Weaknesses and Strengths of the Framework Conditions for Private Equity Business in Germany

Compared with the major competitive markets, German framework conditions for private equity still leave room for improvement. Some changes, however, are already underway.

Over the past couple of months, some crucial decisions have been taken, for example in the field of taxation, which will increase Germany's ability to attract private equity investments. This is the result of an expertise carried out by the Centre for European Economic Research (ZEW) on behalf of the Federal Ministry of Finance (BMF).

Most private equity funds have their origins in the U.S. or in Great Britain. Since the mid-1990s they have also become increasingly active in Germany. They invest in companies, which they build up or restructure, and then finally resell. Private equity business is risky but - if successful - generates high returns. Framework conditions that improve the risk-return profile of private equity investments therefore increase the attractiveness of a location to financial investors.

From that point of view, changes in the taxation of private equity funds and their investors in Germany (caused in particular by the BMF letters dated December 16 and 23, 2003, as well as by the Venture Capital Promotion Act adopted on July 30, 2004) are welcome. They increase the legal certainty of private equity funds and their investors and, at the same time, substantially improve the fiscal conditions for private equity investments at an international level. That applies to the taxation of carried interest (the increased share of generated profit for private equity managers) and the management fee (remuneration for administering the funds) as well as with regard to the conditions for the fiscal transparency of the funds. On an international scale, German regulations on the taxation of capital gains generated by investors in private equity funds can be considered favourable.

However, there is still a lot of work ahead. Especially the question whether a single private equity fund is to be assessed as private asset management has so far been sorted out retrospectively. For investors it thus remains unclear to what extent their profits will be taxed in the future. Moreover, with regard to tax framework conditions, offset losses and the regulations concerning German shareholder loan financing are rather disadvantageous by international comparison.

Low liquidity on German capital markets and the lack of a segment for the stock market flotation of young firms pose further challenges for a much more widespread application of private equity financing in Germany, since they make it much more difficult to sell shareholdings via the stock market. The pay-as-you-go pension scheme in Germany is a poor breeding ground for pension funds that require private equity companies as financially strong investors. Moreover, inflexibilities in labour markets, the regulation of potential capital providers (especially with regard to quantitative investment limits for insurances), and the remaining bureaucratic impediments for companies negatively affect the activities of private equity funds. However, there have been recent improvements to some of these aspects. Among them, for instance, the strengthening of the second and third pillar of pension provision as well as the deregulation efforts concerning the labour market and bureaucratic impediments for companies.

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Contact

Dr. Tereza Tykvova, Phone: +49/621/1235-147, E-mail: tykvova@zew.de

Dr. Peter Westerheide, Phone: +49/621/1235-142, E-mail: westerheide@zew.de