i Deal activity
The German private equity (PE) market began 2019 as it left 2018 (slowly) but gained traction in the second half of the year. Looking at the aggregated numbers for 2019, the deal activity (buyouts) remained on a high level in terms of number of deals (219 deals), although this was a slight decrease compared with 2018 (229 deals). However, the 2019 total buyout volume of €32.2 billion, the highest level since the financial crisis, was mainly driven by six large-cap transactions in the second half of 2019.2 Whereas the number of exits remained constant (44 exits in each half of the year), the volume of exits more than doubled in the second half of 2019 compared with the first half. Nonetheless, the number and volume of exits did not come close to reaching the levels of previous years. One PE-backed initial public offering (IPO) took place in 2019.3
|2019 total||Half-year 1 (HY1) 2019||Half-year 2 (HY2) 2019||Growth from HY1 to HY2|
|Total buyouts (billions of euros)*†||32.2||7.3||24.9||+341.1%|
|Total exits* (billions of euros)†||10||2.6||7.4||+284.62%|
|* See footnote 2; †rounded numbers.|
Large-cap companies continue to be of particular interest, especially for non-German PE investors. In 2019, eight PE transactions exceeded the €1 billion threshold, reaching an aggregate value of €21.9 billion.4 Nevertheless, small and mid-cap companies continue to constitute the predominant part of the deal activity of PE investors in Germany.
In 2019, the aggregate buyout value for PE transactions reached €32.2 billion.5 Compared with 2017, in which a value of €19.4 billion was reached,6 this is an increase of approximately 166 per cent. The number of buyouts did, however, slightly decrease from 227 in 2017 and 229 in 2018 to 219 in 2019.7
|Total buyouts by value (billions of euros)||22.7||19.4||17.9||32.2|
|* Mergermarket; †See footnote 2.|
Germany remains an attractive market for PE investors, and in 2019, PE transactions continued to be an important driver of the overall M&A activity in the market. With an aggregate PE deal activity of €32.2 billion in 2019, PE deals contributed a little less than 45 per cent of the aggregate M&A deal activity of €72.9 billion in 2019.8 Although this is still significantly more compared with 2017, in which PE transactions contributed approximately 30 per cent to the aggregate M&A activity, it more or less reflects the same percentage as in 2018. However, the aggregate M&A activity increased by more than 70 per cent compared with 2018. This shows that the strong competition between strategic investors and financial sponsors for targets in Germany is continuing, whereas the trend of previous years, in which PE investors steadily increased their share in German M&A activity, has slowed down. This might also be a result of strategic investors being willing, to a certain extent, to offer higher prices as they can benefit from synergies resulting from an acquisition.9
Large cap versus small and medium cap
With an aggregate value of €21.9 billion, around two-thirds of the overall buyout value can be attributed to eight large-cap transactions in Germany,10 the largest being the acquisition of Currenta by funds managed by Macquarie Infrastructure and Real Assets (MIRA) (€3.5 billion), followed by the acquisition of BASF (construction chemicals) by Lone Star for €3.2 billion11 and the acquisition of Evonik Industries AG's Methacrylates business by Advent managed funds for €3 billion.12
The majority of overall deal activity was made up of small and medium-cap transactions with an aggregate value of approximately €10.3 billion.13 Whereas this only reflects the transactions that are disclosed, the actual value will be significantly higher, as small and mid-cap focused PE investors, in particular, tend to keep acquisition value secret.
In terms of industries, the highest transaction value was achieved in the chemicals sector (€6.8 billion), which was mainly driven by the acquisition of BASF (construction chemicals) by Lone Star for €3.2 billion and the acquisition of Evonik Industries AG's Methacrylates business by Advent for €3 billion. The chemicals sector is followed by information technology (€5.7 billion), media (€5.1 billion), industrial (€4.6 billion) and other services (€4.6 billion).14 In 2017, the top two industries that attracted PE investors were pharma and healthcare (€6.7 billion) and chemicals (€2.9 billion).15
In terms of number of deals, the information technology sector attracted the most financial sponsors, with 49 transactions in 2019. Although this sector also had the highest number of deals in 2018, with 30 transactions, this increased significantly in 2019, by approximately 63 per cent.16 The information technology sector is followed by the industrial (42 transactions), media (13), other services (12) and chemicals (9) sectors.17
The above figures show that digitalisation is an important driver of M&A activity in the German market. The media sector, which has been of lower interest in past years, is now being perceived as an interesting market. A prominent example is the formation of the German media group Leonine by KKR through several acquisitions in the German market, including Tele München Group, Universum Film, i&u TV and Wiedemann & Berg Film.
Exits (other than IPOs)
In 2019, the number of exits significantly decreased to the lowest level since 2015.18 The aggregate deal value even decreased to the lowest number since 2012. Out of 87 exits (without IPOs) in 2019, in 48 cases strategic investors acted as buyers and 39 secondary buyouts took place. Although the ratio between strategic and secondary buyouts remained more or less the same as in 2018, the aggregate number of exits decreased significantly from 113 in 2017 and 115 in 2018 to 87 in 2019. This is a decrease of approximately 25 per cent. Nevertheless, secondary buyouts constitute an important exit option in the German market. A prominent example is Bike24, which Bridgepoint's Wiggle CRC acquired in 2017 from Riverside and sold back to Riverside in September 2019.
|Sales to strategic investors (value in billions of euros, and number)||16.8||8.2 (60)||4.5 (66)||3.3 (48)|
|Secondary buyouts (value in billions of euros, and number)||14.8||7.4 (53)||9.9 (49)||4.6 (39)|
|* Mergermarket; †See footnote 2.|
ii Operation of the market
As in previous years, in 2019, a large number of transactions were structured as bidding contests, in many cases including a dual-track process such as in the sale of Deutsche Bahn's foreign transportation business (DB Arriva), which was initiated in 2019 with the aim of Deutsche Bahn collecting €2 billion to €3 billion.
The actual numbers show that IPOs rather constitute the exception in Germany (see above). The vast majority of sales processes ultimately resulted in private sale transactions. The sales process around DB Arriva might become a prominent exception in 2020. Shortly after Deutsche Bahn entered into reportedly exclusive talks with Carlyle, the process was stopped in November 2019 and Deutsche Bahn announced on 4 December 2019 that it was in the process of preparing a listing of DB Arriva, which is likely to take place in 2020.19
One-on-one transactions are still the exception, which again shows that the market remains seller-friendly. With vast amounts of dry powder in the market20 and continuous low interest rates, the race for targets continues to be challenging. Time is of the essence in competitive sales processes and PE investors are having to find the balance between a diligent assessment of the targets, limited information in due diligence processes (in particular, in Q&A processes) and the appropriate level of opportunity costs. At the same time, the level of multiples achieved in the market remains high. Depending on the relevant industry, two-digit multiples continue to be unexceptional. In particular, software-based business models are highly competed for and achieve, in general, multiples above average. On a global level, earnings before interest, taxes, depreciation and amortisation (EBITDA) multiples in the technology sector reached an averaged level of 15.5 compared with 13.3 in 2018.21 However, this is, of course, not applicable to all industries. In other industry sectors, the level of EBITDA multiples on a global level even showed a slight decrease compared with 2018.22
Warranty and indemnity insurance
In 2019, warranty and indemnity (W&I) insurances continued to be standard for a large number of processes, particularly in structured large and mid-cap sales processes. In this segment, uninsured deals have become the exception. Particularly on structured sales processes, bidders are generally asked to go with buy-side W&I insurance. A large proportion of sales processes entailed stapled W&I insurance, where the sell side introduces the W&I insurance to the deal. Once the preferred bidders are selected, the W&I process is flipped over to the buy side. Depending on its level of sophistication, the sales process can be structured as either a 'soft' or a 'hard' stapling. Many processes are structured as 'soft' stapling. In a soft stapling, the sell side will only obtain non-binding indications from insurers via its chosen broker based on the initial draft transaction documents, an information memorandum and the financial statements of the target. The ultimate negotiations will be conducted by the buy side after the flip over on the basis of the buy side's due diligence reports. In a hard stapling, the sell side also provides vendor due diligence reports to the insurers and initiates negotiations with the insurers. The draft policy is already provided to the buy side and finalised after the flip over to the buy side. In such cases, the buy side usually also provides top-up due diligence reports.
In structured sales processes, bidders are often asked to cover the potential exposure for operational warranties as well as unknown tax risks exclusively via the W&I insurance policy without any recourse to the seller. In addition, separate title insurances have been seen in the market.
Management equity incentive schemes
For PE investors, the implementation of management incentive schemes is one of the most effective tools to ensure the commitment of the management of the acquired target. There is a broad set of structures used in the market depending on the sophistication of the relevant investors and on the level of the management to be incentivised. While senior management members are often granted straight equity structures, to incentivise mid-level management stock appreciation rights, virtual shares and profit participations, among other things, are relatively popular as they are easy to implement and flexible.
The main goal when structuring management incentive schemes from a tax perspective is to get into a capital gains taxation category (up to 28 per cent taxation plus church tax) rather than a taxation as income category (up to 48 per cent plus church tax). Therefore, straight equity participations are often considered to be more tax efficient for management than stock options, virtual participations, etc. Tax authorities tend to qualify income from management participations as ordinary income, particularly if they have a strong link to the employment or service agreements (leaver clauses), and if the conditions are more favourable than those applicable to the other investors or shareholders. Structuring equity-based incentive schemes also aims at avoiding dry income of the relevant manager, which might be subject to the German income tax regime.
Equity-based incentives often range from 5 to 15 per cent of the issued share capital, taking into account equity-like instruments or shareholder loans. The economic ownership percentage is often significantly lower (e.g., 1 to 5 per cent). The relevant percentages are higher in small and lower mid-cap targets (particularly in the case of the acquisition of owner-managed targets in which the sellers roll over a certain part of their shares against issuance of new shares at the level of the investor). In large-cap transactions, the percentages are usually significantly lower, particularly if the management is asked to invest its own cash to ensure 'skin in the game'. The customary range of such a cash investment would extend to an amount equal to between one and one and a half times a fixed annual salary.
In connection with equity-based incentive schemes, shareholders' agreements usually mainly aim at securing flexibility for the PE investor, in particular with respect to capitalisation (e.g., as regards recapitalisation measures) and exit strategies. This often entails customary agreements on drag-along rights for the investors and cooperation obligations for management in exit situations, as well as holding periods post exit (in IPO scenarios).
The management, on the other hand, is generally granted a limited set of shareholders' rights, such as tag-along rights in exit scenarios or subscription rights in the case of capital measures. The deal for the management is often sweetened commercially by arrangements such as equity kickers, sweet equity or agreed floors for a guaranteed return.
In 2019, the market experienced a certain renaissance of earn-out structures (i.e., structures in which the consideration payable to a seller is contingent upon the future performance of the target business or based on the achievement of certain milestones). In particular, in the high-priced German market, earn-out structures can bridge different views of the parties on the valuation of the target. On one hand, sellers gain the option to achieve a potentially higher purchase price and – in buy-and-build approaches – have the opportunity to use synergies of the existing business of the target and purchaser, to achieve the agreed milestones. On the other hand, purchasers reduce the risk of overpaying or even gain additional finance options.
However, despite the advantages that earn-out structures might bring, the details often require particular focus. The involved parties are well-advised to carefully and clearly stipulate in binding agreements the relevant earn-out triggers as well as the mutual rights and obligations of the parties relating thereto. Whereas from a seller's perspective earn-out protection arrangements (e.g., review rights, security for outstanding earn-out payments, premature payment in change-of-control scenarios) will become important, purchasers will want to make sure to remain flexible and to avoid setting the wrong incentives with the result that short-term goals during the earn-out period beat long-term goals of the business.
II LEGAL FRAMEWORK
i Acquisition of control and minority interests
The legal framework for the acquisition of control and minority interest has not changed materially over recent years and is – apart from certain notarisation requirements under German law, the formalities of which are often accompanied by the raising of eyebrows by foreign investors entering the German market for the first time – in line with what can be expected from a highly sophisticated legal environment. The acquisition of shares is the most common structure, whereas asset deal structures are in most instances the means of choice in distressed scenarios. However, in particular in carve-out scenarios in larger corporate groups, mixed share and asset deal structures were seen in 2019.
The acquisition of a target by a PE investor is often structured as leveraged buyout (LBO) and therefore financed partly by equity and debt. The PE investor typically acquires the target via a special purpose vehicle (SPV) that is held indirectly by the investing funds. In an acquisition structure aiming to acquire a German target, the most common legal form for the acquiring SPV (AcquiCo) is a German limited liability company (GmbH). In a typical LBO, the debt is taken up by the AcquiCo. Often, after closing, either the AcquiCo is merged with the target by way of an upstream merger or a fiscal unity is established between the AcquiCo and the target by way of a profit-and-loss pooling agreement. This optimises the tax structure and eases the repayment of the LBO debt out of the free cash flow of the target.
Equity-based incentive schemes (see Section I) are typically not implemented at the level of the AcquiCo but on a level higher up in the corporate structure.
ii Fiduciary duties and liabilities
The canon of fiduciary duties and liabilities is often stipulated in detail in shareholders' agreements, and is closely negotiated. This applies in particular to buyouts of owner-managed businesses in which the seller remains invested with a substantial stake. PE investors will generally not be involved in the day-to-day operations of their portfolio companies (e.g., by appointing portfolio managers as managing directors), but will rather influence the strategic decisions of the portfolio companies and provide industry know-how through seats on supervisory bodies. The specific legal framework generally depends on the legal form of the portfolio company and the investing entity. Most common are GmbH structures in which the parties are relatively flexible and can agree on a comprehensive regime of rights and duties of the investor. However, certain general statutory shareholders' duties have to be observed and cannot be derogated.
The PE investor has to observe the statutory capital maintenance rules stipulated in Sections 30, 31 and 43 of the German Limited Liability Companies Act (GmbHG) as regards GmbHs and Section 57 of the German Stock Corporation Act for German stock corporations. These provisions stipulate the general principle that the share capital (and, as regards stock corporations, any equity) may not be redistributed to the shareholders (whether openly or covertly). A breach of this principle can lead to repayment claims against the recipient and even personal liability of the management.
In particular, in LBO scenarios in which upstream guarantees and security are requested from the debt providers to guarantee and secure the loans granted to the acquisition vehicle, the capital maintenance rules have to be observed. Upstream guarantees and security can constitute a redistribution of the share capital, in the event that they are not covered by an adequate compensation claim against the borrower at the time of the issuance of the security.23 Also, the management of the securing company remains obliged to supervise the development of the adequacy of the compensation claim after the guarantees and security have been issued. In cases of an increased risk regarding the adequacy of the compensation claim, the management is obliged to request security or indemnification to avoid personal liability pursuant to Section 43 GmbHG. Several aspects and nuances of the requirements for fulfilling this obligation are disputed. In practice, the finance documents will generally contain certain limitation language to limit the personal liability of the relevant management.
German Capital Investment Code
The German Capital Investment Code (KAGB), which implements the Alternative Investment Fund Managers Directive24 into German law, provides for regulatory restrictions regarding distributions to PE investors. Pursuant to Paragraph 292, Section 1 KAGB, distributions, capital reductions, share redemptions or acquisitions of treasury shares are restricted within the first 24 months of control having been obtained over a non-listed company by alternative investment funds. Specifically, distributions that are made to shareholders are prohibited (1) if the net assets according to the annual financial statements fall below the amount of the subscribed capital plus non-distributable reserves, or would fall below that amount as a result of such a distribution (Paragraph 292, Section 2, No. 1 KAGB), and (2) if the amount of the distribution would exceed the amount of the result of the past financial year (plus profit carried forward and withdrawals from available reserves, less losses carried forward and legal and statutory reserves) (Paragraph 292, Section 2, No. 2 KAGB). Similarly, pursuant to Paragraph 292, Section 2, No. 3 KAGB, repurchases of treasury shares by or for the account of the company that result in the net assets falling below the threshold specified pursuant to Paragraph 292, Section 2, No. 1 KAGB are prohibited. Paragraph 292 KAGB does not apply to small or medium-sized target companies (i.e., companies that have fewer than 250 employees, a yearly turnover below €50 million, where the balance sheet total is below €43 million or where the target company is a real estate SPV (Section 287, Paragraph 2 KAGB; Section 2 of the annex to Recommendation 2003/361/EC)).
General fiduciary duties
Shareholders in a German GmbH are subject to a general duty of loyalty towards the portfolio company. The extent of this fiduciary duty depends on the circumstances of the individual case. In principle, shareholders may not induce the company to conduct business that is detrimental to the company or its business if they exert influence on management decisions. The general duty of loyalty may also include a non-competition and confidentiality obligation for the shareholders.
III YEAR IN REVIEW
i Recent deal activity
Germany continued to be an attractive market for PE investors in 2019. Although the overall number of buyout transactions slightly decreased compared with the totals in 2017 and 2018, the aggregate disclosed value of buyout transactions reached the highest level since the financial crisis (see Section I).
ii Key terms of recent control transactions
Sale of Currenta to MIRA for €3.5 billion25
Bayer and LANXESS sold their stakes in the chemical park operator Currenta to funds managed by MIRA, the world's largest infrastructure investor. Currenta manages and operates infrastructure, energy supply and other essential services across chemical parks in Leverkusen, Dormagen and Krefeld-Uerdingen and was a joint venture of Bayer (60 per cent) and LANXESS (40 per cent). Currenta, including a transferred real estate portfolio by Bayer, has a total enterprise value of €3.5 billion before deduction of net debt and pension obligations.
Sale of BASF to Lone Star for €3.2 billion
An affiliate of private equity group Lone Star has agreed to buy BASF's construction chemicals business for €3.17 billion on a cash and debt-free basis. The acquisition is expected to close in the third quarter of 2020, subject to antitrust approval.26
Sale of Evonik Industries AG's Methacrylates business to Advent for €3 billion
In March 2019, Evonik signed an agreement to sell its Methacrylates business to Advent International for €3 billion. The enterprise value was eight and a half times the business's EBITDA.27 The transaction was closed in August 2019.28 The Methacrylates business has 18 production sites and 3,900 employees worldwide.29
IV REGULATORY DEVELOPMENTS
i Merger clearance
PE transactions are often subject to merger control clearance either under the regime of the German Act against Restraints of Competition or under the EU Merger Regulation, if the relevant requirements are fulfilled.
On 9 June 2017, the amendments to the German Act against Restraints of Competition (ninth amendment of the Competition Act) entered into force, tightening the legal requirements for merger clearance. Prior to these amendments, the Competition Act required, inter alia, that (1) the participating companies to a transaction had total worldwide revenues of more than €500 million in the most recently completed fiscal year; (2) at least two companies had domestic revenues of which one company's exceeded €25 million; and (3) another company had domestic revenues of more than €5 million (second domestic threshold).
To date, these thresholds have not been particularly successful in catching transactions with (target) companies that have rather small revenues but strong innovation potential, network effects and high purchase prices (especially start-ups and digital companies). One example is Facebook's acquisition of WhatsApp, which was not subject to a notification requirement in Germany although the purchase price amounted to US$19 billion.30 Since 9 June 2017, an additional threshold based on the transaction value has been in effect. According to this threshold, a transaction must also be notified if (1) the above-mentioned thresholds are reached (except for the second domestic threshold), (2) the value of the consideration for the merger is more than €400 million, and (3) the company to be acquired operates domestically to a significant extent.
The term 'consideration' includes all assets and other monetary consideration (purchase price) as well as liabilities that the acquirer takes over. According to the legislative materials for the new Competition Act, the term 'consideration' is to be interpreted broadly. It includes any consideration that is contingent on subsequent fulfilment of certain conditions (earn-out clauses). In addition, depending on the particular case, reinvestments of acquiring parties granted at a discount (sweet equity) may also have to be considered.31
ii Foreign investment32
The European Union has adopted a framework regulation for the screening of foreign direct investments into the Union.33 The Regulation entered into force on 11 April 2019, although it will not apply until 11 October 2020. Unusually for an EU regulation, it merely provides a legal framework to be completed by the Member States. The decision on whether to set up a screening mechanism or to screen a particular foreign direct investment is to remain the sole responsibility of each Member State. The Regulation essentially contains four elements that are important for the control of direct investment from third countries.
First, the Regulation contains primarily constitutional requirements for the structure of the screening mechanism for direct investment from third countries for reasons of security or public order (transparency, setting a time frame for checks, confidentiality of information and opportunity for legal protection). The Regulation lists the factors that may be taken into account by the Member States or the European Commission in the screening process. These essentially match the criteria to be observed within the German foreign direct investment screening procedure under Germany's Foreign Trade Regulation. Interestingly, industry and labour market policies have not been included, unlike initially discussed.
Second, the Regulation provides for an annual report to the European Commission by Member States on foreign direct investment in their territory. Member States are also required to report on the application of their screening mechanisms. This obligation could certainly have a disciplinary effect.
Third, the Regulation contains a framework for a cooperation mechanism between Member States and the European Commission. The Regulation provides that the European Commission or other Member States may make comments or submit opinions to which the Member State undertaking the screening 'shall give due consideration'. This gives the European Commission and the other Member States (only) a somewhat proactive right to provide comments. The Regulation provides for certain deadlines for the cooperation mechanism. These deadlines will certainly have repercussions on the timing in practice.
As the fourth essential element, the Regulation contains requirements for projects or programmes of Union interest listed in the Annex to the Regulation (for example, the European global navigation satellite systems programmes). In this case, the European Commission has a right to comment.
The Regulation is expected to have at least two effects on the practice of controlling foreign direct investments. First, the obligation to disclose information on planned or already implemented investments – in particular in the case of Article 6 (i.e., foreign direct investment undergoing screening) – to the European Commission and all other Member States significantly increases the risk of disclosure of trade and company secrets. This applies in particular if an investment concerns key industries in another Member State. Second, the cooperation mechanism envisaged will most likely lead to investment screening taking longer in future than it does today. In particular, it will no longer be easily possible for the competent national authorities to take account of the time limit of the closing condition, which is often provided for in acquisition agreements, or of a longstop date according to which a clearance certificate must be available within a certain period. This must be taken into account in future when drafting appropriate clauses.
Similar to most other EU Member States, Germany has already implemented Council Directive (EU) 2018/822 of 25 May 2018 (DAC6) into domestic law. The new Law will create reporting obligations for certain cross-border tax arrangements. Taxpayers and 'intermediaries', such as private equity funds, investment bankers and other advisers, will be obliged to report on a broad scheme of tax arrangements that goes far beyond 'aggressive tax planning'. In principle, the reporting obligations will become effective on 1 July 2020 but DAC6 also covers arrangements that were implemented on 25 June 2018 (the latter to be reported by 31 August 2020). Dealmakers are well-advised to start preparing for the new administrative burdens to come. In addition, it might be advisable in certain situations to agree on mutual reporting obligations between the parties (e.g., in share purchase agreements or in side letters).
Private equity investment will continue to play an important role in Germany in 2020. The vast amount of dry powder in the market and low interest rates force private equity investors to seek attractive targets. Although largely considered to be a high-price environment, Germany remains an attractive market. The political environment will remain challenging. With Brexit having taken place on 31 January 2020 and the upcoming presidential elections in the United States in November 2020, the first year of the new decade might have some obstacles in store for market participants. In addition, the increased tensions with Iran and the trade disputes between the United States and the European Union might entail further challenges. The German industry is in the middle of a transition phase, not only due to the 'Fridays for Future' movement, which will create challenges but also opportunities. The German market will probably see an increase of distressed transactions in various industry sectors, with the insolvency of Thomas Cook being the most prominent example so far. In particular, investors focused on restructuring scenarios might have a busy year ahead in 2020.
1 Volker Land and Holger Ebersberger are partners and Robert Korndörfer is an associated partner at Noerr LLP.
2 EY, Private Equity Transaktionsmarkt in Deutschland, Gesamtjahr 2019.
3 id., IPO of Teamviewer backed by Permira.
4 See footnote 2.
10 See footnote 2.
11 Handelsblatt, 14 January 2020.
12 See footnote 2.
20 Mergermarket, Global & Regional M&A Report 2019, p. 15.
21 id., at p. 11.
23 German Federal Court of Justice, NZG 2017, p. 344.
24 Directive 2011/61/EU dated 8 June 2011.
33 Regulation (EU) 2019/452 of the European Parliament and of the Council of 19 March 2019 establishing a framework for the screening of foreign direct investments into the Union.