The European M&A markets, in particular in Germany, have grown strongly in the past five years fuelled in part by investment pressure from foreign private equity funds. Coming from saturated domestic markets, these funds have taken a new interest in acquiring businesses in Europe. Their growth in size has given them the financial ability, and they have now acquired the local experience, to outbid trade buyers on occasion.
Consequently, the boom in the European management buy-out (MBO) market has grown exponentially, not only in terms of the number of transactions but also in terms of their value. The amount invested in MBOs in Europe in 1998 was almost euro7.4 billion ($8.05 billion) — an increase of over 50% over the 1997 figure of euro4.8 billion. Of this, euro796 million was invested in MBOs in Germany in 1998 according to the German Venture Capital Association.
The main reasons for this growth in Germany are:
- large corporations divesting non-core businesses (spin-offs) and focusing on core activities;
- succession problems faced by many German Mittelstand companies;
- government privatization; and
- the development of the Neuer Markt — providing an alternative exit route.
This article will outline the main features of the MBO market in Germany.MBOs in Germany
An MBO is the acquisition of a target company, or a business, by a consortium in which existing or incoming managers of the target have a stake. While MBOs were already popular after the fall of the Berlin Wall in the privatization of East German businesses, the current wave of MBOs in the form of institutional buy-outs (IBOs) is a more recent phenomenon in Germany. In an IBO the other consortium members include private equity investors who specialize in MBOs and provide the majority of the equity financing.
In particular, the larger, high value deals, are typically driven by institutional investors, with management being offered only a small share in the company as an incentive to remain with the company and help it grow. Conversely, a smaller transaction could see the management take (or retain) a majority in the consortium.
Many venture capital funds, now often referred to as private equity funds if concentrated on buy-outs, are created with the specific intention of investing principally in MBOs rather than venture capital. Most private equity deals in Europe fall within the definition of an MBO. However, there are a number of different types of buy-out (see box Types of MBO).
Recently, the arrival in Europe of some large US players such as KKR, Hicks Muse and Carlyle has further increased the amount of capital available to invest in major buy-outs. Consequently, competition for the right deal is even higher than in recent years and the transaction sizes are steadily increasing. The result is that there is a vast appetite for deals and plenty of experience being offered by private equity houses. An offer that sellers cannot ignore!
Reasons for doing an MBO
Several reasons exist for doing an MBO, all of which are attractive to the parties involved. The resulting deal will usually unlock value and improve returns.
The seller benefits, as they are not selling to a competitor. Further, they may feel less exposed when granting representations and warranties since the management usually sits on the buyer's side. At the same time, due to the leveraged structure, the seller may obtain a higher sale price.
The management will benefit because they will own part of the company and consequently will have a strong incentive to continue to help the company to perform well.
Institutional investors will benefit because they will be working with an existing management team that they trust either because they have backed them in the buy-out or because they have brought them into the transaction. Moreover, they will be able to focus more on cash-flow management and use the leveraged structure to increase the value of their investment when they exit.
Germany has still not come to terms with the succession crisis in many German Mittelstand companies. By encouraging management to take over a company it is possible for a company to have a lifespan that exceeds the lifespan of the founders/owners.Typical structures
The simplest MBO structure usually involves the management and institutional investors who subscribe to new shares in a new company (NewCo) that they set up. The new company then takes a loan from a senior lender in order to acquire the business (asset deal) or the target company (share deal) from the seller (see box Structure of a typical buy-out).
More complex structures will involve various subsidiaries and corporations in different countries, depending on the situation. However, it must be borne in mind that the structure used will be influenced by the ability of each company in the group to:
- be independently profitable, since everything must make commercial sense;
- have sufficient cash flow to repay debt, in order to avoid the leverage effect turning against the transaction; and
- provide adequate security for the debt, in order to ensure the acquisition financing and continued support of the banks.
For example, it would not make sense, in a multi-jurisdictional transaction, to assume large amounts of debt simply to minimize taxes if the company is unable to generate sufficient cash to repay the debt. The right balance between leverage, tax efficiency, cash flow and commercial and operational factors will have to be carefully assessed in each case. Whatever structure is finally chosen will depend on the above considerations and the specific factors relevant to the deal.Main finance providers
In Europe, including Germany, institutional investors and senior lenders provide the majority of financing whilst management's contribution is relatively small in cash terms. Institutional investors would usually expect to achieve a substantial capital growth measured as an internal rate of return (IRR) when the business is sold. The senior lender will want to ensure there is strong cash flow in order that its loan is repaid. It will take security over the assets to cover its exposure to the business. Although management will only invest a small amount they may achieve a very high return when the business is sold.
A common structure would see management being offered a certain percentage of the ordinary shares in NewCo (as an incentive), but only providing a lesser percentage of the total investment required from the management and institutional investor group. Consequently, 100% of the ordinary share capital represents only a fraction of the total management and institutional investment. The remaining investment from these parties would often be by way of (subordinate) debt or non-equity instruments. (see box Structure of a typical buy-out)Other lenders
Mezzanine lenders and high-yield bonds may be used to bridge a financing gap between the amounts financed by equity providers and those from senior lenders. These forms of finance usually only become involved where there is sufficient cash flow and the other holdings are not significantly diluted. However, these financial instruments are only used in large transactions because they are expensive.Equity documents
Three to four main documents are commonly used in German buy-out transactions, namely:
- articles of association/partnership agreement;
- subscription agreement or purchase agreement;
- shareholders agreement; and
- service agreements for management.
As in the UK there may be considerable overlap between these documents and there is some flexibility to choose which clauses go into which documents.
Details depend upon the corporate structure chosen for the acquisition vehicle and whether the investment is in a newly created entity or whether the investment is by way of acquisition of an existing entity or capital increase in such an entity.
The corporate form chosen for the acquisition vehicle will usually be a consequence of tax considerations, financing considerations, corporate governance requirements and to some extent questions of market image and standing. The three main vehicles used as an acquisition vehicle are the German limited liability company (GmbH), the limited partnership (a partnership in most cases with a GmbH as general partner – GmbH & Co KG) and the stock corporation (AG). The stock corporation is less flexible, although it is still considered to be more prestigious. However, the limited liability company is much more common in practice. Increasingly, multi-vehicle acquisition structures are being seen, using a mixture of GmbHs and GmbH & Co KGs to optimize the tax position, while maintaining sensible operational arrangements.Legal issues
The structuring and financing of a transaction is different in each country. Transactions become even more complex when a deal becomes multi-jurisdictional. However, the most important issues affecting a typical German MBO deal structure are considered below. The comments relate to GmbHs, the most commonly encountered vehicle, except where otherwise indicated.Financial assistance
In many MBOs lenders expect the target company to provide financial assistance by way of granting security in forms such as guarantees, pledges or security transfers to third party lenders for obligations of the borrower, its new parent company. Although the granting of collateral by a German GmbH to secure funds borrowed by its shareholders is not prohibited as such or regulated, limitations arise from the rules to safeguard the maintenance of the GmbH's share capital. The rules provide that the share capital will not be repaid to the shareholders. The amount that can be repaid to a shareholder (directly or indirectly via the enforcement of collateral securing liabilities of the shareholder) without infringing the rules is calculated by deducting the share capital, the company's liabilities as well as its reserves for contingent liabilities from the company's assets. A shareholder infringing upon these rules is obliged to refund the amounts required to restore the registered share capital. A violation of the rules may also incur a personal liability for the directors. Furthermore, there is also the risk that such assistance may be treated as a hidden dividend distribution for tax purposes. Thus, the assets of the acquired company can be used as security only under limited circumstances. The security agreement between the company and the third party lender is, however, not generally void or unenforceable. As was recently decided by the Federal Supreme Court (judgment of March 19 1998), the third party lender (usually a bank) is, in general, not liable towards the company to restitute the security infringing the maintenance of capital rules. If however, the bank receiving the security had intentionally conspired with the borrowing shareholder to the detriment of the company or its creditors, the security agreement would be void.
Furthermore, the security agreement could be considered contrary to public morals if the transaction goes beyond simply discriminating against other creditors of the company. A violation of public morals may be considered, for example, if the security agreement were entered into under circumstances which are capable of, and have the intention of, making other creditors believe that the company still has disposable assets, thereby inducing them to grant further loans.
In order to avoid the directors of the GmbH becoming liable under civil and criminal law, it is not uncommon for the security agreement to create upstream collateral to provide for a limitation specifying that the enforcement of the collateral will not lead to a prohibited repayment of share capital. Thus, the enforcement proceeds can only be paid to the secured party to the extent there is no violation of the capital maintenance rules, ie the realization does not result in a direct or indirect repayment of capital to a shareholder. This limits the amount of enforcement proceeds available to the lenders in effect to the open reserves (broadly, the distributable profit reserves and paid in capital reserves) of the GmbH. The financing structure and the security package, therefore, need to be considered carefully early on in the transaction.Board structure
While a GmbH does not generally have a two-tier management structure, the articles of association often provide for one institutionalizing either an advisory board (flexible) or supervisory board (less flexible). They set out the number of representatives that the investors will be entitled to appoint to the supervisory board or advisory board of the acquisition vehicle. In the case of a larger German limited liability company employing over 500 staff, or a stock corporation, a co-determined supervisory board would have to be established by law, which would only have supervisory functions. However, in many buy-outs the target company is too small to make this mandatory board necessary.Liability
The directors are not directly responsible for the liabilities of the GmbH. They are, however, responsible for their own omissions or if they have acted in breach of their statutory duties. Further, a director may be found liable if they are found to have failed to declare the company bankrupt if it was over-indebted or insolvent and thus caused a loss to third parties.Service agreements
Each director of the GmbH will generally have a consultancy or service agreement, which contains the terms of service, salary, benefits and notice periods. It does not, however, contain any details of management shareholdings.Public-to-private transactions
Public-to-private transactions have become popular structures in the UK for private equity investments. The expectation is that more and more going-private transactions will also be seen in Germany and a number are known to be in progress. A number of stock corporations are listed on the German exchanges, including recently listed companies on the Neuer Markt, which have not achieved or cannot maintain satisfactory market capitalizations enlarging the number of potential targets. Private equity investors have gained considerable experience in the German market and ever-increasing amounts of capital are also available, so that major transactions may be tackled.
However, it is still difficult in Germany to take a company private with a complete de-listing from all stock exchanges. In most cases, a public take-over bid will precede a going private, generally coupled with a separate acquisition of a block of shares. The private equity provider and the management team will thereby try to achieve the relevant majorities (usually at least 75% and, if possible, 95%) in order to start the complicated corporate procedures necessary for the implementation of the transaction (change of legal form, mergers etc). Germany still has no mandatory Take-over Code. There is, however, a non-mandatory Take-over Code that is often used as a guide to market practice, even by non-signatories. The German Code reflects many of the principles in the UK Take-over Code and lays down basic guidelines (eg equal treatment, mandatory offer rules, time frame).
Once the relevant majorities have been achieved, financial investors would typically wish to squeeze-out the remaining minority shareholders. Such minority squeeze-out devices are available in several countries but not in Germany. There are a number of techniques designed to achieve a squeeze-out, but none are currently regarded as risk free. Even though it seems likely that a statutory Take-over Code will be presented and come into force (possibly by the end of next year), there is no certainty that the relevant changes in the law will provide for a squeeze-out at an adequate percentage.
Given the capital available for investment in the German market and the readiness of the German business community to allow for more and more private equity transactions, irrespective of the current restrictive legal environment, it is to be expected that practices and structures, which can accommodate the needs of the business community, will be developed in the short- term.Tax Issues
The Tax Relief Act 1998 together with the Tax Reform Continuation Act 1997 provide for changes with considerable effects on the tax structure of transactions. The aim is to reduce tax rates in the medium term, while at the same time providing for a broader assessment basis by reducing tax privileges and the deductibility of losses from income. Corporate income tax on retained profits has been reduced to 40% and the minimum tax rate for businesses to 45% as of January 1 1999 and will be reduced to 43% as of January 1 2000.
A brief overview of the changes:
- abolition of the "half average tax rate" rule for disposals of shareholdings by certain vendors;
- reduction of the "substantial participation" threshold below which vendors can obtain tax reductions on disposals from more than 25% to 10% or more than 10%;
- restricted deductibility of losses;
- restriction of losses carried forward upon a change of shareholders;
- deductibility of financing costs for the acquisition of a foreign enterprise by a resident corporation;
- blocked amount under section 50c of the Income Tax Act (ie restricted step-up potential); and
- increased real property transfer tax.
Thin-capitalization rules apply to shareholder loans if the shareholder of a German corporation holding a material (25%) participation is not taxable in Germany. Interest paid on shareholder loans may only be deducted within a certain debt/equity ratio, which amounts to 3:1 if a fixed interest rate is agreed. In the case of a (qualified) German holding company, a debt/equity ratio of 9:1 applies. Interest payments on shareholder loans exceeding the relevant debt/equity ratio are treated as hidden dividend distributions. The German thin-capitalisation rules can be avoided – for example, if the participation in the German company is acquired by a German partnership. Loans from third parties guaranteed by an overseas shareholder can also be caught by these rules under anti-avoidance provisions.Management tax issues
Any increase in the value of management's shares in the company above the purchase price paid will be treated as capital gains rather than income when that gain is realized upon sale. Currently, capital gains are taxable if the shares are sold within six months or the seller holds a participation of at least 10%.
Where management borrows money to subscribe to shares, they will be able to set the interest costs of the borrowing against the income subject to tax.
In some investments, management shareholders are given a "ratchet", whereby the proportion of the equity to which the management is entitled to is not set at the outset but influenced by the performance of the company. However, the additional incentive is generally only achieved via a positive ratchet, which triggers a taxable charge at the time of granting the new shares. A negative ratchet may be more advantageous as the taxable charge can be postponed until exit or be tax free. Most ratchets are structured as options and as such (in the opinion of the German tax authorities) the tax will be liable on the difference between the fair market price at the time the purchase option is exercised and the aggregate amount paid to exercise the option and any amount paid at the time of grant. The granting of options to the management (positive ratchet) is, according to the prevailing opinion, not subject to income tax.Merger Control Regulation
On January 1 1999 the revised merger control rules under the updated Act Against Restraints on Competition came into force. The previous law has been thoroughly revised, in particular, with regard to the rules on procedure. As a result, the German Federal Cartel Office must be notified in advance prior to every planned merger or acquisition falling under the merger control rules. The deal may not be consummated until the Cartel Office has given clearance. Post-merger notification to the Cartel Office has been abolished.
The turnover thresholds have been simplified so that, subject to certain exceptions, any transaction with effects in Germany must be pre-notified if the worldwide turnover of target group plus purchaser group exceeds DM1 billion. In addition, the acquisition of control criterion, familiar from European law, has been incorporated in the Act against Restraints on Competition. However, the amending statute hardly affects the substantive law.