What are the most significant legal and tax issues currently facing the private equity industry?
Tax regimes across Europe play an important part in stimulating entrepreneurial activity and have a very important effect on the private equity industry. Tax reforms in many European countries over the past few years – and others that are expected shortly – are therefore very important. In the UK, an effective reduction in the long-term rate of capital gains tax, together with some tax-advantaged stock option schemes, are welcome and significant developments – although the complexity that has come with those reforms is regrettable. The impending tax reforms in France, Germany and other European countries are also very significant, and should help the private equity industry to varying degrees.
Pension fund reform has also been high on the agenda recently, particularly in the UK after the publication earlier this year of Paul Myners’ wide-ranging report on institutional investment. Outside the UK, one important priority for the private equity industry must be the reform of pension fund regulations, which impose tight quantitative guidelines on investment. The alternative – so called “prudent man rules”, which require fund managers to carry out sensible portfolio diversification – ought to encourage the inclusion of private equity in more pension scheme portfolios across Europe.
There are also difficulties with European competition law as it applies to private equity backed transactions, and these are the subject of discussion with the European Competition authorities at the moment. Essentially, the way in which some of the thresholds are calculated to determine whether a particular transaction falls foul of competition law restrictions can inadvertently catch some private equity deals which clearly give rise to no competition law concerns, delaying (and in some cases frustrating) the deal.
It is important for the further development of the European private equity industry that Governments should continue to look at ways of fostering small and fast growing companies. The insolvency rules, the rules on raising finance through private placements and the red tape imposed upon small businesses are three examples of important drivers of this which have been identified as priorities for reform in a number of European countries in recent months. As a firm, we are involved in lobbying and advising national and European Governments on these and other issues.
Germany’s Tax Reform has been well documented for the effect it is anticipated to have on private equity and M&A activity. However, can you elaborate on the problems the Foreign Investment Funds Act looks set to cause and possible solutions?
Anthony Tulloch, Partner, Frankfurt responds: German taxpayers, including those investing in a private equity fund, can now expect to pay tax on only half their share of gains on the sale of a company (for individuals) or no tax at all (for corporations). But if a fund falls foul of the Foreign Investment Funds Act (FIFA), none of that applies: the fund’s entire return will be fully taxable.
In the past it has been possible to obtain rulings from the regulators that specific funds do not fall under FIFA, but it is now taking them so long to process ruling applications that it is hardly worth making the attempt.
The only secure way of avoiding FIFA is to invest in a vehicle under German law that invests in parallel with the main fund.
With many companies in continental Europe locked in stock market doldrums for a considerable time, do you expect any increase in “take privates” in those markets?
Notwithstanding the setback for the EU takeover regime, which was thrown back to the drawing board last July, recent legislative initiatives at the national level demonstrate a desire to improve the legal climate for corporate takeovers. For example, Germany has passed a new takeover law and France, in part through the New Economic Regulations law of May 15, 2001, has pushed through additional transparency rules for public takeovers.
These and similar regulatory initiatives are likely to facilitate the PTP transactional framework in the medium-term.
Do you think the recent changes in the tax treatment of stock options in France will ease the buyout process?
George Pinkham, Partner, Paris responds: No, I do not think that the new tax rules can be seen as a change likely to ease buyouts. Under the previous rules, option holders could access a flat tax rate of 40 per cent on option gains (that is, the difference between the option price and the value of the shares on exercise of the options), as long as the sale did not occur within five years of grant. This meant that after five years, they could – on the same day – exercise the options and sell the shares at a relatively acceptable rate (compared to other countries) without having to hold the shares (and bear shareholders’ risks) after exercise.
Under the new rules, the five year period is reduced to four years, but the option holder will now be taxed at 50 per cent on the portion of the annual option gain that exceeds FF1,000,000 (the 40 per cent rate remains applicable under FF1,000,000). It is only if the option holder holds the shares for a further two years (beyond the initial four year holding period) that the portion of the gains exceeding FF1,000,000 benefits from the 40 per cent rate (in this situation the portion below FF1,000,000 is taxed at 26 per cent).
In addition, the new rules do not address other problems. In particular, the option gain realised on the sale of any shares within the four year holding period is treated as salary (instead of capital gains) and triggers social security taxes payable by both the employee and the employer. This additional cost often forces the employer to use a cliff-vesting after four years, which is more difficult to “sell” to the employees than a straight-line vesting over the four year period.
Are you noticing a pattern in the way pan-European venture and private equity firms implement or structure incentive schemes for their investment managers?
Recently, there has been an increasing trend towards the establishment of additional incentive schemes for managers, alongside the traditional carried interest. The purpose of these incentive schemes is further to align the interests of the investment managers with their investors by allowing them to invest their own capital and participate more directly in the fruits of their labour.
In general, there is no “one size fits all” and the structure is dictated by the fund and the participants in the relevant scheme. Thus, the structures of these plans have been extremely diverse reflecting the varied nature of the funds. They include leveraged, full-slice, and sweet equity plans and parallel structures covering several European jurisdictions, and the vehicles used are similarly diverse and can range from partnerships (limited or general) to corporates.
We have found that investors are in general supportive of these plans, as they appreciate the rationale.
What impact will the UK’s Financial Services and Markets Act have for those raising private equity from UK institutions and high net worth individuals?
The Financial Services and Markets Act 2000 (“FISMA”), and in particular the regime for financial promotion under FISMA, creates new opportunities for “private” or “informal” investment outside the scope of regulation. The Financial Services Act 1986 regime was contrived on the basis that every private individual required investor protection standards suited to the most vulnerable. Thus, in principle, nobody could offer a share deal or a private equity fund even to the wealthiest, most sophisticated and least risk-averse members of society without going to the expense of using a regulated financial intermediary.
FISMA fundamentally changes this approach (and not before time). While there remain a number of difficult provisions in the legislation and the various orders made under it, we do at last have a framework under which wealthy or sophisticated individual investors can be directly solicited to take part in direct private equity investments. The test for net worth is set generously low; in fact, provided that the investor has a certificate from his employer or his accountant vouching for gross income of at least GBP100,000 (or net assets of GBP250,000) in the preceding two years and certain other conditions are met, he is accessible by anybody seeking to sell him an investment opportunity. Promoting a private equity fund is still reserved to persons authorised under FISMA. However, the same high net worth test applies, and in effect this means that funds can be offered to known wealthy individuals holding certificates who need not have prior client relationships with the promoter or, indeed, any other investment firm.
A few years ago, a number of Internet trading and information exchange platforms appeared, all aimed at creating dialogue between individual investors and prospective investees.
Many of these foundered as the market for technology stocks disintegrated. But, frankly, their premise was often flawed, since their deal-broking ambitions were likely to remain unfulfilled without authorised status under the Financial Services Act.
While care will still need to be taken under FISMA to ensure that these arrangements benefit from the exemptions and exclusions in the new regime, there is much more scope for web-based private deal brokers now. Assuming that the market for private investment has not lost confidence totally as a result of the TMT slide, FISMA should afford these types of web arrangement a new lease of life.
How does all of this affect institutional participation in private equity? The simple answer is that in regulatory terms there is little change to report. It is primarily the scope to tap the potential of private individuals that makes the platform under FISMA potentially so exciting.
Are Anglo-Saxon legal practices and cultures taking dominance in the continental European venture industry?
Justus Binder, Partner, Munich responds:
The Anglo-Saxon influence on the continental European venture industry has been strong from the very beginning. Although Germany is catching up, the UK still is the only European country where the volume of private equity funds raised and managed considerably exceeds the amount invested domestically.
Especially with the maturing of the private equity markets in continental Europe in the past year, the demand for highly specialised legal services that meet international standards will continue to grow.
How realistic is it for the private equity industry to seek standardisation from the legal profession?
To a certain extent, the equity element is already standardised. As the commercial terms have become relatively standard, so the legal documents and structures that incorporate those commercial terms have become standardised across law firms, and across jurisdictions.
The acquisition element of any deal, however, depends on the type of business being acquired, and is therefore incapable of a high degree of standardisation. As for the position across Europe, law is not like other professions, such as accountancy, where there is some degree of standard in place. Rather, the law in each jurisdiction can differ materially, and this will clearly impact upon the terms and structure of the deal.
Some of the venture capital and private equity firms with established records in parts of continental Europe are beginning to focus their attention on the opportunities presented in central and eastern European countries. How long will it be before the lawyers follow?
In Western Europe, it took a few years for lawyers to follow venture capitalists – despite the fact that European integration offered additional incentives for UK firms to establish in those countries. In the case of eastern European countries, the pace will depend on how fast those countries integrate with the European Union. It is clear, however, that the need of rapid growth and huge investments in those economies indicates a very good prospect for business – and therefore for lawyers.
Private equity and venture capital has a pretty high profile in continental Europe, thanks in part to the Internet bubble. Has this made it a more attractive career for lawyers to specialise in?
Private equity has a far higher profile now than say a decade ago, when it may have appeared a poor relation to mainstream corporate finance work. Now that the size and complexity of private equity transactions and funds has increased enormously, the sector is very attractive to lawyers. The fact that private equity houses are innovative and transaction-driven makes them good clients, and adds greatly to a lawyer’s enjoyment of his or her role.