Trends in Private Equity Activity in Latvia in 2020
The global economic developments in 2020 had significant effects in Latvia, much like in every country. The COVID-19 pandemic impacted the private M&A market in Latvia, among others. All economic activity reduced, with the Bank of Latvia reporting a drop of 2.3% in gross domestic product in the first quarter of 2020 and a staggering 7.1% drop in the second quarter of 2020, as multiple businesses were brought to a halt due to activities to combat the pandemic. Industries such as food services and hotels (HoReCa), tourism, airlines and gaming were hit quite hard due to the mobility restrictions that were put in place for the majority of 2020 in Latvia.
Despite the uncertainties and challenges posed by local and global economic developments, the private equity market remained active during the pandemic. Interest rates for financing remained relatively low and there was capital available in the market in 2020. In fact, according to the data published by the Latvian Private Equity and Venture Capital Association, amounts invested in Latvian companies in 2020 increased compared to investments in 2019. The number of overall private equity transactions in Latvia, however, faced a slight decline. Deal value growth in 2020 was mainly influenced by a large investment made in 2020 by INVL Baltic Sea Growth Fund into Eco Baltia.
There was also a significant increase in the number of divestments in 2020, a trend which may be fuelled by the uncertainties and volatility of the market.
The private equity market is still developing and although the number of investments decreased slightly in 2020 as compared to 2019, which is mainly attributable to the pandemic, it still remained at a high level, compared with the overall market activity in previous years.
Successful industries and largest transactions
Multiple funds still saw an opportunity to proceed with their investments in 2020. There was increased activity in those areas that were the least impacted by the COVID-19 pandemic, such as IT services, fintech and other technology-related businesses, media and telecoms, health, energy and infrastructure. Fintech companies continued to be attractive to investors, despite possible regulatory challenges these companies may face in the future.
According to the Baltic Private Equity and Venture Capital Market Overview 2020, significant transactions include the acquisition by INVL Baltic Sea Growth Fund of a majority stake in Eco Baltia (a sorting, recycling and waste processing company), the investment by BaltCap Private Equity Fund II in Coffee Address Holding (a vending and coffee service company) to fund its acquisition of another company in the industry, and the investment by ZGI-4 in Bio Investments, a biotechnology products and equipment company.
COVID-19 facilitated changes in the business culture both in the region and globally. Business meetings were replaced with calls and videoconferences, which in some cases even increased the speed of communication and exchange of information, and, at the end of the day, also the speed of the whole transaction. Nevertheless, the personal connection is still highly valued in private equity transactions and, whenever possible, flights were organised for investors to meet with the representatives of companies in person, notwithstanding the existing challenges.
Developments in the Regulatory Framework in Latvia
There have been several positive developments in the regulatory framework in Latvia in recent years, which have had a facilitating impact on private equity transactions in the market. The key developments in the regulatory framework in Latvia that took place in 2020 and affected transactions are considered below.
Improvements to the existing regulatory framework are often suggested by non-governmental organisations, such as Foreign Investors Council in Latvia, which is an active participant in shaping and improving the regulatory framework in Latvia. Market participants have welcomed the introduction of stock options and conditional share capital, and the implementation of share categories for limited liability company and other changes to Latvian law in recent years.
The Baltic States, including Latvia, are considered to be quite competitive compared to other European countries when it comes to stock option regulation. Although stock options have been regulated as management and employee incentive programmes for quite some time, companies in Latvia have only recently started to actively consider the implementation of stock options in their incentive programmes. Stock options are a great way of increasing employee and management loyalty and motivation; they also increase knowledge on the use of financial instruments and promote the growth of a company’s value. Stock options are also chosen over other employee incentive or bonus programmes due to a favourable tax regime. Multiple entities in Latvia decided to proceed with implementing stock options in their companies in 2020.
Positive developments in the regulatory framework include the introduction of share categories in the Commercial Law for limited liability companies. This increases corporate flexibility when it comes to the share capital of the most common type of entity in Latvia, and also opens up wider possibilities for using this type of entity as an investment target.
The regulation was adopted in 2020 and entered into force in January 2021. It provides the possibility to include different share categories in the share capital of a limited liability company, indicating the rights arising from each such category, and the number and nominal value of shares. Different categories of shares were previously only a possibility for joint stock companies. With the new regulations, limited liability companies can implement different share categories in their share capital, thus ensuring more attractive investment structures for possible future investors.
Limited liability companies may indicate different rights arising out of each share category (for example, different rights to receive dividends, liquidation quota and voting rights at the shareholders' meeting, or other rights not directly mentioned in the Commercial Law). With these changes, amendments to the nominal value of one share have also been introduced. Previously the nominal value of one share in a limited liability company could not be less than EUR1, but now it can be as small as EUR0.01. Such changes, although small, can be helpful and introduce new possibilities in share capital structuring.
In order to limit the spread of COVID-19 and facilitate the use of electronic means of communication, in March 2020 the Latvian government enacted provisions enabling companies to hold shareholder meetings without the physical attendance of shareholders. The shareholders may attend the ordinary or extraordinary shareholder meeting via electronic means, and the management board is responsible for ensuring such participation and for identification of the shareholders. Remote participation and voting in the shareholder meeting may happen at the initiative of the company’s management board or if requested by at least 20% of the shareholders of the company. In addition, the management board must ensure the possibility for the shareholders to vote before the meeting electronically or by mail.
In accordance with these provisions, it was not necessary for a company to make any changes to its articles of association in order to hold such meetings. Nevertheless, if all shareholders agree to it, it is possible to set out in the articles of association that the shareholder meetings take place only by using electronic means of communication.
For physical shareholder meetings, Latvian law sets out that the meetings must take place in the administrative territory where the legal address of the company is registered. Different provisions could be set out in the company’s articles of association, but the possibility to hold shareholder meetings via videoconferences had not been previously detailed in Latvian laws. Companies are now allowed to hold shareholder meeting completely virtually.
Facilitated by the pandemic, this was an important and necessary change in the regulations concerning shareholder meetings, which previously provided the need for meetings in person. This will undoubtedly change the corporate governance and previous practices of companies, as many businesses are actively using this tool to ensure easier and more effective governance. This will also pose challenges regarding the correct identification of participants, undisturbed process and possible technical difficulties. These changes are not just temporary and will apply to all future shareholder meetings.
Digitalisation in state institutions
The pandemic had helped to jump-start digitalisation processes in state institutions, which have been slowly implemented throughout previous years. Quick and decisive action was required to ensure continuous business and governmental activity when the possibility to hold physical meetings was limited or impossible.
When the doors of many institutions and organisations closed for visitors in March 2020, the Latvian Register of Enterprises, which is responsible for the registration of entities in Latvia, turned completely digital and stated that it will no longer provide its services face-to-face; all activities should now be carried out online or using mail. The Register of Enterprises has also improved the availability of corporate documents for entities registered in Latvia – the majority of corporate documentation (such as the share ledger of a company or its articles of association) is available online without a fee.
The digitalisation will spark a change in company management in Latvia and will ensure deeper involvement of investors in companies, improve the governance of companies and provide more options for financing.
Recent developments in the European Union have resulted in the implementation of new legislation in Latvia concerning reporting obligations for cross-border transactions involving European Union member states. In accordance with the new regulation, as of 1 January 2021 there is an obligation to report cross-border transactions that have certain characteristics which suggest potentially aggressive tax planning. Although the reporting obligation entered into force in 2021, it covers transactions retrospectively.
This regulation also applies to providers of legal assistance in Latvia and to other persons consulting in such transactions.
The importance of effective and quick due diligence should not be underestimated. In accordance with the Baltic Private M&A Deal Points study, which provides an overview of the key characteristics of transactions taking place in Latvia, Lithuania and Estonia, more than 90% of reported transactions in 2020 included a buyer’s due diligence. The trend of conducting a buyer's due diligence has increased steadily over the past few years. While buyers regularly carry out target due diligence for their potential purchase or investment, vendor’s due diligence is still quite a rare sight, reported for only 11% of transactions.
Vendor due diligence and clean team
More and more vendor’s due diligence reports are being prepared to ensure a company's compliance with the increasingly complicated regulatory enactments (such as data protection and anti-money laundering laws) and to prepare for the possible challenges and obstacles associated with the transaction. Vendor due diligence in private equity sellers is especially common. The vendor due diligence report normally includes a non-reliance clause with respect to persons other than the seller. If the report is disclosed to the buyer or its advisers, separate release and non-reliance documentation is prepared.
Specific “clean team” data room and due diligence is still rarely used in the transactions, mainly due to the specific nature thereof and the limited number of transactions.
Form and function of due diligence
Fewer buyers and investors are interested in detailed, descriptive or “full” due diligence reports, considering the timeline and increased costs of the transaction, as well as the fees of legal advisers. In the majority of cases, the buyer’s due diligence is limited in terms of review, and a red flag or issues-only due diligence is carried out.
There are no particular trends when it comes to materiality thresholds and the scope of due diligence, as these are mostly transaction or target-specific and are based on the business profile and size of the target. Typical areas of review include corporate governance, financing, business agreements, real estate, employment, regulatory, environment, IT and IP, supplemented with a data protection and anti-money laundering review.
The vast majority of due diligence reviews are carried out via a virtual data room, although there have been some cases when physical data rooms were prepared. The number of virtual data rooms compared to physical ones has increased significantly over the past decade.
Also, the trend of obtaining warranty and indemnity insurance is quite new for transactions in Latvia, although it is well established in other European countries.
The pandemic has not had a large impact on the way due diligence is carried out, with the exception of management interviews, which are traditionally held via physical meetings and now have to be organised via means of electronic communication.
Lack of regulation
Focus has remained high on shareholders’ agreements and joint venture agreements in private equity transactions, as takeovers are frequently not complete. Although Latvian laws provide some protection for minority shareholders, it is quite common to enter into a shareholder or joint venture agreement. Shareholders’ agreements are entered into despite the fact that they have not been regulated under Latvian law and the provisions thereof have not been defined; nevertheless, some guidance with respect to shareholders' agreements for Latvian entities can be drawn from law practitioners. Due to the lack of regulation, there is also a lot of uncertainty with respect to the enforcement of such agreements.
Provisions of the agreement
Key provisions of shareholders' agreement normally cover the purpose and business of the target, and the governance thereof. Depending on the shareholder structure, the shareholders' agreement could foresee a certain number of management board members. If the business remains managed by the target, the fund could also nominate its representatives in the supervisory board, as an optional collegial institution that supervises the activities of the management board (if the investment target is a limited liability company). In the two-tier governance structure of Latvian entities, the management board is the executive body of the company, while the supervisory board supervises it.
It is also customary to include in the agreement certain matters reserved for the approval of the supervisory board or even the general meeting of shareholders. Such matters would normally include entering into material transactions or carrying out other activities outside the normal course of business. The agreement should also include provisions on management reporting. Although Latvian law foresees that most matters that are in the competence of the general meeting are resolved with a simple majority of votes (with the exception of important matters), the parties may also agree in the agreement on voting on specific matters, such as budget, management board or transfer of shares, and introduce veto rights on certain matters for any of the shareholders. However, in accordance with Latvian law, such provisions must also be repeated in the company's articles of association.
The agreement would normally touch upon financing matters and accounting. It is also important to decide on the dividend policy for the company. The agreement may also look at key performance indicators and bonus policies for the management, and may include management and employee incentives.
A large section of the agreement is normally devoted to restrictions with respect to shares, such as pre-emption rights, rights of first refusal, lock-up period, drag-along and tag-along rights, and the resolution of deadlock situations.