Austria - Frankenstein legislation

Hopes that private equity-friendly legislation would be passed have finally been laid to rest. The draft law recently put forward has fallen well short of expectations and the political power struggle has caused one adviser to contritely call the situation "a never-ending story".

"There has been very little progress in the legislative environment," says AVCO's Jurgen Marchart. "During the last 18 months, we had to deal with three different people who were responsible for the legislation in that field, which has slowed down the progress significantly."

Additionally, Austria's government has far more burning issues to attend to, with funds earmarked to save banks, finance SMEs and invest in infrastructure projects. "Private equity legislation is simply not among the top issues on the agenda," explains Marchart.

The measures passed by the Austrian government to address the issues of SMEs are seen as a mixed blessing: "The government is probably not fully anticipating just how big the contribution is that private equity can make to help weather the storm. Rather than pour public money into the market, the government could enable private equity to provide an economic stimulus that wouldn't actually risk or cost public money. The money is there - all the industry needs is a sensible framework to play its part, but that cannot be reasonably done in this legal vacuum," adds Marchart.

Oldie but goodie

Just before the government dissolved in summer 2008, it drafted the law MiFiG-new. This was a shame, since the old one worked for private equity funds and was widely used. Nevertheless it was abolished at the end of 2007, following criticism by the EU Commission that it was tax advantageous and might therefore constitute state aid. "This position, though, is debateable, as an undue advantage would in practice only be constituted if it is so when compared to other fund structures in other EU-countries; however, it is an advantage compared to other Austrian stock corporations and this can be sufficient to assume state aid," explains Dr Andreas Zahradnik of law firm Dorda Brugger Jordis.

Nevertheless, the old MiFiG ceased to exist at the end of 2008, with a grace period for existing MiFiG structures to adapt to the new rules. However, MiFiG-new is no alternative as it is designed to be compliant with EU-rules on state aid for SMEs and thus not suitable for investments in larger companies.

A new draft for a structure that fills this gap, the Investmentgesellschaftgesetz (investment corporation act), is seen as a step in the right direction by some, but opens up a whole range of issues that need to be addressed before the industry can actually rely on it. Other industry representatives feel the law is "all but useless". The law offers specific tax treatments that take the special situation of private equity funds into consideration if investment companies adhere to a number of requirements.

These issues focus on supervisory and transparency requirements, which do not mesh with the way private equity works. The law requires a custodian bank to hold shares in the target company, which does not make sense to many: "The typical target company of private equity firms in Austria are family-owned private companies, mostly in the structure of a GmbH, that do not issue shares that could be deposited with the custodian," explains Dr Andreas Zahradnik. "It is inconceivable why this requirement should be there at all." This requirement has been copied from the SICAR law in Luxembourg. As one adviser put it: "In Luxembourg it may very well work."

Knee-deep in bureaucracy

Furthermore, the draft law to put out a prospectus every quarter would impose an enormous administrative workload, creating a liability troublesome for small and mid-sized family businesses. This would even be required if the fund only has a limited number of institutional investors, further increasing the administrative burden. "The absurdity is that funds in the form of Austrian stock corporations that only invest abroad, for example in Central & Eastern Europe, can be established in a tax-efficient way without problems, but no suitable new Austrian fund structure for investments in Austria exists. This also applies once the fund attempts to invest in both regions," Dr Zahradnik explains.

The government passed the law in the hopes it would generate "several hundred million euros" in corporate and other tax. However, explains one adviser: "These numbers are fictional, because anybody facing those taxes would simply revert to a foreign structure that is more tax transparent and offers more favourable terms." Several Austrian funds are already bypassing local structures in favour of Luxembourg SICAR and SICAV structures. This is to circumvent the changeable and potentially detrimental environment at home. Apart from the costs potentially incurred, many industry players state that their LPs would prefer to go abroad to use transparent and consistent structures.

Reliability, however, is another area where the law falls short. "At the moment the question is: which segment of private equity is covered at all? The law that provides a favourable environment requires that the investment company has to invest in order to make a company profitable - which is an unnecessary limitation; what about mezzanine financing, growth financing, and venture rounds?" questions one adviser.

In addition, the management has to fulfil certain requirements, such as having never been involved in a bankruptcy. This prerequisite was copied from the requirements for the managers of banks, but makes only limited sense in a private equity portfolio, where the most experienced GPs will likely have had exposure to bankruptcies, thereby limiting their ability to fulfil such criteria and leaving their underlying portfolio companies out to dry. "We have the strange situation of such restrictive clauses - yet no authority who watches over these being fulfilled, which creates legal uncertainty," states Dr Zahradnik.

The current patchwork regulation, described by one as "Frankenstein's monster" makes it unnecessarily complex to invest via an Austrian investment vehicle. This might be a considerable obstacle for the greater part of Austria's private equity industry, since many of the players are very small and might get into trouble with covering administrative costs of fund vehicles abroad.

This is paradoxical, especially in a time when great opportunities await as the financial crisis has changed the playing field considerably. Austria's small and mid-sized companies used to be able to raise cheap debt from banks. With the banks hampered by the credit crunch, this old limitation for Austrian private equity might revert into an opportunity.

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• Regulation
• DACH