Classic convertible loans, a popular financing instrument in the venture capital sector, can also be an investment option for private equity investors at a time when attractive equity investments in Germany are very competitive. In particular, in the context of growth investment, which is often akin to venture capital conditions, convertible loans may be a better alternative when further capitalization is sought alongside the main investor (private equity).
From a venture capital perspective, convertible loans are very flexible financing instruments that are often available on short notice and can usually be completed without much effort. Convertible loans can be characterized by a loan component and a conversion component and are usually found in the early stages of the company’s existence, when the parties were still difficult to evaluate their inception.
However, convertible loans are increasingly being used by private equity investors to develop growing investment opportunities. The terms and conditions of the convertible loan must then be adjusted accordingly. This provides different scenarios for investors to consider, such as a leading private equity investor looking for additional investors. In this case, the lead investor will have a concrete idea of their investment that will allow them to let other, more prudent private equity investors make more senior investments for them, allowing for predictable and attractive returns based on a fixed interest rate, plus options. equity investment later. This is even more so if private equity investors replace corporate debt financing, that is often an alternative route to get further funding.
Another example might be a situation where a private equity investor wants to postpone an equity investment decision while also being willing to invest in a more senior instrument with subsequent options for conversion to equity at an attractive conversion rate (via a predetermined internal rate of return).
German banking supervisory regulations, for credit transaction licenses, must be observed for any convertible loan, regardless of whether the loan is provided by venture capitalists or private equity investors. Although convertible bonds do not require such a license, parties often find this alternative too expensive and inflexible.
Such regulatory permit requirements can be avoided if investors have control over the company from a corporate perspective. Such control can be based, for example, on voting agreements or on transfers of share securities. In the latter process, the borrower’s shares would become collateral for the lender and would be sufficient to meet regulatory control requirements, as opposed to a single share pledge, which would only provide collateral but no control.
Of course, such control is not often desired by the parties, but there may be situations where shareholders believe in the growth of their business and are therefore willing to accept the transfer of such guarantees to enable the company’s next step in growth.
With regards to adaptation of convertible loans, private equity investors want to retain as much freedom as possible. In addition, investors will expect to be able to convert at any time, to exclude discontinuation by the company and, even in the event of a major investor’s exit, to be paid or still allowed to convert. Unlike in the case of venture capital, the company’s conversion or valuation is not based on the next round of financing (including potential discount or valuation limits) but on the pre-agreed internal rate of return of the primary investor’s equity investment or, alternatively, the pre-approved internal rate of return of instruments that can be converted in case of conversion.
In addition, private equity investors will request certain veto rights that can be supported by small equity participation, allowing appropriate minority protection rights in shareholder meetings for investors. Finally, especially in the case of foreign private equity investors, a common “gross tax” on financing can be included in the documentation.
Interest in the growth sector in Germany is growing and will continue to grow. Private equity investors are increasingly investing in the growth sector in part because of high competition for mature companies and attractive business models. Convertible instruments are a good vehicle for investing in this area which is characterized by a higher risk of reducing structural exposure.
Foot on the door
Throughout 2021, we expect private equity investors to use the convertible loan situation as an additional option to enter attractive target company doors even if the current situation / valuation does not (yet) allow direct equity investment.
From a corporate perspective, we feel this arrangement could also be a good option for avoiding debt financing by banks at an early stage, which usually provides for a stricter regime in terms of agreements.
Dr. Nikolaus von Jacobs is a partner and Matthias Weingut is a partner focused on private equity as well as mergers and acquisitions at law firm McDermott Will & Emery in Munich.