The Acquisition And Leveraged Finance Review - Edition 5

Author:Mr Thomas Ingenhoven and Odilo Wallner
Profession:Milbank, Tweed, Hadley & McCloy LLP
 
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I OVERVIEW

The very favourable market conditions for leveraged finance in Europe and Germany experienced in 2016 continued in 2017. The strong market dynamics in 2017 further shifted pricing, leverage and terms in favour of borrowers. As a result, 2017 has been a record year for the leveraged loan market in terms of loan volume and deal count. Borrowers clearly take advantage of the overwhelmingly borrower-friendly dynamic in leveraged loan markets. This environment is driving the large number of refinancings as well as repricings, which is responsible for a large share of the reported volume growth. Availability of funding in Germany is not only driven by the strong domestic bank market, but also by an increasing push of debt funds into Germany. Lending to small and medium-sized businesses used to be firmly the province of banks, often, local relationship institutions. However, debt funds were able to establish a thriving lending practice in recent years, and competition with banks is bringing further pressure on pricing and covenants. A large part of the leveraged loans are still structured as club deals, especially in the small and mid-cap market segment, but unitranche/super senior financings are increasing in number and volume. At the higher volume end of the market, there are typically term loan Bs and high-yield bonds combined with bank revolvers. In addition to favourable pricing and leverage, borrowers also continue to benefit from generally looser terms and covenant packages. This is specifically true for larger mid-cap, large cap and leverage/investment grade crossover financings. For mid-cap and smaller deals, covenants have become looser but largely still continue to remain steady. A leverage covenant remains the standard and even a second or third financial covenant can be seen. On the other end of the spectrum, crossover deals are moving to look increasingly like corporate financings.

The Loan Market Association (LMA) standard documents have established themselves as the dominant documentation standard in Germany for syndicated loan facilities. The LMA published two German law precedents for investment-grade borrowers and for real estate financing. At the lower volume end of transactions, LMA based but shortened documentation prevails, which, if only German banks and borrowers are involved, is often set out in the German language.

II REGULATORY AND TAX MATTERS

i Licensing requirements

In contrast to other jurisdictions (e.g., England), commercial lending in Germany generally requires a banking licence. Under the German Banking Act (KWG), the extension of loans is a regulated banking activity if it is performed on a commercial basis or to an extent that requires commercial business operations. The commercial basis-test is usually met if the lending undertaking is to be conducted for a certain period of time and with the intention to generate profits. Consequently, this requirement is usually met (long) before commercial business operations are required. In practice, the latter criterion is, therefore, of little relevance. It is noteworthy that, according to the administrative practice of the German Federal Supervisory Authority (BaFin), there is no de minimis exemption for lending activities, and the licence requirement under the KWG applies irrespective of whether or not loans are extended to consumers or corporate borrowers.

In principle, only banking activities conducted in Germany are subject to the licence requirement pursuant to the KWG. Commercial lending is generally considered to be conducted in Germany if the lender has its registered seat, or a permanent establishment, in Germany. However, the licence requirement may also be triggered if a lender does not have registered seat or a permanent establishment in Germany, but actively addresses the German market by repeatedly offering loans to individuals or legal entities situated in Germany. Where a lender does not actively address the German market, it may benefit from the 'reverse solicitation' exemption. Pursuant to this exemption, which is based on an established administrative practice of BaFin, no German banking licence is required for the extension of loans to borrowers situated in Germany if the extension of loans is permitted in the (foreign) jurisdiction in which the lender is situated, and the respective lending transaction has not been solicited by the lender but was provided solely upon the initiative and request of the borrower. The distinction between a reaction upon a request to provide a loan, and the solicitation of a loan, offer is highly fact-driven and requires an overall assessment of all circumstances of the individual case at hand.

In order to qualify as 'lending' under the KWG, a person or entity must grant loans, or enter into contractual obligations to grant loans. Hence, the acquisition of a loan, which has already been disbursed in full prior to such acquisition and where the purchaser is under no obligation to extend any (further) credit, does not qualify as 'lending' pursuant to the KWG. The mere administration of the acquired loan by the purchaser in accordance with the loan agreement, does not trigger a licence requirement under the KWG. Therefore, the acquisition of fully disbursed term loans does generally not require a banking licence in respect of the purchaser. There are two important exceptions to this rule. Firstly, a novation, prolongation or other material amendment of an existing loan is treated by BaFin as an extension of credit. As a consequence, a purchaser of fully disbursed term loans, who does not have a banking licence for lending transactions, must not enter into the aforementioned amendments or transactions in respect of the acquired loans. This, of course, limits the available options should the acquired loans, for example, need to be restructured. Secondly, the acquisition must not be conducted on an ongoing or revolving basis. The ongoing acquisition of loans (or other receivables) on the basis of a master agreement would require a banking licence for factoring transactions under the KWG. Lastly, it should be noted that where the purchaser of loans also acquires the role as facility agent or security agent, the exercise of such role may require a licence pursuant to the German Payment Services Oversight Act (ZAG).

Since 2016, there is a further exemption from the general rule that the extension of loans on a commercial basis requires a banking licence. This statutory exemption in the KWG is available for certain alternative investment funds (AIFs) and their managers (AIFMs), and is widely used by credit funds that originate loans within and into Germany. The exemption applies to German AIFs and AIFMs, which in turn are regulated by the German Capital Investment Act, EU-AIF and AIFM, which are subject to the rules and regulations implementing the Alternative Investment Fund Managers Directive. Amongst other prerequisites, the loan origination must form part of the collective portfolio management of the AIF and AIFM. Third-country AIFs and AIFMs may only benefit from this exemption if they have successfully completed the notification procedure for a marketing and distribution of the respective fund in Germany with BaFin. A notification procedure for the marketing and distribution of the fund only to professional investors does not suffice for the purposes of this exemption under the KWG.

ii Taxes and fees

Interest payments under loan agreements are subject to German corporation tax if the lender is tax-resident in Germany, which, together with the solidarity surcharge, amounts to 15.825 per cent. In addition, trade tax imposed and rate set by municipalities applies (roughly between 7 and 18 per cent).

While Germany charges a withholding tax on specific capital investments, interest on loan agreements is generally not subject to withholding tax. Certain exemptions apply, for example, for certain 'hybrid' loans (i.e., loans with an interest rate linked to the borrower's profits or liquidity). Furthermore, in the case of non-German lenders, the German tax authorities could impose a withholding tax obligation on the borrower if the interest is subject to German limited tax liability (e.g., in the case of a non-German lender if the loan is secured by German real estate). Specific attention is, therefore, required in phrasing tax gross-up and indemnity clauses.

Interest expenses are generally tax deductible in Germany. The interest barrier rule limits tax deduction of net interest expenses (interest expenses minus interest income) at 30 per cent of tax EBITDA. In order to achieve deductibility of interest expense of the acquiring entity taking out the financing against operating income of the target in a leveraged buyout, a tax group is usually implemented between both entities by way of a profit and loss transfer agreement. For the purposes of corporation and trade tax, the operating profit may then be set off with the interest expenses. The problem can further be mitigated by a debt pushdown, bringing part of the interest-incurring debt to the same level as the operating profit.

While loans are by default VAT exempt, lenders may opt to charge VAT on interest payments. As it is might be unclear whether the borrower is entitled to a corresponding VAT credit (in the absence of which the VAT paid to the lender would be a definite cost item), such an option is typically excluded from VAT gross-up in loan agreements.

There are no stamp duties payable in Germany. There are notarisation and registration fees in connection with share pledges over limited liability companies and land charges. Notarisation of share pledges may trigger notarisation fees. The registration or assignment of land charges in the land register and the submission to immediate enforcement trigger registration and notarisation fess, respectively. Fees depend on the value of the collateral asset.

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