The Private Equity Review: Luxembourg
i Deal activity
During the course of the past decade, Luxembourg has become one of the most important hubs for private equity capital raising and transaction activity in the world. Every year Luxembourg investment platforms raise huge amounts of capital and deploy it across hundreds of private equity transactions within the European Union and beyond, and this year was no exception.
Luxembourg investment platforms come in different shapes and sizes, as do the managers that manage them, ranging from mega funds with multibillion-euro flagship funds established in Luxembourg managed by Luxembourg AIFMs with many hundreds of Luxembourg holding companies, to more bespoke, stand-alone structures. Private equity managers with a substantial presence in Luxembourg include EQT, CVC, Apollo, Oaktree, Blackstone and Lone Star.
With so many private equity investments being held by Luxembourg holding companies, it is no surprise that a large and increasing number of M&A transactions involve target companies or target groups that are established in Luxembourg. It is fair to say that the majority of M&A activity involving Luxembourg companies concerns holding companies (i.e., Luxembourg companies that hold assets outside Luxembourg, rather than operational companies). However, private equity funds or their portfolio companies have acquired and continue to participate in sales processes involving Luxembourg-based businesses. A particularly hot sector over the past year or so has been the Luxembourg funds sector – fund managers, fund administrators, fund exchanges and the asset management arms of financial institutions – as investors look to gain exposure to the buoyant funds industry (e.g., Estera, a Bridgepoint portfolio company, has acquired Headstart and Allegro).
ii Operation of the market
A Luxembourg private equity structure will often involve co-investment, joint venture arrangements or management incentivisation. In these structures, rather than being wholly owned by the fund, equity or debt instruments are issued by the Luxembourg company to various stakeholders, and for the sponsor it will be essential to maintain control. It is possible under Luxembourg law for the sponsor to maintain that control, while at the same time accommodating the commercial interests of other stakeholders, provided that the appropriate types of company and instruments are used and the rights and obligations of each party are clearly set out in applicable contractual arrangements as well as the constitutional documents of the Luxembourg company.
A key structuring discussion will be in relation to the form of instruments to be issued. Luxembourg law provides for a wide range of possibilities: ordinary share capital, preferred equity, redeemable shares, tracking shares, founder shares, preferred equity certificates, fixed interest loans and bonds, variable interest loans and bonds, or (as is typically the case) some combination of these. A common reason for having a mix of instruments, rather than financing purely through equity, is to avoid a 'cash trap' situation in which there are insufficient distributable amounts to enable a dividend to be declared or shares to be redeemed.
The sharing of the proceeds of an investment – whether during the life of the investment or at exit – can be disproportionate to the amount of share capital or (in the case of debt) principal held by the relevant stakeholders. Management or other stakeholders can hold a de minimis stake in percentage terms, and, therefore (in the case of equity and debt instruments such as bonds that are subject to voting arrangements), a small proportion of voting power, while participating in substantial upside via a commercially agreed waterfall that is linked to internal rate of return performance. There are some Luxembourg law constraints (e.g., it is not possible to entirely exclude the risk of losses or the possibility of obtaining a return – the clause léonine rule), but in general parties have contractual freedom to set out their agreed commercial terms.
Private equity sponsors who structure management incentivisation packages (MIPs) using Luxembourg companies will want to ensure that management cannot prevent them from exercising control and, for example, exiting when the time is right. Management would typically hold a small number of shares and undertake either not to vote or to vote as the sponsor directs. These voting waivers and undertakings must be carefully drafted, and they are often combined with default clauses, powers of attorney, call options or share pledges. Following the recent reform of the Luxembourg companies act, it is possible for a board to suspend the voting rights of a shareholder who breaches the company's constitution. It is also possible in certain types of Luxembourg companies to issue non-voting shares. Where this is not possible, founder shares are a common alternative. These do not form part of the share capital but may be voting or non-voting and may have such economic rights as the articles provide.
Ensuring that management exit when required to do so can be achieved in a number of ways: (1) drag-along provisions backed by call options or share pledges in favour of the sponsor or fund, or (2) by 'corralling' management into a separate MIP vehicle, such as a partnership limited by shares (SCA) or a limited partnership (SCS), which then invests alongside the main fund. Such an MIP vehicle would typically be managed by the sponsor, so that any consents that are required in connection with an exit are certain to be given, with management holding limited partnership interests and, typically, having the benefit of certain limited veto rights designed to protect their economic interests. This means that if there are disputes with or among management members as to their respective entitlements, these disputes are isolated within the MIP vehicle and litigation will not threaten to derail the sales process.
II LEGAL FRAMEWORK
i Acquisition of control and minority interests
The Luxembourg 'toolbox' has expanded over the years and is now extensive and able to accommodate most structuring requirements. A typical private equity investment structure might include one or more SCS or special limited partnership (SCSp) funds to raise capital from investors at the top of the structure, and multiple master, intermediate or asset level holding companies (often Sàrls) below the fund. These holding companies are typically used to accommodate co-investors or joint venture partners, obtain senior, mezzanine or other forms of financing, issue bonds, incentivise management or simply block potential liability.
The Sàrl remains the most frequently used type of Luxembourg entity, but in terms of relative growth the SCS and SCSp have become increasingly popular. The SCA is also another frequently used type of entity. Each of these vehicles has specific features from a legal and tax perspective, and it is important to consider these features in light of the commercial drivers and dynamics of the particular structure.
Increasingly, transaction documents are governed by Luxembourg, as opposed to English or New York, law. Private equity participants are increasingly comfortable with the limited partnership agreements of their flagship funds, investment or shareholders' agreements of their co-investments, joint ventures or MIPs and share purchase agreements governing their exits or acquisitions to be governed by Luxembourg law and submitted to Luxembourg courts or arbitration.
The general principle under Luxembourg law is one of contractual freedom. However, there are some constraints that parties must bear in mind: basic contract law requirements such as ensuring that the rights and obligations of the parties are determinable, limiting the agreements and certain specific clauses in time, ensuring that transfer restrictions and voting undertakings are enforceable, the good-faith principle and avoiding penalties or conditions that are under the subjective control of the party seeking to rely on them.
Regardless of the governing law, Luxembourg corporate law requirements have to be taken into account, and can often have a significant effect. Corporate law issues that regularly arise on private equity structures include the rules and procedure around mergers and demergers, pre-emption rights, authorised share capital, the requirement for consent to transfer to third parties, the inability to have weighted voting rights at board level, the equal treatment of shareholders, the rules against abuse of assets, the requirement to obtain majority thresholds within each share class where the rights of holders of a particular class are adversely affected, the absence of a concept of alternate directors, conflicts of interest and financial assistance. Most market participants will be familiar with these concepts.
Another issue that frequently arises is the 'substance' of a Luxembourg entity. This is relevant from a tax perspective, but also from a corporate perspective. Luxembourg adopts a 'real seat' rather than 'incorporation' theory, meaning that a company that is incorporated as a Luxembourg company can migrate to a different country by virtue of the shifting of its place of effective management. Care must be taken to maintain effective management in Luxembourg – Luxembourg-resident board members and physical board meetings, supported by robust convening processes and minute-taking.
Checking the substance of a target Luxembourg company is one of a number of due diligence issues that often arise on acquisitions of Luxembourg companies. Others include: (1) title and compliance with laws – ensuring that the company's incorporation and subsequent corporate actions have taken place in accordance with the law, and that the shares and any other instruments have been validly issued and are held by the seller free from encumbrances; (2) ensuring that the relevant consents to transfer are identified and obtained; (3) ensuring that the company is in good standing and is up-to-date with its filings, including the approval and filing of its annual accounts; and (4) solvency. In relation to this last item, Luxembourg does not have a balance sheet solvency test, but rather a Luxembourg company is insolvent if it is unable to pay its debts when they fall due and it has lost its creditworthiness.
ii Fiduciary duties and liabilities
The governance of Luxembourg companies has become increasingly sophisticated over the years. The use of two-tier board structures, committees, observers, the delegation of specific powers to specific individuals or groups of individuals, the granting of daily management powers and the use of reserved matters are all common in private equity structures. Most Luxembourg companies will be subject to a conflict-of-interest regime and board composition, quorum and voting thresholds must be structured with attention to the definition of a conflict of interest.
Board members of Luxembourg companies are subject to a range of duties and, as a general rule, owe those duties to the companies to which they have been appointed and not to the shareholders who appointed them. In certain circumstances, board members may take into account the interests of other group companies, but the 'corporate interest' in doing so has to be assessed on a case-by-case basis, including the extent to which the relevant action is expressly set out in the corporate object of the company, the financial means of the company, the materiality of the relevant matter relative to those means, the extent of any remuneration to be obtained by the company and other relevant factors. Director and officer insurance and indemnity is very common, as is the granting of 'discharge' at the annual general meeting of shareholders and at exit.
We have yet to see frequent use of 'fairness opinions' in private equity deals in the same way as they are used in other jurisdictions. Luxembourg law requires valuations to be prepared in certain circumstances, for example upon a contribution in kind of an asset to certain types of Luxembourg company. But there is no general trend towards boards obtaining fairness opinions to support their decisions on exits.
Shareholders of Luxembourg companies do not owe fiduciary duties to the companies in which they participate. However, parties to Luxembourg law-governed contracts do owe a general duty of good faith, and there are rules against abuse of corporate assets and similar minority protections.
It is often crucial to ensure that liability with respect to a particular investment, external financing or joint venture arrangement is blocked and managed at an appropriate level, away from the flagship fund or master holding company. Piercing the corporate veil (i.e., a shareholder becoming responsible for the liabilities of a limited liability company) is rare under Luxembourg law, and parties can have confidence that in the absence of a dissolution, merger or similar form of corporate transaction whereby one entity absorbs the assets and liabilities of another, and as long as the relevant company has normal governance and is managed in a manner that is independent of its shareholders, the liability blocker will be effective. The Luxembourg securitisation vehicle (i.e., a company that is subject to the Luxembourg securitisation act of 22 March 2004, as amended) goes one step further and allows for statutory segregation or ring-fencing of compartments: investors in and creditors of one compartment may not sue on the assets of another compartment. The Securitisation Act 2004 also expressly recognises the validity of limited recourse, subordination, non-seizure and non-petition provisions.
III YEAR IN REVIEW
i Recent deal activity
The main development in recent years in Luxembourg has been the new Companies Act in 2016 and its subsequent 'bedding in', as market participants become familiar with its practical impact. One area that has been the subject of significant attention in contractual documentation and articles of association is the 'Section 189 issue' (now Section 710). Section 710, as it is now, applies to Sàrls and, as well as requiring transfers to third parties to be approved by shareholders representing three-quarters of the share capital, gives shareholders a right to exit by offering their shares to other shareholders or to the company at a price that is set out in the articles or, if no price is stated, at a price to be determined by a court. This may be inconsistent with the commercial intent of the parties and, if that is the case, a number of possible solutions can be deployed. Some market participants simply retain the Section 710 mechanism but state a low price, thus disincentivising its use.
An increasingly important structuring driver is speed. The ability to move quickly is often key to winning sale processes, and to be able to do so while preserving good governance, strong information flows and processes have to be put in place. Relevant corporate bodies must have the information and time that they require to make an informed decision on a particular matter, and once that matter has been approved it has to be implemented quickly: cash often has to flow down a structure in a matter of hours. Often that cash is injected into a Luxembourg company as a combination of debt and equity. On the equity side, the issuance of share capital in most types of companies (excluding certain funds) requires an extraordinary general meeting before a Luxembourg notary, additional notary know-your-customer formalities and the blocking of the subscription monies pending the issuance of shares. Often this has to take place at multiple levels. In response, certain market participants make use of the 'capital surplus' or 'equity reserve account' procedure, which is intended to constitute equity without the issuance of shares and avoid the need for a notary. This is not a mechanism that is set out in the law and it should only be used with appropriate and specific accounting, tax and legal advice. Certain market participants have moved or are moving away from this mechanism and instead use a form of convertible 'shareholder advance' to solve the logistical constraints involved in issuing share capital. The shareholder advance is converted or capitalised into the relevant mix of share capital (with or without issuance premium) and debt as soon as possible following the actual flow of funds.
There have been a number of recent developments in Luxembourg tax law, in particular the implementation into Luxembourg domestic law of the EU Anti-Tax Avoidance Directive (ATAD 1),2 which may have an impact on Luxembourg companies that are used in private equity transactions.
The law implementing ATAD 1 into Luxembourg tax law (the ATAD 1 Law) was passed by the Luxembourg parliament on 18 December 2018. Most of the provisions of the ATAD 1 Law have applied since 1 January 2019 to accounting years starting on or after this date. The Luxembourg legislature has endeavoured to retain the most flexible options granted by ATAD 1 but without leaving the framework designed by the European Union.
The ATAD 1 Law contains, inter alia, a general interest limitation rule, which provides that taxpayers are only able to deduct 'exceeding borrowing costs' incurred up to 30 per cent of the taxpayer's earnings before interest, taxes, depreciation and amortisation. Exceeding borrowing costs are deductible borrowing costs that exceed taxable interest revenues and other economically equivalent taxable revenues the taxpayer receives. Exceeding borrowing costs that cannot be deducted in a given period by application of this new interest limitation rule, as well as unused interest capacity, may nevertheless be carried forward.
In accordance with ATAD 1, the Law grants taxpayers a de minimis threshold of €3 million to deduct exceeding borrowing costs. The Law has further introduced a grandfathering rule for loans granted before 17 June 2016, a carve-out for public long-term infrastructure projects, a carve-out for financial undertakings, including securitisation undertakings, as defined under Regulation (EU) 2017/2402,3 and a carve-out for standalone entities, which are entities that are not part of a consolidating group for financial accounting purposes and have no associated enterprise or permanent establishment situated in a country other than Luxembourg.
This new interest limitation rule may, under certain circumstances, result in additional taxation at the level of Luxembourg companies involved in domestic leveraged buyout transactions, as interest on internal and external debt will no longer be fully deductible. The Luxembourg government's proposal to retroactively amend the new interest limitation rule to allow the Luxembourg taxpayers to opt for the application of the new rule at the level of tax unity should thus be welcomed.
Back-to-back arrangements involving financing companies are not affected by the new interest limitation rule, in the absence of any exceeding borrowing costs.
The ATAD 1 Law also implements into Luxembourg domestic law a new general anti-abuse rule (GAAR) and a controlled foreign company rule (CFC). The new definition of abuse of law under the GAAR should facilitate the tax authorities' burden of proof given that the tax authorities will only have to prove that one of the main purposes of an arrangement is to obtain a tax advantage. The CFC rule has the effect of including certain non-distributed income of low taxed subsidiaries and branches of a Luxembourg company in the company's Luxembourg corporate income tax base. The impact of both the GAAR and CFC for Luxembourg companies involved in private equity investments will have to be assessed on a case-by-case basis, as these rules rely on factual considerations rather than on an objective test. Indeed, the CFC provides for a substance carve-out for controlled foreign companies carrying out a substantive economic activity. With respect to the GAAR, the taxpayer should also be able to avoid the application of the rule if it can demonstrate, in accordance with existing Luxembourg and EU case law, that the arrangement is genuine with regard to all the relevant facts and circumstances, meaning that the arrangement has been put in place for valid economic reasons outweighing the tax advantages of the arrangement.
Finally, the ATAD 1 Law has also implemented into Luxembourg domestic law an anti-hybrid rule, as provided under ATAD 1. This anti-hybrid rule targeted hybrid mismatches (i.e., different characterisations of a financial instrument or an entity), giving rise to a situation of double deduction or deduction without inclusion in the context of a structured arrangement or between associated enterprises. The anti-hybrid rule merely covered hybrid mismatches in a purely EU context. The anti-hybrid rule under ATAD 1 was subsequently amended in 2017 by the second EU Anti-Tax Avoidance Directive (ATAD 2).4 ATAD 2 has, in particular, clarified the material scope of the anti-hybrid rules and has extended these rules to hybrid mismatches involving third countries.
The law implementing ATAD 2 into Luxembourg tax law (the ATAD 2 Law) was passed by the Luxembourg parliament on 20 December 2019. Most of the provisions of the ATAD 2 Law have applied since 1 January 2020 to accounting years starting on or after this date, except for the rule on reverse hybrid mismatches, which will apply from 1 January 2022.
The anti-hybrid provisions introduced by the ATAD 2 Law may, under certain circumstances, result in additional taxation at the level of the Luxembourg companies that are used in private equity transactions, in particular for those companies carrying out intragroup financing activities. The application of these provisions in the context of investment funds needs to be monitored closely, as there are a number of uncertainties in the ATAD 2 Law and lack of guidance as regards the interpretation of a number of concepts. The potential impact of these provisions would, in any case, need to be assessed on a case-by-case basis.
Whether they are acquiring assets within Luxembourg or beyond, private equity funds typically obtain external finance. Luxembourg benefits from a strong but flexible legal framework when it comes to the options for financing private equity transactions. Sponsors can choose from a wide range of financing methods, which vary from equity or equity-linked instruments to hybrid instruments and pure debt instruments.
Standard bank financing remains the preferred method of financing and normally accounts for the major part of the funding of a private equity transaction. Private equity transactions up to €200 million are commonly financed solely by one major international bank. On larger deals, borrowers often approach syndicates to raise the required funds. Although these bank loans normally do not originate in Luxembourg, the borrowers, guarantors and obligors are often Luxembourg-based companies. In recent years, Luxembourg-based alternatives such as debt funds provide an increasingly attractive complement to the standard bank loans, as those funds can often offer better terms.
Issuances of high-yield debt securities are becoming increasingly popular and they offer great flexibility. This method of financing attracts less public attention as compared to standard loans but opens the door to the international capital markets and, therefore, also to additional capital. The Luxembourg Stock Exchange (LuxSE) is very competent and most high-yield debt securities are either listed on the regulated market or on the Euro MTF of the LuxSE. Recently, the LuxSE added a third listing venue – the Securities Official List (SOL). An admission to SOL is a pure listing without admission to trading. Listed securities will appear on the official list of the LuxSE. Admission to SOL is subject to compliance with a specific rule book, which provides for lower requirements in terms of disclosure and documentation compared to the documentation for listings on the regulated market of the Euro MTF market of the LuxSE. In addition, neither the Transparency Act nor the Market Abuse Regulation apply to SOL. It is, therefore, expected that this new listing venue will become popular for listings of high-yield debt securities.
Transactions that require a large amount of external funding are commonly financed by a combination of loans and bonds.
The Luxembourg Collateral Act (of 5 August 2005, as amended) provides a very robust and efficient framework to allow lenders and other creditors to protect their interests. The most frequent way of securing indebtedness in Luxembourg is by pledging the assets of the borrower and the assets of other members of the borrower's group. This can take the form of a pledge agreement over shares, receivables or bank accounts. The robustness of the Collateral Act is a key feature contributing to the attractiveness of Luxembourg as a major hub for European and global private equity transactions – many lenders insist on Luxembourg borrowers and will even have their preferred form of Luxembourg law governed security documentation.
IV REGULATORY DEVELOPMENTS
Many of the domestic deals in Luxembourg are subject to regulatory approval and involve commitments being given by the private equity buyer to the relevant regulator. Sale processes are often specifically adapted to accommodate the requirements of the CSSF (the financial sector regulator) or the CAA (the insurance sector regulator) regarding client information. Electronic data rooms must be used carefully, and they are often combined with physical data rooms and staggered disclosure. Otherwise, sale processes involving Luxembourg targets will be familiar to the international buyer – there are few local idiosyncrasies. Warranty and indemnity insurance is increasingly popular.
From a tax perspective, the Luxembourg government has announced a welcome amendment to the law; namely, a modification to the law introduced at the beginning of 2019, with a retroactive effect as of 1 January 2019, to allow Luxembourg taxpayers to opt for the application of the interest limitation rule at the level of a tax unity.
Looking ahead, we expect to see Luxembourg continue to develop as a private equity hub. While domestic private equity M&A activity is unlikely to increase dramatically, because of the limited number of potential targets (notwithstanding the high levels of interest from potential buyers looking at assets in the funds sector), the buying and selling of Luxembourg holding companies and the general use of Luxembourg investment platforms for deploying capital in private equity deals is accelerating, as is the size of managers' teams on the ground and the use of Luxembourg law in transaction documents. We expect these trends to continue.
1 Frank Mausen, Patrick Mischo, Peter Myners and Jean-Christian Six are partners at Allen & Overy.
2 Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market.
3 Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017.
4 Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries.