Austria: Trends and techniques

Author: | Published: 1 Oct 2010
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As elsewhere, 2010 has not seen any significant comeback for the private equity industry in Austria. There have been exceptions such as a small number of public to private transactions involving private equity funds, notably the acquisition of and subsequent squeeze out of the remaining shareholders of Constantia Packaging AG by One Equity Partners. Mostly however, sponsors have focused on mastering the challenges related to managing existing portfolio companies in a continuously difficult market environment. The widespread need for capital injections or refinancing, combined with a continued scarcity of equity and debt capital, has triggered two notable developments. Firstly, hybrid financings, ie instruments that may qualify as equity for accounting purposes, but offer the benefits of debt instruments with respect to their tax treatment, are becoming increasingly popular. Secondly, banks providing liquidity in some form or another often require sponsors themselves to participate in a financing round. In light of stringent Austrian loan subordination rules, this leads to particular structuring challenges that are now being tested more than ever.

The following article first examines the framework for private equity sponsors seeking to employ a particularly flexible hybrid instrument: profit participation rights. It will then take a closer look at possible financing structures involving a debt contribution of both third party banks and the sponsors seeking to deal with challenges posed by the rules of subordination. Finally, the article gives a brief overview of the recently restated Austrian Insolvency Act, which introduced a streamlined proceeding that may prove useful for sponsors seeking to reorganise a portfolio company.

Profit participation rights

Many private equity sponsors with cash-strapped, over-indebted portfolio companies have a strong interest in expanding their companies' equity while at the same time trying to exclude providers of capital from gaining too much influence over them. On account of their flexibility, profit participation rights (Genussscheine; PPRs), offer sponsors the best of both worlds and constitute a particularly versatile form of financing. Such rights can be structured in many different ways to match the parties' interests. PPR issuances are becoming increasingly frequent as a result.

Essentially, if PPRs are structured correctly, sponsors achieve two goals simultaneously. Firstly, the portfolio company's equity grows for accounting purposes and this is often of crucial importance given the strong leverage of such companies' balance sheets. Secondly, despite their classification as equity for accounting purposes, in many other respects, it is possible to design the terms and conditions governing a PPR issuance in a way much more typical of debt instruments, including, for example, significant restrictions on control and voting rights granted to creditors. In summary, sponsors pursuing a PPR offering of one of their portfolio companies typically enjoy the following benefits:

  • Rights holders have very limited control rights;
  • Rights holders are not entitled to preferred dividend payments;
  • The company's proportionate shareholdings remain unaffected;
  • Absence of fixed payments makes PPRs very cash-flow friendly;
  • PPR offerings are not limited to stock corporations (Aktiengesellschaften); ie the issuer can be a limited liability company (Gesellschaft mit beschränkter Haftung) as well;
  • Certificates may be issued, making it possible to trade PPRs on the stock exchange; and
  • In many other respects, PPRs offer high structuring flexibility.

As noted above, one of the key aspects of a PPR issuance is the company or sponsor's desire to create new equity for accounting purposes. In order to achieve this classification, the key criterion is the extent to which rights holders participate in the profits of the company. Careful consideration must be given to the drafting of the documentation, so that the following criteria are met:

  • Distributions entirely based on the company's profit;
  • Subordination of the rights holders;
  • Rights holders fully participate in the company's losses; and
  • PPRs have no fixed term.

Conversely and importantly, if the company agrees to minimum interest payments, even if no such payments are made in the event that the company incurs losses, PPRs will be classified as debt for accounting purposes. One should note that the requirements set forth in the International Financial Reporting Standards (IFRS) are even stricter. Pursuant to IFRS, it is not sufficient that fixed distributions are made only in the event that the company incurs profits. Additionally, the calculation of the distribution amount itself must be based on a variable, profit-related parameter. If these constraints are not observed, the PPRs will be classified as debt for IFRS purposes.

In this context, it is important to note the following key differences between PPRs and true equity capital, such as the shares held by the sponsor of the issuing company:

  • Contrary to equity shareholders, subscribers to PPRs only share in the company results, but have no control or voting rights; and
  • With respect to profit participation, rights holders typically rank higher than actual shareholders.

However, despite these differences, rights holders, just like equity shareholders, often also share in the liquidation proceeds of the company and are entitled to subscription rights with respect to newly issued shares – a key feature of great strategic importance to both the sponsors and third party investors.

The tax treatment of PPRs under Austrian law varies according to the particular governing terms. Similar to their classification for accounting purposes and depending on the extent to which rights holders participate in the results of the issuer, PPRs may be deemed as either debt or equity:

  • If the PPRs grant the right to share in the liquidation results of the company or if they are automatically, for all practical purposes, converted into equity upon expiration of a certain period of time, they will be treated as equity, ie at the level of the company, both the issuance and subsequent profit distributions are tax-neutral. At the level of the rights holder, if such holder is a corporation for tax purposes, profit distributions will also be tax-free.
  • If rights holders do not participate in the company's liquidation results, PPRs will be qualified as debt. While the issuance is tax neutral for the company, distributions are deductible. At the level of the rights holder, distributions are taxable at a rate of 25%.

A key feature of PPRs is the fact that non-resident rights holders will be subject to tax on income received from the PPRs only if they are qualified as equity. Accordingly, any structure that allows a classification of PPRs as debt for tax purposes offers potentially significant savings including, in some cases, the possibility of double non-taxation.

One final note, often surprising to foreign sponsors, is the levy of capital tax in Austria. As a result of this tax, the issuance of PPRs is subject to tax at a rate of 1% of the issued nominal amount of the PPRs (Gesellschaftsteuer). By law, both the company and the rights holders are liable to pay the tax. However, in practice, it is usually agreed that the issuing company bears the burden, ie the rights holders suffer no corresponding deduction from the paid-in capital. Fortunately, since such tax is payable, no additional duties (Gebührensteuer) are payable in Austria in connection with a PPR offering.

In practice, PPRs are employed in a variety of cases and can be issued with or without additional capital being contributed, depending on the requirements of the individual company. This versatility, along with the features described above, makes PPRs very suitable for private equity sponsors who will often use them as part of a debt mezzanine-swap in connection with the subordination of existing debt creditors. Given that sponsors most often control 100% of their portfolio companies, despite the key procedural hurdle that is the required consent of three quarters of the outstanding share capital, such structures can be implemented very quickly and flexibly.

Loan subordination

Only a few other countries, most notably Germany, have chosen to codify a set of rules providing for the subordination of loans in certain circumstances. The basic scenario often involves an undercapitalized corporation and a shareholder, eg a private equity fund, extending a loan to it. Unlike in other jurisdictions, where the subordination of such loans requires the grantor of the loan to behave in some inequitable manner towards other stakeholders, the Austrian law of subordination (Eigenkapitalersatzgesetz) features very broad criteria that can easily be triggered – even by a shareholder creditor acting in cooperation with other creditors.

In a nutshell, pursuant to Austrian law, a loan will be subordinated if the following requirements are met:

  • The debtor company is either a corporation or a partnership with no individuals as unlimited partners;
  • The grantor of the loan (i) is a shareholder who controls the company, (ii) has a share in the company greater than 25%, or (iii) dominates the company even without being a shareholder;
  • The company is in a crisis, ie it is (i) insolvent, (ii) over-indebted, or (iii) the equity ratio is less than 8% and the presumed debt repayment period is greater than 15 years; and
  • During such crisis, a loan is granted to the company (standstill agreements or bridge loans with a term of less than 60 days are not covered).

If the above criteria are met, a sponsor extending a loan to its own portfolio company is faced with one of two significant disadvantages:

  • Prior to the opening of insolvency proceedings, during an on-going crisis as defined above, the company (i) must not repay the loan, (ii) must not pay any interest to the sponsor, and (iii) in the event any such payments are made, has a claim for repayment of such amounts against the sponsor. Additionally, any collateral granted to the sponsor must not be realised as long as the crisis continues.
  • Consistent with the treatment prior to insolvency, once such proceedings have been issued, the sponsor is subordinated to all other third party claims.

It is obvious that the restrictions just described are a significant burden to any sponsor considering a cash injection for one of its portfolio companies. This problem grows if the company's survival is at stake and additional capital from third parties is only available on condition that the sponsoring fund itself makes a cash contribution as well. In effect, sponsors have to choose between either forfeiting third party funds at the risk of losing the company or making what is tantamount to an equity contribution, which puts them at the lowest position in the chain of creditors.

In light of the above, sponsor funds in Austria are in great need of innovative structures that alleviate, if not eliminate, the disadvantages of the Austrian rules of subordination. Three structures discussed in the market are outlined below.

The first solution one might come up with is a type of conduit transaction. Here, the sponsor fund would not lend directly to the company, but would extend the loan to one or more of the third party banks. In consideration thereof, the banks would then extend a loan in a corresponding amount to the company, along with additional loans that are, however, not funded by the sponsor. A preliminary look at this structure may give the impression that the application of the subordination rules could thereby be successfully averted. After all, the shareholder sponsor did not loan any money to the company and the wording of the law does not cover loans granted to third parties.

Unfortunately, however, it is the prevalent opinion in Austria, that the subordination rules cannot be applied too literally in this context. Accordingly, conduit structures like this would nonetheless trigger subordination. As to the question of which of the loans involved or whether both of the loans involved, will be subordinated, the answer would likely be that only the financing directly granted by the banks to the company would be affected. This is because the law seeks to protect only the company and its independent creditors, rather than creditors who themselves participate in the scheme that triggers the subordination. No subordination is therefore necessary with respect to the monies owed by the banks to the sponsor. In effect, it is clear that this structure does not provide a sufficient remedy for the challenge posed by the subordination rules.

An alternative considered in the context of refinancing portfolio companies is to draft the loan documentation to provide for the repayment of the loan and for interest payments prior to bankruptcy only to the extent that all other, higher-ranking, creditors have been satisfied. The idea behind this is to anticipate in the agreement precisely what the law wants to achieve, thereby avoiding certain negative effects of its application. In other words, if the sponsor agrees to have its claims to interest payments and repayment of the principal prior to opening of bankruptcy proceedings subordinated to the claims of third parties, applying the subordination rules would not be necessary. Accordingly, in the event of bankruptcy, the sponsor-granted loan would not be deemed equity and would therefore rank pari passu with other debt.

The reason why this technique fails to overcome the limitations set forth in the subordination laws is that such rules aim not only to subordinate shareholder loans during the period prior to bankruptcy, but in particular, in the event of and during the debtor's bankruptcy. In order for the principle underlying this structure to be successful, it would therefore be necessary for the sponsor to go one step further and to agree that its claims rank lower than those of other creditors even in the event of bankruptcy. This, however, would be tantamount to an equity contribution, which is precisely what the sponsor wants to avoid.

A third alternative that has recently been discussed requires close cooperation between the sponsor and any third parties participating in the financing. This structure reflects the idea that subordination as such must be accepted, but seeks to remedy the economic disadvantages suffered by the sponsor as a result thereof. In this situation, the sponsor, as requested by the banks, will extend a loan to the company with no restrictions whatsoever applying to the loan documentation. It is agreed, however, that in accordance with the subordination rules, the company will make no payments to the sponsor as long as the crisis of the company continues. Accordingly, during such period, no current interest payments or repayments of the principal are made. In order to not put the sponsor who was willing to participate in the financing at the request of the banks at a disadvantage, the sponsor and the banks will then enter into a sharing agreement. Such agreement provides that any payments received by the banks from the debtor company are shared with the sponsor at an agreed rate. As a result, both the banks and the sponsor will end up with some interest payments.

One must note that this last alternative has not yet been tested in the courts; the risk remains that even in this case, the subordination rules would be applied beyond their wording to capture the arrangement between the sponsor and the banks. Accordingly, it is conceivable that during its bankruptcy the company could reclaim such amount of the interest payments made by the company to the banks, as corresponds to the payments passed on by the banks to the sponsor. However, if the sharing agreement is drafted carefully and it is the clear understanding between all parties involved that the sponsor itself has no claim against the company, strong arguments exist as to why subordination should not be triggered by this setup. In effect, this would then constitute an opportunity for private equity sponsors to make cash contributions themselves and to continue to earn some interest on the capital invested, while also making it a lot easier to raise funds from third parties.

Austrian Insolvency Act 2010

Although the number of insolvencies in Austria has decreased year-on-year during the first half of 2010, market observers expect that such number will be higher during the second half of the year. In light of this, the new Austrian Insolvency Act was adopted just at the right time. It makes it easier, among other things, for existing management to stay in control during insolvency proceedings and thereby incentivises owners and managers to take necessary reorganisation measures at a reasonably early stage during a crisis. Private equity sponsors who manage portfolio companies that are often very highly leveraged and face decreasing cash flows, could derive significant benefits from these new rules.

The part of the Insolvency Act that may be most important to private equity funds is the introduction of a new reorganization proceeding (Sanierungsverfahren). Unlike in the case of a bankruptcy proceeding (Konkursverfahren), the management filing for reorganisation under the Insolvency Act mostly stays in control of the company, subject only to general oversight by a court-appointed receiver. In order to enjoy the benefits of this form of insolvency proceeding, the debtor first has to prepare a reorganisation plan. In it, the company must offer to satisfy a minimum of 30% of creditor claims. In addition, among certain other documentation, the company must propose a financing plan for a minimum of 90 days starting from the date the insolvency proceedings are issued. Once the company has filed for insolvency and presented all necessary documentation, the management will remain in almost complete control of the company upon opening of the reorganisation proceedings,. Only the termination of agreements and extraordinary measures are subject to the receiver's consent. One should also note that the company can still access its bank accounts and handle all its correspondence in its own name.

The receiver, despite its relatively limited powers, does have important responsibilities, however. In addition to supervising and supporting the debtor, the receiver is responsible for challenging existing agreements, verifying the validity of third party claims against the debtor and making decisions affecting a significant percentage of the debtor's assets. Among a few other triggers, in the event that the company's creditors have not adopted the reorganisation plan within 90 days of the issuance of the insolvency proceedings, the court-appointed receiver will take over the management of the company. Accordingly, it is important for the management and the shareholders to prepare well for insolvency proceedings and to carry them out as quickly as possible.

Time will tell if the new Insolvency Act effectively helps companies avert bankruptcy better than the old regime. However, the above-described reorganisation proceedings undoubtedly contain some procedural relief and should be on every sponsor's radar over the next years.

About the author

Christof Strasser is a partner of Herbst Vavrovsky Kinsky. His practice has focused on a variety of mergers and acquisitions, secured lending and project finance transactions for both domestic and international financial institutions, corporates and private equity clients.

Contact information

Christof Strasser
Herbst Vavrovsky Kinsky

Dr. Karl Lueger-Platz 5,
1010 Vienna

Tel: +43 1 904 21 80 -0
Fax: +43 1 904 21 80 -210
Web: www.hvk.at


About the author

Philipp Kinsky is founding partner of Herbst Vavrovsky Kinsky. He advises a wide range of listed and non-listed companies as well as financial institutions in corporate finance, PE/VC and capital markets transactions.

Contact information

Philipp Kinsky
Herbst Vavrovsky Kinsky

Dr. Karl Lueger-Platz 5,
1010 Vienna

Tel: +43.1.904 21 80 -0
Fax: +43.1.904 21 80 -210
Web: www.hvk.at