Private Equity 2020

Last Updated August 05, 2020

Germany

Law and Practice

Author



Bub Memminger & Partner was founded in March 2019 by the merger of leading traditional law firms with special expertise in the areas of litigation, transactions/restructuring and trusted advisory. The private equity team consists of nine lawyers and has recently advised FSN Capital Partners on the cross-border acquisition of the iMPREG Group as well as Lafayette Capital on the restructuring of worldwide sports and leisure equipment producer Kettler.

M&A transactions as such, but even more with the involvement of private equity bidders, where heavily affected by the economic downturn and uncertainty caused by COVID-19. The year 2020 started out a busy one, and then went from full speed to zero within just a couple of days when the full impact of COVID-19 started to materialise at the beginning of March 2020. However, on the transactional side, this shutdown only lasted, for a few weeks, with bold buyers being able to do transaction without debt financing already end of April this year. This improvement in the general markets continued with acquisition debt financing provided by German banks being available again in June/July this year and large-scale financing offered out of London/New York being offered at reasonable terms from July onwards.

This change in the perception of buyers and lenders is what currently drives market participants: At the one side, debt is available at reasonable terms and buyers see that not the whole economy is negatively affected (and certainly not at the same magnitude) by the slow-down caused by COVID-19. On the other side, owners of targets have experienced first-hand how fast market conditions can change and are hence even more willing to accomplish now longer planned sales efforts. The result of this is a surprisingly positive outlook for the rest of the year 2020 with reasonable deal flows levels with some exceptions:

  • large scale transactions are still well behind the deal-flow at the beginning of the year; and
  • one can clearly see a shift in investor appetite for certain industries.

On top of that, the economic downturn that started to be visible already end of last year has been accelerated by COVID-19 and made things even worse for industries that had already suffered before, such as the automotive (supplier) industry. The number of restructurings in this and related industries is increasing at an accelerated pace.   

As can be imagined, there have been more all-equity financed transactions than in previous years, due to the reluctance of banks and debt fund to provide debt financing (if at all) at reasonable terms. Further, the number of restructuring related transactions has clearly ticked off, with restructuring lawyers all of the sudden being busy and with no end to be seen.

But COVID-19 has not only led to these potentially negative impacts. To the contrary, sellers have realised that it may be worth not to hold on forever to targets if they want to sell, and buyers have realised that good assets are the best protection in a market downturn. Hence there is an ever-increasing hunt for stable, well-managed assets in traditional industries.

There has not really been any significant legal development addressed solely to the private equity market in the last three years. The implementation of the AIFMD has already happened years ago and is well reflected.

More importantly was the response by the German government to the COVID-19 situation, with the financial aids and modification on insolvency filing obligations provided for. This has helped to gain market confidence at a rate not foreseeable in April this year, and has helped many businesses to file for insolvency in summer, which would have affected consumer confidence and hence the economy. There have even been special funds dedicated to the VC scene where start-ups have been hurt badly by the reluctance of both customers and investors

One has to distinguish between (i) regulations, which apply to the establishment and due management of private equity funds with domicile in Germany and (ii) the question whether particular laws apply to transactions directly or indirectly contemplated by such private equity funds or funds domiciled outside of Germany.

Regulations Which Apply to German Private Equity Funds

Germany has also implemented the European AIFMD regulation, which provides for a set of regulations dealing with how private equity funds have to be set up, organised, managed, audited and the like, depending on, among others:

  • the type of investor it seeks money from;
  • the type of investments it intends to make; and
  • how it is organised (eg, open-ended funds).

The German law that has put AIFMD in place is called the German Capital Investment Act (KAGB).

As much has been written about AIFMD and its implementation into German law in the form of the KAGB, with very useful information in English to be found at the website of the German regulatory authority BAFIN at www.bafin.de, ie, the authority in charge of the supervision of the KAGB, reference is made to the useful and extensive explanations provided there. As a general statement, private equity managers will find a well-developed set of regulatory rules following the AIFMD with an experienced regulatory body. While service-levels may not reach those that can be experienced in Luxembourg, Germany certainly offers an attractive place to set up and manage private equity funds (if the tax treatment of private equity managers is disregarded for a moment).

Regulations Which Apply to Transactions Undertaken by Private Equity Funds

Transactions undertaken by private equity funds in Germany, be it from funds residing in Germany or abroad, fall under the same legal framework than any other M&A transaction undertaken by a strategic buyer or an individual. If there are differences, eg, on how capital gains resulting from a disposal of a company are taxed, they usually are triggered by:

  • the question on which legal form the target or the seller has;
  • whether substance rules are observed; or
  • which type of investment structure and instrument had been used (real equity or contractual profit-sharing agreements; acquisition via a tax transparent partnership structure or via a corporate blocker, etc).

This being said, the mere fact that a private equity fund contemplates a transaction does not cause any treatment of such transaction to be different from that which may apply if a large German corporate would do such transaction.

This does not mean to imply that the acquisition and sale of a company is regulation free: There are antitrust laws which might require the approval of the German antitrust regulator if a transaction reaches a certain size (be it in terms of sales achieved in the prior fiscal year or in terms of the consideration paid), highly sensitive industries are protected by the German Foreign Trade and Payments Act and there may be employment law implications (both in terms of notification requirements and the need to establish a co-determined supervisory board) depending on the number of employees of the combined structure or the current employment-related conditions of the target. Further, tax laws need to be taken into account on the structuring of any private equity backed transaction to make sure the desired tax treatment for investors (and managers) is achieved.

While all of that may sound irritating and frightening at first glance, Germany is a very well-developed and reliable place for M&A transactions, which provides for an equal treatment of private-equity backed transactions (be it by German or foreign funds) with that of other, domestic buyers. 

Due diligence is usually rather detailed, covering all relevant legal aspects of the target including contracts, compliance with law, corporate measures, real estate, employment, etc. It is usually completed within a four to six-week timeframe, depending on how well prepared and committed the seller is and how many resources the buyer devotes to it. In highly urgent cases, it can be completed within a two-week timeframe, but then certain areas are usually carved out or very high materiality thresholds are applied.

Whether vendor due diligence is performed and if so, for which areas, largely depends on:

  • the deal size;
  • complexity of the target;
  • the state of the target;
  • the intended sales process; and
  • the willingness of seller to pay for it.

To give some light to the aforementioned statements, vendor due diligence usually turns out to be beneficial to seller, as it can achieve/verify that:

  • the due diligence of buyer can be performed based on a well-prepared and fully-equipped data room checked by vendor counsel;
  • potential issues can be spotted by vendor’s counsel and ideally be cured before buyers are approached; and
  • the vendor’s M&A advisor is able to conduct the transaction in a streamlined, swift fashion, as buyers can make themselves familiar with the target based on existing vendor due diligence reports.

These benefits typically outweigh the costs involved with the preparation of such vendor due diligence reports. As a general rule, mid- and large-sized transactions typically involve vendor due diligence reports at least for the areas financial, market, tax and legal, while smaller scale transactions do not have them at all or only for finance matters.

Reliance by vendor’s advisors for the due diligence reports prepared by them to the buyer is a matter of negotiation and the engagement terms with such vendor’s advisor. If it is intended that reliance is given, this should be clearly stated in the terms of engagement agreed between the vendor and such advisor. Further, this will be important for the type of review to be undertaken by such advisor: As fact books (which only describe what has been presented to the advisor) are typically given without reliance, one can observe that full due diligence reports (which analyse and question the data provided to them) are more often prepared on a reliance basis towards the ultimate purchaser.

All types of transactions are seen in the German market: Starting from privately negotiated (exclusive) transactions over auction processes conducted by M&A advisors, be it for “healthy” companies or for companies in a restructuring or insolvency status. From the acquisition of private targets to tender offer bids for publicly listed companies. All of these types of transactions have distinct features and regulatory frameworks, resulting in very different purchase agreements respectively modes of acquisition.

Typically, the fund itself never acquires the target directly. Rather, it establishes a transaction structure with one or more shelf vehicles, driven largely by financing, tax and liability considerations. The fund becomes then the shareholder of the interposed shelf vehicle and may provide an equity commitment letter to the Seller.

Given that Germany is a well-developed private equity market, all sorts of financing arrangements and types of transactions are seen. The majority of the transactions are partly debt financed, but due to the impact of COVID-19 on the overall economy and deal conditions, a significant portion of transactions in spring and summer this year had been all equity transactions.

Besides typical equity or debt arrangements, one also sees hybrid instruments such as mezzanine capital, and debt funds are more and more active in Germany when it comes to the source of the debt financing provided.

Private equity investors invest both in control and minority stake transactions, with the latter typically happening in either venture capital or growth-type of transactions or where family-owned business are selling a minority stake as part of a longer term plan to hand-over the business to a new owner.

Co-investments opportunities by limited partners in a fund are often demanded and greatly appreciated by limited partners, yet they are only happening occasionally. This can be explained by the fact that co-investments are usually not attractive to the managers of a private equity fund – for them, it is more beneficial to call the capital for an investment from all investors in the ordinary manner and, once all capital is invested, raise capital for a new fund.

Consortium transactions are usually found only at the end of large-scale transactions, where the equity ticket is over EUR250 million or in VC-type of financings.

Transactions by private equity sellers are typically carried out by a locked-box mechanism with a fixed purchase price to provide for transaction certainty. For the same reason, deferred purchase price structures such as earn-outs or vendor notes are typically not appreciated by private equity sellers and are only used as a fallback scenario to bridge valuation gaps.

This does not mean that closing accounts, earn-outs, vendor loans, re-investments and the like are not seen in Germany, but they are still an exception and bidders have to be aware that a seller will usually prefer a clean exit by a sale of 100% of its interest with the full consideration payable on closing over any of these alternative structures, unless they realistically provide for as significant higher return. Interestingly, private equity bidders also typically prefer the locked-box, fixed purchase price approach, as it is straightforward and with less work and costs involved than in a closing accounts approach. There are no significant differences between a corporate or private equity seller.

A private equity buyer usually will need to provide for a fund guarantee, together with some information about the financial status of the fund, to give comfort to the seller of the buyer’s ability to pay the purchase price. In case of debt-financed transactions, the equity commitment letter is then supplemented by proof of availability of the debt financing. In a corporate transaction, this is usually handled by a corporate guarantee issued by the top holding company. 

Interest on the purchase price is typically charged and the interest rate usually reflects the anticipated positive cash-flow of the target. The only exception is where the fixed purchase price already prices in the positive cash-flow, which is usually not the case.

For closing accounts, it is typical (and essential) to provide for a mechanism (i) on how the closing accounts are prepared and (ii) in case of disputes between the parties on such closing accounts how it is then settled. This is necessary to provide for some level of transaction security for the parties and make sure that these highly complex economic questions are reviewed and decided by persons who are familiar with the topic (usually accountants who serve as arbitrators).

In a locked-box structure, this is of far less importance and hence the parties usually do not provide for a special dispute resolution mechanism, other than the general one applicable to the other sections of the purchase agreement.

Closing conditions are seen as negative as they reduce transaction security and hence a seller will always aim to have only such closing conditions which are absolutely required, ie, usually only antitrust. Issues such as availability of financing, prior restructurings, new service agreements for employees and the like are typically handled before signing of a purchase agreement or are foreseen as a mere covenant. Only when the bargaining power of the buyer is very strong are these covenants safeguarded by a closing condition (which can then be waived by the party for whose protection it is inserted). The same is true for material adverse conditions.

As a general rule, it is fair to say that closing conditions other than antitrust are the exception and conditionality on third party consents is usually avoided by both seller and buyer as it gives (undue) levy on third parties. 

The use of a "hell or high water" undertaking depends on the bargaining power of the parties. A seller will typically demand it and buyer typically reject it. In an auction for an attractive target, a private equity bidder will usually need to accept it to win the auction.

Break fees are an exception in the German market. This can be explained by the fact that conditional deals are equally such an exception. If conditionality must be accepted (which points to bargaining power on the buyer side or some very particular circumstances demanding it), then the reasons for accepting such conditionality generally also mean that seller will not be successful in demanding a break fee.

A break fee on seller’s side is more often seen than on the buyer’s side and usually only in the context of reimbursing a buyer for transactions costs if seller decides to pursue the transaction with an alternative bidder.

Contractually the parties are only allowed to terminate a purchase agreement if closing has not occurred by a certain time period and the terminating party has not caused the closing delay.

Besides this contractual termination right, the parties always have the right to terminate a contract for cause. However, this requires very specific circumstances, which are not typically existing.

A private equity seller will typically not accept post-closing liability exposure, as this limits its ability to distribute funds to its investors. If it accepts such liability, it is hence in very narrowly-defined circumstances, usually also involving an escrow account that serves as the sole recourse for claims of purchaser. Given that private equity buyers know these issues, they tend to be more understanding that a private equity seller wants to limit its post-closing exposure than a strategic buyer. This has a significant impact on:

  • whether guarantees and indemnities (and the extent thereof) are provided by a private equity seller; and
  • the liability restriction system, ie, limitation periods, de minimis, caps, etc.

Further, private equity sellers do not typically run the business of the target, but rather are only engaged in the advisory board of the target. This limits their knowledge of the business and their willingness to make statements concerning the business.

A strategic seller, in contrast, has more knowledge of the business and availability of funds to the investors is not of the same importance. Hence, as a general notion, one sees that a strategic seller is willing to take on more risk than a private equity seller.

Given that advisors have tended to act for years for both strategic and private equity sellers and bidders, market practice has become more and more uniform. Further, W&I insurance has become a great facilitator to bridge the risk/liability gap.

One has to differentiate whether W&I insurance is involved or not. If W&I insurance solutions are taken on, the private equity seller would typically only be liable (if at all) for title guarantees. Operational guarantees would be given, but the liability of seller would be basically excluded (unless severe circumstances such as fraud or wilful guarantee breaches are at hand).

Without W&I insurance, a private equity seller would usually only give title and authority guarantees and, if absolutely required to get a deal done, very limited operational guarantees where the liability is then typically capped at a very low percentage of the purchase price (typically 5-8%) and a limitation period of 18 months. Tax indemnities by sellers without W&I coverage are then also very selective handled. Management guarantees are seen, but usually in the reinvestment documentation by which managers acquire a stake in the bidding vehicle. Without a reinvestment being contemplated, guarantees given only by the management and not by the private equity seller tend to be more and more an exception and not the norm, unless agreed differently with the management (and then usually if the managers are particularly incentivised).

As it concerns the liability limitation system, both W&I and sellers are typically successful in achieving that the data room is considered to be reasonably disclosed, that known issues are excluded, that claims against third-parties are considered as well as standard de minimis, threshold/cap, limitation periods and overall liability cap provisions. 

W&I insurance has become very common in private equity transactions, with the majority of transactions now having either the guarantees and/or the tax indemnity covered by it. If no W&I insurance is taken on, then the private equity seller usually has to accept that a small portion of the purchase price is paid to an escrow account to fund potential claims of the purchaser.

Common may be too much of a statement, but one can observe that after a transaction has taken place, buyers typically investigate if they have claims against seller for breach of warranties or under a tax indemnity. Whether these claims are then pursued and, if so, whether this develops into a litigation depends on the applicable liability thresholds in the purchase agreement and whether seller and purchaser can agree on a out-of-court settlement. In the vast majority of cases, the guarantee violations do not cross the liability thresholds provided for in the purchase agreement and hence there is no dispute between purchaser and seller.

If litigation in fact happens, this is typically the case when a purchaser feels that material facts have not or not adequately been disclosed.

Public-to-privates do occur in Germany, but if they are compared to overall numbers of private equity transactions, they are just a small percentage of the overall market. 

The relevant thresholds are 3%, 5%, 10%, 15%, 20%, 25%, 30%, 50% and 75%. If such thresholds are crossed, publication duties vis-à-vis the public exist.

A mandatory tender offer must be submitted if a party owns or controls more than 30% of the voting rights of the target. It is important to note that there are extensive rules on the attribution of voting rights held by others, but over which a party has access to.

Cash transactions are the more commonly used method in Germany. If shares of the bidder are offered, they must be admitted for trading at a public stock exchange.

The ability of a bidder to include conditions in its offer are restricted by law. As a general rule, only such conditions are permissible which are not under the sole control of the bidder. Permissible conditions are, eg, antitrust approval or reaching a certain minimum shareholding in the target. A financing condition is, however, not permissible – to the contrary, a bidder must submit a financing confirmation for its offer.

As it concerns deal security provisions, the most standard ones are those of seeking the support and commitment of large shareholders in the target before making an offer, with attention being paid to the fact that:

  • if the 30% voting rights threshold is reached, then the public tender offer must be filed; and
  • holding notification rules are observed.

Besides this, the bidder can also seek to enter into a business combination agreement with the target to agree on break-up fees (in reasonable amounts), information disclosure (to the extent permissible under inside information laws) and the position of the management and supervisory board of the target on the offer.

It has to be noted that the target should generally stay neutral, in particular when it deals with more potential bidders and, hence, burdensome obligations on the target or its management and supervisory board might result in a violation of the target’s management and supervisory boards’ obligations, which might also affect, in severe circumstances, the validity of the share acquisition by the bidder.   

A very important aspect is that most German publicly-listed companies are German stock corporations (AG), which have a dual board structure with (i) the management board (Vorstand) being responsible for the management of the company and (ii) the supervisory board overseeing the actions of the management. The supervisory board members are elected by the shareholders meeting (typically by a simple majority vote), which in turn then nominates, appoints and removes, subject to applicable laws, the management board members. Shareholders have hence neither direct control over the appointment or removal of the management board members, nor would they vote on management issues (unless demanded by the management board at its sole discretion).

The implications of this dual board system on the corporate governance of an AG are manifold and too important to make simplified statements here. If a bidder does not feel comfortable with this structure which only allows it indirect control over the management of the company, it must seek for a change of the corporate form of the target. To do so, it is often preferable to seek for a squeeze-out of minority shareholders, with detailed regulations and case law on how to achieve a squeeze-out being provided for under German law. The most important being minimum shareholding percentages and rules on the consideration to be paid to the minority shareholders.

The precise mechanism to conduct a squeeze-out vary based on which squeeze-out rules are followed (there are different rules for achieving a squeeze-out under German law). As a rule of thumb, a shareholding of 90% or even better 95% by the majority shareholder should exist to do it. 

Irrevocable undertakings are a common instrument where the target has shareholders with a significant share and who can be approached with confidentiality being secured. These are usually approached before the tender offer is formally announced. These undertakings are privately-negotiated contracts and can have, within the limitations provided for by takeover and insider laws, a variety of different provisions.

Most typically, they foresee the commitment of the shareholder to tender its shares into the offer and the right of the shareholder to tender its shares into a competing offer if launched at a higher price. 

Hostile takeover offers are permitted and happen in Germany, sometimes with private equity involvement, but they are the minority in an already oversee able number of takeover offers.

Management incentives are foreseen in the vast majority of the private equity transactions, with the percentage given to group of managers typically between 5-10%.

As to the precise structuring, one sees different approaches, which can largely be divided into:

  • equity-based incentives; and
  • contractual-based incentives.

Equity-Based Incentives

These incentives are typically given in form of real shares, be it ordinary shares or preference shares. To bundle the investment of all managers, one typically provides for a tax-neutral limited partnership in which the managers become limited partners and which in turn holds the shares in the target. The limited partnership is then managed by a general partner, usually owned and controlled by the private equity investor.

Depending on how strong the incentive of the managers shall be, this limited partnership/the manager does then only invest in the instrument which offers the greatest return potential, ie, the ordinary shares. Its position in the acquisition structure is also carefully considered, depending on whether it shall have an increasing envy factor or not. To summarise, if and to what extent managers need to subscribe to ordinary or preferred shares, and if their acquisition of these shares is financed by a loan granted or arranged by the private equity investor, depends mostly on economic reason.

Contractual-Based Incentives

In contrast to equity-based incentives, there are different contractual arrangements which aim to give the manager a share in the exit proceeds or gains realised in such exit. They may be given as an exit bonus scheme, as options to acquire shares in the target (with or without option price) and variances of the foregoing. The benefit of these contractual arrangements is that they are easy to be implemented and managed and hence very cost-efficient.

In contrast to equity-based incentives which, if structured correctly, allow the manager to generate tax-beneficial capital gains, contractual arrangements usually qualify as employment related income.

Vesting is usually foreseen over a three-to-five-year period, with each year or quarter typically providing for a cliff vesting. Vesting typically ends with the manager becoming a leaver. While vested shares can then be held by the manager until an exit (or acquired by the private equity fund at a price usually linked to fair market value), unvested shares can be acquired immediately by the fund at the lower of fair market value and investment amount.

A manager is a leaver if they cease to provide services to the target or its group. If this is due to fault on their side (eg, the manager terminates the employment agreement, the manager violates his management duties so that the employer must terminate him), then such manager is a bad leaver. If their services end for reasons that are not their fault, they are a good leaver (eg, ordinary termination by the employer, sickness of employee, etc). Interestingly, one can see more and more the concept of “Intermediate Leaver”, ie, a manager who becomes a leaver without fault.

The importance of making the differentiation whether a manager is a good or bad leaver can be explained by the following: while a good leaver is generally allowed to keep his vested shares until exit (and then sell them at the fair market price), the bad leaver is required to sell their shares to the private equity investor at the lower of the fair market value and the managers entry price also when it comes to his vested shares.

Managers usually always must sign-up to non-compete, non-solicit and non-disparagement undertakings. While the manager is employed by the company, enforceability of such clauses is very high, as they are also foreseen by law without being provided for in the employment agreement when it comes to senior-level employees.

When it comes to the validity of these clauses after a manager has become a leaver, it is a bit more challenging. But if such clauses are (i) combined with compensation clause that allows the manager to receive at least 50% of the total compensation granted to such manager before he became a leaver and (ii) not extensive in duration/coverage (ie, not more than two years), they are usually upheld.

Management participation is usually seen as a method to provide for exceptional income/returns to management and not as a means to give them control over the daily business or how an exit is conducted. For that reason, the minority rights of managers (in particular once they become a leaver) are very limited and often only apply in case of transactions or payments between the target and the private equity fund, ie, transactions where there might be a conflict of interest. Other than that, the private equity fund retains full majority rights, which, in particular, applies to all questions around an exit.

There are, of course, exceptions, eg, when the stake of the management is exceptionally large and the management might have paid substantial amounts for it. Then it is justified to treat management as every other significant minority shareholder. But these situations are very rare and private equity is always very careful to give management shareholder rights, on top of the strong position they already have by virtue of running the business.

Private equity funds typically seek for significant information and control rights over its portfolio companies. While they should not get involved in the day-to-day business due to tax rules, it is typically foreseen that:

  • funds can appoint and replace the management;
  • funds can instruct management to do certain things;
  • management do need to get their approval on major business matters; and
  • funds have extensive information rights.

As a practical matter, an advisory board is typically established with the majority of its members being appointed by the private equity fund, and such advisory board is then exercising the aforementioned rights vis-à-vis the management on a regular basis.

The extent of the veto rights of such advisory board over management matters can be quite extensive – they may stretch from key decisions such as merging with other companies over the hiring or firing of employees with an annual income of over EUR100,000. 

As long as the private equity fund does not pretend in the public to be the manager of the target, the risk of being held liable for management actions or the liabilities of the target are minimal. The piercing of the corporate veil doctrine is known in Germany, but can only be applied to a very limited number of circumstances where a person has acted and appeared to be the real manager of the business. Veto rights and occasional exercise of instruction rights do not trigger it alone. 

Compliance with ESG rules is more and more of an issue in the German market, as LP investors increasingly tend to invest only in private equity funds who can show that they have a clear ESG policy in place, which is in fact regularly monitored. This has an impact not only when due diligence by a private equity buyer is done, but also subsequently when the private equity purchaser puts ESG rules through by rules of procedures for the management of the target. Compliance with these rules is hence in fact more and more important also by German portfolio companies.

An exit is typically achieved after a holding period of four to five years. The by far most relevant exit path is a sale to another acquirer. Dual paths, ie, an IPO and sales process at the same point in time, are only relevant for companies from an equity valuation of, typically, more than EUR500 million, because of the costs involved and the expectations of public markets. For that reason, not more than a very low single-digit percentage of all private equity exits are undertaken in such a form.

Reinvestments of sellers do happen, but in the majority of cases the private equity seller aims for a full exit. If a reinvestment occurs, this is typically done to bridge valuation gaps or by the management of the target.

In basically all situations with more than one shareholder and where the private equity shareholder has been professionally advised, the shareholders agreement will foresee drag-along rights for the majority shareholder. Key features of these clauses are typically:

  • they can be exercised only by the private equity shareholder;
  • they do not foresee any minimum purchase price or holding period;
  • they give the private equity seller wide discretion on the selection of advisors and how the process is run (assuming arm’s length standards are met).

Only in circumstances where other minority shareholders have a greater say (eg, because they are institutional shareholders or are the founders of the company), the aforementioned key terms might be modified such that a minimum return must be achieved in such drag-along exit or a certain holding period must have been observed. 

If a certain shareholder is granted a drag-right, the respective shareholders agreement usually then also foresees a tag right of all shareholders. This is the other side of the same coin. Tag rights are provided to every shareholder and do not depend on a certain shareholding percentage. Rather, the opposite true; it is even sometimes foreseen that very small minority shareholders have a tag right for their full shareholding and not just proportionally for their shareholding.

As it concerns the beneficiary of such tag rights, these are typically granted to all shareholders, with no distinction being made between management shareholder, institutional shareholders or the like.

Lock-up periods of six to 12 months are typical for both private equity investor and management. It is, however, not unusual that the private equity investor is allowed to sell a significant part of its shareholding already in the IPO and only the remaining stake then being subject to the lock-up period.

Bub Memminger & Partner

Promenadeplatz 9
80333 München

+49 69 870 047 800

+49 69 870 047 849

p.memminger@bubmemmingerpartner.de www.bubmemmingerpartner.de
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Bub Memminger & Partner was founded in March 2019 by the merger of leading traditional law firms with special expertise in the areas of litigation, transactions/restructuring and trusted advisory. The private equity team consists of nine lawyers and has recently advised FSN Capital Partners on the cross-border acquisition of the iMPREG Group as well as Lafayette Capital on the restructuring of worldwide sports and leisure equipment producer Kettler.

PE Investments in Times of Uncertain Markets

The COVID-19 emergence has accelerated the economic downturn that was already visible in Germany from summer last year onwards. While the virus itself might hopefully be under control from next year onwards, its economic and psychological impact will last longer, as it has brought to the attention what many might have forgotten in the last ten years: that economic cycles typically end unexpectedly and that the future cannot truly be planned. Those who have been in business over the last 25 years might remember the abrupt end of the dot.com bubble, the impact of 9/11 and of the Lehman crisis. But many market participants might not have been in business when these events had happened, or simply might have forgotten it, and COVID-19 brought this uncertainty back to the attention of everyone.

This does not mean that transactions will not happen in the rest of 2020 or 2021. Rather to the opposite, one currently sees a wave of sellers realising that if they really wish to sell, they might better do now and accept that it is sometimes better to accomplish a transaction at 90% of the potentially achievable purchase price then no transaction (or not in the foreseeable future) at all. And there are a number of Purchaser who are willing to take some risk and have patience to hold on to investments for longer than just two to three years and hence see the current situation as a unique situation to acquire high-quality assets at a discounted valuation.

But it is also true that this crisis has forced shareholders to review whether the company they are holding on to really has a future, and if so, with which strategy, profitability and balance sheet. Questions and decisions that one was able to avoid in the years 2015-19 are now on the agenda, and in particular leveraged private equity investments are under careful review by the banks and their shareholders.

The following topics are typically reviewed in that context:

Aspects considered by lenders

Will the borrower be able to serve and repay the debt?

Clearly, this is the primary concern of any lender, ie, whether it will be able to receive its interest and repayment when due. Important in that aspect is, whether the borrower is able to serve the debt of other lenders, as they might otherwise take enforcement measures. Lenders will typically review if and which covenants and financial ratios have been agreed in the respective lending documentation.

At which seniority level sits my debt if the borrower should default?

Once it becomes questionable whether the borrower will be able to meet all its debt when due and hence an insolvency risk exists, it is of utmost importance for the creditor to determine at which rank its debt sits and whether its debt is “under or above water”. This analysis drives the future role the lender can play in a potential restructuring negotiation.

How good (and valid) is the security package provided to me and can I seek for an improvement?

Whether the debt of a lender is under or above water is driven by (i) to which company within the borrower group it has provided the debt and how close this company is to the positive cash flow streams of the borrower and (ii) if, and to what extent, the lender has been provided with (asset based) guarantees or securities by the borrower or its group companies, the value of these guarantees or securities, and whether they are in fact enforceable in case of a later insolvency. Sometimes, lenders try to improve their potentially weak position by demanding additional securities, which obviously may be to the detriment of other (unsecured) creditors.

The key item to note is that none of this should be done without the advice of an experienced restructuring lawyer, who might have been in court concerning such topics and knows how judges think about highly sophisticated, but to the normal person often hard to understand, legal structures. If and to what extent securities of a creditor are enforceable in an insolvency, in particular if the securities have been granted in times of crisis, is almost certainly going to be discussed with a later insolvency administrator and any experienced restructuring professional will use such uncertainties also in pre-insolvency restructuring discussions.

What happens if I see that the borrower is in a crisis mode? Can I (or must I) provide new liquidity by means of a new loan or can I get out of existing commitments? What happens with repayments which have already occurred?

Due consideration has to be given to these topics, in particular when it becomes evident to a lender that the borrower might need to file for insolvency. German insolvency laws and courts are quite peculiar on how to handle payments that have been made by lenders to creditors where the financial distress was apparent, and the impact this has on the enforceability of existing securities as well as on received payments.

Am I (or the persons acting on my behalf) liable vis-à-vis a potential insolvency administrator of the borrower or vis-à-vis my institution for entering into the debt commitment in the first place?

Lenders may think they have done something good by extending or increasing a credit line, or providing new credit, and are then later surprised when they hear that they might have assisted in increasing the damage to creditors in extending the lifeline of a company that was not able to be saved. This might be a topic when such an action has caused an insolvency filing to occur only after expiration of relevant limitation periods under relevant insolvency challenge rights.

Further, the employees of the lender who had been responsible for entering into, and the management of, the credit exposure might fear that they are liable under their employment relationship vis-à-vis their employing lender. Whether this is the case or not depends, among others, on how well-informed and careful such individual has acted and whether they have complied with all internal approval and information obligations. 

Can I demand from the shareholder or other stakeholders (eg, business partners) to restructure the business and make financial contributions and if so, how?

A lender has an interest to save its debt commitment from default, in particular if it is not well-secured. For that reason, it may have an incentive to participate in a restructuring exercise where all relevant stakeholders make contributions to secure the future of the borrower. Those contributions may be cash injections by the management, higher sales prices with customers, lower purchase prices and extended payment terms with suppliers, or reduced compensation to managers and employees.

Sometimes, even governmental support might be achievable. In particular, large banks have very experienced workout managers within their organisation, who might have significant know-how to share. From a legal perspective, due consideration has to be given to the limits provided for by law in order to avoid a lender being seen as a quasi-manager or quasi-shareholder of a borrower, in particular where strong covenants and security would allow the lender to play a much stronger role than “just being a lender”. 

Aspects considered by PE shareholders

Which strategy adjustments are required to the business to improve the business and future prospects?

From a private equity fund perspective, the operational and strategic set up and adjustments required in that respect are the items it will likely spend its key focus on. This is understandable, as these aspects drive the decision on whether or not to hold on to the investment and may even increase the investment to save the company. However, this is just one of the questions to be considered and too often has a sound and carefully developed strategic restructuring plan not been put in place simply because it came too late and nobody had paid due attention to when “the train might leave the station”.

How can these adjustments be legally implemented and what are the costs involved?

Once a restructuring plan is involved, the key item, from a legal perspective, is how it can be implemented and at what cost. A sale or closure of loss-making units might become necessary which might result in ongoing liabilities of the units that are intended to be saved. Liabilities which quickly come to the forefront are workforce reduction costs such as redundancy payments, but there might also be subsidies which need to be repaid or damages to be paid to contractual partners for which the surviving units might be liable.

These are just few factors that need to be considered when a restructuring plan is developed. 

How do I avoid that lenders pull the trigger and rather support the restructuring by a standstill and potentially credit waiver?

Once a restructuring plan is developed and its costs are analysed, it usually takes time to see a company in crisis improve. Typically, a company does not have the capital to pay both the restructuring costs and serve its debt, let alone has the liquidity to repay it in full; this may also be the case years after the restructuring has happened. For this reason, standstill agreements with lenders must be negotiated to make sure that the existing debt and its securities are at least not enforced for a certain period in time, ideally coupled with a (partial) credit waiver of the lenders.

Whether this is achievable very much depends on the strength of the lender’s position (see previous comments) as well as the financial contribution to be made by the shareholder. In many cases, the lenders were reasonable and willing to accept significant haircuts if the financial sponsor was willing to make fresh equity commitments and provide for a sound restructuring plan. This said, financial sponsors should not take this task lightly: the key points of contact within financial institutions for credit engagements at risk switch to the work out units, and the professionals active there might have, in contrast to their counterparts on the private equity sponsor side, extensive experience dealing with insolvencies.

Am I able to secure the support of other stakeholder groups, such as, eg, major customers, suppliers and employees?

Besides the commitment of professional lenders, a sound restructuring plan typically involves, as mentioned, contributions by other significant stakeholders, such as customers, suppliers or employees. These groups might accept that payment terms are adjusted, trade credit is given, prices are adjusted for a certain period of time, that wages are reduced or working hours are increased. All of this needs to be negotiated and agreed in a fashion which fits into the overall restructuring plan and its timeline, as well as with respect to later exit plans of the private equity shareholder.

The latter aspect is often missed: if these contributions become repayable in case of an exit, it might mean that the financial sponsor ends up with almost no purchase price, although they have made a significant equity contribution to save the business.

If I am taking on a more active role to achieve the foregoing measures, how do I avoid liability as a quasi-manager of the business?

The managers of a business might not be experienced with regard to a restructuring and might appreciate the help of personnel of the private equity fund. The fund might be more than willing to assist, as this gives it first-hand insight on how the business and the restructuring goes. Yet, the right legal set up must be founded on how the personnel of the fund can engage in such a restructuring to avoid not only the liability of a quasi-manager, but also to not endanger the tax position of the fund, which typically tries to avoid to create a tax presence in Germany.

Do I need to provide further capital to the company, or can I get out of existing (undrawn) financing commitments?

Another important question to evaluate is whether the fund can get out of any existing financing commitment it might have made through shareholder agreements or financing agreements with lenders. These questions typically arise in case of venture capital or growth investments, where a shareholder's agreement might provide for funding commitments along the commercial milestones to be achieved. Lenders tend to mirror these sorts of milestones.

A careful legal analysis might come to the conclusion that an investor might be able to step out of these funding commitments depending on the precise drafting and circumstances at hand. But each and every situation might be different and has to be analysed anew.

If I provide further capital: How do I best do this from a legal and economic perspective?

If the fund is willing to support the restructuring effort with an injection of fresh money, the treatment of such fresh equity, in case of a later potential insolvency, must be considered. Even if it is secured by assets of the borrower, it is likely it will not be upheld in case of a later insolvency. There is a developed legal framework for shareholder funding in times of crisis which should be carefully discussed with appropriate legal counsel. 

Am I protected in case of insolvency from claims of an insolvency administrator or other stakeholders?

The fund might, however, decide that a restructuring plan is not feasible and hence insolvency becomes inevitable or could possibly happen despite an attempted restructuring. This worst-case scenario should always be in the mind of the investor and should be the guiding principle when determining the course of action.

What impact does all of that have on my management, their incentives and my relationship with other potential shareholders?

The management of a company in crisis might realise that they may face liability and risks resulting from a potential insolvency and might file prematurely to avoid such risks, whereas the private equity investor might prefer to hold on and give it more time in order to develop a restructuring plan. This non-alignment of interest is often seen and has lead to negative surprises on the investors side when confronted with an already filed for insolvency.

This non-alignment of interest may increase when management realises that the equity they might have been offered as part of an incentive plan is worthless and ranks behind any proceeds to be realised by investors. Within the shareholders group (assuming that more than one fund is a shareholder), there may be severe issues if certain shareholders are willing to support a restructuring plan while others do not. If and to what extent these differences can be solved, and the proceeds of a positive restructuring are then shared, needs to be carefully discussed and agreed upon before any such measures are taken.

All of these are good and important questions, which are currently discussed almost daily with private equity funds, borrowers and lenders. The German legislator has helped all relevant players tremendously with the revisions made to the insolvency filing obligations, which had the effect that the above-mentioned questions did not need to be discussed and decided within just a couple of days in April and May this year, but rather provided everyone with the time to carefully consider and plan actions to be taken until the end of September 2020. As this deadline has now been moved to December 2020, the relevant stakeholders have gained even more time.

The hope of the German legislator and the general public is that the difficult financial condition many companies currently find themselves in might, by then, have disappeared or at least diminished, but this will likely prove to be unrealistic. For this reason, the additional time granted should be used wisely by private equity funds to restructure their portfolio (where needed) ahead of the expiration of this prolonged insolvency filing exemption and discuss and agree on the aforementioned topics sooner rather than later. 

Bub Memminger & Partner

Eschersheimer Landstrasse 14
60322 Frankfurt am Main
Germany

+49 69 870 047 800

+49 69 870 047 849

p.memminger@bubmemmingerpartner.de www.bubmemmingerpartner.de
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Law and Practice

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Bub Memminger & Partner was founded in March 2019 by the merger of leading traditional law firms with special expertise in the areas of litigation, transactions/restructuring and trusted advisory. The private equity team consists of nine lawyers and has recently advised FSN Capital Partners on the cross-border acquisition of the iMPREG Group as well as Lafayette Capital on the restructuring of worldwide sports and leisure equipment producer Kettler.

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Bub Memminger & Partner was founded in March 2019 by the merger of leading traditional law firms with special expertise in the areas of litigation, transactions/restructuring and trusted advisory. The private equity team consists of nine lawyers and has recently advised FSN Capital Partners on the cross-border acquisition of the iMPREG Group as well as Lafayette Capital on the restructuring of worldwide sports and leisure equipment producer Kettler.

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