M&A Report 2023: Germany
Heiko Gotsche, Christina Mann and Nicole Kubalek, Latham & Watkins
The M&A market had been extraordinarily busy until the first half of 2022, given the high liquidity levels and a vast number of potential targets in attractive industries such as technology. However, the transactional pace has slowed down for several reasons.
With the invasion of Russian troops in Ukraine, geopolitical risks increased, as did energy prices, inflation and interest rates. Even today, a year after the invasion, reliable economic forecasts for target companies are difficult, as historical figures and the validity of business plans have lost some of their significance.
Although the economic outlook is improving and the gloomy forecasts for transactions are brightening, the times for M&A remain uncertain. Banks are still reluctant to provide financing, and debt funds, which are typically more willing to take risks, are also acting more cautiously.
All this places high demands on the transaction parties. They must anticipate unlikely developments and come up with creative solutions beyond established market standards.
Regardless of the muted market activities, in particular on the capital markets, public and private M&A remain key to Germany. While some recent IPOs and public takeovers brought noticeable media attention, private deals are still dominating the league tables. This may change, as the number of (planned) IPOs is remarkable and the recent drop of stock market prices might offer attractive investment opportunities related to listed targets.
One of the larger deals, albeit noticing the first effects of the Ukraine invasion, was the establishment of a global joint venture by Advent International with LANXESS for high-performance engineering polymers with specialty chemicals (HPM Business). The joint venture simultaneously acquired the engineering materials business DEM – one of the leading global suppliers of high-performance specialty materials used in the electronics, electrical and consumer goods sectors – from Royal DSM.
The deal comprised two major simultaneous transactions – prompting a €6.2 billion (about $6.6 billion) joint venture in which Advent will hold a controlling stake. The transaction shows the trend of big corporations towards the concentration of businesses and the carve-out and disposal of non-core businesses, as well as the interest of sponsors to take over industry assets. The transaction also shows that despite the current environment, high-value deals continue to take place as there is still a huge amount of ‘dry powder’ in the market.
This trend is also seen in the infrastructure sector. One of the largest German deals in 2022 was the joint venture between Vodafone and a consortium of infrastructure investors led by Global Infrastructure Partners and KKR, which intends to acquire at least the approximately 81.7% stake in Vantage Towers AG held by Vodafone. The joint venture launched a voluntary public takeover offer to Vantage Towers AG shareholders in December 2022.
Vantage Towers AG is a leading telecommunications tower company in Europe with a market capitalisation of over €16 billion. It has, as a result of a spin-off from the Vodafone Group, been listed on the stock exchange since 2021, including on the MDAX. Besides another joint venture between private equity sponsors and corporations, this transaction is also a take-private transaction, which we are likely to see more of due to already lower valuations of listed companies compared with their private peers.
Economic recovery plans
The market activity for German targets is picking up, with several sales processes on the way. This development is likely to gain traction once the financing and syndication markets come back. What may be changing are deal structures and negotiation dynamics in a less seller-friendly environment.
As an asset class, infrastructure targets have entered centre stage. In addition, distressed assets with financial issues but an otherwise promising business case may attract attention not only from strategic but also private equity buyers.
Carve-outs will also remain important as the economic circumstances have not eliminated or decreased the need of corporations to transform themselves. This is, in particular, true for the automotive sector, which not only has to deal with the shift from traditional petrol and diesel engines to electric, hybrid or alternative models but, in Germany, has increasing competition from the US and Asia in this respect.
Another noticeable trend is outbound investments by German strategic investors, often into the US (rather than Asia), which are expected to grow.
Financial investors remain active and continue to be key to the M&A market. Fundraising had been easy in recent years and private equity sponsors still have considerable funds to deploy. Yet because only limited financing is available in the market at the moment, strategic buyers with readily available cash may have an advantage over financial sponsors with a leveraged buyout strategy. Fundraising becomes harder, in particular for smaller funds or funds with a below-average track record. That said, financial investors do, and will continue to, shape the German industrial landscape through their focus on performance ESG.
Legislation and policy changes
Acquisitions of private companies are primarily structured as share deals and are not governed by any statutory process (other than regulatory clearances). They are a matter of negotiation between the respective bidder and seller, as most relevant statutory provisions are not mandatory.
In contrast, public M&A transactions have to comply with the German Securities Acquisition and Takeover Act, the EU Market Abuse Regulation and the German Stock Corporation Act, and are subject to the supervision of the German Federal Financial Supervisory Authority (BaFin).
Private and public transactions may be subject to German merger control. Furthermore, the Federal Ministry of Economic Affairs and Climate Action (BMWi) has the power to review direct or indirect acquisitions of German-based companies by foreign investors. The BMWi may prohibit any acquisition of 25% or more of the voting rights by a non-EU/European Free Trade Area investor or request commitments if it threatens German public order or security, or violates essential national security interests. In addition, acquisitions of 10% or more of the voting rights in a company active in certain areas of critical infrastructure or in the area of military and defence may be subject to a mandatory filing requirement.
ESG aspects are increasingly considered in investment decisions and in M&A transactions. In particular, ESG due diligence has become an integral part in an M&A process examining whether the target's business model ensures sustainability and what risks and costs exist in relation to compliance with ESG criteria in the future. Findings from ESG due diligence have a direct impact on company valuation, purchase price and transaction documents.
Purchase agreements may, for example, require new guarantees and indemnities relating to, among others, supply chain management or sustainability reporting. The legal consequences provisions (of guarantees and indemnifications) could also be modified selectively to make it easier for the buyer to show and prove reputational damage, or damage caused by the temporary exclusion of the target company from public contracts.
The interplay of the pandemic, the shortage of microchips and other supply chain issues, as well as geopolitical tensions – in particular between the US and China, as well as those following from Russia's invasion of Ukraine – have created challenges for M&A dealmakers. A matrix of sanctions and export control regimes, as well as foreign investment rules, needs to be observed.
Governments and regulators are regularly expanding the reach of sanctions and releasing new guidance, including on giving powers to the police to sanction breaches. An action permissible at the point of deal inception may be prohibited by the time the deal is consummated. Thus, deal teams must remain alert to the rapid pace of change and include clear language in any deal documents to ensure that they do not commit to actions that could become prohibited.
Practice insight/market norms
Foreign investors continue to wonder about the notarisation requirements in Germany, in particular in connection with German limited liability companies (GmbH). Share purchase agreements, including all annexes, must be read out loud by a notary to the parties, a potentially long exercise. Even so, the notarisation process is generally no obstacle to deals but serves as a disciplinary tool to complete negotiations and get the documentation in final shape. Costs can be considerable and need to be factored into the buyer's transaction budget.
Depending on the deal structure, it is highly advisable to seek employment and tax advice early on, as German law has some unique peculiarities in these areas.
Technology helps to facilitate the M&A process by rapid documentation and data handling. However, given that the parties increasingly rely on digital tools, dealmakers are more and more concerned about cybersecurity risks, as a breach can be ruinous.
The scope of legal documentation required for the acquisition of shares in a public company depends on the type of business combination chosen, as well as on the type of shares being acquired and whether these shares are to be acquired through the stock exchange, via a capital increase, or from other shareholders.
Holding 30% of the voting rights in a listed company is considered to provide ‘control’ under German takeover law. Whoever is about to achieve or exceed this threshold directly or indirectly will need to consider a public takeover offer. The offer requires an offer document. Unsolicited takeover attempts are still rare in Germany; however, the general attitude towards hostile transactions is less negative than in the past.
After the decision to launch an offer has been published, the management board is prohibited from taking any action that could prevent the success of the takeover offer. But the management board may search for a 'white knight', take any action within the scope of the management board's powers if approved by the supervisory board, and, if no further legal requirements exist, and take actions that would have reasonably been taken if no offer had been launched. Furthermore, the shareholders may, under certain restrictions, authorise the management board to take action within the scope of the powers of the shareholders' meeting before and independent of any takeover offer.
The BaFin takes a rather restrictive position on the possibility of imposing offer conditions. Voluntary public takeover offers – offers that are made by buyers that do not own shares in the target company or whose shareholding is below 30% – are usually only subject to regulatory approvals, fairly standardised market and company material adverse change conditions, and no defensive measures (such as capital increases during the offer period) being taken. There is often a minimum acceptance threshold for offers, as the acquisition of only some of the shares may not be attractive. Mandatory offers – offers that are triggered once a shareholding of 30% is reached by one shareholder – can only be made subject to regulatory conditions.
Break-up fees in public M&A deals (when the target pays the prospective buyer) have traditionally been unpopular in Germany and few target companies or bidders are willing to accept them.
Because of the changed market conditions, the negotiating parties' price expectations are increasingly diverging. While sellers like to point to past profits and good long-term prospects based on historical assumptions, prospective buyers focus on the deteriorated economic conditions and uncertainties related to future earnings. They are increasingly reluctant to pay the high purchase prices that we saw in the boom years and, in particular, apply the same EBITDA multiples.
On the other hand, there are the sellers that have been spoilt with exceptionally high purchase prices due to the low interest environment which they do not (yet) want to let go without further ado. This is understandable, as they also might have bought at a high valuation, so that a reduction in the purchase price would be particularly painful.
To close the gap, creative purchase price structures are required that bring the interests of both contracting parties to an appropriate balance. This includes the entire spectrum of earn-out clauses, in which variable purchase price components are linked to the future (earnings) development of the target company. In the event of a sale to a financial investor, a participation of the seller in the exit proceeds after a subsequent sale may also be considered.
Drafting the purchase price clauses so that they accurately reflect the commercial understanding of the parties and cover all possible scenarios can be very challenging and requires close coordination of all the advisers.
Overall, the potential for dispute is significantly greater in times of crisis, which can also affect fundamental aspects of the acquisition. This particularly applies to the warranty catalogue, which in some cases has to be supplemented with clauses that protect the buyer against new risks. It is to be expected that new standards are likely to develop here soon. However, warranty and indemnity (W&I) insurers, which protect parties from the consequences of a warranty breach, sometimes view innovations critically. As a result, transaction partners may not be able to outsource contractual liability to the W&I insurer as planned.
Due to the uncertainty about the valuation of identified risks, indemnifications by sellers are also being increasingly used again.
Deal certainty remains one of the most crucial factors besides the purchase price and limitation of liability. Hence, transactions are typically only subject to merger control clearance by the relevant authorities, and foreign investment control clearances. Any further deal conditions would depend on the transaction specifics but may increase together with the other buyer-friendly conditions.
Share purchase agreements relating to German targets are usually governed by German law under the jurisdiction of German courts or arbitral tribunals. Depending on the preferences of the parties, agreements may also be made subject to non-German laws.
IPOs occurred in H2 2022 and Q1 2023, but only a few. There are many IPOs in the pipeline and 2023 promises to be an active year in this respect should the market conditions continue to improve. Trade sale exits are also picking up but there remains some level of uncertainty.
The past year has shown how quickly the seemingly stable M&A market can change because of unforeseen developments. Corporate buyers (as well as lenders) are acting more cautiously today and are no longer willing to accept unilateral contractual risk distributions. This affects the drafting and negotiating of the transaction documents and suggests that the strong seller's market, which has existed for years, could once again shift towards a more buyer-friendly market.
Yet the M&A market is unlikely to collapse – as it did during the 2008 financial crisis – because the negative effects are also countered by several positive factors: many companies are still under high innovation and transformation pressure and are therefore often dependent on acquisitions. Private equity investors have considerable capital to invest and the current crisis also offers interesting opportunities in the M&A market that many decision-makers want to profit from, such as the acquisition of companies that have financial difficulties because of the present turbulence but otherwise have a solid business case and are well positioned in the long term.