Exit strategies for Spanish and Portuguese private equity

Author: | Published: 25 Apr 2003
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Over the last five years, the growth of the Spanish venture capital and private equity markets has outperformed that of most other European countries albeit following the same trends observed in most of Europe such as Germany or Italy. However, the Spanish market is far from mature and is likely to continue to grow in terms of the number of players, the size of the deals and its complexity. In Portugal, notwithstanding the decrease in venture capital and private equity investment in 2001, investment levels increased again in 2002.

Spain and Portugal are particularly attractive as they offer plenty of opportunities to invest in small or medium-sized (often family-owned) companies in need of financing or management skills. Medium-sized and large companies are also investment opportunities as a consequence of divestments by multinationals that redefine their core business, and investors can also put money into under-priced quoted companies with a limited free float. Spanish and Portuguese private equity transactions have tended to concentrate on expansion and leveraged investments.

In 2002 value expansion investments represented approximately 62% of all private equity transactions in Spain, while leveraged buy-outs (LBO), management buy-outs (MBO) and management buy-in (MBI) deals held a 24% share. Just 11% of the latter corresponded to investments in early-stage companies. In Portugal, despite the final figures for 2002 not yet being available, it is estimated that during 2002, value expansion investments, LBO/MBO/MBI deals and investment in early stage companies represented 57%, 28% and 15% of the total venture capital and private equity investment, respectively.

Conversely, divestment continues to be a cause for concern for most private equity funds in both countries. In the absence of an efficient secondary market for medium-sized companies, exit through an initial public offering is in most cases not available and must be substituted by trade sales or secondary buy-outs.

Spanish and Portuguese regulatory framework

Spanish law provides for two types of venture capital entities: venture capital companies (sociedades de capital riesgo) and venture capital funds (fondos de capital riesgo), both subject to the authorization of and monitoring by the Spanish stock market regulator, the Comisión Nacional del Mercado de Valores (CNMV). Although private equity activities are not exclusive to venture capital companies and funds, only these benefit from the favorable tax treatment provided for by Law.

Spanish venture capital entities are subject to stringent investment requirements which, however, have been recently amended to introduce a higher degree of flexibility. At least 60% of their funds must be invested in entities that are not of a financial nature and are not listed on stock exchanges at the time of the investment. However, investments in companies holding shares in non-financial entities or owning real estate devoted to business activities (even if the real estate represents more than 50% of the assets of the target) are now also permitted. Investments must be structured mostly in the form of equity although debt financing is also available in the form of profit sharing loans. Risk diversification rules provide that venture capital entities are prevented from investing more than 25% of their assets in the same company, more than 35% in companies belonging to the same group of companies and more than 25% of its assets in companies belonging to its own group (in the latter case, subject to several requirements aimed at ensuring the transparency of such inter-company investments).

Portuguese law on incorporation and activity of venture capital entities was recently reviewed with the aim of simplifying procedures and allowing the development of the venture capital activity. As in Spain, Portuguese law provides for two types of venture capital entities: venture capital companies (sociedades de capital de risco) and venture capital funds (fundos de capital de risco). Venture capital funds are divided into funds for qualified investors (fundos para investidores qualificados), whose units may only be subscribed or acquired by qualified institutional investors and funds for the general public (fundos comercializáveis junto do público) whose units may be subscribed or acquired by any investor.

The incorporation of a venture capital company or a fund for qualified investors is subject to registration with the Portuguese Securities Market Commission, the Comissão do Mercado de Valores Mobiliários (CMVM). The Commission also authorizes the incorporation of a fund for the general public and monitors compliance with statutory requirements.

Portuguese venture capital entities are also subject to investment requirements. Venture capital entities may not invest in a company for a period exceeding 10 years, while venture capital fund investment in listed securities must not exceed 50% of their funds. Two years after their incorporation venture capital funds must also have no more than 25% of their assets invested in the same company, or no more than 35% in companies belonging to the same group of companies.

Taxation of private equity

Spanish venture capital entities are entitled to a full domestic double taxation tax credit with respect to the dividends distributed by the entities in which they hold a stake. As a general rule, these entities are also allowed a 99% reduction in their corporate income tax for capital gains arising from the transfer of the stake in qualified subsidiaries, provided the stake was held by such entity for a period ranging from two to 12 years. Dividends and capital gains obtained by Spanish venture capital entities are not subject to withholding tax at source.

On the other hand, should the stake in the Spanish target be held by foreign funds or vehicles, rather than Spanish venture capital entities, dividends paid to such non resident investors will, in principle, be subject to a 15% withholding tax. However, no withholding tax will accrue on dividends distributed to EU shareholders entitled to the benefits of the Parent-Subsidiary Directive. The 15% withholding tax rate could also be reduced under the application of double taxation treaties. Capital gains from the disposal of such Spanish interest obtained by European Union resident shareholders and those entitled to the benefits of a relevant double taxation tax treaty are not generally subject to taxation in Spain.

Capital gains of Portuguese venture capital companies resulting from the disposal of shares held for a minimum period of one year, as well as any interest or other financial cost incurred for the acquisition of such shares will not, as a general rule, be included in their taxable income. The income of Portuguese venture capital funds is not subject to taxation.

The non-treaty withholding tax rate on dividends paid by any Portuguese company to non-resident investors is 25%. Where a double taxation treaty applies, capital gains on the sale of shares are not generally taxable in Portugal and dividends are subject to a reduced withholding tax rate. The benefits of the Parent-Subsidiary Directive also apply.

Private law aspects of private equity

Both Spanish and Portuguese contract and corporate law permits the implementation of typical private equity structures with a considerable degree of flexibility and sophistication.

Most private equity acquisitions involve due diligence, acquisition agreements, competition clearance and other similar M&A features. Representations and warranties, indemnities and similar covenants are common practice but must be fine-tuned to Spanish and Portuguese legal institutions for enforcement purposes. A precise definition of the equity structure adapted to the diverging interests of financial, trade and management investors and an appropriate tax plan in the early stages of the transaction are paramount, and may significantly facilitate the exit.

Financing of private equity transactions in Spain and Portugal is often highly structured and complex. These deals include such aspects as the definition of the optimal leverage of the deal, the (senior or mezzanine) debt-to-equity structure and intercreditor arrangements, provision for the upstreaming of funds, and adequate guarantees and securities. Spanish and Portuguese security proves to be less flexible than in other jurisdictions (prohibition of floating charges, financial assistance) although a creative structuring may overcome most of these restrictions.

Corporate governance and other shareholder-related issues are usually dealt with both in the by-laws of the target and in shareholders' agreements. In this respect, Spanish companies registries have came a long way in accepting some of the most common provisions in private equity transactions: come and tag-along rights, preferred shares, investment and dividend policies, minority protection rights, non-competition and other undertakings. These provisions are also accepted in Portugal. Spanish (in particular tax) law has also evolved considerably in relation to management incentives, key management insurances and other instruments that permit the private equity investor to motivate the target management.

The exit rights of the private equity investor are usually provided for both contractually (and secured by means of irrevocable powers of attorney or pledges of shares) and in the by-laws of the target (preferred shares, tag-along and other divestment rights). The choice of the adequate investment vehicle (be it a Spanish or Portuguese partnership or limited liability company, or a special purpose vehicle in a tax-efficient jurisdiction) or other structures (non-voting shares or preferred shares) is also a key element for a successful exit (besides pre-empting many disputes over the term of the investment).