Challenging market environment

Despite the sustained level of activity, the M&A market environment in Germany faced several challenges in 2023. Geopolitical conflicts and persistently high energy prices influenced strategic purchasing decisions. Rising inflation and persistently high interest rates represented additional burdens. The partial decoupling of global supply chains and the intended onshoring of production was another key M&A driver. Despite these challenges, Germany remained an attractive target for national and international corporate buyers.

Stronger focus on buy and build strategies

Against increased financing costs, buy-and-build strategies have become increasingly popular, especially among financial investors. A buy-and-build strategy aims to grow through the acquisition and integration of companies in similar sectors or markets. The advantage is usually that faster growth is achieved than would be possible through purely organic growth. For example, an increase in market share can be achieved by acquiring competitors. Another advantage is that synergies can often be utilised through the combination of several smaller companies by pooling resources and purchasing or enabling access to new markets. This can lead to considerable cost savings. Such a strategy also serves to spread risk by expanding into different business areas or geographical markets. The biggest challenge is the post-M&A integration of the individual add-on targets and the realisation of the intended platform synergies.

Binding through participation

A key aspect of buy and build strategies is the retention of management and executives in the group. If the sellers are to remain in the company management as future external managing directors, it is often intended that they continue to participate in the success of the company by means of reverse shareholding. Such management participation models offer high-value enhancement potential for company management and corresponding incentive effects.

Legally, such investments are often pooled in a partnership structure with unlimited and limited liable partners (“Kommanditgesellschaft”, “KG”), where the unlimited liable partner is a corporation (“GmbH & Co. KG”). Typically, the partnership agreement also provides for agreements in the event of the manager leaving the company (good or bad leaver) and for drag-along/tag-along rights in the event of an exit.

From a tax perspective, such employee participation models can have an impact both at the level of the company and the participating manager, whereby the aim is often for the potential proceeds from the participation program to qualify as so-called income from capital assets and thus be subject to the favourable taxation of the flat-rate or partial income procedure.

For classification as income from capital assets, beneficial ownership of the investment must be transferred to the manager (or his investment vehicle). In principle, the market value should be paid by the manager as consideration for the investment. In a recent decision, the BFH has fortunately also provided further legal certainty by clarifying that even a discounted transfer of management participation (i.e. below the market value) can generally only lead to taxation of the difference in value at the time of the participation, but not about capital gains realised later. This means that in this case the capital gain is taxed as income from capital assets with favourable tax treatment.

Alternatively, there are employee participation programs in which no capital participation is subscribed, but which are concluded purely on a contractual basis between the employee and employer (often referred to as virtual participation). The legal advantage of these programs is that they can be structured much more flexibly. For tax purposes, however, the income generated from this is clearly classified as wages.

AI and technologies in transaction advisory

2023 also saw a further increase in the use of technology in transaction consulting. Tool solutions are increasingly being used, particularly for due diligence reviews and documentation management, which make data selection and analysis as well as the associated risk assessment considerably easier. Buyers are also increasingly using technical solutions to facilitate the necessary integration and post-acquisition investment management. To this end, IT due diligence is increasingly being carried out before acquisition to assess the data information situation and, of course, to check the software structure of the target company.

Tax risk insurance

In addition to warranty and indemnity (W&I) insurance, which is often used as standard in purchase agreements, tax risk insurance is now also increasingly used in the transaction environment. This type of tax risk insurance can cover risks relating to an unclear legal situation. Such an insurance solution is of interest when a high potential tax loss is involved but is unlikely to materialise. By explaining the facts of the case, the providers of tax risk insurance determine relatively quickly the amount of the insurance premium to be paid so that the successful conclusion of an M&A transaction is not delayed.

ESG is gaining in importance

Last but not least, the topic of sustainability (environmental, social, governance - ESG) is becoming increasingly important for buyers. ESG reporting obligations that apply to the buyer (either as part of a non-financial reporting obligation or as a contractual obligation towards banks and other lenders) also require the target company to assess these aspects. In addition to legal, tax, and financial due diligence, ESG due diligence is therefore increasingly being carried out to analyse sustainability aspects.

Conclusion

The M&A market in Germany remains robust despite the difficult market conditions. Additional new trends are those reflecting the new market conditions in transaction structures. Topics such as ESG, employee retention, and synergy gains are becoming more relevant. There are new legal and tax-related stumbling blocks, but these can be overcome with a clever transaction structure.