The current prevailing seller market combined with high purchase prices and the new tax jurisdiction of the financial courts have an impact on the structuring of management participation programs (PPPs).
At MUPET 2019, Prof. Dr. Alexander Götz (left; Blättchen & Partner), Dr. Barbara Koch-Schulte and Dr. Benedikt Hohaus (both P+P Pöllath + Partners) present the latest developments in management participations | Source: Gregg Thorne
Classical structuring and possible alternatives
The classic equity participation of the management in the context of an LBO is predominantly structured in the form of a disproportionate subscription of preferred instruments (shareholder loans or preferred shares) as well as classic equity by the management (sweet equity).
As an alternative, a pari passu investment by the manager (i.e. a proportional investment) is now increasingly supplemented with a bonus. The bonus is due for payment depending on the economic development of the target company and is subject to a leaver scheme and, in some cases, vesting. As the Pari Passu Investment does not have a Leaver Scheme and thus no further link to the employment relationship, the minimum requirements of the German Fiscal Court (BFH) case law assume that the investment is taxed as capital income (see recent BFH dated 04.10.2016 — IX R 43/15). The bonus, on the other hand, is salary that is subject to income tax.
US investors often use so-called hurdle shares, which give the management subscribing to them a share in the value development only when the investor has earned his invested capital plus a minimum return. In exchange, the purchase price of the hurdle shares is usually very low. For tax reasons, the valuation should be documented by an expert opinion of an independent third party when the investment is made. Whether the profits from hurdle shares are subject to capital taxation has not yet been subject of a fiscal court review.
Effects of high acquisition prices on the structuring process
The currently high acquisition prices increase the management’s risk of loss from an MPP investment. This is because the limit for realizing a loss is often reached even with minor deviations from the business plan or the valuation multiple. This can be reduced by a higher proportion of manager investments in preferred instruments. However, the upside to be achieved then also decreases.
This prompts investors to offer managers so-called ratchet-agreements in addition to the classic equity investment in order to make the MPP more attractive. Under these agreements, the managers receive an additional amount from the investor from a certain minimum money multiple or minimum IRR, respectively, of the proceeds accruing above the thresholds.
New case law of the financial courts on sweet equity
In connection with a management participation, the Finance Court of Baden-Württemberg (ruling dated May 9, 2017 — 5 K 3825/14) ruled that the disproportionate subscription of capital instruments such as ordinary and preferred shares by a managing director is not an indication that the MPP income has been reclassified as salaries. The respective capital instruments are to be considered individually in their return. A comparison of the total return on the investment of the manager and the investor would be an inadmissible ex post consideration. If the investor’s profit had been lower, the manager would also have borne a higher risk of loss.
However, another senate of the same court (ruling of 26.06.2017 — 8 K 4018/14) decided in a comparable case for a consultant that the granting of the investment, among other things because of the associated chance of achieving a disproportionately high return in the context of the overall consideration, could certainly qualify as an additional performance-related remuneration for the consulting activity. The fact that the proceeds on the capital shares were identical for the consultant and the investor when viewed in isolation did not indicate otherwise. An isolated consideration does not fully reflect the economic content of the total investment of the investors and managers.
It remains to be seen how the Federal Fiscal Court will decide on this.
Insurance protection of payroll tax risk
The income tax risk associated with MPPs is now insurable in England. Insurance companies are now also trying to tap into the German market. The insurance covers the tax difference between capital and income taxation and the necessary defence costs against payment of a corresponding premium. In return, however, the policyholder must disclose all information and opinions relevant to taxation. Tax consequences related to valuation issues are not insured. It remains to be seen whether and how the market for such insurance will develop in Germany.
A seller-friendly market has led to lean warranty catalogs in SPAs, coupled with W&I insurance and a liability cap of EUR 1. It is a trend, especially among UK investors, to recognise guarantees that the seller does not provide in the SPA to demand from management. In this respect, classic SPA guarantees are partly outsourced into a separate Management Warranty Agreement to be granted by management. W&I insurance is also possible for this purpose.
Restructuring of MPPs in crisis
Due to economic developments, some portfolio companies have recently been taken over by banks for covenant breaks or have even had to file for bankruptcy. For an MPP, the necessary restructuring of such companies often means that even if the turnaround is successful, the investor’s money multiple on the originally invested equity is no higher than 2x or even significantly lower, and the time until exit becomes significantly longer. In line with the increased risk profile, interest rates or dividends on the preferred instruments run at interest rates for longer and the MPP has little realistic chance of attractive returns. Rather, there is a significant risk of a (total) loss. Often, the scenario is exacerbated by dilution due to necessary capital increases based on low valuations.
As in the 2007 financial crisis, there will soon be an increase in the restructuring of MPPs. This can be done by subscribing for common shares or preferred instruments based on the subsequent low valuation. A conflict with an impairment test should be avoided. In addition, managers often have reservations about throwing good money back to the “bad” money. As an alternative, only a bonus model in the form of a virtual shareholding, oriented towards the development of equity value, remains.
The current high acquisition prices lead to changes in the structuring of MPPs. Tax aspects must be taken into account. However, some management teams are more likely to opt for risk reduction and accept tax disadvantages. As the need for restructuring of portfolio companies increases, the need for the restructuring of MPPs is also likely to increase. This is all the more true since the BFH will soon also comment on the tax treatment of sweet equity.