During the past 20 years, private equity has become an essential factor in providing equity financing for German start-ups and more developed mid-sized companies. However, a specific private equity statute could enable Germany to become an even more lucrative investment location for domestic and foreign private equity funds.

Private equity businesses – that is, venture capital and private equity funds – and most of their international investors are increasingly sceptical about investing in Germany, despite some sectors, such as technology or under-valued mid-sized companies, having the potential to be of significant commercial interest.

This is because Germany's legal and tax framework is inadequate. The country has performed poorly by all benchmarks, according to studies of the legal and tax framework of private equity in Europe. In the most recent evaluation, Germany was placed 18th in the European Venture Capital Association's Benchmark Paper of May 2004, in which the frameworks of 21 European countries were compared.

Legal framework

The German economy can only fully realise the potential of private equity if its tax and legal framework sufficiently reflects the national economic significance of the industry. Fortunately, the current German Government has recognised this and announced last year that it intends to improve the tax and legal framework for private equity.

These improvements are expected to arise through the creation of a private equity statute. To do this, the German Government will need to create a framework for establishing and operating fund companies, which must provide tax transparency at an international level. Further changes and clarifications in the law are needed to attract venture capital and private equity investors to German companies. Only through these measures will mid-sized German businesses and young technology companies profit further from these types of financing and be better able to realise their full potential.

Enacting legally-protected transparency for certain fund companies and structures is a critical matter for Germany. A key step will be guaranteeing that funds which are set up purely for asset management will not be subject to any tax exposure at the level of the fund; in corporate structures such as the Luxembourg societe d' investissement en capital risque and the Guernsey-style partnership structure, neither corporate income tax nor trade and income tax accrues.

As long as this protection is not guaranteed in Germany, major international funds will continue to avoid the jurisdiction, while smaller funds that are dependent on German investors will have to be arranged in the midst of the current legal ambiguity and uncertainty.

This legal uncertainty is the focus of the discussions on structuring asset managing limited partnerships which have gone on for the last five years. While a certain minimum amount of legal protection was achieved with a ruling letter of December 2003 and the Venture Capital Promotion Act – or Carry Law – of June 2004, these steps have been insufficient to regain international confidence in German legal and tax legislation.

Within the issue of the current tax framework there is also the matter of how to handle the VAT liability for advisory services by fund advisers. Additionally, the question of how to tax carried-interest capital gains remains unclear. These are capital gains which exceed the equity investment of the active fund initiators and advisers and represent a success-oriented special distribution of profits for the well-performing fund.

Since fund managers in other private equity centres in Europe, particularly London, enjoy largely tax-free carried-interest profit, Germany is at a particular competitive disadvantage and is in need of urgent reform in this area.

At the end of the 1990s, many fund managers relocated to Munich with their funds due to its infrastructure and liberal tax practice at that time concerning carried-interest earnings. However, shortly after the emergence of discussions on setting up tax-transparent funds and the treatment of carried-interest as a pure salary component, they took their money and left Germany for London or even to return to the US.

Immigration taxation and the allowance of start-up loss tax on portfolio companies also remain important issues that require attention. The latter issue particularly affects research-intensive sectors such as life sciences and clean technology, where subsequent profits become a tax liability and thereby present a competitive disadvantage. The handling of management participation in management buy-outs as well as the granting of employee stock options are additional issues.

Due to discussions in the German media about the negative effects of private equity investments and hedge funds in companies like Grohe and the Frankfurt Stock Exchange, the question is increasingly being raised as to whether state regulation for private equity companies and hedge funds is required.

However, a clear distinction between the activities of private equity funds and hedge funds needs to be made. For private equity funds, which acquire interests almost exclusively in unlisted companies – Blackstone's acquisition of shares in Deutsche Telekom is still a rare exception – state regulation appears to be of little benefit. Instead, self-regulation by the private equity industry would be sufficient and appropriate for the structuring and execution of private equity transactions.

However, a number of specific legislative changes do need to be made. The provisions of the German Companies Act need to be updated in connection with granting options and warrants. Closer attention should also be paid to the equity interest of employees, management and supervisory boards in private equity-financed companies, especially where they play a significant role.

The impact of such changes would enable the German technology sector to attract top executives from the academic and business world who would otherwise have pursued careers elsewhere, particularly the US.

Based on previous experience of German legislation, there is little point in attempting to implement the necessary legislative measures through individual laws. The only way to take the necessary legislative steps is to make this issue the topic of a broad political debate which illustrates the benefits of private equity investments. By combining these themes under one law, the national and international loss of faith in German private equity and venture capital can be turned around.

Christoph von Einem is a partner at White & Case in Munich.