By King & Wood Mallesons
Structuring the financing of your investment
In funding an acquisition in Germany, investors regularly use both equity and debt instruments. With respect to the debt capacity of the target, investors need to be aware that lenders will base their credit decision – along with other criteria, such as the security position of the lenders – on the cash flows projected for the coming years. In addition, investors will need to take into account the ratio between debt and EBITDA (Leverage) when structuring the financing.
There is no general rule as to potential leverage levels in an acquisition scenario since they mainly depend on the overall market situation and the projected cash flow of the target group. However, in the current market situation, we often see senior leverage levels above 4.00x and 5.00x EBITDA. Many German banks are, due to restrictions imposed by the European Central Bank, not able to provide loans in such scenarios. Often, in highly leveraged transactions sponsors therefore borrow money from alternative debt providers, like special debt funds (also known as “Unitranche”-financings).
In an acquisition scenario, there are various types of potential debt instruments available to finance the purchase price.
In the German market, the debt structure usually consists of senior bank term loans as a center piece, which can be complemented by junior finance instruments (mezzanine or – even less likely – second lien instruments). The question as to whether mezzanine or second lien debt is required (but also available) for financing will also depend on the leverage level, given that bank lenders are often reluctant to exceed certain leverage levels – in the current market these junior pieces are rare. As said above, with the additional funding option provided by debt funds, in many of such highly leveraged financings Unitranche-financings – either coupled with a senior financing or, more likely, a super senior revolving credit facility (e.g. for general corporate purposes) or separately – are very common. Typically, the Unitranche facilities also have a longer average lifetime and, hence, they often combine senior and mezzanine elements.
High-yield bonds are also fairly common in the German market, although they are rarely used in transactions where the financing volume is below EUR 200 million, and are more likely to come into play to refinance an acquisition post-closing.
From an investor’s perspective, it is key to find a financing solution that is suitable for the financing needs of the target entity. In this respect, investors should not only consider the funding of the purchase price for the investment, but also the financing of working capital needs and potential capital expenditure and addon acquisitions.
In Germany as well as in the rest of Europe, facility agreements are commonly based on, or at least aligned to, the standard facility agreements prepared by the Loan Market Association (LMA) in London. The LMA-based facilities agreement for leveraged transactions is a sophisticated document serving as a starting point in negotiations with lenders, which will – in German transactions – be amended to comply with German law.
The language of the facilities agreement largely depends on the composition of the lenders and the syndication strategy. In large transactions where lenders from different jurisdictions participate in the transaction financing, the facilities agreement will often be in the English language as a means of facilitating the syndication process. However, in particular in mid-market transactions, where the lenders are domestic banks, the German language is commonly used.
Where the financing structure consists of different layers of debt (e.g. super senior revolving credits, senior debt, bonds and shareholder loans), it is common practice to govern the relationship between the creditors in an intercreditor agreement. Such an agreement might also be based on, or aligned to, the standard intercreditor agreements prepared by LMA. It provides for the ranking between the different debt layers and the application of potential enforcement proceeds, as well as usually being governed by German law.
The provisions of an intercreditor agreement, in particular, become increasingly important in a distressed scenario. In order to find a suitable solution, it is essential to conduct a thorough analysis of the impact of the provisions of the intercreditor agreement.
Given that facilities agreements generally contain a change of control clause, the investor needs – in an exit scenario – to factor in the repayment of existing financial indebtedness under the financial documentation.
Under German mandatory law, a borrower may repay a loan with a variable interest rate at any time at the end of each relevant period for which the variable interest is fixed, in each case without having to pay prepayment or breakage costs. Investors, therefore, generally seek to repay existing loans at the end of an interest period to avoid breakage costs, which might be substantial in the case of long-term financings.
If letters of credit were issued under an existing facilities agreement and are still outstanding upon repayment of the facilities, these letters of credit have generally to be returned to the issuing bank or cash collateralised. Alternatively, the purchaser’s lenders could replace outstanding letters of credit, which is often highly complex and time-consuming, or guarantee the outstanding letters of credit in favour of the existing lenders by assuming a back-to-back guarantee (Rückavalierung).
An exit not only requires thorough preparation on the M&A side, but also with respect to the existing financing. Refinancing options should be discussed and taken into consideration at an early stage.
Does German law contain prohibitions on financial assistance?
A German stock corporation (AG) is prohibited from granting financial assistance (including granting of security) for the acquisition of its own shares, and such a transaction would be void. In addition, the granting of security for a shareholder obligation is viewed as repayment of share capital, which is only permissible subject to certain limitations, which are based on a balance sheet test.
Does German law allow compound interest?
Under German law, a debtor may not agree in advance on any compound interest or to pay interest on due interest. Therefore, if a facilities agreement is governed by German law, such an agreement regularly provides for lump sum damages (pauschalierter Schadensersatz) accruing on the overdue interest amount from the due date.
Does German law allow upstream or crosss-tream guarantees or security interests?
The granting of guarantees or other security interests by a German limited liability company (GmbH), a German stock corporation (AG) or a limited partnership with a general partner that is a GmbH or another company with limited liability is permitted in general.
However, German capital maintenance rules provide that the share capital of the company may not be repaid to the shareholders.
The granting of a guarantee or other security instrument for the borrowings of the parent or sister companies (i.e., upstream security or cross-stream security) qualifies, under certain circumstances, as a prohibited repayment of share capital. Since a breach of such rules can result in criminal and/or personal liability of managing directors, it is common practice to limit and restrict the enforcement of the guarantee or security instrument contractually by inserting so-called “limitation language”.