A de Lamotte - Master thesis KUL

i

KATHOLIEKE UNIVERSITEIT LEUVEN
FACULTY OF LAW
Academic year 2013-2014
Private Equity: fiscal and financial regulations of the use of debt in
Leveraged Buyouts
Supervisor: Veerle COLAERT
Master’s thesis, submitted by Aymeric DE LAMOTTE as part of the
final examination for the degree of MASTER OF LAW

ii

KATHOLIEKE UNIVERSITEIT LEUVEN
FACULTY OF LAW
Academic year 2013-2014
Private Equity: fiscal and financial regulations of the use of debt in
Leveraged Buyouts
Supervisor: Veerle COLAERT
Master’s thesis, submitted by Aymeric DE LAMOTTE as part of the
final examination for the degree of MASTER OF LAW

iii

Summary:
This work analyzes the fiscal and financial rules that limit the excess of debt in the European
Union as well as in four specific countries (Belgium, France, the United Kingdom and Germany –
only for the fiscal rules-). The first part of the work gathers and describes economic literature that
leads to the conclusion that the excessive use of debt in LBO’s transactions may lead to sales of
assets and layoffs. It appears that there is a social need to frame the debt. To do so, this work
operates a comparative analysis of fiscal and financial rules. First, national interest deduction
limitations are analyzed and compared. It appears that the German rule has nowadays the biggest
impact on debt into buyouts transactions. In the second part of the work, European and national
financial legislation mainly focuses on two mechanisms that use debt in a specific way: debt
pushdown and dividend recapitalization. First, rules on distribution of dividends are described and
compared. It appears that the new asset-stripping rule of the AIFMD restricts faintly the actual
rules and thus the aforementioned operations. This work sheds the hypothesis that limiting the
capital exhaustion indirectly affects the financial leverage. Secondly, European and national rules
of financial assistance are explained and compared. It appears that in France and Belgium, debt
pushdowns do not enter in the scope of the legal regime. Therefore, this rule will not indirectly
affect the use of debt.
Acknowledgments:
I sincerely want to thank my supervisor Veerle Colaert that has been following my work for a year.
She remained very available and encouraging throughout the all process of my thesis despite the
questionable quality of certain drafts. She gave me very relevant advice when I needed them. I also
want to thank Alan Ryan, Etienne Dessy and Jean-Marie Laurent-Josi for their useful comments.

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Table of Contents
Introduction………………………………………………………………………………...……..1
Chapter I – Definition and context of LBOs…………………………………………………..…...2
Section I –What is a Leveraged Buyout? ………………….……………………………..….2
Section II – International, European and national evolution……………………………...…2
Section III – Characteristics of LBO booms………………………………………................4
Section IV – The financial and fiscal leverage……………………………………................5
Sub-section I – The financial leverage……………………………………………….....5
Sub-section II – The fiscal leverage: A tax incentive…………………………………..7
Section V – Do the legal and economic cultures affect the evolution? ……………………10
Chapter II – The high level of debt: One of the causes of sales of assets and layoffs……………13
Section I - Introduction………………………………………………………….……….....13
Section II – The role of debt in financial distress
buyouts…………………………………13
Section III – The role of private equity funds in financial distress
buyouts……………......16
Section IV – The resolution of financial distress…………………………………………...18
Sub-section I – Introduction………………………………………………...................18
Sub-section II – Financial restructuring and corporate restructuring…….……………18
A – Debt restructuring and asset restructuring…………………………………......18
(i) Introduction…………………………………………………………18
(ii) Debt restructuring…………………………………………………...19
(iii) Asset restructuring…………………………………………...……...19

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B – Layoffs associates with asset sales……………………………………………..21
C – Layoffs…………………………………………………………………………22
Chapter III – National fiscal rules to regulate debt.……………………………………………....27
Section I - Introduction……………………………………………………………..............27
Section II – European legislation…………………………………………………………...27
Section III – National thin-capitalisation rules or interest deduction limitations…..............28
Sub-section I – The United Kingdom………………………………………………....28
Sub-section II – France…………………………………………………………..........30
Sub-section III – Germany…………………………………………………….............34
Sub-section IV – Belgium…………………………………………………………......36
Section V - Conclusion……………………………………………………………......36
Chapter IV – Post-acquisition techniques that increase the level of debt: Dividend recapitalisations
and debt pushdowns………………………………………………………………….…………….37
Section I – Dividend recapitalisation……………………………………………………….37
Section II – Debt pushdown…….…………………………………………………………..39
Section III – The legal regime of the distribution of dividends…………………………….41
Sub-section I – The second company law Directive…………………………..............41
Sub-section II – The national legal framework………………………………..............42
A – The United Kingdom.……………………………………………………….....42
B – France………………………………………………………………..................43
C – Belgium………………..……………………………………………………….44
D – Conclusion…………………………………………………….……….............45

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Sub-section III - Alternative Investment Fund Managers’ Directive: Asset stripping
rule………………………………………………………………………………………………….46
A – Personal and territorial scope of the directive………………………………….46
B – Article 30 of the AIFMD – Asset stripping rule……………………………….47
C – The purpose of the rule and its real impact on asset stripping…………………49
D – Impact of the rule on the legal system and on the two operations……..............49
Section IV – The legal regime of financial assistance……………………………………...51
Sub-section I – The European evolution………………………………………………51
Sub-section I – United Kingdom………………………………………………….......51
Sub-section II – France……………………………………………………………….52
Sub-section III – Belgium………………………………………………….….............53
Sub-section IV – Conclusion……………………………… …………………………55
Conclusion…………………………………...…………………………………………………….56
Bibliography…………………………………...………………………………….…....….............59
Annexes…………………………….……………………………………..………………………..68

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Introduction
“Some LBOs have put a lot of people out of work who probably would still have jobs if their (their
companies) had not been subjected to such leverage. When you take eighty percent of the equity out
of the business and replace it with debt, you have very very little margin for error”. (Nicholas
Brady -Former Reagan and Bush Treasury secretary-)
Research question: How can fiscal and financial rules limit the excessive use of debt in LBO’s?
Methodology: The first part of the work introduces the private equity industry and explains
specifically the financial structure of leveraged Buyouts and how fiscal incentives render debt so
attractive. Furthermore, the legal and economical cultures of European countries do not seem to
influence the development and evolution of the private equity industry. The second part gathers and
describes economic literature that leads to the conclusion that the excess use of debt in LBO’s
transactions may lead to sales of assets and layoffs. It appears that there is a social need to frame the
debt. But what are the legal ways to do so? This work focuses on fiscal and financial rules and tries
to assess how they limit the excessive use of debt in LBO’s. The research will be mainly based on a
comparative analysis of law between France, Belgium, the United Kingdom and Germany – only
for the fiscal rules -. When the rules are oversee by European law, the later will be obviously
decribed. The third part of the work will focus on the available interests deduction limitations in the
aforementioned countries. A comparison and assessment of the rules will be made. The fourth part
is devoted to two financial practices – dividends recapitalisations and debt pushdowns – often used
in the framework of leveraged buyouts and make a specific use of debt. Abusively used, they may
jeopardize the company. European and national legislation of the distribution of dividends will be
analyzed and their impact on the two aforementioned operations will be assessed. Finally, the work
focuses on the European and national legislation governing the financial assistance. It will be
assessed whether financial assistance restricts the use of debt pushdowns.

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Chapter I – Definition and evolution of LBOs
Section I – What is a Leveraged Buyout?
Firstly, it is fundamental to define the topic on which this work is based. A Leveraged
Buyout is a financial transaction used, inter alia, by private equity firms1
, which allows one of
several people, the retakers, to acquire a holding (the targeted company). For this purpose, they
produce legal leverage by creating a special purpose vehicle in the form of a holding called a
Newco (new company). This holding will gather a substantial amount of debt in order to finance the
purchase of the company. An LBO’s particularity is to finance the majority of the purchase of a
company through bonds or loans, ensuring a higher return on the buyer’s own capital. The financing
is therefore comprised of a large amount of debt and some equity2
. With the dividends and the
newly bought cash flow of the company, the debt is progressively reimbursed. When the private
equity firm wants to realise its investment, it can sell the company to another commercial or private
equity firm3
. A LBO is constituted of three types of leverage, namely legal leverage, financial
leverage and fiscal leverage4
.
Section II – International, European and national evolution
The LBO market first began in the United States in the 1960s5
. It progressively made its
way to every member of the European Union except France, the United Kingdom and the
Netherlands, where it remained largely undeveloped until 19966
. In Western Europe, there were 900
buyout/buy-in transactions totalling 20 billion EUR at the peak of the first buyout boom in 1989,
whereas there were only 1400 transactions yielding 140 billion EUR at the peak of the third LBO
boom in 2006. One can see that, proportionally, the number of transactions had not risen
dramatically compared to the value of the transactions. This amount was particularly concentrated

1
This work focuses only on the private equity context and, more specifically, on LBOs undertaken by private equity
firms. Europe comprises more or less 100 active private equity funds that dealing intensively with Leverage Buyouts,
including BC Partners, Bridgepoint, CVC and Wendel, whereas other famous names, such as Apollo, Blackstone and
Carlyle, are American.

2
E Ferran, “Regulation of Private Equity-Backed Leveraged Buyout Activity in Europe”, European Corporate
Governance Institute, Law Working Paper N°84/2007, May 2007, p. 2.
3
E Ferran, ibidem, p. 2.
4
F Lefebvre, LBO: juridique, fiscal, social, Editions Francis Lefebvre, Levallois, 2012, p.
5
The expression LBO was invented during this period by Victor Posner, a rich American businessman.
6
N. Ménard, “La pratique du Leveraged Buy-Out dans l’Union Européenne”, Master 2 professionnel – opérations et
fiscalité internationales des sociétés, Année universitaire 2012-2013, Université Panthéon-Sorbonne-Paris I, Paris, p. 8.

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in the UK, Germany and France,7
and represented approximately ¼ of the worldwide market,8
which was mainly active in the United States. The biggest transactions were American, such as
those of Goldman Sachs and TPG, which acquired Alltel Communications for $39, 6 billion in
2007, and of Goldman Sachs, KKR and TPG, which acquired Energy Future Holdings Corporation
for $42 billion in 20079
.
This evolution has experienced three serious booms and busts10
. The first boom occurred
between 1985 and 1989, and collapsed in the late 1980s and very early 1990s. In the United States,
the volume fell from $88 billion in 1988 to $7, 5 billion in 1991, which is a fall of more than 90%11
.
It took both European and American markets at least seven years for the LBO market to exceed the
total value reached in 198912
. The second boom and collapse took place between 1997 and 2001
with the Internet bubble. In addition, there was an incomparably sharp increase in only two years,
between 2003 and 2005. Although there were approximately the same number of transactions, the
total amount went from 70 billion EUR to 140 billion EUR, a figure twice as large in the space of
just two years. The years 2005-2007 experienced the biggest transactions that the sector has ever
seen. However, in Europe, the private equity industry did not penetrate European economies
equally. For instance, in 2006, Sweden, the Netherlands and the UK’s private equity investment
represented more than 1 percentage point of the GDP13
. This is a considerable amount, considering
that the total investment represents 20% of the GDP in advanced European countries14
.
With the subprime crisis, the private equity industry has fallen sharply, down from a total
value of 180 billion EUR in 1007 to 20 billion EUR in 2009. However, it is interesting to note that
LBO transactions doubled between 2009 and 2010. Although the activity has not reached the
numbers of the pre-crisis period, 2011, 2012 and 2013 have shown a clear regain of activity. The
biggest transactions have continued to occur on the American market15
. So why is the activity still

7
E Ferran, op. cit., p. 2.
8
500 billion.
9
Moody’s Global Corporate Finance, “$640 Billion and 640 Days Later”, special comment, November 2009, p. 9.
10
See annex 1 for the evolution in Western Europe.
11
S Kaplan and J Stein, “The evolution of buyout pricing and financial structure in the 1980s”, The Quarterly Journal
of Economics, Oxford University Press, Vol. 108, N°2, May 1993, p. 34.
12
See annexes 1 and 3.
13
See annex 2.
14
A Watt, “The impact of private equity on European companies and workers: Key issues and a review of the
evidence”, Industrial Relations Journal, 2008, n°39:6, p. 552.
15
J Pama, “Quel avenir pour les LBOs”, Les Echos.fr, November 2011, retrieved 18 May 2013.

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shy, more than six years after the crisis? Three main reasons can be observed. Firstly, the new
banking directions, ‘Basel III’, force banks to improve control of their liquidity and to strengthen
their lending rules. Secondly, the famous ‘wall of debt’ and the debts coming to maturity are still a
major concern. Linklaters published a report saying that, according to the data produced by
Dealogic, the debt that is due to mature in the European Union between 2012 and 2016 is
approximately $550 billion16
. 2014 is an important year, because it represents “the critical point” of
the wall of debt, with $140 billion arriving at maturity. Finally, the sovereign debt and the financial
crisis of the Eurozone do not create a climate of trust for LBO activity17
.
Section III – Characteristics of the LBO booms
Firstly, the two most important LBO booms18
presented cheap access to debt. As one of the
managers of Carlyle once said, “Cheap debt is the rocket fuel. Try to get as much as you can, as
cheaply as you can and as flexible as you can”19
. Without debt, LBOs can simply not exist. In both
periods, there was abundant liquidity on the credit market and low interest rates. While the LBO
rise of 1985 was helped by the development of the junk bond market, the third LBO period
experienced a generous credit market with low interest rates from 2003 until the start of the collapse
of the subprime market in June of 2007. For instance, in 2006, of the $233 billion in LBO loans,
banks financed $133 billion. However, the covenants between the borrowers and the banks were
stricter during the first LBO boom than they were during the third one, which might explain the still
unpaid ‘wall of debt’.
Secondly, as we have seen, the average value of the transactions was higher20
and was also
more risky than it was in other periods. Thomson One Banker analysed all the LBO transactions
worldwide that were valued at more than $10 million over the period 1985-2006, and calculated the
ratio of EBITDA to capital for each year during the entire 21-year period. One can easily see that
the lowest ratios of EBITDA to capital (enterprise value) occur precisely during the boom periods

16
Linklaters, Negotiating Europe’s LBO debt mountain, 2012, p. 1.
17
Linklaters, ibid., p. 1.
18
The first and the third aforementioned.
19
P Thomas, LBO: Montages à effet de levier – Private Equity, 2ème edition, Paris, 2012, 79.
20
This affirmation is true in the United States, in which the market was much more developed. The 1980s saw the birth
of LBOs in Europe.

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of 1989, with a ratio of 11%, and between 2005 and 2006, with a ratio of 10%. These ratios mean
that the prices of the transactions are nine times higher than the EBITDA21
. Furthermore, part of the
debt of the acquisition price was also higher. Ulf Axelson, Tim Jenkinson, Per Stromberg and
Michael Weisbach examined 153 buyouts by five top private equity firms in eight countries (the
USA, Canada and European countries) over the period from 1980 to 200622
and found that the total
debt to capital ratio equalled 73% for transactions in 2004-2006 and 77% for the period between
1985-1989, whereas the other periods varied between 62-65%23
.
Section IV – The financial and fiscal leverage
Sub-section – The financial leverage
The holding (Newco) created by a private equity fund finances the acquisition of the target
company’s shares by using equity and debt.
Equity comes from the fund itself or from private investors that have given money to the fund
because they believe in the project and are expecting high returns from it. Normally, the equity
represents 30 to 50% of the total financing but, during the prosperous period of equity, this was
closer to 10-20%.
Debt is the central theme of this work and is an extremely complex topic, as the entire
operation is based on the use of debt. During the golden period of private equity, certain buyouts
were leveraged up to 90% of the total price. While the organisation of debt can be very simple for
small purchases (less than 10M euros) and can be issued by one specific bank, it can also be more
complex and can be divided into different categories. Generally, in this kind of financial package,
there are different levels of financing with increasing risk levels. There are two main kinds of debt
of varying importance, senior debt and subordinated debt.
Firstly, senior debt constitutes the classic debt contracted with a bank that will be reimbursed

21
VV Acharya, J Franks and H Servaes, “Private Equity: Boom and Bust?”, Journal of Applied Corporate Finance, vol.
19 n°4, Fall 2007, p. 5; see annex 3.
22
U Axelson et al., ““Leverage and Pricing in Buyouts: An Empirical Analysis”, July 2005 working paper, SIFR,
Sweden.
23
VV Acharya, J Franks, H Servaes, op. cit., p. 6; see annexes 4 and 5.

6

in priority. It generally represents a sum of 3 to 5 times the EBITDA24
of the society and is secured
by the assets of the target company. This debt is composed of different slides that are repaid linearly
after a certain period. Each slide has a different interest rate, which varies based on how the
economy is performing. Before the financial crisis, debt was very cheap with an interest rate of 2 or
3%, whereas in 2007, during the crisis itself, the rate could go up to 5% more. Higher interest rates
rendered debt less attractive and more difficult for leveraged firms to pay25
.
Secondly, subordinated debt is mainly composed of high-yield debt and mezzanine debt. The
former is considered to be a non-investment grade bond (junk bond). It has a low rate because it is
an unsecured debt and therefore has a higher risk of default. In contrast to senior debt, it is an
unsecured debt that has the advantage for the issuer of being an all-at-once ‘bullet’ payment that is
due only when the senior debt is completely reimbursed. This is the notion of subordination. In
compensation, the interest rate is higher than it is for bank debt and may be up to 8% higher than
State bonds26
. The junk bond market was used extensively during the first LBO boom in the 1980s.
However, despite having regained popularity since 2009, the high-yield bond market is a market
that can close rapidly in times of crisis. The latter is also a subordinated debt, but is not rated and
ranks last in the hierarchy of a company’s debt. It is often financed by private equity and hedge
funds27
. It resembles high-yield bonds due to the high profitability thereof, but the latter can assume
three different forms. Firstly, the interest rate can paid in cash each year. Secondly, as with other
subordinated debts, it uses also the PIK (payment in kind) mechanism. The debtor has the option of
paying the interest in the form of additional debt in order to increase the value of the debt that must
ultimately be repaid. Issuers are attracted by this option because they can avoid paying cash.
However, after a few years, the interest in cash becomes mandatory28
. Lastly, the third form that the
mezzanine debt can take is participation in capital gain. The debt can be coupled with warrants
(bonds that give access to a percentage of stocks) and the investor has the right to exercise these
warrants at any time, unless this contravenes the stockholders’ contract. This is known as an ‘equity
kicker’ and boosts investor returns. When warrants are attached to regular, subordinated debt, one
can expect a return in the range of 18 to 25%, which is sufficient to attract a myriad of different
investors.

24
Earnings Before Interest, Taxes, Depreciation and Amortisation.
25
Titre 1 « la gouvernance et l’ingénierie financière », Chapitre 50 « Les LBO », www.vernimmen.net.
26
State bonds in Belgium generally have an interest rate of 2-3%.
27
www.macabacus.com, « Capital structure of an LBO », retrieved on 1 December 2013.
28
www.macabacus.com, op. cit.

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Sub-section II – The fiscal leverage: A tax incentive
A business usually has the option of deducting business interest expenses. In fact, one may
deduct interest on loans taken out for the business in order to stimulate investment. However, in the
LBO operation, there are two different entities, the Newco and the target company. The entity that
has contracted a loan with the bank is the Newco and not the target company. The target company is
always the one which is performing. What can LBO protagonists do in order to benefit from this tax
incentive? They apply the mechanism of tax consolidation. This system is the fiscal leverage of the
LBO operation and consists of imputing the fiscal deficit of the holding29
on the benefits of the
target company.
The taxation system strongly influences private equity investment. Fiscal leverage is directly
linked to financial leverage. Scholars generally agree that taxes are one of the key determinants of
corporate financing policies30
. Although the European Union has gained much power, key decisions
regarding the tax and private equity legal environment31
are still predominantly decided at the
national level. Within the European Union, ten States, of which eight are situated in Eastern Europe,
have not instituted a tax consolidation regime, including Belgium, Romania, Bulgaria and Greece.
Some countries, such as France, have implemented a full tax consolidation regime, whereas others,
such as the United Kingdom and Malta, have only implemented partial tax consolidation regimes
called ‘group relief’, only allowing the holding to transfer deficit and amortisation expenses.
Moreover, the threshold of detention of 95% to realise the tax consolidation is less attractive in

29
The amount of interest expense.
30
T Knauer and F Sommer, « Interest barrier rules as a response to highly leveraged transactions: Evidence from the
2008 German business tax reform », Review of Accounting and Finance, Vol. 11, Issue 2, May 2012, p. 208.
31
E Ferran, op. cit., p. 14.

8

France, Luxemburg and the Netherlands than it is in Germany and Italy, where the threshold is
50%, in Spain and the United Kingdom where it is 75%, and in Portugal, where it is 90%32
.
France and Germany can be studied together because, although they present a relatively
different tax consolidation, they both fully transfer the deficit of the Newco to the target company in
an LBO transaction. French legislation33
was put in place in 1988, as was the English one,34
along
with some strict conditions35
. Thus, the company will be preserved in order to pay a portion of the
tax normally due to the State36
. The following paragraph shows an example of how both systems
work in practice. Considering that the fiscal outcome of the BOOMING corporation equals 3
000 000 EUR and that the interest expenses paid annually on the acquisition debt equal 1 050 000
EUR, the portion of the debt not paid as a result of fiscal leverage is calculated as follows:
Tax calculation without tax consolidation
BOOMING taxable income 3 000 000
Corporate tax (e.g. 33%) 990 000
NEWCO taxable income - 1 050 000
Corporate tax (e.g. 33%) 0

32
European Commission official website, «L’imposition des groupes de sociétés en Europe: Un nouveau pas vers la
convergence fiscale/Fiches Pays », p. 1-138.
33
French General Tax Code, art. 223A.
34
Income and Corporation Tax Act 1988, art. 402, 402D and 403.
35
The Newco has to possess 95% of the company.
36
P Thomas, op. cit., p. 96-97.

9

Tax calculation with tax consolidation
BOOMING taxable income 3 000 000
NEWCO taxable income - 1 050 000
Taxable income of the fiscally consolidated group 1 950 000
Corporate tax (e.g. 33%) 643 500
Because of the system of tax consolidation, the company obtains a tax shield of 346 500
EUR (990 000 – 643 500), corresponding to the result of the debt interest expenses on the tax rate
(1 050 000 x 33%). The fact that the LBO in the framework of the private equity industry could
benefit from this tax incentive has been highly contested, because the loan was used to buy the
company and was not used to invest in the company. The debt was not directly profitable for the
company; thus, some may argue that there is no reason to deduct a portion of it. Furthermore, this
tax incentive prompts companies to use debt to finance their purchases. The French Court des
Comptes says that, because of the fiscal leverage, they are highly dependent on banks and on the
stability of the financial sector37
.

37
Cour des comptes, « L'Etat et le financement de l'économie », Synthèse du rapport public thématique, juillet 2012, p.
82.

10

Section V – Do legal and economic cultures affect the evolution?
La Porta developed the theory of ‘legal origin’, which focuses on the effects that a legal
system may have on the economic development within a State38
. In one of his studies, he says that,
in the United Kingdom, it is important to protect the interests of the minority shareholders of
companies. This system favours wealth transmission and the predominance of the stock market to a
greater degree than does the civil law system, in which the same interests are not well protected,
and which favours wealth concentration and the secondary role of the stock market in the economy.
However, this theory has experienced much criticism. Firstly, the research did not take into account
the difference between theoretical protection and the real protection of creditors. Moreover, it did
not take into account the case law that represents the main source within common law countries39
.
Furthermore, some authors have considered that the concentration of shareholders was mainly the
result of social and political factors40
. Moreover, other authors have noted that the protection of
shareholders and creditors within the civil law countries had increased significantly and could be
even as important as it is in the United States41
.
It is generally considered that there are four main legal systems available, of which three are
Romano-Germanic and are based on civil law. The English model is characterised by a common
law legal tradition, which means that there is strong protection for investors and creditors, a strong
application of law and a flexible market. The French model is based on the weak protection of
investors and creditors, a weak application of the law and a highly regulated labour market. The
German and Scandinavian models share similar characteristics, which are situated between the first
two models, such as having a regulated labour market and somewhat strong protection for investors
and creditors alike42
.
The French Model The German Model The Scandinavian Model The English Model

38
R La Porta et al., « Law and finance », Journal of Political Economy, n°106, 1998, p. 1113-1155; N Ménard, “La
pratique du Leveraged Buy-Out dans l’Union Européenne”, Master 2 professionnel – opérations et fiscalité
internationales des sociétés, Academic year of 2012-2013, Université Panthéon-Sorbonne-Paris I, Paris, p. 6.
39
N Ménard, ibid., p. 6.
40
P A Gourevitch and J Shinn, Political Power and Corporate Control: the New Global Politics of Corporate
Governance, Princeton University Press, 2005; N Ménard, op. cit., p. 6.
41
42

11

Belgium
France
Italy
Portugal
Spain
The Netherlands
Austria
Germany
Finland
Norway
Sweden
Denmark
Ireland
United Kingdom
If La Porta’s theory is correct, the legal system should influence the development of financial
evolution. Therefore, with regard to the private equity industry, it could be said that countries with
strong protection for investors and creditors should have preeminent markets in the European
Union. The Common Law countries should have the biggest markets, France and the Netherlands
should be the lowest, and Germany and the Scandinavian countries should be in between. However,
reality is completely different, and the Netherlands, according to annex 243
, is considered to be the
second biggest private equity market in the European Union, whereas France is considered to be the
fourth. Moreover, Belgium has a bigger market than does Ireland. Furthermore, Sweden was the
first market in 2006 and still seems to be the most attractive country for private equity investment.
Recently, La Porta has explained that the theory of legal origin is related to the debate
regarding the “diversity of capitalisms”, which is considered to be a second approach that tends to
classify states according to one more economic criterion44
. Hall and Soskice45
make a distinction
between two forms of capitalism, liberalised market economies 46
and coordinated market
economies47
. The liberalised market economies have a flexible labour market and a high degree of
development in the financial market48
. Watt made the conclusion that “no clear patterns emerge
along the lines of ‘varieties of capitalism’” 49
. Indeed, it seems that this theory is again too
simplistic or too theoretical to order to apply to the LBO market. In fact, the LBO is a type of
investment that has somewhat hybrid characteristics when compared to the capitalist model50
.
Considering the evolution of LBOs, this work can divest itself of the hypothesis that these doctrines
can explain the activity of LBOs and, therefore, that LBO activity is not particularly influenced by

43
This shows European LBO activity in 2006.
44
R La Porta et al., op. cit., p. 285-332.
45
P Hall and D Soskice, Varieties of Capitalism: The institutional foundations of comparative advantage, Oxford,
Oxford University Press. 2001; N Ménard, op cit., p. 6.
46
English and American markets.
47
German and French markets
48
N Ménard, op. cit., 7.
49
A Watt, op. cit., p. 553.
50
N Ménard, op. cit., 7.

12

economic and legal cultures.

13

Chapter II – The high level of debt: One of the causes of asset-sales and layoffs
Section I - Introduction
As stated in the first part of the work, one of the most relevant characteristics of LBO
transactions is the presence of debt, specifically during the two large LBO booms mentioned
previously. The second part will describe corporate and academic studies that shed light on the
hypothesis that the presence of debt played a role in the financial distress that hit the LBO market at
the end of the 1980s and in the second half of the 2000s. Other outstanding academic studies have
made a link between highly leveraged transactions, defaults and bankruptcies. It will also be
asserted that financial distress often leads to asset-sales and, subsequently, to the layoff of staff.
Finally, this chapter will present the conclusion that related asset sales and layoffs may mainly be
the result of an irresponsible and unreasonable level of debt. Certain relevant American studies are
used in this section in order to reinforce the hypothesis51
.
Section II – The role of debt in the financial distress
buyouts
Being financially distressed implies that the liquid assets of the firm are not sufficient to meet
the current requirements of its hard contracts. Broadly speaking, a firm can be considered to be in
financial distress in three situations. Either it has an EBITDA that is less than its interest expenses,
or it attempts to restructure its debts, or it defaults52
. Two American studies, one by Kaplan and
Stein and one by Andrade and Kaplan, focus on the first wave of buyouts that occurred during the
1980s and that partly bust in the early 1990s. More particularly, they discuss the evolution of
buyout pricing and financial structure throughout this period53
. Kaplan and Stein analysed a sample
of 41 deals between 1980 and 1984, and of 83 deals between 1985 and 1989. They found that,
during the first period, only one buyout defaulted on its debt while during the second period, of the
83 buyouts, 22 had defaulted. Nine of these defaulted transactions have subsequently been taken to
bankruptcy court, in addition to the number of deals that might have faced difficulty following the

51
Due to the older and more active LBO market, the number of American academic studies is higher are than those of
Europe.
52
G Andrade and S Kaplan, op. cit., p. 1450; defaulting means not paying the debt when it is due.
53
S Kaplan and J Stein, “The evolution of buyout pricing and financial structure in the 1980s”, The Quarterly Journal
of Economics, Oxford University Press, Vol. 108, N°2, May 1993, p. 313.

14

completion of the study54
.
What factors can explain the sudden collapse of the buyout industry? Are they ex post factors,
such as adverse economic conditions?55
Firstly, as Thomson One Banker and Axelson noted, with
regard to the overall price paid for the transactions and the buyout price to cash flow (EBITDA), the
deals had “a poorly designed capital structure”56
that could increase the likelihood of financial
distress. Column (1) of Table III57
shows that, between 1983 and 1985, the deals had an average
debt to capital ratio of 86, 5 per cent, whereas the deals made between 1986 and 1989 had an
average ratio of 90, 3 per cent. These ratios are not completely correct because they exclude
preferred stock with fixed commitments58
. Moreover, Column 2 shows that the average common
stock to total capital ratio59
was lowest between 1986 and 1989, at 5, 56 per cent. Secondly, one can
see that, in Column 3, the interest coverage ratio60
reached its minimum in 1987 and 1988 during
the first buyout year61
. Five years later, based on a sample of companies62
obtained from the
buyouts already examined by Kaplan and Stein, Andrade and Kaplan63
indicated, in the first column
of Table IV64
, that the average interest coverage ratio of the sample was 0.97 in year zero65
.
Moreover, these companies presented healthy operating margins that were even healthier than was
the industry median in the same year. The first column of Table III66
shows that the average firm in
the sample had an operating margin (EBITDA/sales) of 9.8% in year zero, whereas the average firm
within the industry group only reached 8.5%.
In short, a coverage ratio below 1 is a good indicator of financial distress. The causes of this
are the high presence of debt and a low EBITDA to capital ratio. Kaplan and Stein shared their view

54
S Kaplan and J Stein, op. cit., p. 314.
55
S Kaplan and J Stein, ibidem, p. 314.
56
S Kaplan and J Stein, ibidem, p. 315.
57
See annex 6.
58
This part of equity is occasionally exchangeable into subordinated debt.
59
Common stock includes preferred stock that is convertible into common stock, and is a form of corporate equity
ownership, a type of security.
60
EBITDA, or net cash flow, to the expected total interest payment (both cash and non-cash interests).
61
62
The companies that were taken from the package all defaulted once in December 1995, and all but four were formed
after 1985.
63
G Andrade and S Kaplan, “How costly is Financial (Not Economic) Distress? Evidence from Highly Leveraged
Transactions that Became Distressed”, The Journal of Finance, Vol. LIII, N°5, October 1998.
64
See annex 8.
65
Referring to the first year of financial distress.
66
See annex 7.

15

by saying that they would have expected the buyers, knowing the weakness of their cash flow, to
structure the transaction with less debt in order not to impair the ability to service current debt
obligations67
. According to this logic, Andrade and Kaplan provided the hypothesis that, of the
factors that drive firms to financial distress, high leverage is the primary one68
. After having made
these preliminary observations, Kaplan and Andrade examined the factors that led to distress, which
are shown in more detail in Table III and Table IV. They mention four:
(1) Industry performance,
(2) A firm’s performance,
(3) Short-term interest rate changes, and
(4) A firm’s leverage.
They then assessed the relative contribution of these factors. In Table III, we notice that, on
average, financial distress is not explained by the firm’s performance, the industry performance or
the interest rate. Table IV confirms that high leverage is essentially responsible for financial distress
in the small sample of 31 firms. Kaplan and Andrade isolated a sample of firms “for whom leverage
is the primary, if not the only, source of financial distress”69
.
In conclusion, the evidence from Kaplan and Stein and from Andrade and Kaplan’s studies,
while not unambiguous, “fits well with a version of the overheated buyout market hypothesis”70
.
They answered the question by saying that they believed that ex ante reasons71
(level of debt, price
of the transaction) played a greater role in financial distress than did ex post reasons. However,
Kaplan and Stein put this view into perspective by suggesting that the problems that occurred with
large buyouts during the period of 1988-1989 were driven by a relatively small number of very
large, highly leveraged and highly priced transactions72
.

67
68
G Andrade and S Kaplan, op cit., p. 1445.
69
G Andrade and S Kaplan, ibidem, p. 1457.
70
71
Level of debt, price of the transaction.

72
M Wright and N Wilson et al., «An Analysis of Management Buy-Out Failure», Managerial and Decision
Economics, Vol. 17, 1996, p. 61.

16

Section III – The role of private equity funds in financial distress
Based on a sample of 8 million companies within 15 European countries, Tykvova and Burell
investigated whether private equity-backed companies experienced more financial distress and
bankruptcy than did non-private equity-backed companies between 2000 and 200873
. ‘Buyout
firms’ represent the PE-backed firms, whereas ‘control firms’ refer to non-PE backed firms and
non-buyout firms, which have similar characteristics. In Table 3,74
three ‘financial distress risk
scores’ are selected by the authors to evaluate the financial distress level suffered by the companies
in the sample, as follows: the O-score, the Z-score and the Zmijewski score. Although PE investors
typically chose companies with lower financial distress risks, all the measures suggest that the
distress risk increases during the three years following the transaction. By contrast, for control
companies, the distress risk diminishes, as they grow older. Finally, three years after the deal,
buyout and control companies reach similar distress risk levels75
. Moreover, based on an American
sample, Moody’s argues that, on average, companies owned by the largest private equity firms have
shown higher rates of distress. In fact, approximately one fifth of the deals tracked - 38 of 186 -
have a rating of B376
or lower, compared with around 14% of similarly rated issuers_77
. In 2012,
Hotchkiss, Smith and Stromberg examined the default likelihood and restructuring behaviour of
2,156 firms that obtained leveraged loan financing between 1997 and 2010. Of the 2,156 firms, 991
(46%) are ‘PE-backed’78
and the others are ‘not PE-backed’79
. They discovered that financing of the
PE purchases have lower credit ratings than does the financing of the non-PE purchases80
. They
used Moody’s credit rating numerical score, with 1 corresponding to the highest credit rating81
and

73
T Tykvova and M Borell, “Do Private Equity Owners Increase Risk of Financial Distress and Bankruptcy”, Centre
for European Economic Research, Discussion Paper N°11-076.
74
See annex 11.
75
T Tykvova and M Borell, op. cit., p. 11.
76
Negative outlook.
77
Moody’s Global Corporate Finance, « $640 Billion and 640 Days Later », Special Comment, November 2009, p. 1.
78
They define a firm as being ‘“PE-backed’” (‘“PE sponsored’”) when it is acquired through a leveraged buyout and is
held in a managed private equity fund for purposes of active control. A private equity fund is defined as a limited
liability partnership managed by a general partner who raises outside funding from a set of limited partners.
79
According to the authors, this term includes “public corporations with not controlling shareholder, as well as public
and private companies that may be controlled by non PE investors, including hedge funds, investment management
companies, financial institutions, and other corporations. Controlling interests held by individuals and families are also
considered non PE-backed. In which no PE fund has had a controlling ownership stake for at least five years”. (p.4).
80
E Hotchkiss et al., “Private Equity and the Resolution of Financial Distress”, July 2012, retrieved 20 February 2014,
p. 16.
81
AAA.

17

27 to the lowest credit rating82
. Panel B of Table 2 shows that the PE-backed average score of 20.3
corresponds approximately to a B2 rating, compared with a score of 18.2, or a B credit rating, for
non PE-backed firms83
. These results support the hypothesis that PE-backed firms are more
leveraged than are non PE-backed firms, and thus face greater financial distress.84
As Moody’s
says, “distress offers a rough indication of future default rates, since a lower credit rating
translates into a higher likelihood of default”85
.
Nevertheless, even if there is a higher proportion of financial distress after the transaction, the
authors do not find evidence that PE investors lead their firms to excessive financial distress ending
in bankruptcy. They even allege that firms with experienced private investors have a bankruptcy
rate that is lower than that of similar, non-buyout companies86
. Moody’s study also argues that
companies affiliated with the 14 largest private equity firms have experienced similar rates of
default87
as other companies over the analysed period. In fact, between January 2008 and
September 2009, private equity firms showed a 19,4% rate of default compared to a rate of roughly
18,6% for similarly rated companies_
. However, of the biggest LBOs that were created in the
middle of the overheated period, four of the 10 had already defaulted and a fifth, Energy Future
Holdings Corp., was likely to be in default shortly88
. The study undertaken by Hotchkiss et al.
nevertheless arrived at slightly different results. They analysed the likelihood of default of the PE
backed-firms and the non PE-backed firms,89
and discovered that the average percentage of annual
default was higher for PE backed firms, with an average of 5.1%, whereas the average default of
non PE-backed firms was 3.4%90
. One can also see the growth of the PE market throughout this
period because of the rising number of PE-backed firms91
. Finally, ‘PE exited’ refers to firms that
were previously owned92
by a PE fund.

82
C.
83
E Hotchkiss et al., op cit., p. 11.
84
Make a reference to P Halpern, R Kieschnick and W Rotenberg, “Determinants of financial distress and bankruptcy
in highly levered transactions”, The Quarterly Review of Economics and Finance, 2008, p. 772-783.
85
Moody’s Global Corporate Finance, ibidem, p. 4.
86
T Tykvova and M Borell, op cit., p. 15.
87
Moody’s defines a default as a non-payment of principal or interest on a timely basis.
88
Moody’s Global Corporate Finance, op. cit., p. 3.
89
E Hotchkiss et al., op cit., p. 11.
90
Table 2; see annex 12.
91
E Hotchkiss et al., op. cit., p. 11.
92
Within the five years prior to the default.

18

However, the default rate is approximately the same, which is partly due to the fact that
distressed companies under LBOs have been able to renegotiate certain maturities and have pushed
the payment of the debt forward. This has led to the expression the ‘wall of debt’, which refers to
the huge amount of debt that is still to be paid. This debt could lead to a higher rate of default and
bankruptcy in the private, equity-backed companies. This probability will be analysed in section IV.
Section IV – The resolution of financial distress
Sub-section I – Introduction
After having closely examined the relationship between high leverage and financial distress,
this chapter highlights potential ways of resolving the distress. This section approaches the
resolution of distress from a general perspective, which means that it does not focus exclusively on
distressed PE-backed firms, but also considers distressed non PE-backed firms. The same rules
apply to both situations.
Sub-section II – Financial restructuring and corporate restructuring
A - Debt restructuring and asset restructuring
(i) Introduction
After having described the framework in which debt can be resolved, it is important ask how
this can be accomplished. Two main possibilities lie in the hands of managers, restructuring the
financial contracts or restructuring the assets. Both possibilities can be used via either public or
private procedures. The choice of one method over another depends on the costs and benefits of the
method. For instance, using asset restructuring when the secondary market is illiquid is not a good
idea, whereas asset sales can be effected via efficient mechanisms, such as auctions, in which case
the cost of use may be lower93
.

93
E S Hotchkiss et al., op. cit., p. 5.

19

(ii) Debt restructuring
Restructuring the debt means negotiating with creditors and reformulating the terms of
contracts. This procedure may give rise to several possibilities. Firstly, the bank may reduce the
payments or defer them to a later date. Secondly, the technique of “replacing the hard contract with
soft securities that have residual rather than fixed payoffs” can be used 94
. Replacing the existing
debt with a new contract that diminishes the interest or principal payments, or which extends the
maturity, generally resolves financial distress95
. However, incomplete contracts, asymmetric
information between debtors and creditors and multiple creditors are factors that can hinder the debt
renegotiation. Furthermore, when there are multiple creditors with interests that are not congruent,
it may be difficult to achieve a consensus among them. In addition, in this situation, each creditor
might be eager to receive their payment in full and thus force the liquidation of the firm’s assets.
One of the reasons that formal proceedings were put in place was in order to avoid this “common
pool” problem96
. During the two private equity booms, there were often public debts with many
creditors – a situation that rendered renegotiations more difficult. In fact, it is more likely that
contracts will be incomplete when the relationship is not symmetrical and the interests of the
creditors are not congruent.
(iii) Asset restructuring
If the debt cannot be renegotiated, hard assets97
can be wholly or partially sold in order to
meet the payment obligations. Some say that financial distress may also provide benefits, such as
leading to the sale or discontinuation of poorly performing assets but, in this situation, it is not the
poor performance of these assets that prompts firms to sell them; rather, it is the burden of debt and
the maturity thereof, leading to the need to raise cash rapidly. Asset sales are a direct consequence
of financial distress and appear to be an important solution for resolving financial distress98
.
Asquith, Gertner and Scharfstein99
, Hotchkiss, as well as Brown, James and Mooradian, have100

94
95
E S Hotchkiss et al., ibid., p. 5.
96
E S Hotchkiss et al., ibid., p. 5
97
Long-term investments, such as plant and machinery.
98
99
P Asquith, R Gertner and D Scharfstein, “Anatomy of Financial Distress: An Examination of Junk Bond Issuers”,
Quarterly Journal of Economics, 109, 1994, p. 625-658.

20

demonstrated that, in both procedures,101
distressed firms showed a high frequency of asset sales. In
his 1995 study, Hotchkiss demonstrated that firms that avoided bankruptcy and which emerged
successfully from Chapter 11 sold a major portion of their assets. Moreover, Asquith, Gertner and
Scharfstein discovered that selling assets was an important means of avoiding bankruptcy. They
found that, of the 21 companies that sold over 20% of their assets, only 14%102
filed for bankruptcy,
whereas of the sample of firms with small or no asset sales, 49% filed for bankruptcy103
.
As a result, while financial distress and asset sales are directly related, they also share the
same determinants, namely leverage and poor performance. The first determinant was challenged
by Andrade and Kaplan, who believe that financial distress, and therefore asset sales, arises even if
the company is economically healthy. Moreover, three authors - Ofek104
, Kruse105
and Jensen106
-
demonstrate that the probability of asset sales increases with the firm’s debt level. Jensen and Ofek
think that higher leverage also significantly increases the probability that certain specific
operational actions, such as asset restructuring and employee layoffs, will be taken when
performance deteriorates107
. In addition, the higher the proportion of short-term debt, the greater the
likelihood that creditors may influence the decision to liquidate assets108
. Finally, the liquidation
costs can also play a role. The efficiency of the restructuring process will depend heavily on the
level of liquidation cost109
. For instance, the liquidation cost may be lower if the assets are sold as a
going-concern package, instead of as a piecemeal sale of assets or through a competitive method
such as an auction110
. However, the costs can be affected if the entire industry is financially
distressed and if it is difficult for the industry insiders to compete.

100
E S Hotchkiss, “Postbankruptcy Performance and Management Turnover”, Journal of Finance, 50, 1995, p. 3-21; E
S Hotchkiss, “Investment Decisions under Chapter 11 Bankruptcy, Doctoral Dissertation, New York University, 1993.
101
In and out of court.
102
14%.
103
104
E Ofek, “Capital Structure and Firm Response to Poor Performance”, Journal of Financial Economics, 34, 1993, p.
3-30.
105
T A Kruse, “Asset Liquidity and the Determinants of Asset Sales by Poorly Performing Firms”, Financial
Management, 31, p. 107-129.
106
M C Jensen, “Active investors, LBOs and privatization of bankruptcy”, Journal of Applied Corporate Finance, n°2,
1989, p. 35-44.
107
E Ofek, op. cit., p. 4.
108
109
110
Used extensively in certain north European countries.

21

Even more problematic is when the leverage is very high and creditors put extreme pressure
on the debtor, which can lead to inefficiently liquidated assets. As Shleifer and Vishny have argued,
depressed prices often occur when potential buyers of those assets are also financially distressed111
.
Andrade and Kaplan contribute to the body of evidence in saying that distressed, private equity-
backed companies make intensive use of fire sales. This is one of the quantitative, estimated costs
of financial distress. Table XI.B112
shows evidence of desperation113
asset sales. The sale of assets
may occur at different periods, as detailed in the short text above table XI.B. Of a sample of 31
distressed firms, only nine firms did not sell assets in desperation in order to resolve financial
distress. What is significant is that 23 firms114
were obliged to sell assets they may normally have
retained, only because they were too highly leveraged. This work states the hypothesis that it is the
presence of high leverage that mainly dictates this situation. In other words, private equity funds are
selling assets of economically healthy companies only to resolve a financial problem for which they
are entirely responsible. Following Kaplan and Andrade, “it seems unlikely, therefore, that the
sample firms – even those that experience a negative performance shock – would have required
such belt tightening absent the debt”115
.
B – Layoffs associates with asset sales
Some recent studies, such as those by DeAngelo and DeAngelo,116
Asquith et al.117
, Ofek118
,
Opler and Titman,119
and Padilla and Requejo,120
have documented that, within voluntary workouts,
numerous and important operational changes are imposed upon firms that are allowed to continue
with their operations. In particular, these studies found that there are significant asset sales and
employee layoffs from the pre-distress period. Some of these changes, such as asset sales and

111
E S Hotchkiss et al., op cit., p. 14.
112
See annex 14.
113
The term ‘desperation’ is used when the company is forced to sell assets it otherwise would wish to retain or that are
part of core operations as defined by the company.
114
A significant majority.
115
G. Andrade and S Kaplan, op. cit., p. 1482.
116
H DeAngelo and L DeAngelo, “Union negotiation and corporate policy: A study of labor concessions in the
domestic steel industry during the 1980s”, Journal of Financial Economics, 30, pp. 3-43, retrieved 12 March.
117
P Asquith, R Gertner and D Scharfstein, “Anatomy of Financial Distress: An Examination of Junk Bond Issuers”,
Quarterly Journal of Economics, 109, 1994, p. 625-658.
118
E Ofek, E, op cit., p. 3-30.
119
T Opler and S Titman, “Financial distress and corporate performance”, Journal of Finance, n°49, p. 1015-1040.
120
A. J. Padilla and A. Requejo, « Financial distress, bank debt restructurings and layoffs », Spanish Economic Review,
n°2, 2000, p. 73-103.

22

business divestitures, may simply be undertaken to raise cash and to repay part of the outstanding
debt121
. Moreover, two studies by Kaplan122
and Smith123
reveal that there is a link between
divestitures and changes in the number of employees post-buyout124
. Firstly, Kaplan distinguishes
between buyouts involved in acquisitions and divestitures in his analysis of 76 U.S. public-to-
private transactions. In his subsample, excluding companies with acquisitions and divestitures, he
found that private equity-backed buyouts reduce employment relative to the industry by 6.2%,
between one year prior to the transaction and one year thereafter. His results, however, were not
significant. For the entire sample, including companies with non-organic growth, he found
significant employment decreases of 12% over the same period relative to the industry. In addition,
Smith found significant industry-adjusted reductions in employment from one year prior to the
buyout to one year thereafter, although this only concerns companies that sold a major portion of
their assets after the transaction.
C – Layoffs
Layoffs that are not associated with plant closures and asset sales do not increase the
current liquidity, but do affect the firm’s future revenue stream125
. The following studies analysed
employment growth in PE-backed firms, but they do not specify whether the layoffs were linked to
assets sales.
Much American and English academic research has focused on the consequences that LBOs
may have on employment. Overall, most of the researchers seem to highlight the substantial job
losses in LBO restructuring following the acquisition126
. In 2010, of the 18 American and English
papers written on the subject, 13 found evidence of employment reduction in the post-buyout

121
A. J. Padilla and A. Requejo, op cit., p. 74.
122
S Kaplan, “The effects of Management Buyouts on Operating Performance and Value”, Journal of Financial
Economics, Vol. 24, 1989, p. 217-254.
123
A J Smith, « Corporate Ownership Structure and Performance », Journal of Financial Economics, Vol. 27, 1990, p.
143-164.
124
E Lutz and A K Achtleitner, “Angels or Demons? Evidence on the Impact of Private Equity Firms on Employment”,
Special Issue Entrepreneurial Finance, n°5, 2009, p. 61.
125
A. J. Padilla and A. Requejo, op. cit., p. 74.
126
A Watt, op cit., p. 560; see inter alia S J David et al., “Private Equity and Employment”, The National Bureau of
Economic Research, 2011, p. 1-22 – Perhaps considered as the most important study on the subject - ; R Cressy, F
Munari and A Milpiero, «Creative destruction? Evidence that buyouts shed jobs to raise returns», Venture Capital,
vol.13, n°1, January 2011, London, p. 1-22; J Liebeskind et al., « LBOs, Corporate Restructuring, and the Incentive-
Intensity Hypothesis”, in: Financial Management, Vol. 21, n°1, p. 73-88.

23

period127
. Many of these studies made a comparison with similar companies that had not yet been
taken over. Some of them will be analysed in more depth. Firstly, Cressy et al. discovered that, of a
sample of 57 buyout companies and 57 non-buyout companies, there was 7% less employment in
the year after the transaction, which decreased by up to 23% after the first four years. In the fifth
year, the fall decelerated to 21%128
. However, the authors say that while it is true that jobs are lost
at first, since profitability rises, “those firms that achieve greater productivity through the buyout
may in the end become net employers”129
. The second study, perhaps considered as one of the most
important studies on the subject, is that of Steven Davis et al. and used a sample of 11, 000
worldwide transactions 130
that occurred between 1980 and 2005 131
and compared them to
companies of similar industry, age and size. The study revealed that, two years after a buyout,
private equity firms decreased employment by 17.7%, while their non-PE peers cut this level by
10.9%. The difference between the two samples grew to 10.3% over five years132
. However, the
study notes that “greenfield” jobs increased to a greater extent in PE firms than they did in their
peers. Ultimately, private equity firms had a 3.6% lower net employment growth than did the
controls over the two-year period post-transaction133
.
However, these studies are generally more focused on the USA and the UK’s private equity
industry. There are studies focusing on Belgium134
and on France135
that show a positive impact of
private equity on employment. However, except for the two aforementioned studies, the analysis of
French and Belgian private equity employment is rarely conducted by academics. Thus, there are
too few studies for the data to be completely reliable.
One hypothesis is that the French and Belgian market for LBOs is newer than is the English and
American market. For instance, David’s sample dates from 1980, whereas the Belgian LBO market
only came into being in the late 1999s. Another hypothesis that could explain the improved results

127
R Cressy, F Munari and A Milpiero, «Creative destruction? Evidence that buyouts shed jobs to raise returns»,
Venture Capital, vol.13, n°1, January 2011, London, p. 3.
128
R Cressy, F Munari and A Milpiero, op cit., p. 18.
129
R Cressy, F Munari and A Milpiero, ibid., p. 18.
130
A little more than half are companies not headquartered in the US.
131
From this sample, they eliminated transactions that did not entail some degree of leverage, such as venture capital
transactions, those that were not classified by Capital IQ as “going private”, “leveraged buyout”, “management buyout”
or similar terms, and eliminated deals that did not involve a financial sponsor, like a private equity firm.
132
S J David et al., “Private Equity and Employment”, The National Bureau of Economic Research, 2011, p. 10.

133
S J David et al., ibidem, p. 10.

134
V Toubeau, « Private Equity Firms in Belgium – Value Creators or Locusts? », Solvay Business School, Working
paper – Unpublished document, Brussels, 2006.
135
Q Boucly et al., « Job Creating LBOs », HEC Paris, Working Paper, Paris, 2009.

24

is the shareholder and stakeholder culture. Both the USA and the UK have a lower commitment to
employees because of their more shareholder-oriented approach. 136
However, as previously
outlined, this argument can be put into question regarding the evolution of buyouts in Europe. The
theoretical stakeholder culture did not preclude France from experiencing the second LBO boom,
with transaction prices that consisted of an excessive proportion of debt.
Furthermore, the Commission is sceptical about the capacity of private equity funds to
remain competitive. In 2005, the Commission launched an important study, called the “Merger
Remedies Study”,137
which conducted an ex-post evaluation of the remedies accepted in merger
cases notified during a given period138
. In some cases, the European Commission accepts that
concentration occurs in conditions in which some commitments are respected by the undertakings
concerned in order to diminish the impact of the concentration on the competition to as great a
degree as possible. One of these remedies is divestiture, which means that the condition of the
merger is the sale of a part of the assets. A company that has too great a market shares could
endanger the competitive environment. This study focuses specifically on the implementation of
these remedies and the factors that may have negatively or positively affected the implementation
thereof139
.
In the event of a divestiture remedy, the Commission raises concerns regarding the
suitability of the purchaser. The wrong choice of purchaser may be considered to be the single most
important cause of the remedy’s ineffectiveness. In other words, the incorrect selection of the
purchaser may contribute to reducing the competitiveness of the divested business. The
Commission obliges the parties to the concentration to find a purchaser that fulfils the following
requirements: “(1) the proven expertise (2) the necessary financial resources (3) the incentives to
maintain and develop the divested business as an active competitive force in competition with the
parties and other creditors and (4) be independent and unconnected from the parties”140
. Firstly, by
‘proven expertise’, the Commission means “know how and organizational and management
capability, as well as expertise in a specific market and experience with the prevailing business

136
E Lutz and A K Achtleitner, op. cit., p. 61.
137
European Commission, “Merger Remedies Study”, Directorate-General, October 2005.
138
1996-2000.
139
European Commission, “Merger Remedies Study”, Directorate-General, October 2005, p. 11 §4.
140

25

practices in the industry”141
. With the exception of certain types of divestitures, by saying that
financial investors typically do not have operational experience in an industrial business, the
Commission seems to be sceptical of their ability to run the company correctly when compared to
an industrial investor142
. Furthermore, in cases when a business model for financial investors
typically involves holding acquired businesses for only a certain period143
, some interviewees in the
study stressed the importance of considering the exit plans in order to assess the suitability of the
financial purchaser144
. Knowing the intention of the financial investor with regard to exit plans can
be reassuring. Alan Ryan145
interpreted paragraph 14 as saying that “the commission shares its
doubts on the ability for the financial investors because we cannot be sure that they will invest into
the business and maintain competitiveness at term. It is therefore the factor that lead to the
ineffectiveness of the remedy”146
. When the Commission talks about the business model of the
financial investors, it implicitly talks about the debt. This business model does not coincide with the
desire of the Commission to find a long term and competitive purchaser. Allan Ryan adds, “If the
company is not managed on a competitive way, what will happen with jobs at term? They will
disappear. The Commission is sceptical on the probability that the viable jobs will be there in 5 or
10 years”147
.
A Second concern of the Commission is that a suitable purchaser must have the necessary
financial resources. Money coming from the cash-flow or from the new investor must be invested in
the development of company. Many companies depend on R&D expenditure to stay competitive148
.
However, the aforementioned study by Andrade and Kaplan noticed that, when highly leveraged
transactions are in financial distress, one of the quantitative costs is the investment cut. Their study
shows that all companies in the sample cut investments to “meet the firm’s debt burden”149
. On
occasion, this was not costly for the company and therefore did not affect its competitiveness but, in
the majority of cases, money was used that could have been better employed for necessary

141
142
143
Often pre-determined.
144
European Commission, “Merger Remedies Study”, Directorate-General, October 2005, p. 101-102 §14.
145
Currently antitrust, competition and trade partner at the law firm Freshfields Bruckhaus Deringer;
146
Private interview with Alan Ryan on the 25th
of April 2014 at his domicile.
147
Private interview with Alan Ryan on the 25th
of April 2014 at his domicile.
148
149
Andrade and Kaplan, op. cit., p. 1482.

26

expansion or competitive demand150
. For instance, Leaseway Transportation Company cut into its
capital expenditures to make up for shortfalls in operating cash flow to pay back debt.
Thus, if our global research on employment does not show an undoubted conclusion, the
scepticism of the Commission and the cuts in investment, resulting in the lack of midterm
competitiveness, agree with the hypothesis that too much debt leads to layoffs.

150
Andrade and Kaplan, ibid., p. 1476.

27

Chapter III – National fiscal rules to regulate debt
Section I – Introduction
Every business has positive qualities and flaws. The task of policymakers is to contribute to
creating an environment in which “economically worthwhile activity can take place but abusive
conduct that is socially wasteful is curtailed” 151
. Private equity-backed leveraged buyouts are not
an exception to this rule. As has been seen, fiscal leverage prompts companies to be highly
leveraged and thinly capitalised152
. This section of the work will focus on the fiscal rules that aim at
controlling the debt. In order to fight against this high level of debt, European countries have
implemented certain specific rules concerning the limitation of the deduction. Even if their primary
goal is not to regulate the level of debt within private equity transactions, they nonetheless touch
directly on the LBO industry. These rules are numerous and take many forms, such as thin-
capitalisation rules and changes according to the country. This work will analyse those that apply
within three countries, namely the United Kingdom, France, Germany and Belgium.
Section II – European Union rules
This part does not concern tax legislation because the European Union has no competence to
regulate on that matter but has still its relevance. Indeed, as the following national interest
deduction limitations, the European institutions take some initiatives in the case the AIF presents a
substantial level of leverage153
. They considered that leverage exceeding three times the net asset
value154
of the Alternative Investment Fund is employed on a substantial basis155
. In such cases, the

151
E Ferran, op cit., p. 12.
152
OECD, “ Thin-capitalisation legislation: A background paper for country tax administrations”, Tax & Development,
August 2012, p. 3.
153
European Parliament and Council Directive 2011/61/EU of 8 June 2011 on Alternative Investment Fund Managers
and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) N° 1060/2009 and (EU) N°1095/2010
(2011) OJ 174/1, preamble (46).
154
Equity.
155
Commission delegated regulation (EU) N° 231/2013 of 19 December 2012 supplementing Directive 2011/61/EU of
the European Parliament and of the Council with regard to exemptions, general operating conditions, depositaries,
leverage, transparency and supervision COM(2012) 8370 final, art. 111 §1.

28

home regulator requires specific information156
so that it can identify the extent to which the use of
leverage contributes to the build-up of systemic risk. If it is the case, the competent authorities of
the home Member State have the power to impose limits to the level of leverage that an AIFM is
entitled to employ. However, they must first notify the restrictions taken to the ESMA157
, the
ESRB158
and the competent authorities of the relevant AIF159
. Two specific methods are used to
calculate the leverage: the ‘Gross’ method and the ‘Commitment’ method160
. However, according
to the Commission delegated act on leverage, it would appear that certain types of borrowing will
not be included in the meaning of ‘leverage’ for the purposes of the AIFMD, such as if the AIF in
question has a core investment policy focused on acquiring non-listed portfolio companies of any
leverage at portfolio company level, and provided that the AIF does not have to bear potential
losses beyond its investment in the portfolio company161
. It means that when the leverage of a
private equity fund is calculated, the debt residing within its portfolio companies must not be taken
into consideration.
Section III – National thin-capitalisation rules or interest deduction limitations
Sub-section I - The United Kingdom
The United Kingdom has no generalised interest expense limitations like those of France
and Germany, and it relies on the arm’s-length principle to regulate excessively leveraged financing
structures. The provisions of the legislation in force in the United Kingdom are enshrined within the
Income and Corporation Taxes Act of 1988162
. Prior 1995, any interest was considered as a
distribution of profits in the case “it represented more than a reasonable commercial return on the

156
(2011) OJ 174/1, art. 24 §4.
157
The European Securities and Markets Authority.
158
The European Systemic Risk Board.
159
(2011) OJ 174/1, art. 25§3.
160
Commission delegated regulation (EU) N° 231/2013 of 19 December 2012 supplementing Directive 2011/61/EU of
the European Parliament and of the Council with regard to exemptions, general operating conditions, depositaries,
leverage, transparency and supervision COM(2012) 8370 final, art. 7 and 8.
161
MacFarlanes, « The Alternative Investment Fund Managers Directive: The UK’s proposed regime for sub-threshold
private equity, real estate and hedge fund managers », May 2013, London, p. 2.
162
‘ICTA’.

29

loan”163
and therefore was not deductible. The rule is the same whether the company granting the
loan is a resident or a non-resident. This means whether the bank was national or non-national was
not important. In contrary, in the case that a United Kingdom non-resident company accorded a
loan to a related164
company any interest was treated as a ‘distribution’ even where the interest is
not an unreasonable commercial return on the loan165
. The Finance Act 1995 modified the rule by
introducing the arms-length principle and by guaranteeing the equal treatment of national
companies and related foreign companies166
. Despite modifications, these rules were challenged in
front of the European Court of Justice in the case Test Claimants in the Thin Cap Group
Litigation167
. The ECJ claimed that, even prior to 1995 and, specifically between 1995 and 2004,
the English rules presented a situation of national discrimination because the tax provision on a
resident company was different depending on whether the loan was granted by a related resident
company or by a related non-resident company. Because national companies were better treated
than were foreign companies, the ECJ decided that article 49 of TFEU had been violated168
.
In essence, the main difference between the United Kingdom, France and Germany is that
the United Kingdom does not use the debt ratio, the interest coverage ratio or the interest expense
limitation to assess whether a company is thinly capitalised. In fact, according to HM Revenue and
Custom, “in tax terms a UK company (which may be part of a group) may be said to be thinly
capitalized when it has excessive debt in relation to its arm’s length borrowing capacity, leading to
the possibility of excessive interest deductions. The arm’s length borrowing capacity of a UK
company is the amount of debt which it could and would have taken from an independent lender as
a stand alone entity rather than as part of a multinational group”169
. If the interest expenses of the
debt exceed a firm’s arms-length capacity, the administration can deny tax deductions. It is a
hypothetical debt capacity. However, one of the criticisms of this rule is that it lacks certainty. It is
indeed difficult for borrowers to correctly assess how much debt violates the arm’s-length standard,
and lenders have no incentive to evaluate the organisation’s hypothetical, stand-alone debt

163
Income and Corporation Taxes Act 1988, section 209(2)(d).
164
In this case it means that the parent company holds 75% of the capital of the subsidiary.
165
Income and Corporation Taxes Act 1988, section 209(2)(e)(iv) and (v).
166
Income and Corporation Taxes Act 1988, section 209 (2) (da).
167
Case C-524/04, Test Claimants in the Thin Cap Group Litigation v Commissioners of Inland revenue (2007), I-
02107.
168
Case C-524/04, Test Claimants in the Thin Cap Group Litigation v Commissioners of Inland revenue (2007), I-
02107.
169
HMRC INTM 541010 – Introduction to thin capitalisation (legislation and principles).

30

capacity170
. After all, the higher the level of debt, the higher the remuneration for the banks. As
Stuart Webber says, “Lending rules of thumb may be helpful in determining a range of debt
capacities but actual loan agreements are often the result of detailed discussions between lender
and borrower, in which trade-offs among debt limits, collateral and loans covenants are
negotiated”. Moreover, Jean-Marie Laurent Josi, Managing Director of COBEPA,171
argued during
an interview172
that independent bankers are influenced by the type of borrower and may blindly
trust renowned private funds that have proven to be efficient financial analysts. This lack of
certainty can also lead to inefficiency. This criticism may help to explain the reason(s) that no other
major country is using this method. Indeed, in France, the arms-length principle and the transfer
pricing rules are a sine qua non condition for lending and do not alone determine whether the
company is thinly capitalised.
Sub-section II - France
Before the tax law of 2013, there was a system that enshrined the principle of full interest
expense deduction in France. However, some anti-abuse rules have been progressively implemented
within the French General Tax Code in order to sanction certain situations that abused the
leverage173
.
The first and most famous anti-abuse rule is the “Amendement Charasse”,174
introduced in
1988, which has the aim of removing the deduction of interest expenses contracted at the occasion
of an operation from the framework of the tax consolidation system. The “Amendement Charasse”,
often qualified as ‘sale to himself’, refers to an operation of acquisition that does not lead to a real
change of legal control of the target company175
.
The second is important in terms of the purpose of the work and is a thin-capitalisation
regime. Article 113 of the financial law of 2006176
completely modified article 212 II of the French

170
S Webber, op. cit., p. 694.
171
COBEPA is an independent, privately held investment company based in Brussels that was created in 1957, with a
net worth of 1.5 billion EUR.
172
Private interview with Jean-Marie Laurent-Josi on the 15th of November 2013 at his domicile.
173
L Hepp and P Le Roux, « Coup de rabot sur la déduction fiscale des intérêts d’emprunt dans les LBO », Option
Finance : La lettre des fusions-acquisitions et du private equity, CMS Bureau Francis Lefebvre, Monday 22 October
2012, p. 2.
174
French General Tax Code, art. 22B al. 7.
175
L Hepp and P. Le Roux, op. cit., p. 2.
176
Law n°2005-1719 of 30 December 2005 of Finance for 2006.

31

General Tax Code and introduced the thin-capitalisation regime only for loans between related
companies. When a company is considered to be thinly capitalised, its interest expenses are no
longer deductible. A company is considered to be thinly capitalised if it cumulatively exceeds the
three following limits. Firstly, the average amount of loans granted by related companies must not
exceed 1.5 of the amount of equity177
. Secondly, the total amount of interest expenses due to related
parties must not exceed 25% of the EBITDA. This means that the interest coverage ratio178
must not
be lower than four. Thirdly, the amount of interest due to the company by all related undertakings
must exceed all interest that is due by the company to the related companies179
. However, the
amount that exceeds the three aforementioned ratios must be up to 150 000 EUR. Article 12 of the
finance law of 2011180
added a section 3 to the article 212 and has considerably extended the rule.
Indeed, the thin-cap rule now also applies to loans granted by third entities secured by related
parties. This concerns loans attributed by financial institutions, such as banks; and therefore senior
debt, which generally represents the major part of debt in a financial LBO. However, sureties
accorded by related entities must secure this debt. There are many different kinds of sureties, such
as real (movable and immovable properties) or personal sureties. As we have seen, the holding that
contacts the debt generally covers it with the assets of the target company. If the debtor does not
repay the debt and becomes bankrupt, the bank takes priority regarding specific assets of the target
firm. Furthermore, interpreting the French General Tax Code, one can consider that the holding and
the target firm are related companies181
.
The third is called the “Amendement Carrez”,182
and has been in place since the first of
January 2012. It presumes that the interest expenses linked to the acquisition of the company shares

are non-deductible when the holding is not capable of proving that the decisions related to these
shares and the control of the target are not assured by the company. The French text aims at shares
of foreign companies and does not only focus on those of French companies. Although this measure
does not primarily target LBO operations, it will certainly threaten the operations structured by

177
Debt/equity ratio.
178
EBITDA/interest expenses.
179
French General Tax Code, art. 212 II al. 1
180
Law n°2010-1657 of 29 December 2010 of Finance for 2011.
181
Article 39 al. 12a) of the French General Tax Code says, “independent links are considered to exist between two
companies when one of them holds directly the majority of social capital of the other or exerces in fact power of
decision”.
182
French General Tax Code, art. 209 IX.

32

foreign countries in practice183
. The purpose of this rule is to more or less restrict the deduction of
interest expenses in France when the French holding is only chosen by an international group with
the exclusive goal of deducting the interest expenses without giving any right of control to the
holding that acquired the shares. However, the chances are good that the private equity industry will
be greatly affected by this. Indeed, over 60% of the private equity funds are based in the United
Kingdom and a large percentage of this is used for outward investments in the EU. Therefore, the
holding has to prove by every means possible184
that it possesses decision autonomy and that it
effectively has the control that is normally conferred on it185
. This proof must be provided within 12
months after the acquisition of the company186
. An important matter that arises from this new tax
anti-abuse rule is its compatibility with European and International legislation, as this rule presents
a clear discrimination between nationals and foreigners. For example, if a French investment fund
creates a holding in France that acquires a French target, then the tax administration will not verify
whether the holding has decision autonomy. If the investment fund is English, however, verification
will be undertaken, although there are not as many requirements as there are for the nationals.
However, the law of the European Union states that, if a national measure restricts the freedom of
establishment, or the free movement of capital is prohibited, the rule should be justified by being
proportional to and motivated by the over-riding reason of general interest187
. Previous national
measures limiting the deduction of interest expenses were already condemned by the European
Court of Justice. For instance, the ECJ censured the old German thin-capitalisation regime in
2002188
and censured the Dutch regime, which subordinated the deduction of the interest expenses
on condition that the branch realised taxable benefits in the Netherlands189
. In this regard, Francis
Lefebvre’s book illustrates the role of judges and applies a small test by assessing the compatibility
of the tax rule with the European Union law. This says that the verification of compatibility with the
European Union dispositions requires answers to a set of three questions. First, can the difference of
treatment be considered as a restriction to the freedom of establishment? If the answer is
affirmative, can the “Amendement Carrez” be justified by the imperious reason of tax evasion? If

183
L Hepp and P Le Roux, op. cit., p. 3.
184
Some types of proof are mentioned in the preparatory documents of the French tax administration (Projet inst. 16-3-
2012 n°90 – Projet inst. 16-3-2012 n°100), such as active participation in the general assemblies, having the shares
available and making contracts linked to these shares.
185
CMS Bureau Francis Lefebvre, LBO”, Editions Francis Lefebvre, Levallois, 2012, p. 75.
186
French General Tax Code, art. 209 IX §1.
187
CMS Bureau Francis Lefebvre, op. cit., p. 81.
188
Case C- 324/00, Lankhorst-Hohorst GmbH v Finanzamt Steinfurt (2002), ECR I-11779.
189
Case C-168/01, Bosal Holding BV v Staatssecretaris van Financien (2003), ECR I-9409.

33

this is the case, is the measure proportionate to the pursued objective? Even if the fight against tax
invasion may justify the measure, the measure could be considered as disproportional to the pursued
objective because it applies automatically without distinguishing whether tax evasion has occurred.
For instance, in the case of LBOs, an English investor will not come to France because he or she
necessarily wants to profit from the tax deduction regime, but rather because he or she wants to
invest in a business holding in which s/he has confidence.
Finally, the “Amendement Carrez” could also be a problem regarding the clause of non-
discrimination presents in most of the bilateral tax conventions190
. In 2003, the French Conseil
d’Etat in the case “SA Andritz”191
censured the old article 21-1° of the French General Tax Code
on the grounds that it was contrary to the clause of non-discrimination within the French-Austrian
convention of 8 October 1959. Indeed, the terms of article 26§3 of the convention obliges that a
French subsidiary company of a Austrian parent company must be seen, for the application of
article 212-1° and 145 of the French General Tax Code, as being from the same nature that a French
subsidiary company of a French parent company192
.
The Finance Law of 2013 buried the principle of full deduction for LBO operations of a
certain proportion by introducing article 212bis within the General Tax Code. Thus, even if an
acquisition is not thinly capitalised and even if it has not successfully avoided the aforementioned
anti-abuse rules, only 85% of the interest expenses would be deductible, starting from 2012, and
75% from 2014. Therefore, there will be a partial reintegration of 15% from 2012 and of 25% from
2014. Moreover, this partial reintegration only affects interest expenses that remained deductible
after the application of the three aforementioned anti-abuse rules. The only exception to this
generalised character is that this measure of reintegration will only be triggered when the total
amount of net financial interest expenses exceeds 3 million EUR.

190
OECD Model Tax Convention, art. 24, 25.
191
Council of State, SA Andritz,, Paris, 30 December 2003, Appeal number n°233894.
192
Council of State, SA Andritz,, Paris, 30 December 2003, Appeal number n°233894.

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