Expectations were high in the private equity industry for 2017 and it is safe to say that 2017 met those expectations – it was a record-breaking year for private equity fundraising, with more capital raised globally than ever before. Although macroeconomic factors tended to support uncertainty, private equity repeatedly demonstrated its robustness, proven by its ability to cope with disruptive times of economic turbulence, political uncertainty and social upheaval, but also increased public scrutiny and regulation. However, as we pointed out in the previous edition, the United Kingdom's vote to leave the European Union and the related negotiations of the Brexit terms, Donald Trump surprisingly winning the US presidential elections and since demonstrating going his own way, the banking and economic crisis in Italy, the continuing Greek woes and the weak economy in some other European countries still do not allow the private equity industry to rise above its uncertainties.
As a result, there continues to be a disconnect between the number of deals and transaction volume versus the capital available and raised by investors. The bulk of capital is also supported by banks and debt funds, which are continuously hungry to lend. Furthermore, interest rates remain low as the European Central Bank and governments pursue loose monetary policies to spur investments and growth, which is another reason for the continuous flow of capital to private equity funds.
Thus, the challenges in 2017 remained basically the same as in 2016, since the global situation has not changed significantly, with a degree of geopolitical and economic uncertainty and currency volatility: there is plenty of capital causing fierce competition between investors that chase few and even higher-valued targets.
Preqin's latest report on global private equity development shows that 2017 witnessed the largest amount of capital (US$453 billion) raised in any year.2 With record levels of dry powder, growth of raise funds and the nearly zero interest environment, underlying macroeconomic conditions are almost perfect for private equity investment models. However, there is a shortage of acquisition targets to meet the demands, which means that competition for deals remains fierce. The flood of money in private equity has driven up purchase prices significantly and eliminated the formerly large gap between private and public market valuations. According to Preqin, 88 per cent of investors consider valuations to be the greatest challenge facing the private equity industry in the year ahead.3
The industry has focused again on new concepts, as it becomes more and more difficult to realise the intended returns with the traditional methods. Mere financial engineering has been a thing of the past for quite some time now. Optimising the operations of the portfolio companies (with the effect of longer holding periods) has been one of the answers to date. There is an emphasis on driving down portfolio company costs and improving margins. Continuing trends also include more buy-and-build activities.
In this environment, Germany seems to maintain its position as the new core market for private equity in Europe. The development of the private equity market in Germany, Switzerland and Austria (GSA) will continue to stand out from the market in the rest of Europe in 2017, as in the previous year. Even if the record numbers from 2016 could not be reached, where the total value of the transactions rose by 51.7 per cent to €41.3 billion,4 2017 was a solid year with overall activity (buyouts and exits) of €34.7 billion.
In terms of diversification of investments, the industrial and chemicals sector continues to be top-ranked in 2017 for the number of transactions. Although these sectors lost some share in 2016 and 2017 compared to the period from 2012 to 2015, they still lead in volume with a 22 per cent share. By contrast, the buyout value deteriorated significantly compared to 2012–2015, when the industrial and chemicals sector still accounted for 18 per cent of the shares, but only 12 per cent in 2016–2017.
A notable disparity could be seen in the energy, mining and utilities sectors. The high stake of 16 per cent in value and the lower stake of 4 per cent in volume show that the transactions dominating these sectors are few in number but large in volume.
II FACTS AND FIGURES: EUROPEAN PRIVATE EQUITY in 2017
After the optimistic years of the past, with a continuing growth in the European private equity market, even though there was a slight decrease in 2016 in terms of value and volume of deals, there was a marked improvement in 2017 in both volume and value.
In the buyout segment, volume increased from 1,295 transactions in 2016 to 1,431 in 2017.5 At the same time the overall transaction value increased from €108 billion to €140 billion. While 2016 was characterised by a growth disparity in value and volume, in 2017 the volume to value differential was evident in acquisitions. This is reflected in the 10.5 per cent increase in volume and the 22.3 per cent surge in value. Furthermore, the number of buyouts (30) valued at more than €1 billion was the highest number of mega-deals since the financial crisis. In addition, the upward trend could also be observed in the lower mid-market (between €15 million and €100 million) with an increase in deal count of 14.9 per cent.
This observation is paralleled by the developments in the exit market, in which the number of transactions improved from 983 in 2016 to 1,023 company sales in 2017. In Q2 2017, six of the top 10 largest exits of the year were made, resulting in an exits leap by 18.4 per cent on a value basis.
After the setback in 2016, in particular regarding the UK and Ireland market, caused by the uncertainty since the Brexit referendum, investors do not appear to have completely adapted to the fact that the United Kingdom is leaving the European Union: private equity buyout activities in the United Kingdom plummeted from €28.7 billion in 2015 to €12.5 billion in 2016, the lowest level of buyout activity since 2009.6 Nevertheless, the United Kingdom and Ireland continue to dominate the European private equity market in terms of value and volume, claiming 22 per cent of the total buyout activity in 2016–2017. However, compared with their share of 25 per cent in the years 2012 to 2015,7 this was a notable fall.
The losses suffered by the United Kingdom and Ireland led to single percentage point volume gains in France, Germany and Benelux in 2016–2017, accounting for 18 per cent, 13 per cent and 11 per cent respectively of all European buyout volume. However, the most noticeable change in value was recorded in the Nordic countries, gaining four percentage points from 2012–2015 to 2016–2017, now claiming 14 per cent of all European buyout value. This increase is mainly due to three top 10 acquisitions in the Nordic countries: the €4.7 billion Visa deal in Norway; the €4 billion buyout of Finnish energy group Elenia by Allianz Capital Partners, Macquarie Infrastructure and Real Assets, and the country State Pension Fund; and the acquisition of €3.6 billion Finnish real estate group Sponda Oyj by Blackstone Group.
As already mentioned, Germany, Switzerland and Austria remained the leaders in the European private equity market even though in the buyout sector, volume decreased slightly in 2017 with 228 buyout deals in total, compared to the record-breaking 232 deals in 2016. However, in 2017 there were six transactions in the €500 million-plus bracket, one of which was the third biggest private equity deal in Europe in 2017 – the €5.2 billion buyout of the German generic drugmaker STADA by the financial investors Bain Capital and Cinven.
Although there was a decrease in mega-deals exceeding €1 billion during 2016, there were 30 buyouts in 2017 valued at more than €1 billion, representing an increase of more than 30 per cent year on year.
For exits, the numbers recovered in 2017 compared to the previous year with a notable uplift of 4.1 per cent, rising to 1,023 company sales. This means that the positive trend in volume observed in recent years (up 20 per cent in 2013, 11 per cent in 2014 and 20 per cent in 2015), with the exception of 2016, will continue. Similarly, in terms of value, with exception of the shortfall in 2016, the upward trend seen in previous years (100 per cent in 2014 and 12 per cent in 2015)8 will continue in 2017 with 18.4 per cent growth.
III SIGNIFICANT TRANSACTIONS AND KEY TRENDS IN EUROPE
Unlike 2016, 2017 was characterised by mega-deals exceeding €1 billion. The impact of Brexit and the associated uncertainty in the financial market seem to have diminished as no other deal size bracket was able to achieve such growth as the €1 billion-plus segment.
In Q2 2017, the three biggest exits of the year in Europe were made: Blackstones' divestment of UK warehouse and logistics company Logicor to China Investment Corporation, valued at €12.25 billion, the exit of AWAS, a Dublin-based aircraft lessor, by Terra Firma alongside its co-investor, the Canada Pension Investment Board, to Dubai Aerospace Enterprise for €6.9 billion and NB Private Equity Partners' offloading of pharmaceutical developer Patheon to Thermo Fisher for €6.5 billion. Thus, 2017 can be regarded as the year in which mega-deals have recaptured the European market.
Europe's three biggest buyouts in 2017 were the €6.8 billion purchase of Unilever's global spreads business by Kohlberg Kravis Roberts, followed by the €5.6 billion takeover of Nets, a Danish payment processor, by Hellman & Freidman, and the €5.2 billion buyout of the German generic drugmaker STADA Arzneimittel AG by the financial investors Bain Capital and Cinven.
ii Key trends
As in 2017, the market concentrated on finding suitable assets, on fee structures and compliance with tightening regulatory requirements on both sides of the Atlantic. Trends observed in previous years are still valid, including longer holding periods, extended buy-and-build activities, the application of warranty and indemnity (W&I) insurance policies and trading in secondaries.
Typically, private equity funds hold their portfolio companies for three to five years on average before exiting. This holding period has increased in small steps, reaching an average of six years in 2014. One of the reasons for these longer holding periods is the macroeconomic stagnation and uncertainty caused by the financial crisis beginning in 2008. In 2017, the median holding period returned to a 'new normal' of five years.9 Parallel and in line with the observed trend to longer holding periods are the continuous buy-and-build activities, which are used to increase potential exit returns. This corresponds with the increasing number of add-ons, which funds can use to execute buy-and-build strategies. For several years, the number of add-on deals globally increased notably and make up around half of all deals today. On the other hand, so called quick flips (i.e., transactions with a holding period of up to three years) decreased in the last few years. In 2008, at 44 per cent, nearly half of all buyouts were quick flips. More recently the number has retreated by half, to around 20 per cent. This sharp drop of quick flips is a result of factors such as high prices, limited future market beta and tax reform in the United States, under which carries generated from investments held for a maximum of three years will be taxed at the higher ordinary income rate. These factors make it rather unlikely that quick flips will experience an upswing in the foreseeable future, but rather indicate the continuous trend to longer holding periods.10
A further trend is the growing familiarity with and use of W&I insurances in transactions. Under these insurance policies (usually), the buyer insures the risks occurring in case of a breach of the representations and warranties or indemnities that are given in a sale and purchase agreement. Damage claims incurred as a result of a breach of a representation and warranty or indemnity are paid by the insurance company (which, apart from certain exceptions, may not turn towards the seller), subject to the terms and conditions of the policy, including baskets and caps as agreed. While the majority of W&I insurance policies are issued to buyers, seller policies also exist. Thus, a W&I insurance reduces significantly the risks of the seller to become liable for damage claims under the sale and purchase agreement. In 2017, new and increasingly aggressive insurers in the Australasian region have driven certain overall market trends: first, the excessive prices for insurance have fallen, which means that the cost of insurance for larger deals is lower than ever before, and second, the decline in surplus prices with simultaneous low primary interest rates led to the average premium rates in 2017 falling below 1 per cent of the sum insured for the first time. As the uptake of W&I insurance on deals increases globally, more and more US$1 billion-plus deals are being insured, which means that regularly insurance programmes of $100 million-plus are being structured. As a result the average amount of insurance per deal underwritten by the market has risen from US$30 million in 2016 to almost US$65 million on average in 2017. The significant growth in the M&A insurance market is also reflected in the following figures: there was an increase of 76 per cent in the number of M&A insurance policies in Q1 2017 compared to Q1 2016.11 The falling premium rates, lower retention levels and new insurers entering the market are the reasons for this development, resulting in continuing fierce competition among W&I insurers.
Last but not least, foreign investors, in particular from the United States but also from China, are increasingly seeking to invest in Europe (in the case of US investors also, as valuations and multiples are lower than in the United States). Countries of particular interest are the strongest markets (i.e., the United Kingdom, Germany and France).
IV LEGAL FRAMEWORK FOR PRIVATE EQUITY FUNDS IN GERMANY AND EUROPE
i Legal form of private equity fund vehicles in Germany
The legal framework for private equity funds has not changed significantly in recent years. The biggest change on the regulatory side was introduced through the transformation of the Alternative Investments Fund Managers Directive (AIFMD) into national law. For this purpose, Germany established the Investment Code (KAGB), which came into effect on 22 July 2013. As to the legal form of vehicles, German (corporate) law offers various types. Generally, vehicles for funds can be organised in the legal form of a stock corporation (AG), a limited liability company (GmbH) or a form of a limited partnership (GmbH & Co KG). Furthermore, the KAGB provides variations of the AG and the KG, the investment-AG or investment-KG, introducing additional regulations. Generally, the legal form now depends on the specific fund concept with regard to the invested assets of an open or closed-end fund and its circle of investors.
From a practical standpoint and an investor's tax perspective, the limited partnership in the form of a GmbH & Co KG still prevails for German private equity funds. The limited partnership (KG) essentially has two kinds of partners – LPs (limited partners) and GPs (general partners). While the investors subscribe for limited partnership interests, thus becoming LPs, the sole GP of the limited partnership is a separate company usually organised as a limited liability company in accordance with the Limited Liability Company Act (GmbHG). With the combination of these two legal forms, investors combine the advantages of both. In particular, the personal liability of investors is limited to their liability contribution, as LPs are only liable for debts of the limited partnership up to the liability amount registered with the German commercial register. Since German law does not require a minimum liability amount, usually only a small portion of the actual capital commitment of an LP is registered with the commercial register as liability amount, and as such revealed to the public. Once an LP has fulfilled his or her obligation up to the respective liability amount, and has not received a repayment in the meantime, the LP does not assume any further responsibility for the liabilities of the limited partnership. In contrast to the LPs, a GP of a limited partnership is liable for all obligations of the partnership without limitation. In a GmbH & Co KG, the liability of the GP (as limited liability company) is limited to the assets of the company. Its shareholders cannot be held liable for more than the capital contribution paid (or owed) by the respective shareholders.
Furthermore, based on the principle of freedom of contract, the partnership agreement can be tailored in a very flexible way to the needs and objectives of the investors. In general, investors as LPs only have limited information rights compared to other legal forms unless broader information rights have been agreed upon in the partnership agreement. Also the entry and exit of investors in and out of a GmbH & Co KG are simple and do not require a notarial form. Thus, the accession of a new investor as LP is uncomplicated and cost-efficient. In addition, there are beneficial tax rules if the GmbH & Co KG as a limited partnership is not engaged in business activities for German tax purposes. Last but not least, the limited partnership agreement does not have to be revealed to the public and, in particular, does not have to be registered with the German commercial register.
ii Monitoring of PE funds in Germany
According to the KAGB, AIFMs are now obliged to establish a depositary for AIFs under their management. This depositary shall, inter alia, review legal title in an AIF's assets on a continuous basis. The depositary's obligation is not limited to holding companies, but applies to all subsidiaries in the case of a holding structure within the portfolio. Additionally, the depositary may not solely rely on an AIF's due diligence, but is requested to also conduct its own review.
Types of private equity transactions
The typical private equity transaction structure has not changed significantly in recent years. From a legal standpoint, the acquisition of interests or shares remains the most important type of transaction, in most cases, of a private equity transaction in the form of a leveraged buyout (LBO). In an LBO, usually all or the majority of interests of the target company are acquired by the private equity investor, although the acquisition is funded only fractionally with equity, while the larger portion of the purchase price is financed with bank or other third party debt (leveraged transaction). The leverage shall be defrayed by the free cash flow of the target company.
Under German law, several acts deal with disclosure obligations that apply to all shareholders and investors, thus also for private equity investors. The most relevant disclosure obligations relate to stock corporations and, in particular, listed companies. The German Securities Trading Act (WpHG) sets forth various thresholds for equity holdings in listed companies that trigger certain disclosure requirements, while the German Stock Corporation Act (AktG) governs all companies organised as a German stock corporation. According to the WpHG, everyone reaching, exceeding or falling short of 3, 5, 10, 15, 20, 25, 30, 50 and 75 per cent of the voting rights in a listed company by purchase, sale or any other means is obliged to notify both the company and the competent Federal Financial Supervisory Authority (BaFin). The same obligations apply for persons who 'act in concert'.
To capture all sorts of arrangements to build up positions in a German listed company, the German legislator also extended the disclosure requirement for 'financial instruments' by including 'other instruments' that do not necessarily qualify as financial instruments but grant the right to acquire voting shares or vote such shares.
To restrict undesired activities – in particular by financial investors – the German Securities Trading Act enhanced, in a similar way to respective provisions under the US Securities Exchange Act, the transparency of certain financial transactions obliging an investor to disclose its specific intentions with the target company and the sources of the funds to finance the transaction. Thus, an acquirer of an essential participation (i.e., a participation reaching or exceeding a threshold of 10 per cent of the voting rights) is, subject to certain exemptions, required to disclose the aforementioned information regarding the purpose of the transaction and the origin of funds.
Concerning stock corporations (no matter whether listed or not), the German Stock Corporation Act sets forth that any enterprise (thus, private investors are not subject to this obligation) reaching a threshold of more than 25 or 50 per cent in the capital of a stock corporation, or that whenever that enterprise falls below these thresholds, it is obliged to promptly notify the stock corporation. If the enterprise fails to fulfil its disclosing obligations, it will lose its rights rooted in its shares.
To make the shareholder structure of non-listed stock corporations more transparent, the AktG limits the admissibility of bearer shares. This amendment came into effect on 31 December 2015. Since then, non-listed stock corporations may generally only issue registered shares.
On a European level, besides the above-mentioned implementation of the AIFMD into German law and the additional provisions introduced in the KAGB, the industry is facing further changes in the legal regime. Solvency II (adopted by the European Parliament on 11 March 2014)12 created new insurance regulations as of 1 January 2016 that require insurance companies to hold more liquid assets, restricting the amount that can be invested in private equity. The Markets in Financial Instruments Directive II (MiFID II), the update of the MiFID, was adopted by the European Parliament in April 2014 and published in June 2014 after formal adoption by the Council of Ministers. In addition, the European Commission resolved on a revision of the EU Pension Funds Directive (IORP) – IORP II – which must be transformed into national law by January 2019 and has far-reaching consequences for both the funding of pension schemes and the way they are managed.
The sentiment in the private equity industry is predominantly characterised by optimism and positivity for the development of the private equity market in Europe in 2018. Almost half (49 per cent) of the private equity houses13 expect the European deal market for private equity to get slightly better in 2018, while 45 per cent of the respondents assume it will stay broadly the same. This compares with only 5 per cent of the firms that anticipate that it will get slightly worse. German private equity firms are slightly below the average in terms of optimism: 45 per cent of them expect a slight improvement, but only a tiny minority of 2 per cent expect a slight deterioration. The Benelux countries are most confident in the development of the private equity market in Europe in 2018; 65 per cent expect the situation to get slightly better in 2018 and none of the respondents expect it to get worse.14
On the whole, investors remain optimistic that Europe will still be a region for investments that have high potential in 2018. Most European countries still offer a high grade of legal certainty in a stable environment, which continues to be an essential argument for future investments. However, there are record levels of dry powder now exceeding €1 trillion and leverage in the global private equity market, caused by the huge amounts of money successfully raised in recent years, which means that deals have never been more expensive. This results in fierce competition among private equity investors. Ninety-nine per cent of private equity firms expect competition for investments to remain the same or to increase in 2018, with 15 per cent believing competition will rise significantly and 55 per cent that it will increase slightly.15 In addition, more competitors from outside the industry, such as pension funds and insurance companies, are developing a taste for the private equity model, which increases competition. Furthermore, additional players, such as Chinese investors, are becoming more and more established in the market. In light of the above, investors will most likely be pulled into fierce competition and private equity houses are well advised to analyse pricing even more carefully.
Despite a very solid investment environment in Europe and investor confidence seen in the public market, the following risks should not be overlooked: some parts of Europe are still fighting with macroeconomic stagnation and structural challenges, while many European countries are having difficulties in finding their European identity, paving the way for the re-emergence of populist political groups and parties harmonising with anti-euro politics. In particular UK's decision to leave the European Union has caused uncertainty and unpredictability as there seems to be a deadlock in the crucial questions of the Brexit terms. The lack of clarity can make it difficult for investors in terms of investments over a five or 10-year period.
To mention just some of the influencing factors, the continuing uncertainty about which direction Europe is going, the Italian banking crisis, Greece's continuing woes, a potential interest rate increase in Europe, the fact that the US yield curve has flattened to its lowest level in 10 years in 2018 (which is seen as a reliable indicator of an impending recession in the world's largest economy) and last but not least, President Trump himself, may affect the private equity market in the longer run. Given all these uncertainties, private equity funds will have to closely analyse the possible scenarios in each investment. Identifying companies with the resilience and flexibility to weather a market downturn and negotiating the right price remain the main challenges.
1 Benedikt von Schorlemer is a partner and Jan van Kisfeld is an associate at Ashurst LLP. Benedikt and Jan would like to thank their research assistant Rachel Wünsch for her contributions to this chapter.
2 2018 Preqin Global Private Equity & Venture Capital Report.
4 See PWC Private Equity Trend Report 2017.
5 See PWC Private Equity Trend Report 2018.
6 Centre for Management Buy-out Research (CMBOR) – Report Winter 2016.
7 See 'PwC Private Equity Trend Report 2018'.
8 See 'PwC Private Equity Trend Report 2017'.
9 Bain & Company, 'Global Private Equity Report 2018'.
11 JLT Specialty, 'Global M&A Insurance Index 2017: Half Year Update'.
12 Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) (recast).
13 The following survey results are based on a survey conducted by Mergermarket's research and publication division on behalf of PwC, who spoke to 250 private equity principals in Europe.
14 See 'PwC Private Equity Trend Report 2018'.