Venture Capital and Private Equity
2007 Butterworths Journal of International Banking and Financial Law, n.º 6
Venture capital and private equity financing has proven its importance to the Spanish financial market both in terms of volume financed and beneficial effect on the economy.
In relation to volume, Spain has been one of the most active European countries in venture capital and private equity, behind only Britain and France, and at the same level as Germany and Italy. According to the Spanish Association of Private Equity Entities (ASCRI), since 1986 EUR 13.42 billion has been invested in a total of 3,381 firms in Spain. This investment has been steadily increasing from 2001 to 2005 when it totalled EUR 4.118 billion.
Venture capital and private equities have made a great contribution to the Spanish economy. A recent survey made by ASCRI pinpoints two empirical findings that show how this kind of investment has been beneficial to the overall economy:
- Venture capital or private equity backed firms created employment at a much faster rate than other firms. Their aggregate workforce showed an average annual growth of 14.7%, against the 5.7% recorded in the group of comparable firms which had no venture capital or private equity backing.
- Venture capital or private equity backed firms grew more quickly than other firms. Their sales volume and gross margin showed an average annual rise of 24.7%, compared to 9% recorded in the group of comparable firms which had no venture capital or private equity backing.
The SPANISH LEGAL FRAMEWORK
The development of venture capital and private equity activities in Spain has been made in tandem with the enactment of modern legislation. During the eighties and nineties, although venture capital and private equity were only partially regulated, several tax, substantive and regulatory provisions existed. Only in 1999 the first complete Spanish regulation on venture capital and private equity was enacted. While this law was welcomed by the venture capital and private equity sector, it contained some significant constraints and, for better or worse, its implementing regulations were never fully enacted. To keep up with the evolution of the Spanish market and assist in the development of this kind of investment, in 2005 the Spanish Government integrally revised the legal regime applicable to venture capital and private equity and enacted Law 25/2005 (the “New PE Law”).
Benefits of the New PE Law
The New PE Law has been considered very useful by market operators in engendering a greater development of venture capital and private equity activities and entities (“PE Entities”). In particular, the New PE Law has been praised for:
- Providing more flexibility to the rules governing the investment of the funds raised by PE Entities.
- Simplifying the regulatory obligations and requirements applicable to PE Entities.
- Regulating new types of entities, such as PE Entities of PE Entities.
- Maintaining a very favourable tax system for venture capital and private equity investments.
PE Entities are defined under the New PE Law as those financial entities whose main purpose is the investment, on a temporary basis, in the share capital of companies which fulfil the following requirements (“Eligible Companies”):
- non-financial companies (i.e., banks, mutual funds, insurance companies, etc., are excluded), although the investment in holding companies of non financial ventures is permitted;
- non-real estate companies, although PE Entities may acquire companies with more than 50% of their assets being real estate provided that at least 85% of such assets are used for the purposes of carrying out an economic activity; and
- companies not listed in a primary stock exchange market, although PE Entities may acquire listed companies provided that such companies are de-listed within the 12 months following the acquisition.
The New PE Law expressly states that the investments made by PE Entities must be temporary but does not determine minimum and maximum time limits for those investments. However, a tax incentive exists which supports the temporary nature of PE Entities’ investments: tax benefits enjoyed by PE Entities, as it is explained below, only apply to investments that are held for less than certain provided time limits.
PE Entities are also entitled to carry out ancillary activities, such as providing advice to Eligible Companies, granting profit-sharing loans (préstamos participativos), and extending other types of financing to Eligible Companies held in their investment portfolio.
PE Entities and PE Entity management companies are not authorized to perform any other activities.
TYPES of PE Entities
Corporations and Funds
PE Entities may provide the form of corporations or funds.
In the first case, PE Entities are established as a corporation and managed by their own corporate bodies or, when the management is delegated in the by-laws, by a PE Entities’ management company.
Regarding PE Entities established as a fund, a management company will always manage the PE Entity on their behalf. The liability of the investors in this kind of funds is limited to their contributions to the PE Entity and, conversely, the creditors of the investors or the management company have no recourse against the fund.
Companies which qualify as management companies of PE Entities are mutual fund management companies, companies authorised to manage investments on a discretional basis, and those other corporations specifically authorised by the CNMV to manage PE Entities. Management companies are allowed to sub-delegate the management of the PE Entities’ investment portfolio. Management companies will remain liable for any damage caused by the delegate manager, except when such sub-delegation was required by the PE Entity.
Simplified and Ordinary Regime
The New PE Law provides a two-pronged regime that may be chosen upon the inception of the PE Entity: an ordinary legal regime and a simplified legal regime.
The ordinary legal regime is applicable to all PE Entities that do not qualify and apply for the simplified legal regime. The simplified legal regime is designed for those kind of investors, such as professional, sophisticated or institutional investors, that require less protection in comparison to non-professional investors. To qualify for the simplified legal regime, a PE Entity must comply with the following requirements:
- The PE Entity does not raise funds through the public distribution of its shares or stakes;
- Investors (other than institutional investors and the PE Entity’s managers, officers and employees) shall commit an investment of EUR 500,000 or more; and
- The number of investors does not exceed 20 (excluding institutional investors and directors, managers and employees of the entity or of its management company).
In any event, whether subject to the ordinary or the simplified system, PE Entities must obtain the prior authorisation from the Comisión Nacional del Mercado de Valores (“CNMV”), the Spanish securities regulator. The CNMV must grant the authorisation unless the legal requirements are not met (i.e., minimum capital requirements, management and accounting organisation, management experience, etc.) or the supervision of the PE Entity cannot be guaranteed (i.e., when the PE Entity group lacks transparency or when there may be difficulties in inspecting the PE Entity). In the event that the CNMV does not expressly grant this authorisation or deny it within the legally established term, the request for authorisation of a PE Entity subject to the ordinary system will be considered rejected. Conversely, the request for authorisation of a PE Entity subject to the simplified system will be considered granted if the CNMV does not expressly reject the authorisation within the legally established term.
The CNMV has supervisory powers over the PE Entities that include the authority to approve the amendment of the constitutional documents (other than certain changes that only require ex post notice to the CNMV, i.e., change of domiciles, etc), revoke the authorisation in certain given cases (i.e., breach of conditions imposed in the authorisation, insolvency, misconduct, etc), and to oversee the periodical information submitted by the PE Entities (namely, annually audited financial statements and management accounts).
Mandatory Investment Coefficient
PE Entities are not completely free to choose how to invest 60% of its eligible assets (the “Mandatory Coefficient”).
The general rule is that the Mandatory Coefficient shall be invested in Eligible Companies, by purchasing shares or convertibles issued by such companies.
Notwithstanding the foregoing:
- up to 50% of the Mandatory Coefficient may be invested by granting profit-sharing loans to Eligible Companies; and
- up to one third of the Mandatory Coefficient may be invested in other Spanish PE Entities and certain foreign PE Entities (i.e., PE Entities domiciled in an OECD Member State), provided that the target PE Entities have not invested more than 10% of their eligible assets in other PE Entities.
- all or part of the Mandatory Coefficient may be invested in companies listed or negotiated in a Spanish or foreign stock market specialised in small and medium size companies (such as the Spanish Alternative Stock Market or the London Alternative Investment Market), provided that the foreign stock market is not located in a tax haven.
The New PE Law provides limited temporary relief for breaches of the Mandatory Coefficient, namely:
- a general relief of the Mandatory Coefficient is granted during the three years immediately following the registration of the PE Entity with the CNMV;
- a 24 month relief of the Mandatory Coefficient is granted after a PE Entity makes a significant divestment;
- a 24 month relief of the Mandatory Coefficient is granted after a non-mandatory capital increase made by any PE Entity established as a corporation;
- discretionary relief of the Mandatory Coefficient may be granted by the CNMV, at the PE Entity request based on market conditions; and
- investments made in companies that, subsequently, go public, qualify for the Mandatory Coefficient for a period of 3 years thereafter.
Free Investment Coefficient
Subject to the compliance with the Mandatory Coefficient, PE Entities’ may invest the rest of their assets in other instruments defined by the New PE Law, namely:
- debt instruments negotiated in regulated or secondary markets;
- shareholdings in non-Eligible Companies (including mutual funds and other PE Entities that do not comply with the requirements set out for the Mandatory Coefficient);
- profit-sharing loans;
- any type of financing to Eligible Companies held in their investment portfolio; and
- in the case of PE Entities established as corporations, up to 20% of their share capital in fixed assets required to conduct their business.
An additional rule regarding investments is the obligation to diversify the investments.
PE Entities established under the ordinary legal regime may not invest more than 25% of their eligible assets in the same company, or more than 35% in companies belonging to the same group.
PE Entities subject to the simplified system may not invest more than 40% of their eligible assets in the same company or group of companies.
In addition, PE Entities are not allowed to invest more than 25% of their eligible assets in companies belonging to the same group of the PE Entity or of its management company. These investments are subject to specific authorisation in the constitutional documents of the PE Entity, to the establishment of formal mechanisms to avoid conflict of interests, and to periodical reporting obligations.
Incomes obtained by the PE Entities through the transfer of their stake in Eligible Companies will benefit from an exemption of 99% of the corporate tax provided that the transfer is executed from the second to the fifteenth year following the acquisition of the stake.
An additional requisite, in the event that the company in which the PE Entity holds its stake is listed in a securities market set out in Directive 2004/39/CEE, is that the transfer of the stake is executed within a period of three years from the date on which the company was listed.
In general, dividends obtained by the PE Entities from their stake in Eligible Companies are exempt from corporate tax, regardless of the shareholding percentage and the moment when the stake was acquired. On the contrary, the interests accrued on the amounts lent by the PE Entities through profit-sharing loans do not benefit from the special tax provisions introduced by the New PE Law.
In relation to taxation of the proceeds gained by the shareholders or unit holders of the PE Entities through dividends or through the sale of their stake:
- non-resident persons without a permanent establishment in Spain will not be subject to taxation in Spain, except if the income is obtained from a tax haven;
- Spanish companies, in general, are not subject to corporate tax on the dividends, and the income obtained through the sale of their stake will benefit from a deduction to prevent double taxation; and
- there are no special benefits or deductions for Spanish individuals.
PE Entities of PE Entities
PE Entities of PE Entities must invest at least 50% of their Mandatory Coefficient in other Spanish PE Entities, or in other foreign PE Entities domiciled in an OECD Member State. Along with the diversification requirements set forth for any other PE Entity, PE Entities of PE Entities cannot invest more than 40% of their assets in a single Spanish or foreign entity. Finally, the target PE Entities should not have invested more than 10% of their eligible assets in other PE Entities.
The New PE Law has been in force for only one year. It is certainly too early to assess its real impact and whether or not it assists in the growth of the Spanish venture capital and private equity industry. In fact, some important parts of the legal regime, such as important elements to calculate the Mandatory Coefficient, are yet to be defined by the implementing regulations. One fact is, however, certain. During 2005, only 35% of the venture capital and private equity investment was funnelled through Spanish PE Entities. In 2006 that trend almost reversed, with only 36% of the total investment made by international PE Entities. In that same year, almost 50 new PE Entities were registered with the CNMV, which a significant number if compared to the 221 PE Entities that were licensed in Spain by the end of 2006. Last month, a PE Entity of PE Entities began trading for the first time in the novel Alternative Stock Market (MAB), while some other market players announced their intention to follow suit shortly. Conversely, the venture capital and private equity investment has fallen from EUR 4.11 billion in 2005 to EUR 2.71 billion in 2006. The number of closed transactions has boomed, however, to 612, a fact that, if considered jointly with the increase of Spanish PE Entities, reflects the fact that the development of a local venture capital and private equity industry benefits small caps, usually neglected by international investors. All in all, the launch of the New PE Law appears to be auspicious indeed, and, market conditions permitting, it is expected to reinforce an industry that was already bolstering in Spain.