foreign companies to become shareholders of Czech companies (except the general rule under which a limited liability company with one shareholder must not be the sole shareholder of a Czech limited liability company). Structuring is mostly tax driven. Another aim of using an acquisition vehicle (NewCo) may be the limitation of liability. Financing and providing of security is a third factor impacting the structure.

From a tax point of view, an offshore vehicle (for example, a Dutch entity) might be favourable when it comes to exit as the capital gain would not necessarily be taxed in the Czech Republic.

As a particularity, Czech law knows a special method of taking control of an enterprise (other than a share or asset deal) – the sale of an enterprise regulated by special provisions of the commercial code. The sale of an enterprise is a special kind of asset deal where all assets and liabilities are transferred to the purchaser by virtue of law with some exceptions such as tax and other public liabilities, which remain with the selling entity. This might be favourable in particular where material tax risks are found in the due diligence. This structure (equally as a pure sale of selected assets) may, however, be unfavourable for the seller as the proceeds are subject to Czech taxation at the level of the Czech entity selling the assets (enterprise). Further, the proceeds from the sale have to be distributed by the Czech seller. The sale of an enterprise as a going concern offers the advantage of not being subject to VAT and so cash flow problems regarding postponed input VAT refund can be avoided. Further, acquisition of an enterprise as a going concern enables the buyer (a Czech SPV as a rule) to disclose/create goodwill (for reasons of simplicity assumed as the difference between the purchase price and the book values of the assets acquired less liabilities). Goodwill may also be depreciated for tax purposes. In share deals, the goodwill must not be created and is almost hidden indefinitely in the acquisition price of the shares.

Under some double-tax treaties (for example, the Czech-German treaty) Czech taxation applies to the purchase price if: (i) the seller is a foreign entity; and (ii) the purchaser is a Czech entity. This could impact structures where use of Czech purchase vehicles is intended but is unacceptable for the seller due to unfavourable tax implications.

Further consideration regarding structuring might involve Czech partnerships, especially in connection with foreign transparent entities. Such structures may, under certain conditions, result in regular taxation of profits in the Czech Republic, although further distribution up to the ultimate owners/individuals may be tax free.

How is management brought into an investment and what tools are available to give management a performance-based participation package?

Members of the management can be involved in the transaction by granting them a stake in the target company. This participation maximizes the management's motivation to contribute to a successful investment. The personal commitment of the management is even greater when the stake is financed by loan. Third parties can only grant the loan, as the company itself is, pursuant to the Czech Commercial Code, not allowed to lend money for the acquisition of its own shares. This applies to joint stock companies as well as to limited liability companies. A fortiori the granting of interest relief is excluded.

The process of vesting, that is, converting rights into full ownership, can be realized by call options on a contractual basis.

Management ratchets, that is, arrangements whereby the management's percentage of the equity will be increased according to the achievement of certain pre-defined targets, are in principle possible pursuant to Czech legislation. The increase in the stake can be realized by means of an option agreement on a contractual basis. Good leavers/bad leavers clauses for the case where a manager leaves the company are used.

Generally, remuneration paid out in connection with employment (for example, bonuses) is subject to the same taxation rules as regular salary. Remuneration of members of management boards or supervisory boards is generally not tax deductible for the Czech company. For the individual members – Czech tax residents – the remuneration is put on the same footing as employment income. For Czech tax non-residents, a 25% Czech withholding tax applies. Taxation of option schemes depends heavily on the structure of the scheme.

How would you undertake due diligence on a potential investment/buyout on behalf of a private equity fund?

If it comes to due diligence, the main difference is not whether an institutional or a strategic investor is looking into a Czech target but the specific risks arising from the target's current and previous business activities.

Special focus from a private equity fund's view might include management due diligence and possible restrictions on a later exit. Further, not only the investor's but also the lender's needs have to be observed.

If the target owns substantial real estate this will always form a major focus of a legal due diligence. The reason is that, under Czech law, there is no principle of bona fide acquisition of title even if the seller is registered as the owner in the land registry. It is therefore essential to review acquisition titles routinely for 10 years, as this is the period for acquisition of ownership by acquisitive prescription. Depending on the acquisition structure, tax due diligence would typically form another focus. The intensity of the due diligence process is also influenced by the willingness and ability of the seller to provide representations and warranties and the seller's credibility.

Are auctions a common feature of the buyout market in your jurisdiction? If so, how are auctions structured, how competitive can they be and which laws govern them?

Czech law has specific rules for mandatory public auctions (tenders) only, and these will rarely apply to targets of private equity investments. Specific rules are also in place for the sale of assets of insolvent companies; recently, there have been attempts to sell stakes or all assets by way of sale of an enterprise.

When it comes to the sale of stakes in Czech companies, the seller usually sets up private tenders; Czech law leaves the rules mostly to the seller's discretion, although general legal principles have to be observed. Czech law is not familiar with culpa in contrahendo: so it is recommended that any pre-contractual damage be covered by a special agreement at an early stage of a tender, both from the seller's and from the bidder's perspective.

Do secondary buyouts occur? If so, what are the special features associated with this type of transaction?

The market has seen some secondary buyouts such as the recent sale of CZIK Investment Ltd's stake in the petrol-card system CCS Ceská spolecnost pro platební karty, along with the original shareholders' stake to Advent International. Special features include the fund seller's limited (by period and amount) readiness and ability to provide representations and warranties and a general trend to have the main agreement governed by a law other than Czech law (typically, UK law).

Do public-to-private transactions occur in your jurisdiction and what are the specific legal issues relating to these types of transactions?

The first and second waves of privatization were finalized in the nineties. Only a limited number of state-owned companies remain to be privatized, the largest being state-owned electricity producer and supplier CEZ. The authority in charge of performing privatization transactions is the National Property Fund, which will be taken over by the Ministry of Finance as of January 1 2006.

Finance

What types of debt financing are commonly used in leveraged buyouts?

In larger deals, typically local and foreign banks (with or without a branch in the Czech Republic) are involved. Senior acquisition loans are usually granted to typically non-Czech holding companies with a view to refinancing the target company's debt. Borrowers would be interested in pushing the acquisition loan down to the target; this debt push down may be realized by structures such as post-acquisition merger. In CEE transactions, banks are generally willing to leverage up to 70% and seek 30% equity. Maturity of senior debt is usually in a range between six and eight years. Mezzanine finance is available but not used in many structures. Foreign banks would normally consider investments over €100 million. Though the regional deal flow is rather generated by smaller to mid-sized transactions, deals in a range of €150 million to €200 million are becoming more common. Using London LMA standard documentation has also become more common. Banks are interested in stable cash flows and established businesses, leaving a considerable number of opportunities to private equity investments.

What types of security do debt providers typically use to protect their investments?

The most sought after security in Czech deals is real estate. It is almost impossible to obtain local financing of a substantial amount without real estate security.

When it comes to shares in a Czech joint stock company, under the Securities Act, pledged shares may not be pledged again. It is questionable whether shares may validly be pledged in one pledge agreement but in favour of more than one pledgee. Due to the legal uncertainty, shares in joint stock companies are mostly pledged to one creditor only and this issue is dealt with in inter-creditor agreements.

Another obstacle is the ban on pledges containing forfeiture clauses, that is, where the ownership passes directly to the pledgee in case of default. Instead, the realization of the pledge has to be by sale (private sale possible for movables, prescribed procedure in case of shares in a limited company and for foreclosure). The last amendment of the Commercial Code has introduced a new section implementing the EC Directive 2002/47 on financial collateral arrangements. Under these new rules, certain restrictions on enforcement of collateral have been abolished for: (i) banks; (ii) financial institutions; and (iii) companies fulfilling at least two out of the following three criteria:

• total assets exceeding Kc600 million
• net yearly turnover of at least Kc1.2 billion
• equity of at least Kc60 million

For these companies, a simplified procedure of collateral enforcement applies, including private sale, forfeiture clause and performance of rights arising from the subject of security (such as dividends).

Further, the directive has also been implemented in Czech bankruptcy law with the effect that collateral provided to a company as described under (i) – (iii) is not affected bankruptcy proceedings over the collateral provider.

Is it possible to do a post-acquisition merger of the target and the acquisition vehicle to secure the acquisition debt?

Czech financial assistance rules are strict and apply in the same scope both to joint stock companies and limited liability companies. The prohibited financial assistance includes granting advances, loans or credits, or securing any credits or loans made to acquire the company's shares, or securing any other obligations relating to the acquisition of these shares. Given the prohibitions' broad scope, legal practitioners have developed a route that, according to most legal experts, does not breach the provisions of financial assistance and consists of a merger buyout. In this structure, a Czech acquisition vehicle receives the acquisition loan, acquires the stake in the target and the target and the acquisition vehicle then merge. After the merger becomes effective, the assets of the target company can be used for securing and repaying the acquisition loan. This route is, however, time and cost intensive and the acquisition loan has to be secured by other means for the period between acquisition and the merger becoming effective. Discussions continue on permitting financial assistance in certain circumstances (such as, under fair market conditions and complying with capital maintenance rules) and altering the prohibition of financial assistance to a limited liability company to reflect the European directive that applies this rule to public limited companies only. The outcome of these discussions is uncertain at this stage.

Is it possible to structure deals so investments can be owned by a holding company in a tax efficient jurisdiction?

This is, indeed, usually the case for an inbound investment. Investments in Czech targets are put into a holding company ideally combining both the friendly tax regime in its country of tax residency and a reasonably developed network of double-taxation treaties securing the reduction of (Czech) withholding taxes.

What techniques are used to put in leverage and bank debt in your jurisdiction without triggering rules preventing financial assistance?

Under the Czech financial assistance rules, neither a joint stock nor a limited liability company may provide security for purposes of securing debt used for its acquisition. A draft amendment is being discussed that would abolish or ease this restriction for limited liability companies. This would have a positive impact on financing structures. But even if this amendment is passed, capital maintenance rules have to be observed.

Is it possible to issue share warrants or other equity conversion tools in your jurisdiction? If so, how may they be used?

A Czech joint stock company may grant convertible bonds (160 CC) if expressly admitted under its statutes, if it simultaneously decides on a conditional capital increase requiring a two-thirds majority resolution of the general meeting. The issuance of corresponding securities (warrants) is possible (217a CC) both for share certificates and book-entry shares.

However, this tool has so far rarely been used in Czech PE transactions.

Exit strategies

What types of exits (for example, trade sale or initial public offerings) are possible in your jurisdiction?

Trade sales remain the most common form of exit. The domestic IPO market is still underdeveloped and does not constitute a serious exit option for private equity investors. The market has seen some secondary sales of private equity funds, such as the successful sale of CCS to Advent Int.

How might a fund pull out of an investment in the event of difficulties?

By the exit routes described above. No secondary market or funds specialized in acquisition of distressed investments in CEE has yet been established.

Developments

Are any forthcoming changes to legislation expected that will affect the sector?

A big obstacle for financing so far is the rule of Czech bankruptcy law under which secured creditors only receive a maximum of 70% of the proceeds of the sale of the asset securing their receivable. By the long-awaited amendment of the Bankruptcy Act, which is being discussed in parliament, this rule is going to be abolished and secured creditors are going to be entitled to 96% of the proceeds (after deduction of the costs of the sale). The amendment also strengthens creditors' rights in the creditors' committee. The amendment is expected to come into effect during 2006.

There are ongoing discussions on abolishing financial assistance rules for limited liability companies; at this stage it cannot be foreseen whether amendments will be adopted and what form they will take.

Author biographies

Barbara Kusak Nörr Stiefenhofer Lutz Barbara Kusak is a local partner in the Prague office of Nörr Stiefenhofer Lutz, admitted to practise both in Germany and in the Czech Republic. She profiles in mergers and acquisitions, with a focus on private equity. Since joining Nörr Stiefenhofer Lutz Prague in 1999, she has advised numerous clients on acquisitions and divestments, both on the corporate and the financing side. Kusak speaks Czech and German (native languages), English and French. Recently, she advised CZIC Investment Limited and several original shareholders on the sale of petrol card provider CCS Ceská spolecnost pro platební karty to Advent International, Hexion Specialty Chemicals, a portfolio company of a US private equity house, on Czech aspects of refinancing the group, and Fresenius Kabi AG on the acquisition of a majority stake in the leading Czech producer of infusion liquids, and on the subsequent squeeze-out of minority shareholders. Barbara Kusak is personally recommended by European Legal 500 for the Czech Republic, corporate and commercial, including mergers and acquisitions. Ing Roman Zenaty Nörr Stiefenhofer Lutz Tax advisor and auditor Roman Zenaty is a local tax partner in the Prague office of Nörr Stiefenhofer Lutz. Areas of his specialization include tax and accounting structuring of M&A transactions, international taxation, value-added taxation, corporate income tax and accounting methodology. He has recently advised, among other clients, the Mittelrhein Verlag and Saint-Gobain groups on the merger of several subsidiaries and the Magna Group on the contribution of real estate into a company. He has also been in charge of tax structuring an international real estate investment fund. Zenaty speaks Czech, English and German.