Germany: a primer for private equity funds

Author: | Published: 10 Oct 2001
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Private equity firms are excited about Germany for good reason. Germany is increasingly attractive to private equity firms as a result of an unusual confluence of factors, including the unprecedented availability of investment opportunities as well as the increasing interest of German institutional investors in diversifying their portfolios to include alternative asset classes. In the case of public corporations, the German market has demanded that "shareholder value" be maximized, creating a renewed focus by major corporations on their core businesses and resulting in the proposed divestiture of numerous non-core businesses. This trend will accelerate as a result of recent tax reform legislation, which will exempt the corporate gain on such sales from taxation. Demographic trends and political stability have also contributed to the increase in the number of investment opportunities for private equity. The founders of a significant number of German family-owned enterprises are reaching retirement age, and their heirs are simply not able or willing to inherit the mantle. The advent of new high-tech enterprises in need of expansion capital is another factor contributing to the panoply of investment opportunities available for private equity.

The exit scenarios for private equity in Germany are robust, although perhaps not at their historical peak. The development of the financial markets and emergence of a stock culture in Germany have created exit opportunities that simply did not exist a decade ago. Private equity firms have already begun to take advantage of these opportunities and will undoubtedly continue to do so for the foreseeable future. The German private equity market, while more crowded than a few years ago, is less crowded that in the US and the UK – at least for now. Recent legislative efforts relating to tender offers and the proposed Fourth Finance Market Act are expected to lift the legal environment of the capital market for exit scenarios to a more comparable international standard.

Players in the German private equity field need to be conscious of the special features of the German business landscape that impact transactions involving German companies. While many of these special features are evolving, others remain as a stable part of the business scene.

Structure and certain terms of German private equity funds

A private equity fund organized in Germany is often structured as a tax-transparent limited partnership (Kommanditgesellschaft or KG) with a limited liability company (Gesellschaft mit beschränkter Haftung or GmbH) acting as the general partner with unlimited liability (GmbH & Co KG). This basic structure is similar to the typical structure of private equity funds organized in the US and the UK. Furthermore, the key economic terms of German private equity funds – asset management fee, carried interest, hurdle rate and "deal by deal" distribution provisions – are, or are in the process of becoming, generally similar to the economic terms of private equity funds investing in other developed country private equity markets. Nevertheless, there are certain terms or other characteristics of German private equity funds that may not migrate in the direction of US or UK market terms as readily as the above key economic terms.

Fee income

German fund sponsors do not typically charge fees (such as deal and structuring fees, or annual consulting and monitoring fees) to the fund's portfolio companies. As a result, the fee income sharing provisions heavily negotiated in the agreements governing, for instance, US leveraged buyout funds do not apply. Furthermore, German funds must be careful not to engage in a trade or business in Germany, which would jeopardize capital gains tax exemption to individual investors upon the portfolio company's disposition. There is a risk that, if the general partner or its affiliate charges a fee for services to the portfolio company, the fund itself may be deemed engaged in a trade or business in Germany. Investors should also be aware that discussions within the German tax administration may result in changes to certain rules relating to business income and the taxation of carried interests. It is too early to predict the outcome of these discussions, but a decision is expected later this year (see separate insert below).

Limited partner defaults

German fund partnership agreements tend to include more forgiving terms regarding defaults by limited partners on capital contributions, primarily because of the potential unenforceability under German law of the tougher default provisions so often seen in US fund agreements. German Company Law generally allows "hair cut" or other forfeiture clauses only in special circumstances. Unlike in a US fund, where a defaulting limited partner forfeits 50% or more of its capital account, loses substantially all of its rights to participate in the fund's profits and may have to wait until the fund's liquidation before receiving any cash, under German law such contractual sanctions may be found to be excessive and, if so, will be enforced only to the extent that the sanction is capable of being reduced by a court to a reasonable level.


It is common in German private equity fund partnerships, although not standard in German funds organized as entities other than partnerships, that all limited partners have a pro rata "right of first offer" if a limited partner wishes to sell its interest in the fund to anyone other than its affiliate or an existing limited partner. If this right of first offer becomes too deeply embedded in German private fund term sheets, it could inhibit the development of an active secondary market for German partnership interests.

Sponsor's standard of care

Sponsors of private equity funds organized in Germany are only indemnified if they are not "negligent". This "simple negligence" standard of care (rather than "gross negligence") is prevalent in a greater proportion of German funds than is the case in the US. Although the concept of "gross negligence" exists in Germany, it is not recognized under English law. This simple negligence standard of care may have been adopted because of the UK origins of some of the sponsors active in the Germany private equity fund market.

Supervisory board membership

Private equity funds that receive a significant portion of their capital from US pension plans typically seek to operate as a "venture capital operating company" (VCOC) in order to qualify for exemption from certain requirements of the US Employee Retirement Income Security Act of 1974 (ERISA). One of the requirements for funds to qualify as VCOCs is that at least 50% (by cost) of their investments include the right to participate substantially in the management activities of the portfolio company, which is often satisfied by the fund obtaining the contractual right to appoint a member of the company's board of directors. In the case of German private equity funds, however, active involvement in the management of the portfolio company or membership on the company's management board increases the risk that the fund is deemed engaged in a trade or business, which would make capital gains tax exemption to individual investors unavailable when the investment is sold. If the fund negotiates the right to appoint a member of the company's supervisory board, which in turn can appoint members of the company's management board, the fund can probably take the position that it has the right to participate in the management activities of the portfolio company for VCOC purposes but that it is not engaged in a trade or business in Germany.

Supervisory board membership and special service agreements

Investors and sponsors of funds often seek to combine membership of the supervisory board of a portfolio company with service agreements under which the investors or sponsors provide services to the portfolio company. There are a number of pitfalls investors and sponsors should be aware of: in the case of a German stock corporation or other type of company required by law to have a supervisory board, the services of a supervisory board member which fall within the member's regular supervisory duties cannot be made subject of a special service agreement without the consent of the general assembly (Hauptversammlung). Special services that do not fall within the regular duties of a supervisory board member may be the subject of a service agreement without shareholder action, but must be approved by the supervisory board, and the interested member must abstain from voting. The approval may be granted prior to the services being rendered or the agreement being entered into, or retroactively, but the approval should describe in detail the extent of the services rendered and the basis of the fees agreed. If these provisions are not observed, the service agreement is void. Special care should be taken if the service agreement is entered into between the portfolio company and its shareholder as such agreements may come under heightened scrutiny from a tax point of view as potential hidden distributions of profits (verdeckte Gewinnausschüttung). To avoid problems at the outset, the agreement terms must be fixed prior to the commencement of the services and in compliance with industry standards and should not contain any services on the part of the shareholder that can normally be expected from a shareholder anyway.

Structuring a leveraged acquisition of a German business

The most common corporate forms for German commercial businesses are the corporation (Aktiengesellschaft or AG), the limited liability company (GmbH) and the limited partnership with an AG or GmbH acting as the managing partner with unlimited liability (AG & Co KG or GmbH & Co KG). In the case of all three types of companies, it will usually be desirable to structure an acquisition so that acquisition debt is ultimately placed at the same level, in terms of the group holding structure, as operating revenues and assets. This is particularly important in Germany because there are a number of restrictions on the timing and amount of dividend payments by German corporations and limited liability companies. Dividends may only be paid from profits and distributable reserves shown on the company's audited accounts and, in the case of a corporation (AG), interim mid-year dividends are not permitted, so that cash flow generated by a business may not always be immediately available for distribution to the acquiror to service its acquisition debt.

In the case of German corporations, financial assistance rules further prohibit upstream loans, guarantees or pledges of assets to repay or secure indebtedness incurred to acquire the corporation's own shares. While this rule does not apply to limited liability companies, upstream loans or guarantees by such companies must generally be limited to amounts which could be paid out as dividends of profits or distributions of other free reserves so as not to impair the company's capital. In the case of both types of German legal entities, distributions of profits to non-EU shareholders to service acquisition debt incurred by such shareholders will also be subject to German withholding tax.

Placing debt on the German operations avoids dividend withholding tax and also enables interest deductions to reduce taxable profit in Germany. The most common structure for a German acquisition is the creation of a German acquisition vehicle (typically a German limited liability company to avoid the more constraining corporate procedures required for a corporation) to acquire the German target or its assets using a combination of equity and acquisition indebtedness. In the case of an asset acquisition or an acquisition of a limited partnership, operating cash flow can then be applied to service acquisition debt free of the corporate law constraints on dividends and other distributions applicable to corporations and limited liability companies. In addition, interest on the acquisition debt will directly offset operating profit for tax purposes. In the past, these advantages often led acquirors to cause German targets in corporate or limited liability company form to be converted into limited partnerships either before or after the acquisition. This had the additional benefit of permitting a tax-free step-up in the basis of the assets of the target company for tax purposes. Under the tax reforms to take effect on January 1 2002, however, this tactic will be of practical interest in only limited cases, since capital gains on shares in a German corporation or company (as opposed to sales of assets or partnership interests) will be exempt from German corporate taxation and a tax free step-up in basis will no longer be permitted.

As opposed to an asset acquisition or the acquisition of a limited partnership, in the case of the acquisition of a German corporation or limited liability company by a German acquisition vehicle, dividends and other distributions and upstream loans and guarantees are still restricted under German company law. Moreover, under the new German tax reform legislation, the acquisition vehicle's interest deductions would not be available to offset the target's operating profits in the absence of tax consolidation and also would be disallowed to the extent of dividends paid by the target in any year.

However, the traditional limitations on applying leverage in acquisitions of a German corporation or limited liability company are now surmountable. One possibility may be for the German target and acquisition vehicle to merge, so that interest expense may be serviced from operating revenue without the payment of a dividend. Such mergers may be on a tax-free basis. At least to date, the German courts have not followed the reasoning of French or Italian courts in holding that, in some circumstances, such a merger constitutes an abusive end-run around financial assistance or other corporate rules. Another possibility is for the target and the acquisition vehicle to enter into a Profit and Loss Absorption Agreement, whereby the acquisition vehicle assumes the profits and losses of the target and therefore obtains the equivalent of tax consolidation, so that its interest deductions reduce taxable operating profit for German federal tax purposes and partially (to the extent of 50%) for German "trade" tax purposes.

Squeeze-outs: finally possible

At present, German company law does not provide any satisfactory mechanism equivalent to the Delaware squeeze-out merger for eliminating minority shareholders. A German parent corporation (AG), but not a foreign corporation or a German GmbH, can elect to "integrate" a 95% or more owner subsidiary in corporate form (AG) and thereby obtain 100% of the subsidiary's shares, but the minority shareholders in the subsidiary must receive an offer to receive either cash or shares in the parent company, at their election. The adequacy of the offer (and hence the valuation of the subsidiary) is subject to review by a regional court in a special proceeding (the so-called Spruchstellenverfahrens), which often lasts for years. In the case of a highly leveraged German acquisition vehicle, minority shareholders, if they accept the offer to acquire shares, may well obtain a stake in the acquisition vehicle which is significantly larger, in percentage terms, than their original stake in the target.

The proposed German Takeover Act (expected to enter into force January 1 2002) will amend the Stock Corporation Act to provide a far more acquiror-friendly squeeze-out mechanism. Once 95% or more of the shares of a German corporation (AG) are held by a single shareholder (whether German or foreign and regardless of corporate form), a shareholders' meeting may be held to resolve that such shareholder will acquire all remaining shares against cash payment only. Most significantly, if the squeeze-out is made at the offer price and follows a mandatory or voluntary tender offer in which 90% or more of the offeree shareholders accepted the offer, the squeeze-out price will not be subject to court review. The new squeeze-out rule will not apply to limited liability companies (GmbHs) but there may be a possibility in some cases to transform a GmbH into an AG and then apply the squeeze-out rules.

Tax ruling affects the climate for private equity funds and sponsors

The private equity industry in Germany is very concerned about a potentially adverse ruling under discussion by the German tax authorities. Rumours exist that, among other things, have prompted the German edition of The Financial Times (August 28 2001) to publish a gloomy report - in fact far too gloomy a report. It is worthwhile exploring who will be affected by the ruling if it is issued in the form presently being discussed.

With regards to capital gains, the purpose of the exercise is to avoid paying taxes altogether. For investors in corporate or similar form and for many institutional investors, such as pension funds organized as trusts, the new tax legislation, generally effective from 2002, makes this possible even without recourse to double taxation treaties. In particular no minimum holding is required to enjoy the exemption.

For German individual investors, achieving tax free capital gains has always been the objective when structuring venture capital/private equity funds. Germany generally does not tax capital gains in the hands of individuals (leaving aside certain exceptions) provided that the individual investor for tax purposes is considered an "investor" as opposed to being engaged in a trade or business with respect to trading in securities (in the latter case, capital gains would be business income and taxable). Generally, the threshold is extremely high before an investor in securities is considered to be engaged in a trade or business. The German Supreme Tax Court has only recently confirmed this in a scenario which involved leveraged investments and the use of options (BFH,DER Betrieb 2001, 1287).

The proposed draft ruling under discussion seeks to establish specific criteria as to when a venture capital/private equity fund is engaged in an investing or in a trading activity so that capital gains constitute taxable business income. (Although the situation of foreign individual investors is not covered in this article, certain foreign individuals may nevertheless be protected under tax treaties barring Germany from taxing capital gains on the sale of shares.)

The second area that the potential ruling is concerned which relates to the taxation of the "carried interest", a subject dear to fund sponsors.

The gist of the proposed ruling
So far no "official announcements" exist. However, according to officials and others familiar with private equity funds, the German tax authorities have discussed the following criteria. A venture capital/private equity fund would not be engaged in a trade or business if the following requirements are met:

  • no reinvestment of capital gains;
  • long-term holding of the portfolio companies not less than three to five years on average;
  • no assumption of management activities in the portfolio companies;
  • only equity is used to make the investments (public funding would be acceptable); and
  • participation in each portfolio company limited to no more than 25% of the voting capital.

It is the 25% threshold that has given rise to most of the public outcry. Venture and private equity funds often hold a greater than 25% interest; if a fund exceeds this threshold only with respect to one portfolio company, the fund's entire income would be "tainted", ie even capital gains with respect to portfolio companies in which the fund holds less than 25% would be considered to come from a trade or business. As a consequence, an individual German investor would no longer receive capital gains entirely tax free but rather the gain would be taxable. As of 2002 this would mean that 50% of the gain is subject to income tax, and before 2002 all of the gain at ordinary rates. If the fund is organized as a German partnership, trade income tax attaches, which tax, however, would be creditable against income tax and would not create an additional burden in most cases. With respect to the no management activities criterion, it is generally believed (and the ruling is unlikely to change this) that the exercise of shareholders' rights, which in the case of a GmbH are quite far reaching, and the appointment of members to a supervisory board do not constitute management.

By contrast, corporate investors would not be affected by the "deemed trading income" approach of the potential ruling: as of 2002 their capital gains from the sale of shares (even if held through a partnership) are exempt irrespective of whether the shares are held in a trading activity or not. In the present discussion, this aspect is often overlooked, but institutional investors (most notably pension funds, both foreign and German pension funds established under the new German pension fund regime) will, unlike in the past, be much more important for the venture and private equity industry. If the portfolio companies are held through a German partnership, the controversy regarding trade income tax becomes relevant. Yet, from a planning perspective, one would be able to structure around trade income tax.

As concerns the taxation of "carried interests", the authorities allegedly take the view that fund managers will not per se realize tax free capital gain income (in any event provided that the other requirements are met under which an individual investor is not taxed upon capital gains from the sale of shares). Rather, the authorities want to look to the size of the equity investment of the managers in the fund. In practice this means that if the managers only have a marginal equity investment in the fund the "carried interest" would likely be considered service income taxed at ordinary rates. This has to be contrasted against the other theoretically possible alternatives: (i) no taxation at all; or (ii) 50% taxation.

Industry lobbyists have already begun to influence the shape of the ruling. According to the latest information from the Federal Finance Ministry, a draft ruling will be published in October along with the invitation to submit comments. Any action on the legislative front is not planned (contrary to certain rumours) and one can expect to see the final ruling by early 2002. Officials have confirmed that there will likely be a grandfathering of funds in existence at the time of the ruling to the extent it contains stricter rules. It is difficult to predict the final shape of the ruling, however, it is likely that the 25% threshold will be relaxed. This criterion has rightly drawn substantial criticism and is not supported by existing case law. One would hope that, in light of the recent German Supreme Tax Court decision which took a much more relaxed view on leveraging of investments, the other requirement whereby a fund may only use equity would also be significantly relaxed. In the author's view it is unlikely that the tax authorities will confirm that the carried interest is tax free capital gains income to the fund managers.

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