Expectations in the private equity industry for 2018 were not as high as for 2017. Despite this, 2018 was a record-breaking year for the private equity market, with the highest deal volume in history. Although macroeconomic factors tended to support uncertainty, private equity, as in previous years, 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, Brexit, whose terms are still not agreed between the EU and the UK, which led to the resignation of Theresa May as Prime Minister of the UK, the trade conflict between the US and China, a slowing economy in the US, the continuing banking and economic crisis in Italy 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 2018 remained basically the same as in 2017, 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 developments shows that 2018 witnessed another large amount of capital (US$432 billion) raised.2 With record levels of dry powder, growth of raise funds and the nearly zero interest environment, the underlying macroeconomic conditions are almost perfect for private equity investment models. However, there has even been an increase in the shortage of acquisition targets compared to 2017 to meet demands, meaning that competition for deals remains fierce. The flood of money into private equity has driven up purchase prices significantly and eliminated the formerly large gap between private and public market valuations. According to Preqin, 68 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 intended returns with traditional methods. Mere financial engineering has been a thing of the past for quite some time now. Optimising the operations of portfolio companies (with the effect of longer holding periods), in particular with a focus on digitalisation, 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 have maintained its position as the new core market for private equity in Europe. The development of the private equity market in Germany, Switzerland and Austria will continue to stand out from the market in the rest of Europe in 2018, as in the previous year. Even if the record numbers from 2016 could not be reached, when the total value of the transactions rose by 51.7 per cent to €41.3 billion, 2018 was a solid year with overall activity (buyouts and exits) of €38.3 billion.
In terms of diversification of investments, the industrial and chemicals sector continued to be top-ranked in 2018 for number of transactions. Although these sectors lost some share in 2017 and 2018 compared to the period from 2013 to 2016, they still lead in volume with a 22 per cent share. The buyout value increased slightly compared to 2013 to 2016, when the industrial and chemicals sector accounted for 16 per cent of shares, and 17 per cent in 2017 and 2018.
A notable disparity could be seen in the energy, mining and utilities sectors. The high stake of 11 per cent in value and the lower stake of 3 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 2018
In 2018, the European private equity market reached a post-crisis high in terms of both value and volume.
In the buyout segment, volume increased from 1,417 transactions in 2017 to 1,566 in 2018.4 At the same time, the overall transaction value increased from €140 billion to €175 billion. This is reflected in an 11 per cent increase in volume and a 25 per cent surge in value. Furthermore, the number of buyouts valued at more than €1 billion (47) was the highest number of mega-deals since the financial crisis. In addition, an upward trend could also be observed in the lower mid-market (between €101 million and €250 million) with an increase in deal count of 15.6 per cent. Every other deal size bracket trended downwards in 2018.
This observation is no longer paralleled by developments in the exit market, in which the number of transactions decreased from 990 in 2017 to 945 company sales in 2018, resulting in a drop in exits of 13.1 per cent on a value basis.
After a 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: 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 2017 and 2018 compared with their share of 23 per cent in the years from 2013 to 2016.5 In value terms it is notable that the United Kingdom and Ireland have dropped from 31 per cent between 2013 and 2016 to 23 per cent between 2017 and 2018. Despite this drop, which has mainly benefited the Nordic countries, regardless of the Brexit uncertainty, the UK and Ireland remained the leaders in terms of buyout volume.
In value terms, the United Kingdom and Ireland account for 23 per cent, the Nordic countries for 16 per cent, France for 15 per cent, Iberia for 13 per cent, Germany for 10 per cent, Italy for 9 per cent and Benelux for 8 per cent of all European buyout volume.6
In 2018, there were nine transactions in the €1 billion-plus bracket. Among those, the €4.6 billion buyout of the German energy services provider company Techem by the financial investors Partners Group together with Caisse de Depot et Placement du Quebec and Ontario Teachers' Pension Plan from Macquarie was the biggest private equity exit in Europe in 2018.
European exit activity in 2018 was less promising. The numbers decreased in 2018 compared to the previous year with a notable drop of 4.5 per cent, falling from 990 to 945 company sales. This means that the positive trend in volume observed in recent years (with the exception of 2016, a permanent increase in volume was seen from 2013 until 2017) did not continue. One of the reasons for this development might be seen in general partners (GPs) awaiting and observing publicly listed assets, which may be undervalued in unsettled stock markets.
III SIGNIFICANT TRANSACTIONS AND KEY TRENDS IN EUROPE
2018 was characterised by mega-deals exceeding €1 billion. Regarding buyouts, the €101 million to €250 million bracket grew by 15.6 per cent in 2018, while the other deal size segments trended downwards. In 2017, mega-deals recaptured the European market, and in 2018, their volume reached an elevated level.
In 2018, four of the top 10 European exits were located in the UK:
- Global Infrastructure Partners' divestment of a 50 per cent stake in Gatwick Airport to VINCI Airports, valued at €6 billion;
- the exit of Sky Betting and Gaming by CVC Capital Partners to The Stars Group for €4.5 billion;
- BTG, a UK pharma group, was acquired in a public takeover for more than €4 billion by Boston Scientific; and
- the remaining stake of 60 per cent in EMI Music Publishing was sold by Mubadala Investment to Sony Corporation for approximately €1.6 billion.
Europe's two biggest buyouts in 2018 were:
- valued at €10.1 billion, the purchase of Dutch chemicals group Nouryon, a specialty chemicals division of AkzoNobel, by Carlyle Group and Singaporean sovereign wealth fund GIC; and
- the buyout of the majority of Recordati, an Italian pharmaceuticals group valued at €6.3 billion, by CVC Capital Partners, Public Sector Pension Investment Board and Stepstone Group.
ii Key trends
As in 2018, the market concentrated on finding suitable assets, 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 macroeconomic stagnation and the uncertainty caused by the financial crisis that began in 2008. In 2017, the median holding period returned to a new normal of five years.7 Parallel and in line with the observed trend to longer holding periods are 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 they make up around half of all deals today. On the other hand, quick flips (i.e., transactions with a holding period of up to three years) have decreased in the past 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 in 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.8
A further trend is the growing use of W&I insurance policies in transactions, which are now standard in certain sectors, in particular for private equity transactions where purchasers require protection against deal risks and sellers look for a clean exit and an increased internal rate of return, all of which can be achieved with W&I insurance. Under these insurance policies, (usually) the buyer insures against the risks occurring in cases 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. The bulk majority of W&I insurance policies are issued to buyers. Thus, W&I insurance significantly reduces the risks of sellers to become liable for damage claims under a sale and purchase agreement. As a result of the market entry of a number of new players and the intense competition among insurers, prices for insurance coverage have fallen drastically. This trend, which began in recent years, also continued in 2018. The average premiums for W&I policies in 2018 fell to 0.6 to 0.9 per cent of the insured sum for real estate transactions, and 0.8 to 1.5 per cent of the insured sum for corporate deals. In addition to standard W&I policies, special contingent policies covering already known risks (which are usually excluded) are also more and more common, and certainly at much higher premiums. The demand for W&I policies is still growing globally. Lower average premiums, lower retention levels and new insurers entering the market are the reasons for this development, resulting in continued fierce competition among W&I insurers.
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 limited partnership (KG), the investment-AG or investment-KG, introducing additional regulations. Generally, the legal form now depends on a specific fund's 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 KG essentially has two kinds of partners: limited partners (LPs) and GPs. While investors subscribe for limited partnership interests, thus becoming LPs, the sole GP of a limited partnership is a separate company usually organised as a limited liability company in accordance with the Limited Liability Company Act. 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 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 a 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. The entry and exit of investors in and out of a GmbH & Co KG are also simple and do not require a notarial form. Thus, the accession of a new investor as a LP is uncomplicated and cost-efficient. In addition, there are beneficial tax rules if a 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 private equity funds in Germany
According to the KAGB, alternative investment fund managers are now obliged to establish a depositary for alternative investment funds (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, and 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 BaFin, the German Federal Financial Supervisory Authority. 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 has 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 to vote such shares.
To restrict undesired activities – in particular by financial investors – the WpHG 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 (whether listed or not), the AktG sets forth that any enterprise (private investors are not subject to this obligation) is obliged to promptly notify the stock corporation regarding the following: reaching a threshold of more than 25 or 50 per cent in the capital of a stock corporation, or whenever the enterprise falls below these thresholds. 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 legal regime changes. Solvency II (adopted by the European Parliament on 11 March 2014)9 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 its 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 had to be transformed into national law by January 2019 (the corresponding implementation act in Germany came into force in January 2019) and which 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 rather characterised by optimism for the development of the private equity market in Europe in 2019. More than half (56 per cent) of private equity houses10 expect the European deal market for private equity to get slightly better in 2019, while 35 per cent of respondents assume it will stay broadly the same. This compares with only 7 per cent of firms anticipating that it will get slightly worse. German private equity firms are distinctly above the average in terms of optimism: 70 per cent of them expect a slight improvement, and only a tiny minority of 5 per cent expect a slight deterioration. The Benelux countries are confident about the development of the private equity market in Europe in 2019 as well: 58 per cent expect the situation to get slightly better in 2019, although a significant 13 per cent of respondents expect it to get worse.11
On the whole, investors remain optimistic that Europe will still be a region for investments that have high potential in 2019. 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 US$2 trillion12 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 has resulted in fierce competition among private equity investors.13 All private equity firms expect competition for investments to remain the same or to increase in 2019, with 29 per cent believing competition will rise significantly and 44 per cent that it will increase slightly.14 In addition, more competitors from outside the industry, such as pension funds, family offices 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, although the competition for deals from Chinese investors is not expected to increase but to stay broadly the same in 2019.15 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, certain risks should not be disregarded, with the following being some examples: the more critical outlook regarding economic developments in many regions of the world, including the trade conflict between the US and China and the US's policy of increased protectionism; as well as the never-ending Brexit struggle that finally resulted in Theresa May stepping down as the United Kingdom's Prime Minister. The impact of Brexit is mirrored in a survey by PwC in which 45 per cent of respondents stated that Brexit makes the UK a less attractive destination for investments in 2019.16
Given the uncertainties in the market, private equity funds will have to closely analyse any possible scenarios for each investment. Nevertheless, the bottleneck of investment opportunities with a fierce price competition as a consequence will, in our view, continue to be one of the main limiting factors of the private equity industry in 2019.
1 Benedikt von Schorlemer is a partner and Jan van Kisfeld is a former associate at Ashurst LLP. The authors would further like to thank research assistant Manuel Freiwald for his contributions to this chapter.
2 2019 Preqin Global Private Equity & Venture Capital Report.
4 PwC Private Equity Trend Report 2019.
7 Bain & Company, Global Private Equity Report 2018.
9 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).
10 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.
11 See footnote 4.
12 Preqin Research Blog by Naomi Feliz (28 January 2019), 'Alternatives in 2019: Private Capital Dry Powder Reaches $2tn'.
13 PwC Private Equity Deals Insights 1Q 2019.
15 Roland Berger Private Equity Outlook 2019.
16 See footnote 4.