The last few years, in particular 2021, were very strong years for the private equity industry with a high number of deals (both in the mid-cap and large-cap segment). Compared to these exceptionally high levels, the German private equity market has significantly slowed down in 2022. This slowdown has been driven by inflationary pressures, interest rate hikes by several central banks and looming recessions in key economies fuelled by the continued adverse impact of the COVID-19 pandemic, the war in Ukraine and growing global tensions.
As a consequence, private equity sponsors are presently faced with uncertainties and risks which are difficult to assess. In addition, significantly higher financing costs put pressure on the valuations of potential targets, leading to lower valuations compared to previous years. However, given that private equity funds have remained well capitalised and lower entry prices are seen as an attractive opportunity, there is still an appetite for deals. In general, there is a shift from large-cap buyouts with high leverage to smaller all-equity deals, often combined with share-for-share exchange structures to mitigate the impact of increased financing costs.
Private equity investors were particularly active in the following sectors in Germany in 2022: industrials and chemicals, TMT, and pharma, medical and biotech. With the necessity for many corporates to become leaner and more profitable, in particular in light of adverse macro-economic developments, there is a trend towards carve-out transactions. Furthermore, in light of substantially increased financing costs, deals with share-for-share exchange structures have become more common.
In the last three years, several legal developments have impacted private equity investors, in particular in 2022.
Foreign Direct Investment Law
Several amendments to the German foreign direct investment (FDI) review regime had a significant impact on transactions by private equity investors in Germany. The German government is very focused on these reviews and has the authority to unwind transactions that have not been cleared within five years after their signing. Any failure to comply with mandatory filing requirements may also lead to up to five years' imprisonment or result in an administrative fine of up to EUR500,000.
Data Privacy Law/GDPR
In recent years, portfolio companies have been facing challenges in achieving full compliance with the data protection requirements set by the EU General Data Protection Regulation (GDPR). Since its implementation, there have been several landmark decisions on the interpretation and understanding of this regulation, which require a careful review of the internal data protection policies and compliance status. Furthermore, special requirements for the transfer of personal data to territories outside the European Economic Area (EEA) set by the "Schrems II" decision and the ineffectiveness of privacy shields have to be taken into account.
Anti-Tax Avoidance Directive (ATAD 2)
Substance requirements and recent international developments such as the EU's second Anti-Tax Avoidance Directive (ATAD 2) and the so-called Unshell Directive (on rules to prevent the misuse of shell entities for tax purposes) have had a relevant impact on how funds as well as their investments are structured.
Regulatory Approval Requirements for Private Equity Transactions
Generally, each private equity transaction concerning a German target (group) or a foreign target with an indirect German subsidiary or substantial German operations in a target group, should be assessed to decide whether a German foreign investment review (FIR) or antitrust clearance will be required.
Key Aspects of German FIRs
Should a non-EU/EEA acquirer acquire 10% or more of the voting rights in a German Target or additional shares crossing the thresholds of 20%, 25%, 40%, 50% or 75% of the voting rights, a German FIR clearance may be required by the German Federal Ministry for Economic Affairs and Climate Action (Bundesministerium für Wirtschaft und Klimaschutz or BMWK). In relation to defence-related companies, acquisitions by non-German acquirers from within the EU/EEA are also within the scope of a German FIR. Share acquisitions well below the relevant threshold (eg, 10%), may be relevant should the acquirer acquire governance rights as if it held voting rights above the relevant threshold (eg, additional board seats, veto or information rights). In relation to private equity investors, the BMWK reviews the acquisition structure up to the ultimate general partner (even if a German or EU/EEA portfolio company is the direct acquirer) for the applicability of a German FIR.
If the contemplated transaction concerns critical infrastructure, certain case groups enumerated in Section 55a of the Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung or AWV), in particular, healthcare and hi-tech products, or defence-relevant industries as set out in Section 60 AWV, require a German FDI filing, and clearance needs to be obtained prior to closing the transaction. In other instances, a voluntary application for the issuance of a certificate of non-objection (Unbedenklichkeitsbescheinigung) may be recommended in an individual case. In voluntary filings, a closing may take place – in close co-ordination with the BMWK – prior to the issuance of a certificate of non-objection.
In a base case scenario, a German FIR filing takes one to two months (phase I review). This may be extended to six to nine months or longer in the case of a phase II investigation.
Key Aspects of German Antitrust Rules
A proposed transaction requires obligatory notification of the competent German Federal Cartel Office, pursuant to Sections 35 et seq of the Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen), if the following requirements are met:
The clearance process generally takes between one and five months depending on the complexity of the case (subject to "stop-the-clock" events and statutory extensions).
Holder Control Filings
Where a private equity investor acquires 10% or more of the economic interest or voting rights in a regulated German financial company, it may have to file an obligatory holder control filing with the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht or "BaFin") including, among others:
Prior to BaFin's clearance, the transaction may not be closed.
Anti-money Laundering (AML) and Sanctions
In May 2022, a German Sanctions Enforcement Act was passed for the effective enforcement of sanctions against Russia and against sanctioned Russians in Germany. In particular, sanctioned persons are required to disclose their assets in Germany. As part of this, the AML rules were also tightened.
A legal due diligence for private equity clients is typically limited to a review of data room information and certain public sources. The focus areas for the legal due diligence vary from deal to deal and are tailored to the target and its business operations, also taking into account the contemplated deal structure (asset deal versus share deal) and other important aspects. In general, the legal due diligence covers corporate matters, commercial agreements, finance matters, employment/pensions, GDPR compliance, IP/IT, regulatory, real estate, and litigation.
The key findings identified in the course of the due diligence are usually presented in the form of a short report ("red flag report"), also providing clients with recommendations for the mitigation of risks arising from the transaction and commenting on the commercial impact of these risks. A comprehensive report summarising all legal aspects of the target has become uncommon and is usually only requested for transactions with an increased risk profile. In the past, red flag reports were sufficient to obtain debt financing from banks and warranty and indemnity (W&I) insurance coverage from insurance providers. However, it remains to be seen whether current global developments and the adverse economic impacts associated with heightened uncertainties and risks will lead to the comeback of more comprehensive due diligence reports, which were common in Germany about ten years ago.
In the case of an auction sale, sellers (and their advisers) commonly conduct a vendor due diligence in order to simplify and speed up the interested parties' own due diligence exercise, thereby streamlining the transaction and negotiation process. In addition, a vendor due diligence gives the seller the advantage of identifying potential areas of non-compliance with applicable laws or other value items and allows it to properly tackle those issues before or during the course of the transaction.
Vendor due diligence reports are generally provided without any reliance by the sellers' advisers thereon and potential buyers must sign a release letter in advance before getting access to such reports. Even after obtaining these reports, buyers will still typically conduct an additional ("top-up") buy-side due diligence in order to confirm the results of the vendor due diligence report.
German transactions concerning the acquisition of shares in a privately held target company are typically carried out by means of entering into a share purchase (and transfer) agreement where, depending on the legal form of the target company, special statutory form requirements such as notarisation apply. For listed targets, the acquisition will be carried out on the basis of an offer document which is published by the bidder. Depending on the place of the target's incorporation and the market on which the target's shares are listed, prior approval of the offer document by BaFin or another European regulator may be required.
In general, there is no structural difference between a privately negotiated transaction and an auction sale in terms of the acquisition documentation. However, auction sale processes usually enable the seller to push through more seller-friendly terms which, in the case of privately negotiated deals, would require strenuous negotiations. This applies, in particular, with regard to the details of the purchase price mechanism, the scope of the seller's warranties and indemnities, covenants and other undertakings of the seller, as well as general risk allocation.
Private equity funds typically use an acquisition structure comprising several special-purpose vehicles (SPVs) incorporated in Germany and/or countries with a favourable tax environment for private equity investments (typically Luxembourg, the Netherlands or the Channel Islands). These acquisition structures, which are developed on a case-by-case basis, taking into account tax, legal and regulatory aspects as well as the requirements of debt financing, allow private equity sponsors to ring-fence their investments and facilitate future exit options and cash repatriation.
Tax and Regulatory Aspects
Tax and regulatory aspects are often among the key drivers when considering whether or not a transaction should be facilitated through a German or foreign acquisition vehicle. If the acquisition is (partially) financed by debt (shareholder loans, third-party debt) a German acquisition vehicle may – under certain restrictions, including interest capping rules – allow for a pooling of the target's earnings with at-arm's-length interest expenses by implementing a German tax group. Such tax grouping is generally not possible if a non-German acquisition vehicle directly acquires a German target.
The private equity fund as such is not a party to the acquisition documentation (which is usually also excluded under the fund documentation). However, private equity sponsors are usually asked to prove certain funds to the seller by means of an equity commitment letter signed by the private equity fund.
Private equity transactions are typically financed through equity which is funded by the private equity sponsor (which will then be pushed down to the acquisition vehicles by means of equity or debt instruments) and third-party debt. In certain scenarios, the seller may be willing to offer to also participate in the financing of the transaction through vendor financing by means of a vendor loan or vendor notes.
Third-party debt providers are typically banks. Alternative financing sources such as debt funds and family offices have become more common in recent years as they may offer more flexibility and arrangers may be willing to bear higher risks and to act more quickly.
Equity commitment letters are customary in German PE transactions to demonstrate certain funds, enabling the seller to enforce payment of the purchase price as well as damage claims or break fees in the case of a deal broken after signing the transaction.
The majority of German PE transactions are control investments, yet minority investments of between 20% and 49% are also seen in the German market (especially if current owners are looking for a strong partner to finance the next steps in the target's business). In recent years, especially in large-cap transactions and public takeovers, two or more private equity investors are frequently seen acting together.
Club deals or syndicates are mainly seen in large-cap transactions. Due to the average deal size in the German market, the majority of investments by private equity funds are made by a single investor. It is not uncommon for other investors to be invited to co-invest with the private equity funds, either as passive investors or co-investors at the level of the acquisition structure. Furthermore, it is also common for private equity investors to reserve a right for future syndication.
For the past few years, the extremely seller-friendly market environment has resulted in locked-box accounts being the predominant consideration structure, in particular in private equity acquisitions. In transactions where strategic investors have invested or where the target business has been carved out of the business of the sellers, closing accounts are more common to determine the final purchase price and allocate the risks and upsides between signing and closing. In light of the increased risk of adverse changes to the economic situation of a target company until closing, caused by the current geopolitical situation, there has been a strong comeback of closing account mechanisms in 2022. Buyers are no longer willing to accept and fix a purchase price at signing on the basis of accounts that may not properly reflect the situation of the target at closing. As the level of purchase prices has been comparatively high in recent years, earn-outs have become less frequent.
In case of a locked-box consideration, the parties will agree on "no leakage" undertakings as well as undertakings to ensure that the business is conducted in the ordinary course (and/or consistent with past practice) between signing and closing.
While private equity buyers typically provide equity commitment letters, corporate buyers will usually provide parent guarantees. Reverse equity commitment letters by the sellers are rare but sometimes requested in the case of closing account deals to secure the buyer's purchase price adjustment claims against the seller.
Whether or not leakage is subject to interest remains a negotiated item between the parties. In light of negative interest rates and the fact that the purchase price is often not subject to an interest ticker, disputes regarding interest on leakage have been limited in the last few years. However, in the current environment with increased interest rates, these discussions may become more relevant again, as sellers will request interest on the purchase price between signing (or even the economic effective date) and closing the transaction, enabling the buyer to request equal treatment in this regard.
Typically, no particular dispute resolution mechanism is agreed for locked-box consideration structures, as the purchase price has already been fixed by the parties (usually based on the last audited financial statements). Therefore, only mechanics for leakage remediation and the scope of such remediation are required. Any potential risks in connection with the audited financial statements forming the basis of the buyer's valuation and purchase-price determination will be covered (at least partially) by a (subjective) warranty given by the seller on the true and fair view of such financial statements.
The preliminary purchase price calculated by the seller on the basis of estimated cash, debt and net working capital figures prior to closing is subject to a customary purchase price adjustment mechanism alongside the right to review and challenge the closing accounts that have been prepared by either the seller or the buyer (the buyer usually has the right to prepare the closing accounts and determine the final purchase price).
In private equity transactions, both parties usually aim to limit the number of conditions precedent to closing to ensure the highest possible degree of transaction certainty. In most transactions, the conditions precedent are limited to merger or other mandatory regulatory clearances. In particular, private equity sellers are usually reluctant to accept further conditions (such as change-of-control waivers, third-party consents or material adverse effect (MAE)/material adverse change (MAC) clauses). In light of experiences during the COVID-19 pandemic and the war in Ukraine, it is anticipated that buyers will more often try to negotiate MAE/MAC clauses as conditions precedent in order to protect themselves against an unforeseen adverse impact on the target's operations. It remains to be seen how the market in Germany will react to these developments.
Although often requested by sellers, private equity-backed buyers are reluctant to accept "hell or high water" clauses. In most situations, such provisions can be avoided by providing the sellers with sufficient reassurance that no merger control issues exist. If not, such clauses are at least limited in such a way as to ensure that no other portfolio companies held by the private equity sponsor are affected.
Break fees are frequently seen in auction-process situations once the seller pursues the transaction with a selected bidder. However, they are not necessarily standard in German private equity transactions. When the seller has granted exclusivity to a certain potential buyer, these provisions are an adequate tool to safeguard the seller and bring additional transaction security (eg, by motivating the buyer to obtain antitrust clearance). In certain cases, break-up fee arrangements agreed outside the transaction agreement require notarisation to be valid under German law. While pure cost reimbursement clauses can be agreed free of form, break fees that are structured as contractual penalties may effectively force the buyer to conclude the share purchase agreement and may therefore require notarisation if the share purchase agreement itself requires it. Particular attention should be paid to this issue if the break fees provide for a lump sum and not for the reimbursement of specific costs.
Reverse break fees (ie, a break fee in favour of the buyer) are not common in German private equity transactions.
In practice, statutory termination provisions are regarded as too extensive and are therefore replaced, to the extent legally permissible, by limited contractual termination rights of the parties.
Failure to Fulfil Agreed Conditions
The most relevant reason for termination of a sale and purchase agreement (SPA) is failure to fulfil the agreed closing conditions (eg, due to a failure to obtain regulatory clearances). The SPA usually specifies an end date by which all closing conditions must be fulfilled (a so-called long-stop or drop-dead date). This period is typically based on the expected maximum duration of the required merger control or other approval procedures, but should leave additional room for unexpected delays, especially in the case of procedures covering foreign jurisdictions or delays in connection with political or other crises, such as the COVID-19 pandemic.
Further Termination Rights
In addition, in some German law-governed SPAs the MAE/MAC clause is structured as a termination right in favour of the buyer. Further termination rights are commonly agreed when one of the parties does not fulfil its duties to effect the closing of the transaction or in the case of fraud or wilful misconduct of the seller (the latter cannot be fully excluded contractually).
Exclusion of Termination Rights
Termination rights are, to the extent possible (ie, not in the case of a termination for fraud or wilful misconduct of the seller), fully excluded for the period after closing of the transaction. This is mainly due to the technical difficulties arising out of a reversal of a business acquisition. However, this exclusion is not mandatory – where the transaction structure is fairly simple, a reversal of a transaction may be possible within a limited period of time after closing, depending on the extent of integration and restructuring measures already implemented by the buyer.
It is in the interest of private equity sellers to reduce the scope, amount and time for liability risks as much as possible. SPAs therefore often include instruments to that effect, such as liability thresholds, liability caps, de minimis provisions, baskets, mitigation obligations, etc, which are used in combination or individually, depending on the negotiating power. Time limitation periods vary for different types of claims and are, for example, usually longer for fundamental warranties and tax warranties as compared to business warranties.
W&I insurance is very common in the German M&A market and helps limit or exclude the liability under the seller's warranties.
Minimum Scope of Warranties
It is standard in Germany to exclude the statutory liability regime for warranties and limit the scope of the warranties to an agreed catalogue. Naturally, any private equity seller will try to reduce the set of warranties as much as possible. The minimum scope of warranties comprises title to the shares, capacity of the seller and the shares being free of encumbrances (so-called "fundamental warranties"). Warranties related to the operations of the target (so-called "business warranties") vary more widely in scope and are usually subject to intensive negotiations.
Data Room Disclosure
Unlike in many other jurisdictions, full disclosure of the data room against the business warranties is typically allowed in German law-governed transactions (ie, the information disclosed in the data room is deemed to be known to the buyer). Moreover, actual knowledge excludes seller's liability. Concepts of attributed or construed knowledge are frequently negotiated between seller and buyer.
Typical time limitations for fundamental warranties are two to five years and the liability for such fundamental warranties is in the aggregate typically limited to the amount of the purchase price. Business warranties are typically also limited to one to two years and capped at a certain percentage of the purchase price; for tax warranties, the standard is seven years. In the case of W&I insurance for business warranties, the seller's liability is capped at EUR1.
Indemnities in favour of the buyer are often agreed by the parties if there are significant known risks outside the normal scope of the business and the parties agree that the buyer should not bear these risks. This is particularly the case if (known) risks cannot be estimated with sufficient accuracy to reflect them in the calculation of the purchase price. The most important examples are tax liabilities, environmental risks, significant legal disputes or special product liability risks, but also risks in connection with personal data protection breaches and compliance violations.
Unless explicitly excluded in the SPA, indemnification provisions also apply to alleged claims and liabilities which ultimately do not materialise. As an alternative, the seller may undertake in the SPA to pay the buyer an amount equal to any liabilities arising out of a certain risk plus compensable damages (covenant).
W&I insurance is very common for private equity transactions of any type.
Purchase Price Retentions
Purchase price retentions, such as escrow accounts, are usually not agreed in connection with private equity transactions, except as security for specific risks identified during due diligence.
The most commonly litigated SPA provisions in connection with private equity transactions in Germany pertain to the determination of the final purchase price in closing account structures, warranties and earn-outs. For the latter, this applies in particular with respect to valuation questions or the achievement of certain milestones triggering payments under the earn-out.
In recent years, private equity investors have been among the most visible players in public-to-private transactions. Key deals include the takeovers of Aareal Bank, alstria, Axel Springer, Stada, Telecolumbus, VTG and Zooplus, as well as the failed takeover attempt of Scout24.
German notification obligations are strict and seek to prevent the secret build-up of a major stake. For targets listed on a regulated market, in particular, the Prime Standard of the Frankfurt Stock Exchange, investors are required to disclose their shareholdings when these reach the 3%, 5%, 10%, 15%, 20%, 25%, 30%, 50% or 75% thresholds. For financial instruments such as derivatives, the same notification obligations start at 5%. The German thresholds are thus significantly lower than the minimum 10% required under the European Transparency Directive. As a special notification obligation under German law, an investor reaching or exceeding 10% of the voting rights is required to inform the target about the objectives of the investment and the origin of the required funds (debt versus equity financing).
For the purposes of calculating an investor's shareholding, voting rights are, inter alia, attributed if they are held by a subsidiary or any other affiliate of, or by persons acting in concert with, the investor. Non-compliance with German notification obligations results in the loss of voting rights, dividend claims and may even lead to the investor being fined by BaFin. Even when a direct shareholder complies with its notification obligations, the same adverse consequences apply in the case of violations by an indirect shareholder such as the parent company or any of the parent company's affiliates.
For targets listed outside the regulated market, notification obligations only apply once the investor's shareholding exceeds 25% and 50%. In 2022, Germany saw the largest public takeover of a company listed on an unregulated market ever, with commercial real estate company DIC Asset AG successfully acquiring a majority stake in logistics real estate experts VIB Vermögen AG.
The threshold for mandatory takeovers is 30%. Other forms of influence, such as board seats, are not taken into account. In limited cases (eg, for investments required for a restructuring), BaFin can grant an exemption from the obligation to launch a takeover offer. In practice, mandatory offers are rare. Instead, private equity investors typically launch a voluntary takeover offer before crossing the 30% threshold, giving them more options on how to structure their offer and, in particular, to introduce conditionality.
The majority of bidders in Germany offer a cash consideration, and private equity investors practically always do. It is, however, also possible to offer liquid shares or a combination of cash and shares. This is typically the case for business combinations of major listed companies such as the Deutsche Wohnen/Vonovia merger. Recent case law has, however, significantly tightened the requirements for shares to qualify as sufficiently liquid. In view of this development, it is unlikely that exchange offers will become more frequent in the near future.
While mandatory takeover offers cannot be subject to offer conditions (other than clearances required by law, such as merger or FDI clearance), this restriction does not apply to voluntary takeover offers. The most common conditions (apart from regulatory clearances) are a minimum acceptance rate, MAC clauses relating to a certain stock index or the target (eg, absence of notifications regarding compliance violations or a drop of EBITDA), and no increase of the share capital of the target. In general, however, Germany significantly limits the extent of available conditions and prohibits any conditions that are within the bidder's control. In particular, a takeover offer cannot be subject to a financing condition; in fact, proof of financing is a prerequisite for obtaining BaFin approval to launch the offer.
In a friendly takeover, the bidder and the target will enter into a business combination agreement to enhance transaction security. Such agreements typically require the target's management and supervisory board to support the offer, prohibit the target from frustrating an offer condition or soliciting a competing offer, and in many cases, also contain break fees. However, the enforceability of such fees under German law is not guaranteed. In return for increasing deal security, the target will ask for a number of concessions from the bidder, in particular, with respect to the future composition of the target's board and the job security of its employees.
The rights of the bidder are governed by law and the articles of association of the target. A simple majority in the shareholders' meeting is typically sufficient to determine the composition of the supervisory board (and thus, indirectly, of the management board), except for scenarios with statutory employee representation on the supervisory board. In some cases, however, the articles of association may raise the threshold for dismissing supervisory board members. A majority of 75% of the votes in the shareholders' meeting enables a bidder to amend the articles of association, resolve capital increases and approve the conclusion of a domination and/or profit-and-loss transfer agreement. This kind of agreement provides the bidder with far-reaching instruction rights vis-à-vis the target's management.
If the investor holds 95% of the shares of the target following completion of the takeover offer, it can squeeze out the minority shareholders against payment of an adequate cash compensation. A takeover law squeeze-out can only be initiated within three months following expiry of the offer. The adequacy of the cash compensation can be challenged by the minority shareholders. If, however, at least 90% of the shares subject to the offer have been tendered, the offer consideration is deemed to be adequate compensation for the purposes of the squeeze-out. In addition, German corporate law provides for other types of squeeze-outs which may be available to an investor with a shareholding of at least 90%.
In most cases, the bidder will only launch its offer after obtaining irrevocable commitments from major shareholders. Negotiations have to be highly confidential and take place only shortly before going public with the offer in order to avoid any leakage and to avoid triggering disclosure or mandatory bid requirements. The parties may agree that shares subject to irrevocable commitments should not be tendered but rather sold outside the takeover offer, which eases the bidder's need to prove financing. However, the consideration for a takeover offer cannot be lower than the consideration granted by the bidder or any of its affiliates for share acquisitions during the six-month period prior to the offer.
When giving irrevocable commitments, major shareholders will seek to negotiate withdrawal rights in the case of a competing offer with a higher consideration, if the bidder does not increase its offer to match the competing offer. However, bidders have successfully resisted these requests in cases where their initial offer already adds a strong premium to the target's current share price.
There are no special provisions restricting hostile takeover offers (ie, offers not backed by the target's management or supervisory board). However, given that resistance from the target's management reduces deal security, such offers are rare in Germany, including for private equity investors. In a hostile takeover offer, management will, among other things, issue a negative reasoned opinion regarding the offer, engage in discussions with major shareholders and search for a white knight (a friendly company) that could launch a competing offer.
Management incentivisation through participation in the future value creation of a target company plays a crucial role in most private equity transactions. These programmes usually aim to mitigate or at least reduce the principal-agent problem and to align interests between management and sponsors. Such schemes can be structured either as co-investments through (indirect) participation of the management in the target's equity or as mere contractual arrangements, essentially entitling management to a bonus payment should certain key milestones be achieved. While contractual arrangements are easier to implement and maintain, it is more common for private equity sponsors to offer senior management and advisers the opportunity to co-invest in the target with own money, alongside the private equity fund, thereby facilitating a real co-investment. Depending on the transaction, the pool for such co-investments can amount to up to 10% of the target's fair market value.
In a typical management equity programme, a mix of preferred instruments and ordinary shares (indirectly) held by management will govern the management's risk and return profile. So-called growth shares (only entitling holders to the value creation after their acquisition), hurdle shares (providing holders with value participation once a certain hurdle is achieved) or ratchet shares (entitling holders to a certain return) are common. Tax risks associated with these kinds of special shares are, however, even higher than in a common structure comprising a mix of preferred and ordinary instruments.
In any case, careful structuring of the programme is essential to achieve treatment as a real co-investor from a tax perspective, thereby giving management the opportunity to benefit from the preferential capital gains taxation in case of an exit. Management's co-investment is regularly pooled in vehicles in the form of partnerships such as a German or Luxembourg partnership which is managed by either a German limited liability company or a Luxemburg limited liability company. This kind of indirect investment structure allows private equity sponsors to establish, among other things, appropriate governance and avoids having multiple minority shareholders at target level.
Private equity sponsors regularly have the right to buy back the equity interests held by the management members once their employment or service agreements with the target have ended or have been terminated. Terms for such buy-backs and, in particular, the purchase price to be paid to leaving management members, usually differentiate between the circumstances triggering the exit of the respective manager. It is quite common to distinguish between an exit triggered by the participant, which generally results in a so-called "bad leaver" scenario, and the so-called "good leaver" scenarios where the sponsor or target wishes to terminate the employment or the participant otherwise ceases to work for the target. In the case of a termination for cause, the manager is also qualified as a bad leaver. In the case of a bad leaver scenario, the purchase price is generally the lower of the fair market value and the manager's initial investment. The calculation of the buy-back price is, however, also typically linked to vesting rules. In these cases, time-vesting provisions according to which interest vests on a pro rata basis over a pre-agreed period, are common. Leaver qualifications and the vesting rules will then determine the buy-back price for the interest. As with all other aspects of management equity programmes, leaver provisions need to be carefully drafted so as not to endanger the desired tax treatment and to be enforceable under German law.
Customary restrictive covenants discussed between private equity sponsors and management are non-compete and non-solicitation undertakings. It is quite common to make reference to existing non-compete (and possibly non-solicitation) clauses in the respective employment agreements. Alternatively, underlying documentation for the management incentive programmes, such as shareholder agreements, and – if a pooling vehicle for management is interposed – partnership agreements may contain separate obligations to not compete or solicit while investment in the management investment programme takes place (plus an additional period following the disposal of the interest in the management investment programme by the management). Existing restrictions under German employment law, especially concerning non-compete provisions following a termination of employment, have to be taken into account.
Like other minority investments, shareholder rights of management in management participation schemes are relatively limited. In equity programmes, it is, however, important to grant a participant at least basic shareholder rights (eg, voting rights) for tax reasons. Depending on the structure of the management incentive programme, private equity sponsors may optimise shareholder governance of the target by interposing – tax transparent – management pooling vehicles (see 8.2 Management Participation) between the top holding company of the target group and the co-investing managers. This limits the number of actual shareholders of the target and helps streamline decision-making at shareholder level. To protect their co-investment, management usually asks for some kind of anti-dilution protection in turn. Private equity sponsors may therefore agree to pro rata subscription rights for the management (through the pooling vehicle) or guarantee that any capital increases of the target will be based on current fair market value.
It is very common for private equity sponsors to implement a new corporate governance regime at their portfolio companies, in particular, a catalogue of reserved matters, in order to ensure control over the portfolio company's management and the decision-making process. Typical measures that are made subject to sponsor approval are:
In addition, private equity sponsors will be granted comprehensive information rights (subject to legal limitations) as well as the right to appoint or nominate members to corporate bodies, such as an advisory or supervisory board.
The general principle of German corporate law that the liability of a company (eg, of a limited liability company) is separate from the liability of its shareholders has no general exemption based on a doctrine such as piercing the corporate veil or the group of companies doctrine. However, there are certain exceptions to this general rule where shareholders' liability may apply, particularly in the following cases:
Whether or not, and to what extent, a private equity investor imposes compliance policies on a portfolio company depends on factors such as the nature of the portfolio company's business, the availability of existing compliance policies or the private equity investor's investment guidelines. Large private-equity investors typically have an extensive set of policies available, which they seek to implement across their portfolio companies.
The holding period for private equity investments varies and depends on a number of factors, such as the phase of the portfolio company's life cycle, when the investment was made, and general market conditions for an exit. The most common form of divestment is a trade sale to a third party (as part of an auction sale). Given the strong market conditions in recent years, a growing number of transactions have been run as dual-track sales or even single-track IPO exits. A trade sale also offers the advantage of a full exit, whereby – in the case of an IPO – the private equity investor may be required to retain a significant stake.
Drag-along rights are usually included in shareholder agreements governing the rights and obligation of the co-shareholders. Private equity sponsors, in particular, insist on having a drag-along right to facilitate their subsequent exit. In general, private equity sponsors co-ordinate their exit efforts with co-shareholders so that formal utilisation of the drag-along right is not required and it is thus rarely seen in practice. Such utilisation is often only necessary if a co-shareholder is unco-operative and tries to retain its shareholding. Even then, a drag-along right is used as a threat, rather than actually being exercised. There are various forms of thresholds linking the right to exercise drag-along rights to the sale of all or more than 50% of the stake held by the private equity sponsor or, in some cases, even to the achievement of certain value thresholds.
Management shareholders sometimes enjoy tag-along rights alongside other provisions protecting their minority shareholding. Tag-along rights usually either allow the management shareholders to sell their entire participation (full tag-along right) or to sell an amount proportionate to the participation sold by the private equity investor (pro rata tag-along right).
In the case of an IPO, private equity sellers are expected to enter into customary lock-up undertakings with the underwriting banks. The most common lock-up period is 180 calendar days following the listing. Customary carve-outs, among other things, allow for a transfer of shares to affiliates and pledges in connection with financing transactions, providing private equity investors with sufficient flexibility during the lock-up period. Relationship agreements are not relevant for German IPO exits, and applicable corporate law makes it difficult to include many of the provisions customary in UK agreements. However, German governance rules already provide for extensive protection of minority shareholders.
The year 2022 has been characterised by significant headwinds for the mergers and acquisitions market in Europe and Germany, which also impacted the private equity market. Amidst the high inflation rate, high energy prices in Germany, which have not been seen in years, and shifts in the global economy caused by the Ukraine conflict, as well as rising global tensions and unstable supply chain as a result of the COVID-19 lockdowns, the private equity market in Germany was actually surprisingly positive in its performance, with the exception of the large buyout market, where a significant decline is evident. It should be noted, however, that the activity in the small and medium-sized segment remained relatively stable and was only in the low double-digit percentage range below its peaks in 2020.
On a deeper level, some segments have suffered greatly from the above-mentioned trends, whereas others could maintain or even increase their numbers and volume of transactions. It is true that valuations declined in general along with the decline in the general stock markets, but since Germany has not been caught up in the special purpose acquisition company (SPAC )wave, valuations of potential targets have also been driven more by fundamentals such as business prospects and research activity of targets than by capital market trends.
Developing Trends in 2023
At a more granular level, what are these trends and developments likely to continue in 2023? These would include declining valuations and a shortage of capital in private equity and, in particular, the venture capital segment, as well as pressure on traditional German assets such as automotive or production due to supply chain issues. It may be common knowledge that energy prices are rising and the general industry trends are evolving, but others such as the increasing impact of regulatory conditions on deal execution are relatively unknown to the broader market.
Declining valuations and shortage of capital
In recent years, quite a number of German start-ups have been successful in achieving unicorn status and raising capital to internationalise their operations, particularly in the software, mobility and consumer sectors. On the back of that wave, the number of VC and growth funds that entered the German market tripled over the last five years, which fuelled further valuations. This trend has stopped and reversed. It has become increasingly difficult to raise funds in that segment, many start-ups have gone out of business or have reduced their operations, thereby negatively impacting the growth equity market as well. While there will always be exceptions, this trend will continue into 2023 and could result in a real market correction.
In line with this, a continuing decline in valuations in the overall private equity market will be seen, as increasing costs negatively impact the profitability of target assets, rising interest rates will make deal financing more expensive, and the overall uncertainty in the market will require a risk premium to be applied to business forecasts.
Niche segments will outperform the general market
As in every downturn, there have been segments that have not been negatively impacted by general trends and which will actually benefit from the overall uncertainty. As a result of ongoing mandates, there are not too many details that can be revealed, however, one can see a significant increase in infrastructure private equity, which will continue due to political decisions taken in Berlin and Brussels. Furthermore, the healthcare segment, with its subsegments and consolidation strategies, has been and will continue to be strong. There is, however, an increasing pushback from politics, government and courts against a further consolidation among doctors and hospitals, as we have observed in our practice in recent months. As such, each bidder is advised to carefully select its advisor in order to ensure that they are aware of these trends, which can vary greatly from one region to another.
Another segment that might still be small overall in total number of deals, but which will continue to grow (at a lower valuation level than one year ago) is the German “deep tech” space (for lack of a better term). It refers to the thousands of small and medium-sized, research-intensive, German companies, often founded only in recent years that focus on inventions in the medical, veterinary, production, energy, recycling, chemical or IT-related arenas. This might come as a surprise, as the overall concern of a “de-industrialisation” of Germany due to macro-economic trends and political decisions are not unfound. However, this research-intensive market segment has grown significantly over the years and is no longer only of interest to strategic buyers, but also to investors who are willing to finance operations prior to significant cash-flow generation from real products.
Convergence of venture capital with traditional private equity
In spite of the negative short-term outlook for capital and valuations, innovation and digitalisation will continue to have an increasingly significant impact throughout all segments of the economy described above, leading to a convergence between venture capital, growth capital and traditional private equity investment. Many established, large asset managers, who traditionally focused solely on large-scale buyouts, now have a fund dedicated to this segment. Meanwhile, successful venture capital funds have been able to raise such substantial amounts of capital that they resemble more and more traditional private equity growth funds, except for their focus on non-majority positions in their target companies (although the rights granted to them contractually often achieve the same). Also, in that context, one should note that consolidation strategies that were previously applied to “traditional” economies are now increasingly being employed in segments such as online market places or IT, and it is becoming evident that the boundaries between traditional fund segments is becoming increasingly flexible as time passes. This trend will continue.
Regulatory scrutiny and ESG
The regulatory environment becomes more and more deal critical and has developed from a niche item in the due diligence exercise ten years ago to a potential deal killer nowadays. The change in the political power in Germany due to last elections, and a continuing worldwide political tension, has accelerated this trend. A takeover of a German robotics company like Kuka by Chinese Midea six years ago would nowadays be blocked by political veto. The underlying concerns have now also expanded into sometimes more remote areas such as basic infrastructure, healthcare, technology or large-scale industry deals as such, and also apply to minority investments. Recently, the government opted to block the acquisition of a minority stake in the Hamburg port by a Chinese company, and politicians stated their opinion on how they would respond to the possibility of Mercedes-Benz being acquired. It is imperative that this trend is taken into account early in the transaction negotiation process and discussed with the political decision makers before transaction rumours make their way into the media.
More importantly, and often overlooked, is the impact that “know your customer” (KYC) requirements and health, safety and environmental regulations have on the deal market today. Over the past 24 months, a number of important EU regulations and German specificities have come into force and will continue to do so in the near future. However, not all operating businesses, let alone funds, are aware of the implications of the changes on their businesses and transactions. It might, for example, mean that during due diligence it turns out that the target asset does not fully comply with all (new) environmental or safety laws, which does not only result in potential losses to the underlying business, but could also pose a significant obstacle to private equity (existing or future) owners who take environmental, social, and governance (ESG) very seriously. ESG requires the adherence to health, safety and environmental guidelines.
Further, certain party transactions have become “undoable” due to new KYC regulations and every market player is well advised to lock into this aspect before significant resources are dedicated to a particular party. If in old times market players might have thought that things are “solvable” and hence can be neglected, they might now be surprised that either notary publics will refrain from notarising transactions if KYC checks have not been performed, or that banks simply keep funds in escrow until they have been able to determine the ultimate beneficial owner in a corporate structure. Furthermore, funds themselves, when fund raising, initiating capital calls, or paying purchase price to sellers, have their own responsibility to determine who their real counterparts are, and non-compliance with that obligation will result in severe fines and damage. There is no doubt that this led, and will continue to lead, to the exit of many potential LPs as investor in funds or of bidders as potential acquirers of assets.
These words suggest that compliance with ESG or EU taxonomy rules will become a crucial factor in the private equity industry, and greenwashing discussions concerning certain public funds will also affect private funds. Ideally, every fund should be prepared to investigate whether its actual activities align with its public announcements, let alone what is legally required.
More transaction and investor related disputes
Unstable times mean that buyers who thought to have struck a fair deal four months ago might want to get out of a deal before closing because the business outlook has worsened. It has already happened in 2008 and 2009, during the COVID-19 crisis, and has begun to occur now as well. Even if buyers do not wish to take such drastic measures, they are more carefully investigating whether claims may be made for indemnity or guarantee breaches. The expectation is that the number of such claims will increase in the next 12 to 18 months.
In addition to this “normal” development that occurs in every downturn, another development that is relatively new and results from the high valuation growth of start-ups in 2019–2021, namely, down rounds and the issues that accompany them. In a down round, capital is raised at a valuation lower than the valuation applied in the previous financing round, and because of the hype in the start-up space in the last 24 months, investors often forgot to demand traditional devices which would have protected them from the diluting impact such down rounds have on their existing ownership in a start-up, both from a legal and more importantly from an economic standpoint. When this is combined with the fact that fresh capital seeks to be prioritised in the capital structure, and the founders realising that their ownership stake may be of no value if all liquidation preferences of investors must be satisfied first, then there is a perfect storm of misaligned interests in such down round financings. If the expectations of declining valuations prove correct, more of these disputes will be seen in the next 12–18 months.
Carve-outs and pick-up of large-volume buyout deals
It may come as a surprise due to the existing slowdown in large buyouts and the macroeconomic and political circumstances described above, but predictions are for an increase in the deal flow of large buyouts in 2023 in a particular segment of that market, namely carve-outs from large industrial players. Increasing margin pressure and rising interest rates are causing headaches to many CEOs and CFOs of strategic players, who must adapt their businesses to new supply chain reality, energy efficiency targets and new industry innovations at the same time. Declining capital market valuations and intense debt financing restrictions will restrict the amount of capital available to them from traditional financing sources. This will result in an increasing level of carve-outs by these players to large buyout funds, who have a large amount of unallocated capital and remember how they have acquired these assets that later generated the highest returns to them during times such as these.
Therefore, a number of larger carve-outs could be seen in the next 12–18 months.
PIPE transactions and taking privates
As a result of decreasing valuations in public equities, a substantial increase in minority investments by private equity into publicly listed companies (PIPEs), or even the taking private of listed companies by private equity funds with knowledge in that area, is on the cards. This is an area which has been traditionally en voque when valuations on listed markets decline and this firm has already advised on the first of these types of transaction in 2002. In recent months an increasing number of these transactions has been apparent. The legal framework upon which these transactions occur is much different from that of a traditional buyout or private financing round and the selection of an experienced advisor becomes even more relevant, as violations of applicable laws could result in substantial fines and even loss of voting rights. But there is a strong interest for listed companies to entertain discussions with interested investors to strengthen their capital base, which will grow even further when the financial results of listed companies come under pressure and debt financing sources become even more restrictive.