Pitfalls with debt-financed transactions

​The extent to which the existing financing liabilities are to be or can be redeemed as part of the transaction must be determined in advance as part of the due diligence. The redemption of the existing financing of the target company can be influenced on the one hand by the interests of the buyer, particularly if existing financing is to be replaced by the buyer's own financing with more favorable conditions. In this respect, it must first be clarified whether this is contractually possible or possible following negotiations with the existing financing party. On the other hand, it is possible that the target company has attractive debt financing, but such financing will be cancelled as a result of the transaction. This ap-plies in particular if the change of ownership of the target company, i.e. a change of control and corresponding clauses, threatens to result in cancellation by the existing financing party. At best, this should be clarified in consultation with the financing party, otherwise the existing financing of the target company may suddenly be cancelled. From the buyer's perspective, the bank should be approached as early as possible. As a rule, the seller will be rather hesitant and only allow contact to be made and the transaction process to be disclosed to its own bank if there is a high level of transaction security, i.e. only after signing and before closing.

​Once it has been determined that existing financial liabilities need to be repaid, the next step is to decide how this can be realized in a practical manner. Here, conflicting interests often clash. The seller usually has no interest in initiating new debt financing for the target company. This applies equally to the existing management if it will resign from the target company upon completion of the transaction. Conversely, the buyer wants to acquire an adequately capitalized company. If a change of management is intended as part of the transaction, the financing documentation can also be signed by the future management, whereby it should be noted that the appointment of the new management may take place shortly before completion - with strict internal guidelines - or may be obtained from the current management via comprehensive indemnification obligations. 

Thus, it is common practice that debt financing can be utilized at the same time or, at best, separated by a logical second with the execution of the purchase agreement; for the respective documentation, a kind of automatism must then be provided for via linked conditions precedent, which makes it possible to disburse the funds to pay the purchase price and redeem existing liabilities, thereby simultaneously redeeming the existing collateral and (in turn simultaneously) making new collateral effective. This must be agreed in due time with the financing parties involved. 

Alternatively, it is possible that the debt financing is granted by the acquisition company and the target company can draw on financial resources via the acquisition company upon closing of the transaction. The acquisition company leaves the resulting repayment claim against the target company as a shareholder loan. 

​Financing parties are regularly unwilling to provide financial resources without receiving sufficient collateral. As the often used acquisition company itself does not have extensive assets and is therefore not capable to provide collateral, lenders generally demand substantial collateral or access rights in relation to the target company and any subsidiaries, which may often hold the main assets in the acquisition of groups. 

For example, the pledging of shares in the target company and other assets or the granting of guarantees between the companies may be considered. In this case, it may be required that the subsidiaries provide ascending collateral to the acquired parent company ("up-stream"). The aim is to mitigate the structural subordination of the bank to the direct creditors resulting from the shareholder position. 

However, the relevant capital maintenance regulations must be observed. In the case of a GmbH, for example, the assets required to maintain the share capital may not be disbursed to the shareholders. In the case of a public limited company, any so-called "financial assis-tance", i.e. measures to realize the acquisition of shares in this company, is critical anyway.

In practice, this problem can be solved in several ways. For instance, restriction clauses ("limitation language") can be used to prevent the net assets of the GmbH from falling below the share capital amount when the collateral is provided or realized, depending on the type of collateral. However, this in turn can reduce the value of the collateral provided to such an extent that further measures (e.g. debt push) are required to improve the position of the lenders.

Another possible solution is the conclusion of a domination or profit and loss transfer agreement between the acquisition company and the target company immediately after completion. Pursuant to section 30 para. 1 sentence 2 German Limited Liability Companies Act (GmbHG), a payment can then be made to the shareholders. However, it must be considered that the legal situation has not been conclusively clarified. According to the predominant position, the exception to capital maintenance is only granted based on the loss compensation claim contained as part of the intercompany agreement. The management is obliged to continuously review whether such an intercompany agreement may have to be terminated for cause if it is foreseeable that the controlling company will not be able to compensate for any losses. Consequently, the controlling company must have sufficient creditworthiness in order for the dependent company to be able to invoke the exception in section 30 para. 1 sentence 2 GmbHG.