By Eyk Henning
FRANKFURT--The prospect of Britain leaving the European Union threatens to undermine the proposed merger of Deutsche Börse AG and London Stock Exchange Group PLC, according to politicians, regulators and bankers.
But even if Britons on Thursday vote to remain in the EU, the deal to create one of the world's largest exchange groups, with a market capitalization of $30 billion, faces growing political concerns in Germany.
Deutsche Börse and LSE in February revealed plans for a tie-up that they said would better compete with aggressive rivals in the U.S. and Asia. Executives from both companies have promoted the merger as significant step for the integration of Europe's capital markets because it would improve financial stability and the real economies' access to funding.
The merger partners earlier this month said that LSE's investors would get to vote on the deal on July 4, while the tender period for Deutsche Börse shareholders ends on July 12. The dates are crucial because shareholders will be able to decide after the U.K. referendum.
People working on the merger privately acknowledged that obstacles to closing the deal in the current structure would be formidable in case of a British exit from the EU, or "Brexit," because of likely mounting political objection, tighter regulatory scrutiny and a shift in the valuation of both companies.
One of the main points of criticism is the perception that Deutsche Börse would be controlled from London through a proposed new holding company. Deutsche Börse Chief Executive Carsten Kengeter last year received high-level political backing to base the holding company there, according to people familiar with the matter.
"Why is the location of the holding company and its management London, even though Deutsche Börse AG is the obviously stronger partner?" said Florian Rentsch, a member of parliament from the Free Democratic Party in the state assembly of Frankfurt's home state, Hesse, in a private letter to Mr. Kengeter that was seen by The Wall Street Journal.
Hessian Economic Minister Tarek Al-Wazir of the Green Party must give the merger permission to proceed and hasn't publicly revealed his intentions.
Other state politicians from across the political spectrum have publicly raised concerns.
"Regardless of the outcome of the U.K. referendum, the head quarter of a combined group needs to be in Frankfurt" given Deutsche Börse is the bigger company, said Michael Boddenberg, member of the CDU in the parliament of Hesse. He added that the U.K. corporate governance system puts greater emphasis on shareholder value and that it is questionable whether that can be aligned with our goal of strengthening Frankfurt as a financial hub, for instance when it comes to investments into the IT infrastructure.
Officials at Germany's financial watchdog, BaFin, privately raised concerns over the merger in case of a Brexit because Britain's finance industry--including the new holding company--would be outside EU supervision.
Other potential threats some investors see in a Brexit are a sharp drop in the value of the British pound and lower trading volumes on the LSE, both of which would skew the deal's valuation.
Even if the U.K. votes to stay in the EU, the intricacies of German takeover laws and Deutsche Börse's shareholding structure may impede a deal. At least 14% of Deutsche Börse's capital is held by index funds, according to calculations by the Journal. Those investors often tender only after an offer is complete because of internal rules.
The technicality could complicate reaching the 75% minimum threshold necessary to complete the deal, people familiar with the matter said.
Executives in both camps have also warned that LSE and Deutsche Börse could become prey for bigger rivals in the U.S. and Asia if the deal falls through. The owner of the New York Stock Exchange, Intercontinental Stock Exchange Inc., said in May it wouldn't bid for LSE but could reconsider should LSE not merge with Deutsche Börse.
Chicago Mercantile Exchange, the world's largest stock operator by market value, could consider approaching Deutsche Börse, Mr. Kengeter speculated in May.
Write to Eyk Henning at email@example.com