The German FDI review of minority co-investments

February 2024 | SPOTLIGHT | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

February 2024 Issue

Current high interest rates are forcing private equity (PE) funds to be more creative in order to finance their investments. One way is for sponsors to invite more co-investors, often sovereign wealth funds or pension funds, to provide equity financing alongside the sponsors. Such co-investors usually acquire non-controlling minority stakes. Investment structures usually use foreign entities, such as Delaware law or Luxembourg law governed limited partnerships.

The co-investments are mostly indirect and are made through several layers of interim fund holding entities, blockers or aggregators. Subject to the size of their investment, co-investors ask for specific governance rights such as board seats, veto rights and specific information rights.

The German foreign direct investment (FDI) regime is among the most active and broadest investment screening regimes in Europe. Its scope covers direct and indirect investments in German businesses, regardless of the sector. The control thresholds which give the German FDI authority, known as the federal Ministry of Economics and Climate Action (BMWK), jurisdiction over an investment are much lower than in merger control. Therefore, even indirect minority investments can be subject to German FDI review and may trigger an obligation to file for FDI clearance.

As a result, minority co-investments may not necessarily fly under the German FDI radar. Due to several peculiarities of the German FDI regime, co-investors and sponsors need to take German FDI implications into account if the investment target includes a German business. Otherwise, closing of the co-investment, and therefore receipt of the co-investor’s funds, may be delayed due to unanticipated German FDI intervention.

Voting rights only, no-look through

In the case of a share deal, generally the German FDI regime only applies if the investment involves the acquisition of voting rights. The acquisition of purely non-voting interest is generally out of the screening scope. In other words, the percentage of acquired equity is not relevant, only the percentage of voting rights. The jurisdictional thresholds, i.e., the percentage of voting rights that allow the BMWK to exercise jurisdiction over an investment, are 10, 20 or 25 percent, depending on the activity of the German business.

However, the crux of the German FDI regime is that a no look-through approach is taken when calculating whether the investment exceeds the relevant jurisdictional threshold. In the case of an indirect investment, i.e., where the co-investor does not directly invest into the German target and non-100 percent holding entities are between the co-investor and the target, the dilutive effect is not taken into account.

The German FDI rules would rather look at each holding level separately to determine if on each such level itself the voting rights exceed the relevant threshold. This rather formalistic approach is not necessarily intuitive and does not correspond to the way the percentage of the co-investor’s stake in the overall investment is calculated from a commercial perspective. As a consequence, while parties may think that a co-investment is below a relevant jurisdictional threshold, German FDI jurisdiction may indeed still apply.

As an example, an EU private equity firm, the Sponsor, envisages to acquire through one of its EU funds a target group, headed by a Luxembourg TopCo and a German wholly owned subsidiary OpCo. Investor A is a non-European Union (EU) entity, participating in the transaction as a co-investor. Investor A’s investment will amount to 9.5 percent of the overall investment amount required to acquire TopCo group. Investor A will have no veto rights or board seats. OpCo carries out activities that would trigger a German mandatory FDI filing for any non-EU investor acquiring 10 percent or more of the voting rights directly or indirectly in OpCo.

Other co-investors will together invest 30.5 percent of the overall investment amount. Investor A and certain other co-investors will invest indirectly into TopCo through jointly held InvestCo, a Luxembourg limited partnership, the general partner of which is controlled by the Sponsor. InvestCo will hold 80 percent of the shares and voting rights in an intermediate Luxembourg Sponsor-controlled entity which will hold 40 percent of shares and voting rights in TopCo. Investor A will hold 29.69 percent of the shares and voting rights of InvestCo. On a look-through basis, Investor A’s participation in OpCo is 9.5 percent and therefore below the relevant jurisdictional threshold of 10 percent.

However, from a German FDI perspective, Investor A is deemed to have exceeded this threshold because it holds more than 10 percent in InvestCo, InvestCo holds more than 10 percent in TopCo and TopCo holds more than 10 percent in OpCo. As a consequence, before consummating its co-investment, Investor A would need to submit a German FDI filing and obtain clearance of its indirect investment in OpCo.

Can co-investors avoid German FDI screening?

One way to dodge a German FDI screening in such cases without lowering the investment amount is to structure the co-investment more directly and separately. If in the above example Investor A uses a separate investment vehicle which it wholly owns (and which could still be managed by a Sponsor-controlled general partner, and this investment vehicle then directly holds the 9.5 percent equity and voting rights in TopCo, the co-investment stays below the 10 percent threshold because the multilayer holding structure requiring a multiplication of the interim holding stake to arrive at 9.5 percent on a look-through basis is avoided.

Should this direct and separate structure for Investor A for any reasons not be feasible, and a more indirect investment structure used instead, another way to avoid German FDI screening is to reduce the voting rights of Investor A on the level of InvestCo to just below 10 percent, while the equity percentage remains unchanged, or to have Investor A acquire purely non-voting shares in InvestCo in the first place.

From a structuring perspective, ideally the non-voting shares are created under the InvestCo’s articles and constitutional documents (e.g., as a separate class of shares) rather than only by way of waiving voting rights of the voting shares under a shareholders’ agreement. A contractual waiver may not be recognised by the BMWK as ‘real’ non-voting shares.

Acquiring voting shares and relying on the arguments that a limited partner (LP) interest would per se carry only very basic voting rights, the limited partnership would be managed by the sponsor-controlled general partner and the investment would therefore be completely ‘passive’ and thus not be subject to FDI scrutiny, is not risk free. The German FDI rules simply refer to voting rights and do not differentiate between the scope of those voting rights.

Therefore, from a German law perspective, generally any right resulting from an equity interest enabling a vote in shareholders’ or partners’ meetings could be a relevant voting right for German FDI purposes. There is no safe harbour under the German FDI rules that would allow a limited partner that exceeds the jurisdictional voting rights threshold to be generally deemed a ‘passive’ investor because it is merely an LP. However, the ‘passiveness’ of an investor could be favourably taken into account in the BMWK’s risk assessment during its review of the investment.

What role do governance rights play?

If the co-investor acquires voting rights and those voting rights stay below the jurisdictional threshold, the BMWK could still have jurisdiction to review the transaction if the co-investor acquires so-called ‘atypical control’, due to the acquisition of: (i) board seats; (ii) veto rights over strategic business or personnel decisions; or (iii) access to sensitive information relevant to public security.

Such atypical control cases do not trigger a mandatory filing. However, if the BMWK determines atypical control is acquired it may have the authority to review the investment ex officio, despite the co-investor acquiring voting rights below the relevant jurisdictional threshold. In order to have jurisdiction, the BMWK would need to argue that the atypical control rights give the investor influence over the target equal to voting rights above the jurisdictional threshold.

To avoid ex officio review, governance rights need to be structured accordingly and board seats, strategic veto rights and certain information rights must be avoided. However, there are no clear guidelines for when such rights constitute atypical control. The BMWK has discretion and makes a case by case assessment. While careful structuring provides a good argument against BMWK jurisdiction, a certain degree of uncertainty can remain.

To further mitigate the ex officio risk arising from relevant governance rights, the co-investment could comprise non-voting shares only. Under the current German FDI rules, atypical control requires the co-investor to acquire at least one voting share alongside the governance rights. Purely contractual governance rights should therefore generally not give the BMWK jurisdiction.

Conclusion and outlook

Minority co-investments can fall into the scope of German FDI screening. However, they can be structured in a way that avoids or mitigates the risk of the applicable German FDI regime. Structuring may have to be reconciled with other aspects, such as tax and governance considerations. Therefore, in co-investments involving a German business, FDI analysis should be made part of the deal structuring as early as possible.

Structuring alternatives will likely narrow in the future. In the course of its evaluation of the German FDI regime, the BMWK has indicated that, in particular, the acquisition of atypical control could in the future be reviewable even if no acquisition of voting rights occurs. As a consequence, mere contractual governance rights could then be sufficient to trigger German FDI jurisdiction over a co-investment.

Mirko von Bieberstein is a partner and Lukas Nigl is an associate at Cleary Gottlieb Steen & Hamilton LLP. Mr von Bieberstein can be contacted on +49 69 97103 204 or by email: mvonbieberstein@cgsh.com. Mr Nigl can be contacted on +49 69 97103 218 or by email: lnigl@cgsh.com.

Mirko von Bieberstein and Lukas Nigl

Cleary Gottlieb Steen & Hamilton LLP