Private Equity Update – Germany (November 2020)

Private equity transactions are often (also) financed with borrowed funds to bring about certain leverage effects. The use of debt capital influences the relevant key figure of the so-called internal rate of return, as (under ideal circumstances) it increases the return on equity and thereby affects the result of the aggregate investment in a positive manner.

The corresponding acquisition financing will be generally agreed by the special purpose vehicle ("SPV"), as it is, after all, the SPV that will acquire the target and will have to pay the purchase price. So as to bring the interest to be paid to the lenders under the acquisition financing together with the target's returns for tax purposes, private equity investors regularly implement a so-called debt push down. Such a debt push down is regularly even a condition of the lenders, as the SPV regularly has no assets (other than the investment in the to be acquired target) which could serve as collateral for the lenders¹

There are several instruments that suggest themselves for such a debt push down under German law, with the most common being described in the following overview.

1. Mergers

The SPV and the target can be merged with each other so as to transfer all assets and liabilities of the transferring entity to the acquiring entity by way of universal succession. Upon such time as the merger becomes effective, the business acquired and the acquisition financing will be unified in one hand and the transferring entity will cease to exist by law. Regularly so-called upstream or downstream mergers are possible.

1.1 Upstream merger

In the case of an upstream merger, the target as the transferring entity will be merged with the SPV as the acquiring entity. As a result, the target including all of its assets and liabilities will be absorbed in the SPV and ceases to exist. The financial burdens resulting from the acquisition financing can then, generally, be asserted as business expenses of the SPV within the scope of the general principles as a consolidation of the acquired business and acquisition financing has taken place.

Where the SPV is a German limited liability company (GmbH) or a German stock corporation (AG), it is not yet definitively resolved under corporate law whether and when such an upstream merger can violate capital maintenance rules provided by the German Limited Liability Companies Act (GmbHG) or the German Stock Corporation Act (AktG). In such a case, a merger would be impermissible under corporate law. Capital maintenance rules would e.g. be violated if the merger was made at the target's book values, while the SPV had higher acquisition costs than the sum of these book values, i.e. if a so-called merger loss was incurred. Very plainly speaking: The SPV has acquisition costs that generally correspond to the sum of the target's market value plus transaction costs, which are oftentimes likely to be higher than the target's book value (for instance, due to a goodwill and/or silent reserves of the target). In such a case, it is therefore possible that the SPV will have negative equity following the upstream merger, which can be a violation of sections 30 GmbHG, 57 AktG.

However, this problem is generally relatively easy to avoid in terms of corporate law by conducting a so-called step up in the course of the merger by transferring the target's assets and liabilities to the SPV at the acquisition costs (section 255 of the German Commercial Code (HGB)) instead of at book values (section 24 of the German Reorganization Act (UmwG)). It can surely be assumed that, in general, target companies' equity capital has a positive market value. But, of course, this is not necessarily the case and negative market values are possible; an upstream merger should then be refrained from for reasons of capital maintenance.

1.2 Downstream merger

In the case of a downstream merger, the SPV as the transferring entity will be merged with the target as the acquiring entity. As a result, all of the SPV's assets and liabilities will be vested in the target accordingly, i.e. in particular the acquisition financing, and the SPV ceases to exist. Also in this case, corresponding financial burdens from the financing can then, generally, be asserted as business expenses of the acquired business.

Further, a downstream merger, the transfer of a so-called merger loss can violate the capital maintenance rules provided by sections 30 GmbHG, 57 AktG (see above). After all, it is, as a rule, essentially only the liabilities from the acquisition financing that are transferred to the target without such liabilities being backed by material assets of the SPV. The only other relevant asset of the SPV usually was the SPV's share in the target, and after the merger has become effective such share in the target is held by the SPV's shareholders so that essentially only debts are transferred to the SPV.

The individual case will need to be considered. Please note that, as a rule, a violation of section 30 GmbHG should only be possible if the loss transferred by the SPV to the target in the form of a German GmbH by way of the downstream merger exceeds the target's freely disposable assets. Section 57 AktG is stricter as it does not permit a refund of equity to shareholders without this being limited to the free assets of the AG; oftentimes, it is argued that transferring a loss to an AG by way of a merger always constitutes such a refund of equity and that this is regardless of whether the target has a reasonable amount of freely disposable assets. In the case of an AG as a target, a downstream merger should therefore often be out of the question in general (unless you transform the target on the form of an AG into a GmbH prior to the downstream merger).

To resolve these issues, it would need to be verified in each individual case whether, in commercial terms, a so-called step up (that is, ideally, as tax-neutral as possible) would be possible before the merger in order to uncover any hidden reserves existing within the target in the course of the merger. If this is not possible, e.g. for tax reasons, a downstream merger should generally be refrained from for precautionary reasons. The details on how to treat merger losses legally have still not been definitively resolved under German law. One should not rely on the views taken in German literature that deny conflicts with the capital maintenance rules under the GmbHG and the AktG for reasons of liability.

2. Tax group

If the target is a corporation, the debt push down will regularly be effected by establishing (and conducting) a tax group (steuerliche Organschaft) between the SPV as the controlling entity (Organträger) and the target as the controlled entity (Organgesellschaft). For this purpose, the SPV and the target will enter into a profit and loss transfer agreement (and, in the individual case, possibly also a domination agreement). Very plainly speaking, the SPV and the target as a contract based group will then be treated as a single taxable entity for tax purposes. Therefore, expenses incurred by the SPV in connection with the acquisition and holding of the target can generally be deducted from its returns. This in particular applies to the interest to be paid by the SPV under the acquisition financing (but also all other acquisition costs to be considered). Thus, the tax group is generally an efficient and often-used tool to economically effect a debt push down without modifying the legal structure of the group. However, a tax group should always be well-prepared, implemented and de facto conducted, as otherwise it will not be recognized for tax purposes. Seemingly small details can jeopardize the tax recognition of the tax group even years after concluding the profit and loss transfer agreement (also retrospectively).

In terms of corporate law, in particular please note in respect of a tax group that the SPV has a loss assumption obligation with regard to the target as a result of concluding the profit and loss transfer agreement (section 302 AktG). The target, on the other hand, must pay its profits to the SPV (section 301 AktG) and may also be liable for their taxes (section 73 of the German Fiscal Code (AO)).

Another advantage of the tax group is that the capital maintenance rules provided by sections 30 GmbHG, 57 AktG (see above) no longer apply to a unlimited extent with regard to the target so that it should generally be possible that e.g. the target creates third party securities in favor of the SPV (e.g. for lenders under the acquisition financing). However, it has not yet been definitively resolved under German law whether these statutory reliefs of the capital maintenance rules will also take hold in the typical private equity constellations, where the SPV is in fact nothing more than a vehicle without further substance. This is because, as soon as the target is ailing and possibly dependent on loss compensation by the SPV, quite regularly the SPV will be ailing, too. Therefore, despite the existence of a tax group it is advisable to include a market standard limitation language in the collateral documentation, with such limitation language providing that the collateral issued by the target in connection with the acquisition financing may only be exploited by the security holder (and/or must be remitted to the target) if the capital maintenance rules under sections 30 GmbHG, 57 AktG would be violated otherwise.

If the target is an AG, with regard to the ban on circumvention under section 71(a) AktG, the target should not create any securities until the profit and loss transfer agreement has become effective. Otherwise, the provision of collateral by the target in the form of an AG could be void as a circumventing transaction. Although the effectiveness of the provision of collateral is primarily a matter for the lenders, its invalidity should quite regularly constitute a violation of the provisions of the acquisition financing and trigger a corresponding termination right of the lender.

3. Other options

In general, there are further options of doing a debt push down at least commercially. By way of example, on can think of the following instruments:

• Leveraged distributions or leveraged loans of the target towards the SPV

• Accession to or assumption of debt by the target with regard to the acquisition financing (regularly to be expected in the form of a distribution in favor of the SPV -- capital maintenance and limitation language should be kept in mind in this regard, too; from a lender's perspective, section 418 of the German Civil Code (BGB) must be considered)

• Change of the target's legal form into a GmbH & Co. KG (limited partnership with a limited liability company as general partner) and subsequent accrual of the limited partnership (KG)'s assets within the SPV upon the GmbH's withdrawal from the GmbH & Co. KG as a general partner (so called collapse merger)

• Leveraged acquisition of its own shares by the target from the SPV (provided that this is permitted under corporate law in the individual case)

If the target is an AG, the ban on circumvention provided by section 71(a) AktG (see above) must be observed at all times so that some forms of debt push downs will quite often not be possible. However, please note the possibility of the AG changing its legal form into a GmbH before the debt push down in this case, as well. Also, as a rule, lenders prefer such forms that best allow the target's operational business to be brought to the same level as the acquisition financing has been agreed on by the SPV.

From a lender's perspective, mergers, accruals and tax groups are regularly preferable to any other forms. In practice, we often see a combination of a tax group and an accession to or assumption of debt.

4. Tax considerations²

Especially for tax purposes, it must always be carefully verified which type of debt push down will be preferable in the individual case. In fiscal terms, the individual types are, in part, very distinct, and oftentimes the tax assessment will be the decisive factor in selecting the type of debt push down. In this regard, in particular also existing loss carryforwards or real property of the target company can play a role, but what must also be included in the considerations is the topic of the interest barrier, in particular. As, in conclusion, economically speaking, the point is that the target satisfies a debt of its shareholder, faulty structuring may result in a hidden profit distribution by the target to the SPV, especially in the case of violations of the capital maintenance rules.

5. Final remarks

It always depends on the individual case which form of debt push down can be implemented. In particular matters of tax and capital maintenance should regularly be the decisive factors. Due to the possible liability scenarios (as the case may be, also under insolvency law) associated therewith, the topic of capital maintenance should not be underestimated. In individual cases, besides the shareholders' and managers' corporate liability stemming from a violation of capital maintenance rules specifically provided for, all parties involved in a debt push down may face a tortious liability as a result of an unlawful interference destroying the economical basis (existenzvernichtender Eingriff) of the affected entity and, as the case may be, may have to face consequences under insolvency law and criminal law, too.

Additionally, it is important that the acquisition financing be documented in line with the debt push down. If, for instance, the debt push down takes the form of a merger, this should be illustrated accordingly, after all, the shares in the transferring company, and with it possibly corresponding liens over them, will cease to exist upon such time as the merger becomes effective. This may not really result in a risk or even damage for the lender, but violations of the covenants of the acquisition financing should be avoided at all times (see above). It is not uncommon thatlenders will require a debt push down of a certain type so that considerations along this line will need to be made with regard to the later debt push down between the SPV and the target even before agreeing the acquisition financing.

In general, a debt push down should almost always be possible, and the best possible type in a certain case can quickly be found and implemented with the help of experienced advisers.

¹ In principle, it is also conceivable to transfer the collateral to be provided to the lenders under the acquisition financing to the SPV by way of singular succession after completion (e.g. receivables, IP rights, collateral property, etc). In practice, however, this is likely to be an exception, so that this option will not be discussed further herein. In particular, a disruption of the SPV's other business operations and the collateral to be provided is often out of the question.

² The subject of taxes will only be touched upon here and will be dealt with separately.