Convertible loan structures in German private equity: the rise of a new instrument

September 2021 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2021 Issue

Convertible loans have regularly been used in the venture capital (VC) sector. Now, however, they are increasingly an investment option for private equity (PE) investors – hardly surprising in times where attractive equity investments in Germany are very competitive.

Growth investments can resemble VC investments, so a convertible loan can be a better alternative when further capitalisation is sought in addition to a PE lead investor. This can replace typical debt financing. Convertible debt can also make sense where a PE investor wants to postpone an equity investment decision.

A convertible loan tends to be a very flexible financing instrument that is often available at short notice and can usually be arranged without much effort. This makes it attractive from a VC perspective. The instrument has a loan component and a conversion component. It is usually used in the early stages of a company’s existence. Here, it can still be difficult for the parties to evaluate the start-up.

However, in the meantime, PE investors have begun to use convertible loans to develop further growth investment opportunities. In this case, the terms and conditions of a convertible loan will be adjusted to a certain extent. Investors should consider different scenarios, for example when a PE lead investor is seeking additional investors. Here, the lead investor will have specific ideas about its investment that enables it to let another, more prudent PE investor make an investment that is senior to them.

This allows the PE lead investor a predictable, attractive profit based on a fixed interest rate, coupled with the option of a later equity investment. This is even more obvious if an additional PE investor substitutes a debt financing, which might be the alternative option for the company. A different scenario might see a PE investor wanting to postpone an equity investment decision, although it is willing to invest into a more senior instrument with a later option to convert, based on a predetermined internal rate of return, into equity at an attractive conversion rate.

German banking supervisory regulations which permit credit transactions must be observed with respect to each convertible loan, whether the loans are granted by a VC or PE investor. These regulations would not apply to a convertible bond, but parties generally consider this alternative to be too costly and inflexible. However, regulatory permission requirements would not come into play if the investor has control over the company from a corporate perspective.

Control can be based on a voting agreement or a security transfer of shares. If the latter, the shares in the borrower would form collateral for the lender and tick the box for requiring regulatory control, as opposed to a sole share pledge, which would only provide collateral, but not qualify as control.

Certainly, granting control is often not the intention of the parties. However, in certain cases the shareholders might believe in their growth business and consequently accept a security transfer to enable the company’s next growth stage.

When customising a convertible loan, a PE investor will want to retain as much freedom as possible. Moreover, it will want to be able to convert at any time, to prevent termination by the company and, even in the event of an exit by a lead investor, to be paid out or still be allowed to convert. As opposed to the VC case, a conversion or company valuation is not based on a later financing round, including a potential discount or valuation cap, but on a previously agreed internal rate of return of the lead investor’s equity investment or, alternatively, a pre-agreed internal rate of return of the convertible instrument in the event of conversion.

In addition, a PE investor will request certain veto rights that can be backed by a small equity participation, which enables corresponding minority protection rights in the shareholder meeting for the investor. Finally, especially in the case of foreign PE investors, a ‘tax gross-up’ common in financing may be included in the documentation.

The number of growth sector investments in Germany continues to rise. PE investors are attracted to this space against the background of generally increasing competition in more mature markets and appealing business models. Here, convertible instruments are a good means to invest in this area, characterised by higher risk in structurally reducing exposure.

We expect PE investors to use convertible loan situations more often as an additional option to target companies, even when the current situation or valuation does not allow for a direct equity investment. From a founder and company perspective, this set up could also be a good option to avoid bank debt financing at an early stage, which usually imposes stricter covenants.

Nikolaus von Jacobs is a partner and Matthias Weingut is an associate at McDermott Will & Emery. Mr von Jacobs can be contacted on +49 89 12712 230 or by email: njacobs@mwe.com. Mr Weingut can be contacted on +49 89 12712 233 or by email: mweingut@mwe.com.

Nikolaus von Jacobs and Matthias Weingut

McDermott Will & Emery