Despite the recent economic slowdown and the entailed (M&A) market disruptions, the outlook for private equity funds overall remains positive. Investors must adapt to increased pressure on distributing sale proceeds, as well as an economic environment in which financing costs, inflation and energy prices are comparably high and supply chain issues are more likely to impact business operations. However, private equity funds still have extensive amounts of “dry powder” to deploy, and global business trends that are materialising in Germany, such as digitalisation, increasing demands for healthcare, decarbonisation and energy transition, are likely to continue to provide plenty of opportunities for investment and further growth.

One of the main aspects affecting private equity transactions in Germany is the evolving regulatory environment and the rising scrutiny of antitrust and foreign direct investment (FDI) authorities. Adding to the pre-existing layers of governmental control concerning private equity transactions, recently introduced EU foreign subsidies regulations will require close attention from private equity investors. Finally, considerations concerning potential ESG risks of targets will continue to be a vital aspect of many investment decisions, as well as of negotiations regarding transaction documents and the management of portfolio companies in 2023.

Over the last year, the German M&A market faced disruption caused by the impact of geopolitical events and a challenging economic environment. In particular, the war in Ukraine, supply chain issues, surging energy prices, interest rate hikes and soaring inflation resulted in not only an economic slowdown and uncertainty in the capital and financial markets but also a downturn in private equity deal activity, especially compared to the exceptionally successful post-COVID-19 period in 2021.

This changed macroeconomic reality has accelerated (but not exclusively caused) the ongoing general trend of private equity buyers entering into a wider variety of transaction structures. Different transaction structures can, for example, allow for investment with reduced or even no use of external debt (and less dependency on volatile syndicated loan markets especially), instead relying more on equity funding. In 2023, private equity investors continue to not only pursue the usual and still predominant control investments but also utilise more bespoke investment structures in the form of secondary or even tertiary buyouts (ie, from other financial sponsors), minority and growth investments, or co-investments with other financial sponsors such as sovereign wealth funds. Engagement in buy-and-build processes and a focus on value creation in existing portfolio companies through bolt-on acquisitions have become more popular in uncertain times. Continuing the trend of recent years, business sectors in which private equity buyers exhibit a high level of investment activity include healthcare and life sciences, technology, software and energy, as well as there being increasing interest in the consumer, logistics and infrastructure sectors.

Foreign Subsidies Regulation

The EU’s new Foreign Subsidies Regulation (FSR) introduced a third regulatory review tool for transactions (in addition to merger control and foreign direct investment (FDI) reviews). Certain large M&A transactions, including those involving targets with EU revenues of at least EUR500 million, must be notified to the European Commission in the circumstance that the undertakings concerned (ie, the acquirer’s and the target’s groups that will be combined in an acquisition scenario) obtained financial contributions of more than EUR50 million in total from non-EU governments in the last three years.

The FSR review will have implications on the due diligence process and deal timelines – financial sponsor investors will have to screen targets for subsidies in the due diligence process and implement into the transactional documents any necessary conditions precedent, co-operation and disclosure obligations, and clauses on the assignment of risks.

Law on Foreign Direct Investment

After several reforms in the preceding years, Germany’s screening system for FDIs has remained unchanged since 2021. Reportedly, the authority is preparing a major overhaul which will likely result in all rules on FDIs being integrated into a new FDI screening law.

The German authority responsible for FDI screening continues to be very busy, reviewing more than 300 national notifications in both of its latest reporting periods (the 2022 and 2021 calendar years). While the number of in-depth (phase two) reviews has dropped to a historically low level, the number of prohibitions due to FDI concerns has risen sharply. So far, private equity investments have not been viewed as critically as other types of investment; however, recently, the authority has shown greater interest in the origin of funds invested into private equity. This means that private equity funds with a large non-European investor base may undergo greater scrutiny.

Under German FDI rules, mandatory and suspensory filing obligations are triggered for acquisitions of companies active in a number of sectors.

Continuing ESG Regulation Trends

The EU continues to increase regulation relating to ESG, including legislation that directly and indirectly addresses non-EU companies if they use the EU single market for their businesses and are generating turnover within the EU. Specific focus lies on sustainability reporting and supply chain due diligence obligations concerning EU and non-EU companies. Further relevant topics that are increasingly regulated include climate change and energy use, biodiversity and environment, and circular economy, meanwhile sustainable finance regulations undergo refinement.

Private equity investors themselves are usually not directly subject to these wide-ranging ESG topics, but most of their portfolio companies are or will be, which is why investors are required to pay close attention to upcoming EU legislation and take ESG compliance topics into account when assessing a potential investment decision.

Law on Merger Control

Merger control filings are often triggered due to the parties’ revenue. However, private equity transactions are typically cleared in phase one, unless the private equity investors (through one of their existing portfolio companies) already engage in activities that overlap with (or have significant vertical links to) those of the target.

Law on Foreign Direct Investment

Private equity investments are also often subject to clearance by the German FDI authority. Even where filings are not mandatory, the authority can “call in” (and ultimately prohibit) transactions for up to five years after signing. Many private equity firms therefore submit (voluntary) filings.

Under the EU screening regulation, other member states are often informed of (and invited to comment on) investments in Germany. However, in a recent decision (Xella, 13 July 2023), the European Court of Justice confirmed that investments made through existing companies based in the EU are not subject to the screening regulation and its co-operation mechanism. It remains to be seen whether the German authority will adapt its national screening mechanism to exclude such investments from screening altogether. While not very likely, this could lead to a situation where foreign private equity firms no longer have to undergo FDI screening for investments made through EU portfolio companies.

Changes to Anti-bribery, Sanctions and ESG Compliance

Recently, ESG compliance has become more regulated, and it is expected that traditional compliance topics, such as anti-bribery and sanctions, will develop in the same way. Currently, the EU seeks to reform corruption offences under EU law, which will potentially introduce further compliance obligations for companies in the near future. Hence, private equity investors may need to update their portfolio company monitoring practices.

The legal due diligence of private equity buyers usually comprises the review of documents contained in the (predominantly virtual) data room and information obtained from public sources (eg, the commercial register or land registers). The level of legal due diligence largely depends on the transaction set-up and the target’s business. For example, in an auction process or in the case of a secondary (ie, the acquisition from a financial sponsor), the scope of, and the time allocated for, a due diligence review is typically limited compared to bilateral situations.

Key areas of focus for legal due diligence are typically corporate law, finance, commercial contracts, employment-related matters, compliance, intellectual property, IT and data protection, real estate, litigation, public permits and subsidies. More recently, private equity buyers have begun to focus on ESG risks as well. Generally, private equity buyers prefer receiving a focused “red flag report”, which is limited to the presentation of material key findings and recommendations on how to address and protect against the associated risks in transaction documents. Fully fledged descriptive reports have become rather exceptional.

Some financial sponsor investors are taking advantage of a cooling M&A market to conduct more thorough due diligence and negotiate favourable legal terms before moving forward with acquisitions.

While legal vendor due diligence is not uncommon per se, it is carried out in less than half of private equity deals (many of which are organised as auction sales). It generally aims to promote the efficiency of the sale process and to ensure that the seller knows the target as well as the buyer does after having carried out customary purchaser due diligence, thereby preventing potential disadvantages to the selling side in the negotiations of the share purchase agreement (especially with respect to the seller’s warranties).

In most cases, the vendor due diligence results in the preparation of a comprehensive “legal fact book”, rather than a typically shorter and risk-focused “vendor due diligence report”. Offering reliance on a legal fact book is the clear exception, whereas reliance on vendor due diligence reports is more common (this is usually offered to the purchaser and sometimes also to financing banks or warranty and indemnity (W&I) insurers).

Most private equity transactions in Germany concern acquisitions of privately held companies and are concluded by negotiated share purchase agreements, which must be notarised by a German notary if the target is a German limited liability company (GmbH). The sale processes can be structured either as bilaterally negotiated deals (often with exclusivity granted to the potential purchaser) or as competitive auctions (typically advised and co-ordinated by an investment bank or an M&A adviser). In an auction process, all bidders conduct their due diligence and negotiate economic and legal deal terms with the seller in parallel, progressing through the different stages of the transaction process until the signing of the share purchase agreement.

Fierce competition, comparably high pace and the tight timeline of auction processes tend to result in more seller-friendly deal terms in the transaction documents, especially concerning the purchase price mechanism and the liability concept.

Public takeovers are much rarer due to the smaller number of listed companies and the highly regulated takeover process. Buyers of listed companies must submit a public takeover offer to all shareholders and must adhere to strict public offer procedure and rules under supervision of the German Federal Financial Supervisory Authority (BaFin).

A private equity fund does not (directly) acquire the target company itself and hence does not become a party to the transaction documentation (with the exception of an equity commitment letter proving that the acquiring entity will have sufficient funds available to finance the acquisition upon closing, which is usually requested by the selling side).

Instead, to optimise and ring-fence the investment, private equity investors set up tailored corporate acquisition structures, usually comprising two or more special purpose vehicles (SPVs) incorporated, for example, in Germany, Luxembourg or the Netherlands. One of the higher-level entities in such a structure acts as a holding company (HoldCo), which in turn is the sole shareholder of the ultimately acquiring entity (BidCo). Often, a further SPV is installed between HoldCo and BidCo and is designated to become the borrower under the external acquisition debt financing agreements (FinCo).

One of the characteristic features of private equity transactions is the funding of them through a combination of equity (pushed down from the private equity funds (and any co-investors) to the acquisition vehicle) and external debt financing. The latter was traditionally provided by banks, but specialised debt funds have become increasingly engaged as acquisition financing providers in recent years. The combination of debt and equity funding is a focal point in the economic structuring and valuation of the investment, as private equity buyers seek to benefit from the “leverage effect” that is driven by a high debt-to-equity ratio and a large debt financing component.

Since the acquisition vehicle of a private equity investor is usually a newly acquired shelf company without any of its own financial resources, the selling side typically requires a formal (and enforceable) commitment provided by the fund to finance the payment of the purchase price upon closing of the transaction. Hence, private equity funds provide a guarantee to the seller, in the form of an “equity commitment letter”, that they will provide the acquisition vehicle with sufficient funds to pay the equity-funded portion of the purchase price upon closing. Similarly, as regards the debt-funded portion of the purchase price, external financing providers usually equip the acquisition vehicle with a “debt commitment letter”, in which they agree to disburse the loan after fulfilment of the limited conditions precedent by the acquisition vehicle (“certain funds”). Certain funds are usually obtained from private equity buyers to provide the selling side with transaction certainty and to give themselves a competitive edge in an auction process.

Over the last decade, private equity investors have demonstrated that they no longer only pursue majority/control investments but increasingly evaluate and implement various forms of co-investments. Predominantly in large-cap transactions that entail extensive funding requirements for the buyer (even more so when sufficient external debt financing is not available), two (or more in rare cases) private equity sponsors may team up to enter into the transaction as co-investors (“club deal”). Sometimes, financial sponsors invest as a consortium with their limited partners (eg, sovereign wealth funds or pension funds). In recent years, the German M&A market has experienced several investments by financial sponsors acquiring a stake in large-cap, family-owned companies, often with only a minority participation. Generally, private equity buyers’ rationales for co-investing or forming joint ventures vary. Their rationales include considerations such as securing financing or equity syndication in order to limit risk exposure, or potential operational synergies between the co-investors (or their existing portfolio companies).

In recent years, locked-box consideration mechanisms have been chosen more often than completion accounts mechanisms for transactions involving private equity sellers in Germany.

In a locked-box sale and purchase agreement, the purchase price is determined (and fixed in the share purchase agreement) based on a historic balance sheet of the target. Economically, the acquisition is thus treated as if it were completed on the last balance sheet date, and any subsequent leakage from the target company will be deducted from the final purchase price, with additional purchaser protection provided through ordinary course provisions. For the private equity investor, this has the advantage of high certainty at signing regarding the final purchase price amount. Furthermore, the locked-box process is typically swifter and less prone to disputes between the parties. However, locked-box is not a feasible approach in cases where the target has no recent accounts that a locked-box could be based on, such as in carve-out scenarios.

For private equity sellers, the locked-box is particularly attractive as, unlike with completion accounts mechanisms, there are no balancing payments made after closing, and the private equity seller can therefore distribute the sale proceeds immediately after closing. In a completion accounts mechanism, the purchase price is calculated after closing, based on a closing date balance sheet of the target and calculation rules set out in the share purchase agreement. This is generally more accurate and precisely reflects the actual transfer of ownership of the target from seller to buyer.

Market volatility and uncertainty have been catalysts for an increase in earn-out structures bridging valuation gaps. Typically, earn-out triggers are specific, value-adding events, or future revenue or EBITDA developments (or a combination of various factors). Other forms of deferred consideration and vendor loans are rarely used in large-cap deals (in mid-cap deals, the situation is a bit different).

In share purchase agreements with a locked-box consideration mechanism, the parties usually address the gap period – and the expected cash generation of the target – between the locked-box date (ie, the date of the relevant balance sheet) and the closing date economically, by agreeing either on interest charged on the purchase price, or on a fixed per diem amount to be added to the final purchase price (“equity ticker”). Conversely, interest is – occasionally but not very commonly – charged on any leakage amount to be indemnified by the seller or to be deducted from the final purchase price upon closing.

The prevalence of dispute resolution mechanisms largely depends on the consideration structure used. As share purchase agreements with a locked-box already contain the fixed price that is subject to limited adjustments (leakage, equity ticker, etc), they usually do not provide for designated dispute resolution mechanisms.

In contrast, dispute resolution mechanisms are the clear market standard in share purchase agreements with a completion accounts mechanism, typically providing for different escalation steps. Firstly, the parties are often required to discuss the completion accounts and purchase price calculation in good faith to reach an agreement. If they are unable to do so within a certain period of time, they are typically obliged to engage an independent expert, usually from one of the Big Four accounting firms, who gets access to all relevant documentation and whose final expert report becomes binding for the parties in respect of the purchase price calculation.

Private equity investors seek the highest achievable degree of transaction certainty and aim to use conditions as a risk mitigant only where necessary. Hence, share purchase agreements usually (only) contain regulatory conditions concerning suspensory antitrust and foreign investment regimes (and, since mid-2023, the EU foreign subsidies regulation). Further closing conditions are occasionally seen with respect to carve-outs, which need to be completed before closing of the main transaction. Other than that, including additional conditionality (third-party consent, shareholder approval, etc) is very uncommon in German transactions involving private equity investors. While material adverse change/effect (MAC/MAE) clauses had a short revival in 2020, in the wake of the COVID-19 pandemic, they are now rarely seen in transaction documentation.

So-called hell or high water undertakings are usually not, or only hesitantly, accepted by private equity investors unless the buyer has thoroughly assessed the regulatory risk profile and is comfortable that there are no overlaps and regulatory clearance will thus be granted without, or with only limited, conditions. In addition, private equity buyers usually narrow the scope of a hell or high water undertaking such that they should not be under the obligation to provide or accept commitments vis-à-vis (antitrust) authorities which would result in an unreasonable commercial hardship. Due to the risk of breaching obligations towards their investors, private equity buyers heavily resist against any provisions obliging them to sell-off any of their existing portfolio companies.

In case a deal cannot be closed by the longstop date (eg, because no merger clearance is obtained or if the buyer does not accept conditions imposed by the authority) and is therefore terminated by a party, some sellers request a break fee to be paid by the buyer to the seller (also referred to as a termination fee). Such break fees are mainly requested (although usually rejected by private equity investors) in competitive auction processes and aim to incentivise the buyer to push the deal to completion, as the (typically fixed) fee can be substantial and amount to a high one-digit percentage of the target’s enterprise value. Sometimes, break fees are also covered by the acquiring funds’ equity commitment letter. In contrast, “reverse” break fees for the benefit of the buyer have been rarely seen in German private equity transactions in recent years.

As they are deemed to be too extensive, parties typically exclude statutory termination rights to the extent permitted and agree on contractual termination rights tailored for the relevant transaction. Such termination rights may only be exercised until closing.

The most common contractual termination right is triggered by the non-fulfilment of the closing condition(s) by a certain longstop date. The longstop date is typically a date six to twelve months from signing of the share purchase agreement, depending on when fulfilment of the closing conditions is expected. In debt-financed transactions, the longstop date in the transaction documentation needs to be aligned with the financing agreement.

Furthermore, the seller usually requests a termination right if the buyer fails to pay the purchase price or perform any other material closing action.

Due to the set-up of private equity investors and their obligation to distribute sale proceeds to their limited partners, private equity sellers seek to limit their liability in the transaction documentation as much as possible (probably even more so than corporate sellers). Making provisions for potential liabilities under the share purchase agreement would negatively impact the amount of proceeds to be repatriated to the investors. Therefore, private equity sellers tend to push for favourable liability caps and short periods of limitation.

In secondaries (ie, where one financial sponsor purchases from another), private equity buyers typically accept less than the customary commercial warranties they would expect from strategic sellers.

Scope of Warranties

Private equity sellers seek to limit their liability under the share purchase agreement to the greatest extent possible. Providing “fundamental warranties”, which are given in relation to title, capacity and solvency, is the market standard for any kind of seller in Germany. Apart from that, private equity sellers will resist to provide and hotly negotiate any business warranties. Unlike in the UK, in Germany it is unusual for managers of the target that are not also selling shareholders to provide any warranties.

Limitation of Liability Under Warranties

Liability for warranty breaches in most cases is subject to various tailored limitations; eg, de minimis provisions, thresholds, baskets, deductibles or plain caps (plain caps typically range from 10% to 40% of the purchase price for business warranties and are 100% for fundamental warranties). If the buyer takes out warranty and indemnity (W&I) insurance, liability is usually capped at one euro (EUR1). Limitation periods typically vary from two to five years for fundamental warranties and from one to three years for business warranties.

Data Room Disclosure

Full disclosure of the data room against the business warranties is typically heavily negotiated, but it is commonly seen in German private equity transactions. Depending on the scope of disclosure provision, all documents contained in the data room are deemed to be known to the buyer and thus potentially limiting the seller’s liability.

Indemnities

Issues that have been identified in the due diligence and that bear the risk of materialising after signing may be addressed by specific indemnities rather than by purchase price reductions. As private equity sellers wish to distribute their sale proceeds to the fund investors as swiftly as possible, they usually provide the buyer with no, or only narrowly tailored, indemnities. Generally, in German private equity transactions, it is not uncommon that share purchase agreements contain an indemnity for tax liabilities.

Warranty & Indemnity Insurance

It is common that (fundamental and business) warranty as well as tax indemnity claims in German private equity transactions are covered by W&I insurance. For business warranties and tax indemnity, the seller’s liability is usually capped at EUR1 and the purchaser may claim compensation for related damages from the insurer only without recourse to the seller. W&I insurance allows for a clean exit for the private equity seller, while simultaneously providing the buyer with desired (substance-backed) protection of warranties.

Purchase Price Retentions

Escrows, holdbacks and similar instruments to secure a party’s liability under the share purchase agreement are rather uncommon in private equity transactions in Germany.

Seller’s Covenants

Share purchase agreements sometimes contain specific covenants of the seller. If the parties agree on a locked-box consideration mechanism, the seller usually covenants to continue to run the business in the ordinary course until closing. Unlike corporate sellers, private equity sellers are very hesitant to provide any further restrictive covenants, such as non-solicitation or non-compete undertakings, due to their inherent ambition to complete a clean exit without any post-sale liabilities. If they agree to restrictive covenants, private equity sellers try to narrow their scope and make sure that the provided obligations do not expand to their funds or other portfolio companies which are unrelated to the sold company.

Litigation concerning private equity transactions is rather rare. Private equity buyers are usually hesitant to initiate litigation against (corporate) sellers as this poses a reputational risk and might result in other potential sellers avoiding engagement with, or selling to, the investor in the future.

Private equity buyers are not likely to rush to litigate claims under the share purchase agreement against managers who sold their shares and are still operating (and are often reinvested in) the company, as they are usually considered crucial for the value creation of the company.

Generally, provisions that are prone to litigation concern earn-outs and other purchase price adjustments. However, disputes over completion accounts are mostly settled via the dispute mechanism set out in the share purchase agreement; ie, they are eventually settled by the independent expert’s binding opinion.

In Germany, private equity-led public-to-private transactions are not uncommon. Recent examples include the takeover of Software AG by Silverlake in 2023, the voluntary public offer for Aareal Bank AG by Advent International and Centerbridge Partners in 2022, and the takeover of Zooplus by Hellman and Friedman and EQT in 2021.

A private equity investor who reaches, exceeds or falls below a threshold of 3%, 5%, 10%, 15%, 20%, 25%, 30%, 50% or 75% of the voting rights in an issuer of shares “by way of acquisition, disposal or otherwise” must notify the issuer and BaFin of this circumstance without delay, within four trading days at the latest. In addition to voting rights from shares, voting rights from other financial instruments must also be reported, whereby an input threshold of 5% (instead of 3% for shares) applies in this respect. For the purpose of reaching the specified thresholds, the voting rights of subsidiaries or persons acting in concert, which may often include advisory (investment) banks, are also attributed to the acquirer of the shareholding. These notification obligations are in addition to the existing obligation of the target company, if any, to publish an ad hoc announcement pursuant to Article 17 of the Market Abuse Regulation (MAR), particularly if the imminence of a takeover can no longer be kept confidential.

If the private equity investor acquires control in a listed company, it must publish this information immediately, within seven calendar days at the latest. Then, within four weeks of this announcement, the private equity investor must submit a takeover bid (“mandatory offer”). Control is assumed if the bidder holds at least 30% of all voting rights in the target company. Control may also be assumed by way of attribution of voting rights from shares in the target company that are held by other shareholders. This includes, for example, subsidiaries and associated companies of the bidder as well as trustees acting on its behalf.

The vast majority of public takeover offers made by private equity investors contain a fixed cash consideration. The consideration must be at least equal to the weighted three-month average share price prior to the publication of the intention to take over. It must also be at least equal to the value of the highest consideration granted or agreed in the context of prior acquisitions within the six months prior to the publication of the offer document. Subject to certain restrictions, it is also possible to offer liquid shares as consideration.

Execution conditions in takeover bids are permitted in Germany, provided that they are objective and sufficiently specific. Typically, a minimum acceptance threshold is included in a voluntary takeover offer. Other conditions typically encountered in voluntary takeover offers are, for example, MAC clauses or the granting of required regulatory approvals, the latter of which being the only condition permitted in mandatory takeover offers. In contrast, the takeover bidder always bears the financing responsibility for the takeover offer and must prove certain funds for the offer to be approved.

The bidder typically controls the target if it holds more than 50% of the voting rights at a general meeting. A 75% majority grants further wide-ranging options to determine the governance of the target, including the potential to amend the articles of association or to conclude a domination and/or a profit and loss transfer agreement that provides the bidder with instruction rights towards the target’s management. Unless a domination agreement is in place, controlling the target does not entitle the investor to instruct the target’s management.

Debt Push-Down

A debt push-down, under which the bidder’s loan liabilities taken out for the acquisition financing are assumed by the target, is only permitted under very restrictive conditions in Germany. It typically requires a domination and/or a profit and loss transfer agreement between the bidder and the target.

Squeeze-Out

There are different types of squeeze-out under German law. For a squeeze-out under takeover law or stock corporation law, the investor as the main shareholder must hold at least 95% of the shares in the target; whereas, under conversion law, a 90% shareholding is sufficient for a squeeze-out. For the transfer of shares, adequate compensation is payable to the minority shareholders.

The irrevocable (or, often in practice, limitedly revocable) commitment of a shareholder of the target to tender its shares into the bidder’s public offer is a common instrument. Typically, the irrevocable commitment is the first document (after a confidentiality agreement) to be negotiated in the context of a takeover, as it provides the bidder with the necessary certainty that the bid has a realistic chance of being successful. It is sometimes agreed that the committing shareholder remains bound by the irrevocable commitment even if a competing takeover bid is published (so-called hard irrevocable commitment), although exceptions to this are not unusual; eg, if the competing offer exceeds the price of the irrevocable commitment by a certain percentage (so-called semi-soft irrevocable commitment).

Equity incentivisation for management is used very commonly by private equity investors to align investor’s and management’s interests. Typically, a share of between 5% and 15% of the equity ownership is allocated to the management. Since the investment may also include shareholder loans or other debt instruments, management often holds 1% to roughly 5% of the economic equity investment. The shareholding per manager typically varies depending on their position in the company; a CEO alone may, for example, be allocated over 2% to 4%. In secondary buyouts where management was already invested, it is often expected that management reinvests substantial amounts of their net proceeds (eg, 40–50%) into the new management participation structure.

Usually, individual managers do not directly hold a participation in the target company but rather invest through a joint investment vehicle, which is typically set up in the form of a tax-transparent partnership.

“Sweet equity” is commonly used to ensure substantial economic participation by management in the target company. This is typically achieved by splitting the investment into different tranches, consisting of preference shares or shareholder loans on the one hand and ordinary shares on the other hand. While the investor subscribes for both tranches, management only acquires ordinary shares. In contrast, mere contractual agreements on deviating exit proceeds allocations (eg, sharing of proceeds, awarding of an exit bonus or similar structures), which are also sometimes used in Germany, are generally less favourable for the management, as it is not unlikely that the receipt of proceeds by the manager thereunder triggers wage tax.

Leaver provisions are absolutely standard in German management participation programmes. Most commonly, a participant’s leaver event prior to an investor’s exit triggers a call option for the investor on the (non-vested) participant’s interest.

Often, the purchase price for the participant’s interest depends on whether the participant is considered to be a “good leaver” or a “bad leaver”. While the classification of a participant into these categories may vary, generally speaking, a good leaver is a manager who leaves the target group for reasons outside of their control, such as retirement, redundancy or illness. A bad leaver is a manager who leaves of their own accord. A typical purchase price formula is “fair market value” in a good leaver scenario and “lower than fair market value and investment cost” in a bad leaver scenario.

Provisions on vesting are also common, and they are usually structured as a time-vesting mechanism. Performance-related vesting provisions are less common (also due to inherent tax requalification risks).

Non-compete and non-solicit obligations that restrict manager shareholders are commonly used in management participation programmes. Typically, these restrictions apply for the duration of the manager’s shareholding and thus, in view of the leaver rules, typically match the duration of the employment relationship. It is, however, possible to agree on non-compete and non-solicit obligations that apply for another one or two years after the termination of the shareholding.

Often, such restrictive covenants are also agreed to in the employment contract. In instances where restrictive covenants refer to post-contractual periods, a compensation of at least 50% of the latest remuneration is required in order for them to be effective. While it is not entirely clear whether this employment law requirement also applies to a post-shareholding restrictive covenant, this compensation obligation is often mirrored in the shareholders’ agreement to ensure that the restrictive covenants therein are binding and enforceable.

The typical minority protection rights granted to manager shareholders are pro rata subscription rights in the case of additional share issuances, and co-sale or tag-along rights in the case of a majority sale. Other than that, minority rights in German management participation programmes are rather limited. In particular, there are usually no reserved matters which would require the manager shareholders’ prior consent. As a general rule, the investor may freely determine the timing and structure of an exit, with the manager shareholders being obliged to fully support the exit process.

Shareholder control and information rights are essential for a private equity investor. The key control mechanisms for a private equity investor in a co-investment situation are (i) participation in or control of the decision-making corporate bodies of the company (management board and advisory board or supervisory board), and (ii) veto rights over strategically important operational decisions and fundamental matters of the company. The control rights depend on the shareholding stake acquired by the private equity investor and are typically implemented in a governance structure which gives the investor the right to (i) nominate representatives to the decision-making corporate bodies and (ii) be consulted on or veto certain measures. As a shareholder of a German limited liability company, an investor has comprehensive information rights set out by law. In addition to these statutory rights, and depending on the legal form of the company, additional information rights may be required for a private equity investor to monitor its investment as well as to satisfy its reporting obligations towards its own investors and financing banks, such as through an annual business plan and budget, board packs, and monthly and quarterly management accounts. Such governance and information rights are typically set out in a shareholders’ agreement.

The extent to which a shareholder can be held liable for actions of its portfolio company mainly depends on the legal form of the portfolio company. Regarding a German limited liability company, which is the most widely used legal form for corporations in Germany, the personal liability of the shareholders is, in principle, limited to their capital contribution only and otherwise excluded by operation of law. In certain circumstances, there are exceptions to this rule. These circumstances include in the case of mingling of assets of the company and of its shareholder(s), substantive undercapitalisation of the company, or existentially destructive interference with the assets of the company without compensation. However, in the practice of private equity transactions, these “piercing of the corporate veil” examples are not of relevance.

For private equity investors, a private sale to another financial investor (secondary buyout) or to a strategic investor (trade sale) is the most common type of exit in Germany, and it is often conducted by way of an auction process.

For larger portfolio companies, private equity investors usually also assess the feasibility of an IPO as a route that eventually leads to a complete exit. However, the outcome largely depends on the conditions of the equity markets. If the equity markets are expected to be favourable, commonly a “dual-track” process is initiated, which means that the investor prepares for a private auction sale and an IPO in tandem, ultimately proceeding with the option that achieves the best valuation.

Due to the current debt market conditions, a “triple-track” process, where recapitalisation is prepared in parallel to the IPO and the private sale, are rather rarely pursued in Germany. 

Furthermore, in recent years, exits by sale to another fund (either a newer ordinary fund or a special purpose fund) managed by the same general partner (so-called fund-to-fund sale) have become increasingly popular. This type of exit allows investors to hold on to portfolio companies with an expected value development that is not aligned with the current owning fund’s life cycle.

Lastly, it is not uncommon for a private equity fund to remain invested in the company after selling a majority stake (reinvestment or rollover). The minority participation allows the fund to participate in a further increase of value.

For private equity sellers, it is crucial to be able to offer the entire target business for sale to a potential buyer. Hence, most shareholders’ agreements contain drag rights for the benefit of the majority investor, entitling the investor to force minority shareholders to sell their participation on the same terms. Correspondingly, minority shareholders typically have a tag right allowing them to co-sell their participation on the same terms by which the majority shareholder sells its participation to the buyer.

Thresholds for the right to exercise a drag right vary and depend on the negotiations between shareholders; however, typically, a drag right is triggered if the majority shareholder sells more than 50% of the shares in the company to a third-party buyer. Sometimes, lower thresholds are also seen, especially for tag rights. In practice, it is uncommon to actually exercise (and enforce) a drag right. Rather, its mere existence and the shareholders’ co-alignment are sufficient for implementing a concurrent sale of shares.

Private equity investors will seek to implement measures to achieve “IPO readiness” (eg, converting the issuer from a limited liability company to a stock corporation (AG)), prior to listing but rather late in the process, in order to sustain statutory shareholder control rights as long as possible. Upon the listing of the portfolio company, it is customary that the private equity seller is restricted from selling its remaining shares for, for example, 180 days (“lock-up”). Furthermore, private equity investors usually incentivise the key managers of the portfolio company through bespoke management equity participation or exit bonus arrangements, which, in the course of the IPO preparations, need to be aligned with public market requirements (or rolled over into a capital markets-ready incentive scheme).