Latest considerations in Sino-German M&A

Author: | Published: 28 Aug 2013
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Chinese dealflow into the European powerhouse continues to rise. But investors must beware the differences between German and US law

Over the last two years German industry has become increasingly attractive for Chinese investment. According to official figures from inward investment agency Germany Trade & Invest, in 2012 China became the third largest foreign investor in Germany (in terms of the number of projects).

"German transaction practice is characterised by various peculiarities distinct from the US"

German industry has proven to be robust in the wake of the financial crisis, and Chinese investors are particularly attracted by the solidity of underlying business models. Auto parts, energy and metals have been most attractive for Chinese companies, and manufacturing and technology show the clearest signs of further activity.

Chinese investment into the country tends to follow well-developed tracks. For example, investment structures are well tested, advisers are acquainted with expectations and practices of non-domestic investors, and the legal framework of investments has been refined to resemble arrangements in international transactions, particularly as found under US law. However, German transaction practice is characterised by various peculiarities distinct from the US, and as Chinese companies tend to be more familiar with US practice, they need to be aware of these differences.

Governing law

Transactions involving German targets and sellers are principally governed by German law, even when the buyer/investor is non-German. Only in rare instances will a different governing law be agreed by the parties. Given that content and structure of German transaction documentation have adjusted to international standards, that often tend to be governed by US or English law, this may not be considered material. Further, the German legal regime should be considered sufficiently mature to accommodate the needs of the parties to an international transaction.

Purchase price

Unlike in the US, a considerable number of German transactions are entered into on the basis of a locked box purchase price. This appears to be a concept relatively unknown in China. The purchase price is not calculated on the basis of an adjustment as at closing, but on the basis of relevant items (for example, debt or cash) contained in a balance sheet. The economic risk of the business from this balance sheet date will vest with the purchaser, namely the cash/profit generated will remain with the purchaser. Consequently, the purchase price will be increased by the estimated (positive) cash flow generated by the sold business after the relevant reference date, usually on the basis of an agreed interest rate which attempts to reflect the cash flow. By proposing a locked box, sellers attempt to secure foreseeable returns from the sale.

In general, a purchaser will only agree to a locked box concept if the time span between the relevant balance sheet date and closing is not too long. Usually this must be significantly less than one year. The longer the time period, the higher the risk that a purchaser may face unexpected developments of the business.

Still, in rare instances locked boxes covering a period of close to one year may be agreed. It is crucial for any purchaser to be sufficiently protected, and if Chinese investors are less familiar with these structures, special care needs to be taken.

Firstly, the purchaser should request that the balance sheet that constitutes the basis for the purchase price calculation be warranted. Secondly, it should look for protection against unexpected developments during the locked box period. This should include assurances that: no cash flows out to the seller, among others, through business which is not at arm's length terms; no transaction cost are borne by the target; and, operations are conducted consistently with past practice.

Warranties and indemnification by private equity sellers

One fundamental issue in German M&A that Chinese buyers must be aware of is the approach taken by private equity funds as sellers. These entities tend to strictly limit their exposure under representations and indemnifications contained in a sale and purchase agreement (SPA). Their goal is to maximise the proceeds available for distribution to their own fund investors immediately after closing. Any potential liability or amount that would be kept in escrow would be considered to reduce the proceeds available for distribution, and thereby make the price offered by a potential buyer less attractive.

This means that private equity funds will request at the outset that any risk identified by a purchaser, and any comfort it needs, be taken into account in the purchase price. To the extent further comfort is requested, the seller's goal will be reflected in various respects, particularly:

  • by limiting the scope of representations and indemnifications preferably so that, if at all, only select warranties will be given besides those as to capacity and title; or
  • by agreeing on caps on liability (and likewise any escrow) that are calculated on the basis of actually identified risks.

Having said this, it is worth mentioning that not only private equity funds will resist a wide scope of representations. Strategic sellers will also expect that a purchaser will not request any broad catalogue that may be found in rule books, but only such representations that are indicated by the results of due diligence.

Broad warranty catalogues, as may be customary in US transactions, are not the rule in Germany. This is due to the relatively low threshold by which courts may consider sellers acting fraudulently. A seller will be very concerned that allegations of fraud are excluded – should fraud be given limitations on representations, indemnifications might be void and statutory law would apply instead.

Disclosure excluding liability

"Broad warranty catalogues, as may be customary in US transactions, are not the rule in Germany"

By the same token – this not being confined to private equity funds – sellers will only in exceptional cases accept that merely specific disclosure (for instance, in the SPA and its exhibits) would exclude their liability.

On the contrary, sellers will expect that all information disclosed in the course of due diligence will in some way be attributed to a purchaser, so that a purchaser's knowledge of these facts may bar it from raising claims for breaches of representations. There exists a broad variety of concepts that may be agreed. For instance any facts disclosed, or only gross negligent unawareness of a breach of a representation, may exclude the purchaser's claims. The underlying rationale is that due diligence is not viewed as a mere tool of risk assessment, but also as means to limit protection in the SPA. The specific applicable standard will often be subject to in-detail negotiation.

Transaction security

Similar to the view that future liability of a seller should be limited to a foreseeable extent, sellers will usually wish to achieve maximum certainty that a transaction will finally be closed. Consequently, they will try to limit the risk by restricting the scope of conditions to closing as much as possible. Accordingly, it is rarely agreed that any covenants contained in an SPA have to be complied with until closing. Instead a seller will usually only agree on those covenants that could be qualified to safeguard the goodwill of the business sold.

At the outset, sellers may attempt to have compliance with covenants further qualified by materiality. This may then be further defined by, for instance, reference to agreed euro values.

Similarly, sellers will be reluctant to have representations granted as at the date of closing and their accuracy at that date be a condition to closing. While this may be considered fairly standard in US and Chinese transactions,, in a German context sellers will resist such far-reaching bring-downs. Again, they would seize upon the argument that an inaccurate representation may give rise to allegations of fraud. Therefore, German sellers would, for instance, request that any bring-down be confined to facts which are under their control.

Finally, German sellers will be reluctant to agree to the inclusion of the absence of a material adverse effect as a closing condition. German sellers will often not agree to abstract language that only refers to a material adverse change, but will insist on specifically defined wording. For example, it would have to make reference to the adverse impact on turnover, Ebitda [earnings before interest, taxes, depreciation and amortisation] or the target's general financial condition. By the same token they will try to limit the provision to facts that relate to the target company itself, and will not accept reference to market or political events.

Recent developments and the eurozone

As the European economic crisis has increased the risk of busted deals, structures have developed to mitigate these risks for both German sellers and foreign investors. One example of this was AXA Private Equity's 2012 sale of HSE24 to funds advised by Providence Equity Partners. In this deal, a structure was developed to address the uncertainties of financing and risks of an aborted auction process. This innovation won private equity deal of the year at IFLR's  2013 European Awards.

Even if a financing-out is not agreed in the final agreement, uncertainty may remain as to whether the a purchaser or its financiers might try to pull out of a transaction. In 2012, such a scenario was even more likely in light of the still looming financial distress of Greece and the uncertainties about its continuing membership in the eurozone. The timeline of the process was roughly as follows:

An auction process may principally provide a proven tool set to secure the sale of a company because (hopefully) several interested parties may participate. On the other hand, the existence of such a broader group makes it more difficult to maintain confidentiality, or not as strictly as a seller wishes. This can mean the external deal community (including banks and potential bidders) would be aware that the sales process had kicked-off and possibly about its development. Should a transaction not close, a seller may be left with a tainted asset. In particular – rumours may have it that the asset's quality was the reason for the unsuccessful process.

"Due diligence is not viewed as a mere tool of risk assessment, but also as means to limit protection in the SPA"

Therefore, in the HSE24 deal, the desire was to structure a process which prioritised confidentiality, and closing was essentially sure once confidentiality within a comparatively small group of individuals could no longer be preserved. To such end, discussions from the beginning were held with one interested party only, of which the seller was convinced that this party's industry expertise as well as reliability from past transactions would support this kind of approach. Of course and needless to say, the quality of the asset to be sold also must justify this kind of approach.

Under the chosen process the interested party was not permitted to conduct full due diligence until the purchase agreement was signed. Instead it was provided very limited information and access to management to discuss issues it believed to be critical – all of such disclosure being subject to the seller's assessment as to importance and relevance. On this basis and parallel to the process, the parties started to negotiate the transaction documents. No banks of the purchaser were permitted to be involved in the process.

In lieu of this the seller arranged for stapled financing. Once the transaction documents had been signed the purchaser could conduct a full due diligence and also involve banks. The period available for this was very limited, essentially the time until which relevant merger clearance had been obtained. In the event the purchaser could arrange for financing through banks other than those that had committed the stapled financing, it could utilise such financing if the completion time schedule was not delayed.

And finally….

German sellers are more likely to show an affinity or interest in the future wellbeing of the individuals who are employed by the target business. It may therefore be important, to them, for a purchaser to provide a good home after the transaction completed, and even have the purchaser be contractually bound to commit to certain goals. So a final piece of advice to a potential Chinese purchaser is to turn such a request into a positive - accommodating a seller's wishes may prove to be a useful lever in a competitive situation.

By Skadden Arps Slate Meagher & Flom partner Lutz Zimmer in Munich