Where there's a will, there's a way

01 February 2008

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Legislation in the current political and economic climate is bound to lag behind. Laws that were passed under certain circumstances seem outdated and too slowly implemented now. And doubtlessly, for the time being, the market turbulences and world economy will continue to have a far bigger effect on the market than legislation. Nevertheless, in the DACH region, Germany and Austria both passed - or are in the process of passing - legislation that will affect the market. Deutsche unquote" invited two legal representatives to discuss current legal developments in their region and state their opinion on the effect this legislation will have on the private equity industry.

Christof von Dryander, Partner, Cleary Gottlieb Steen & Hamilton

Germany

Germany's political landscape is undergoing a strong shift towards the left end of the political spectrum, meaning that more interventionist actions are likely to be taken and clashes with the free market economy will become inevitable as a result of this more protectionist bend.

We are seeing two main topics emerge that are of interest to Germany's private equity industry: the Risikobegrenzungsgesetz, which directly targets the industry, and a discussion about foreign wealth funds (Staatsfonds), which raises the question of whether and in what way to regulate investments from foreign governmental investors, especially in terms of strategic industries.

In regard to Staatsfonds, it is questionable under EU rules whether Germany can pass effective legislation unilaterally that restricts cross-border transactions. One possibility that is being discussed is to create a domestic fund that takes minority stakes in companies to pre-empt investments from undesired foreign investors. The debate about protectionist measures against Staatsfonds seems to have calmed down after the US, which had previously been cited as the prime example for effective regulation of foreign investments, welcomed the inflow of foreign governmental money in the effort to stabilise the banking system in the wake of the sub-prime crisis.

The Risikobegrenzungsgesetz, which is still hotly debated in German political, economic and legal circles, is not expected to hamper the domestic private equity industry. The law will be limited to investments in listed companies, which accounts for only a small portion of activity. Moreover, the new law will not prohibit or limit foreign investment, but only increase transparency. Transactions that make economic sense and are beneficial will go through as per normal. Increased regulation also always presents new opportunities for creative structuring around technical legal rules. An example of this can be seen in the new tax rules for debt financing by German companies - the new law limits interest payments to 30% of EBITDA.

Exceptions apply, however, for taxpayers that can demonstrate a higher portion of debt on a group-wide basis, which opens the door for creative corporate restructurings by highly-leveraged international private equity groups. Furthermore, acting in concert will be more heavily regulated by the Risikobegrenzungsgesetz. Again, this rule will only affect investments in publicly-listed companies. This new rule is intended to make collaboration among investors, as allegedly happened in the well-publicised Deutsche Boerse case a few years ago, more transparent to the target and the market. Again, it is unlikely that the new rule will effectively regulate parallel stake-building by financial investors or limit what has been perceived in political circles as blackmail of management by corporate raiders.

As a result of the current credit crunch, it has in any event become much less likely that a large listed company will be taken over by financial investors, a concern that provided the impetus for much of what we now see in the Risikobegrenzungsgesetz. In another effort to increase transparency, when taking stakes in publicly-listed companies, stakeholders will have to disclose their intentions and the source of their funds once their stake reaches 10%, 15%, 20%, 25%, 30%, 50% or 75%. This will come on top of the existing disclosure rules, which require notifications of stock purchases to the baFin and the target whenever stakeholders reach 3%, 5%, 10%,15%, 20%, 25%, 30%, 50% or 75%. Sanctions for breach of the notification obligations will also be tightened. Previously, stakeholders lost their right to vote and to collect dividends only as long as they were in breach of their obligations: given that German companies hold shareholders' meetings and pay dividends only annually, it was easy to manoever around the rules. In the future, the sanctions period will be extended to cover an additional six months after the failure to notify has been cured.

Finally, the Risikobegrenzungsgesetz will require greater disclosure of options and other derivative instruments on German shares and new rules restricting shareholders from having their nominees entered into share registers instead of the true beneficial owner.

Overall, the efforts of the German Government reflected in the Risikobegrenzungsgesetz have resulted in significant negative publicity, are likely to affect the international perception of Germany's free-trade attitude, but in the end will have little impact on private equity or other M&A activity in Germany.

Moreover, the issue of transparency did not appear out of the blue: private equity investors have had to deal with much further-reaching disclosure obligations when acquiring German financial institutions, so regulations requiring more transparency are not unprecedented.

Dr Gerd Konezny, Tax consultant and certified auditor, Leitner + Leitner

Austria

While Austria has not been a hotbed of private equity in the past, there has been an increase in transactions and in the establishment of private equity/venture capital funds in Austria. This is less fuelled by widely-publicised takeovers of Austrian companies by foreign private equity investors, and more by transactions in the Austrian 'middle class', as well as an increased interest in private equity and venture capital as an asset class and form of investment.

Austrian legislators introduced a particular concept for a fund vehicle called 'Mittelstandsfinanzierungsgesellschaften' in 1994, which was the dominant form to structure a private equity or venture capital fund in Austria for Austrian investors. This vehicle was heavily criticised for its narrow regulations that made it impossible to acquire majority stakes or to use a leverage and restricted the scope to interest in target companies established in Austria. The commission saw this as a infringement of the European State Aid regulations, which spelled the end of this legal form: Mittelstandsfinanzierungsgesellschaften in this model could only be founded up to 31 December 2007.

At the end of 2007 a new concept of Mittelstandsfinanz-ierungsgesellschaften had been introduced to replace the former concept. This regime for private equity and venture capital funds is intended to close the financing gap for small and medium companies who find it hard to raise capital, as they are usually unable to achieve an IPO. Legislators wish to make Austria more attractive for small and medium-sized companies as well as their investors. The new concept is based on a non-transparent structure, either a stock company (Aktiengesellschaft, AG) or a limited liability company (Gesellschaft mit beschrankter Haftung, GmbH). While not limiting investments to domestic investors, the new concept incorporates a number of significant limitations for private equity/venture capital funds:

- the acquisition or the increase of an interest cannot exceed EUR1.5m per 12 months;

- majority stakes cannot be acquired;

- the use of leverage is excluded.

If a fund conforms to the requirements of this legal corset, the legislator 'rewards' and exempts it from any corporate tax on capital gains and waives tax on any distributions to the investors, so that, apart from interest, the profits of the fund are received without any tax burden. It is without doubt that this new scheme will - thanks to its unfavourable requirements - not contribute to creating a suitable, internationally attractive environment in Austria for the private equity industry.

Partnerships (Offene Handelsgesellschaft, OG; Kommanditgesellschaft, KG) qualifying as non business, but pure asset management from a tax perspective, have not been widely used in Austria yet. Due to the insecurities and inadequacies of the new concept of Mittelstandsfinanzierungsgesellschaften, this is beginning to change. Against this background, other foreign fund structures draw more interest from Austrian fund managers, especially SICAV (Societe d'Investissement a Capital Variable) and SICAR (Societe d'Investissement a Capital Risque) seem to grab the Austrian private equity scene. Even if these could represent a 'magic bullet' under some conditions, this alternative causes some risks of an unwelcome tax burden and requires tax modeling in the interest of the investor and the management company as well.

However, since the beginning of 2007, a new Austrian fund concept is being discussed. This is much needed considering the fact that the Mittelstandsfinanzierungsgesellschaften law is beyond doubt the be all and end all.

The new fund concept should be based on a classical LP structure, allowing all forms of holdings of and auxiliary services according to international best practice and assumes a transparent fund for tax purposes, which allows for the profits of the fund to be directly attributed to investors. The business of the fund would be explicitly qualified as asset management for tax purposes. Consequently there is no risk that the fund or the Austrian management company qualifies as an undertaking establishing a permanent establishment and constituting a tax burden in Austria.

It is worth mentioning that, to complete the concept, additional provisions regulating any commitments due to government supervision and reporting regulations are needed. This scheme for private equity and venture capital funds should render a reliable status for the fund and the fund management.

Finally, it remains to be seen whether those who speak in favour of this concept will prevail and whether the legislator takes steps to realize it and thus supports this internationally competitive concept that takes the nature and requirements of the private equity and venture capital industry into account and would take a major step towards the development and strengthening of the domestic industry. ...to be continued!