Almost too good

Germany has delivered robust economic performance and a surfeit of investment opportunities – so why are three of the country’s private equity professionals wary about the country’s future prospects?

Germany’s strong performance since the credit crisis has placed the country at the forefront of the European Union’s efforts to stabilise its ailing collective economy. The German private equity market is one of Europe’s most mature, and has recovered from the blows dealt pre-crisis by hostile politicians.

The prognosis for both the German economy and the buyout industry appears to be favourable – but as some of the industry’s leading players argued during a sponsored roundtable discussion in Munich recently, it is precisely during such times that politicians strive to shoot themselves in the foot with ill-conceived regulatory measures.

Fears of economic contagion spreading from Europe’s failing fringe – Greece being a prime example – and the effect that would have on consumer confidence, have also created a sense of wariness and sense of uncertainty.

The three participants, PwC’s Richard Burton, Perusa’s Christian Hollenberg, and Capvis’ Daniel Flaig, discussed trends affecting dealmaking and fundraising. The trio noted progress had been made in repairing some of the damage famously dealt to private equity during the infamous heuschrecke (locust) debate back in 2005, and pointed to the country’s buoyant exit market as a positive sign of the industry’s health. They also help debunk some myths about the country’s vast mid-market, the Mittelstand.

PEI: Let’s begin by discussing the macroeconomic climate in Germany – what does it look like at the moment and how does that relate to the private equity industry here?

Daniel Flaig

Flaig: The economic outlook is extremely positive –growth rates will continue: 3-4 percent for Germany, so it’s the strongest performer in the Eurozone. The reasons for this are centred on Germany’s industrial base – it has been driven by trade with Asia and other BRIC countries. The weak euro is helping Germany a lot. If you look at the differences, it’s remarkable – if Germany still had the deutschmark, and Italy the lira, the difference in valuation of the currency would be 30 percent. Germany got a lot more competitive compared to other European countries because of the euro, and this seems to be continuing.

On the downside, today it looks like Germany is virtually at full employment – there’s a risk of inflation as a result. Rising wages, inflation, and higher raw material prices could drive up [asset] prices.

Hollenberg: I agree for the most part. In a way we have the same constellation that we had in the ‘Wirtschaftswunder’ years [the period of economic reconstruction, development and growth in West Germany and Austria in the post-war years]: relatively low interest rates, the world around us growing and accessible to German exporters, and a reasonably weak currency.

The only thing I’d add is the consumer sector doesn’t look quite as good – there’s been a downward trend for some time. People are becoming more wary of what’s going on in the world, particularly in southern Europe. If a shadow’s coming from somewhere it might come from the consumer spending side. Other than that, it looks like a continued positive scenario until either something major happens somewhere in the world, which can always happen, or we do something really dumb, which I wouldn’t exclude either – Germans tend to do that when they feel everything is going in the right direction.

Burton: I fundamentally agree. The German economy is in a good place at the moment. It’s almost too good though, particularly for private equity. There are some effects for private equity which aren’t necessarily positive – one being that many German corporates are in very good health again, they’re cash-rich, and therefore likely to be buyers rather than sellers. That’s one factor which seems to be causing a lack of primary deals.

PEI: … and presumably they provide increased competition for deals, driving up prices?

Burton: Yes, but it’s good for exits.  I think one other factor is that the period of extreme boom-to-bust and then back to boom in a very short space of time, in the classic German industries like automotive, has unsettled some investors, particularly international ones who may understand the local environment less well than homegrown ones. We’re seeing quite a lot of that in exit processes at the moment for those assets.

PEI: If you look at what’s happening on the European periphery, in Greece for example, how much of a worry is that for the German economy?

Hollenberg: There could be an impact on the banking landscape, if they need to write off a lot of their loans, that could lead to credit contraction. It could lead to major scepticism amongst consumers, because they probably realise that Greek debt is their personal debt in the end, because Germany will have to pay for it. On the other hand, the magnitude of Greece’s debt is not that huge – it’s a big headline thing but as long as it doesn’t spill over into Spain or Italy, I wouldn’t be too worried. However, there’s a fair chance of that happening, but for now the impact is contained.

Flaig: There’s a global question – how are countries going to restructure their debt? It’s not only Greece – it’s Germany, the UK, the US. If we continue as we do today with money printing, it’s probably not too bad for the economy in the short run, but in the long term, inflation will pick up more, and this could lead to a different cycle.

The governments could start to save rather than spend, and that could lead to a downturn. It doesn’t look like that’s happening at the moment. Politicians tend to go for the option that keeps them in power, which is to say the short term option, so that means inflation is more likely.

Burton: The challenge for fundraising over the next two years is going to be significant enough anyway, without the additional uncertainty of investing into a euro-denominated fund. What is the future of the euro? It’s another thing to think if you’re a non-euro investor.

PEI: Focusing on the asset class itself in Germany, what are the major trends you’re seeing? You touched on the increasing strength of corporates – what does that mean for PE firms?

Burton: A lot of the dealflow we’re seeing at the moment, too much in fact, is either exits from PE funds or classic secondary buyouts. The exits may go to trade, they may go to IPO, or they may go to PE, but there aren’t a lot of primary opportunities, there’s far too few, particularly in the upper segment of the market. The larger funds are feeling rather frustrated at the moment.

I think there’s more opportunity in the middle and lower segment. The fact there’s a lot of exits is a good thing, especially if you’re an LP, but the issue is there aren’t many big corporates carving out businesses for sale. The few carve-outs that happen are going down the IPO route or the corporates are issuing high yield bonds, because that’s a very easy way for them to meet their requirements. It’s much easier to do that than to sell to private equity.

Flaig: There’s certainly a lack of deals in the upper segment of the market. We see some spin-offs coming to the market. Corporates needed some time to recover from the crisis. They were in cost-cutting mode, and their strategy now is that they’re going to clean up their portfolios, or perhaps buy things. What we are missing are families and private owners. They have disappeared since the crisis, in the mid-market at least. I wonder why that’s the case – I could understand in the beginning, because you had no market, bad pricing, bad outlook. But today you have high valuations, debt available, and a positive outlook, so if there’s a fundamental need to sell a company why not go to market now?

Christian Hollenberg

Hollenberg: We’re discussing a number of add-ons to our portfolio companies at the moment. The targets are owned by people who’d never even thought about selling their business. We just approached them; it’s a completely bilateral thing. That’s the only thing that really works at the moment.

I wouldn’t say prices are cheap – sellers aren’t stupid, they know what their companies are worth. But at least it’s halfway reasonable and it’s an acceptable process.

Aside from that, we’re seeing some smaller assets come up for sale but in the larger segment it’s very quiet. Perhaps it’s because, at least in Germany, we’ve had over-capacity of private equity funds in the larger segment, and they’ve soaked up everything there possibly could be in terms of transactions and we’re now just in a natural void that will take time to fill.

PEI: People always talk about the Mittelstand, or SMEs, as an enormous universe of potential private equity-owned businesses. Do you think GPs are failing to tap into that market still?

Hollenberg: I’ve never believed that. It’s been the story for the last 20 years at least. Since I’ve been in the business, there’s always been a reason why there’d be this huge opportunity with the Mittelstand. First it was succession issues, then it was the tax thing, then it was the globalisation reason. You can find all sorts of reasons behind the argument but it has never happened and it never will. There is a set number of deals in our size range – it doesn’t vary much and it doesn’t depend on how the economy is doing, unless it’s in an extreme state. That number is probably a little lower than people think it is. As a percentage of GDP, transaction values may not jive with the enormous GDP figure Germany has and the percentage may be higher in the UK say, but we’re not such a transaction-orientated economy either.

Flaig: There’s a fundamental difference between German families and entrepreneurs and Anglo-Saxon ones. That’s driving what you just described. A family in Germany will define themselves through ownership of a company through the generations. Maybe at some point you might sell it, but it’s a generational thing. If you go to the other extreme, in say California, it’s part of your professional life that you start a company, you sell it, you start another one and so on, so you get much more dealflow from this different natural behaviour.

Burton: It’s good to make a distinction between the traditional family-owned company in Germany and an entrepreneurial founder of a company who maybe comes from a younger generation, is internationally educated, and is much more aligned with the private equity mentality. For those people, there’s no issue to sell to PE – indeed, it’s probably their objective. But for a traditional family owned company, coming out of the Wirtschaftswunder, probably third or fourth generation, that process of getting used to the idea of selling to PE will go very slowly, if at all.

PEI: Do you think there’s still lingering fallout from the locust debate? Are you as an industry more warmly received than you were five years ago?

Hollenberg: It’s quite pragmatic. People accept different types of investors. The only issue is some people don’t like to have an investor who in the end will end up selling the business again. But it could also be an issue with a strategic. I wouldn’t say we have a lower reputation than other types of buyer though. We tell people we are partners for a limited time, and we think that each and every business goes through phases where it will have an ideal type of investor and if that phase changes, a different type of investor will need to take over. It depends entirely on the situation.

Flaig: It has changed but there is still some reservation. It’s not driven by the locust debate any more though, it’s just driven by a different attitude we have, that’s more focused on cash-flow. A lot of family owned businesses are not managed to generate cash, so there’s a different mentality. Sometimes people have difficulties with that.

Burton: Perhaps the fear of private equity that may have existed a few years ago has been replaced with a fear of acquisition by an Asian strategic player. Does a traditional German company want to be owned by the Indians or the Chinese? It’s a bit of an irrational fear perhaps, but there is fear there, that technology could be “transferred” East. Comparing the two scenarios, possibly it’s a case of better the devil you know with private equity.

Flaig: It’s easier to deal with PE – imagine a typical Mittelstand company being sold to an Indian or Chinese buyer. I have difficulty imagining the discussions they’d have, the time it would take, and it would be difficult to build up trust between the parties. It’s a difficult one, but the trend is there. We see more Indian, Chinese, Asian buyers in the market.

PEI: What of the distressed and turnaround opportunity here? In other parts of the world, the expected increase in such deals didn’t really materialise – is that the case here?

Hollenberg: That’s been the case for the last 20 years. People who approach this market with a purely distressed and turnaround focus will be disappointed. We don’t think that segment of the market is rich enough to justify an institutional fund. If you want to play purely in that segment, do it with your own money – you don’t need a fund for that.

The more interesting segment is one where distress plays a role in it, but where the link is not distress per se, but your ability to do something with the business once you own it or to create value within the transaction itself.

Burton: Maybe the more interesting opportunities are for groups of companies, with more than a billion in sales, which clearly need to be restructured. There are a number of those around at the moment but they’re only accessible to the larger professional teams, and there it’s all about operational improvement and what they can bring to the table, and not about being able to pay one euro or one million euros.

PEI: Do you think banks will shed more assets?

Flaig: During the crisis they were very quiet. Now they are looking at those companies on their books and a lot of them have recovered very well, and their debt level is more or less appropriate. But you have other companies which came out of the crisis on a different long-term EBITDA level, which doesn’t match the leverage they have on their balance sheets. Here you see the banks saying, “You have to fix it.” If the owner can’t supply new equity, then you get situations where a sale is pushed forward or a refinancing situation is looked for.

Hollenberg: But they will be priced like normal buyouts. Typically these are nice businesses, intelligent people selected them before, and they just got it wrong either valuing or financing them, so it’s easily fixable and you don’t need any turnaround or restructuring expertise to do that.

Burton: Of course we have the refinancing “wall” or whatever you like to call it, which I imagine will create some opportunities running up to 2015. But will it be big opportunity these funds are hoping for? Probably not, because the issues and problems will get dealt with in a number of different ways, the easiest of which is of course via an exit.
Hollenberg: Some of the refinancings that need to be done in the German market are refinancings of mezzanine programmes which systematically have attracted very poor credit risks and business models.

Flaig: There seems to be a solution to it with small bonds which are now on the market in Germany. It seems to replace mezzanine products.

Hollenberg: It’s an interim solution to the final solution which starts with ‘i’ and ends in ‘y’.

PEI: On the financing side, how willing are banks to lend at the moment? And how attractively is debt being priced?

Flaig: It’s black and white I would say. If you have a business which went well through the crisis, had a track record in lending and paying back the debt, you’ll get very high multiples again. I was shocked seeing what sort of multiples were in the market – on larger transactions up to 6x EBITDA again, all back-ended – so very close to the terms we saw in 2007. Pricing is still clearly higher than in 2007 but it’s coming down slightly. So I fear we’re getting back to the same problems we were seeing two years ago. In other cases, if banks don’t like a company, there’s no financing available – there’s no reasonable in-between area.

Hollenberg: On large deals it’s back to bubble times, absolutely.

Burton: We saw as high as 7.5x on the Kabel BW deal. Okay, it was infrastructure-esque. But we’re seeing things like covenant-lites coming back. Financing is no longer the key constraint to deal-doing. The key constraint today is agreeing on valuation.

PEI: How much equity are you putting into deals?

Flaig: It depends. For some time now the rule has been 50:50, but that has been loosened. We’ve gone down to 40ish of equity, but certainly not 25 that we’ve seen before.

Burton: It must be a danger sign when it goes below 40. Telecoms and cable deals might justify less equity but even the larger deals in that space have been up around 40 percent equity.

PEI: On the exit side, how are processes being run?

Richard Burton

Burton: For the larger assets, a dual track process is most common. But there can also be a dual track between atrade sale and a bond offering, for example, as a means of financing a dividend recap to at least generate a partial exit – there’s some of that going on. Putting all your money on one horse in the current market is probably not the best strategy at the moment unless you’re absolutely certain it will come off.

Exits are at an all-time high, globally, at the moment, largely driven by the US I guess. April and May have seen some very large exits, like Nycomed, which was amazing.

Hollenberg: We almost feel compelled to pursue exits because the climate is so good. If we had a choice we’d rather have a poor climate this year and maybe a better one next year. We’re still in the middle of add-on acquisitions. The question is, do you leave that on the table, and sell a company as it is, or do you wait until you finish your work and exit when we’re ready for it? Currently we intend to complete the add-ons we have in the pipeline, but we’ll think long and hard about doing some of the more remote add-ons that may drag into next year.

Our focus is on both sides at the moment. Our oldest company dates back to 2005, while the youngest is from 2010, so it depends where you are in the cycle. We are thinking of selling businesses now because the exit environment is so good at the moment.

PEI: Are LPs demonstrating much appetite for co-investments as the market improves?

Flaig: They are keen on co-investments but we’ve also had a few disappointments when investors changed their minds during the process. There aren’t so many LPs who have the team in place to handle co-investments well. It’s a different kind of work compared to doing a fund investment. We’d love to have more investors co-invest because it gives us more flexibility in terms of deal size which in turn gives you more diversity in your fund.
Hollenberg: We’re right in the middle of negotiating a deal that would be too large for our fund. There is interest from 100 percent of our investors who are structurally able to do co-investments, so that appetite does appear to still be there.

Burton: What you go into at the outset is not necessarily how a deal will end up – it can go through a number of often quite tortuous routes. That’s exciting though. The traditional process is only seen in a minority of cases. The sort of controlled auction process that you saw in 2005, 2006 is quite rare now.

PEI: What are your main concerns about regulatory measures like the AIFMD?

Burton: I think most of our clients are a lot more relaxed about it now in the final draft than the first! There’s probably more concern, especially from the larger funds, about the Dodd-Frank legislation coming out of the US – perceived as more restrictive in terms of investment flows and fundraising.

Flaig: AIFMD will be just an additional cost, it won’t change anything in real life, just more reporting, more paperwork. Another lawyer to employ!

Hollenberg: I’m very relaxed about regulation. My thinking is that we’ve saved a lot of jobs with what we do, a lot of companies wouldn’t be around if we hadn’t invested in them. If for some reason the government wants us to stop doing that, then we’ll do it on our own, without an institutional fund, completely out of any regulation, we can do whatever we like, and there’ll be fewer jobs saved and fewer companies invested in, if that’s what they want.

PEI: Do you think there’s still work to be done in terms of educating politicians as to the merits of private equity?

Hollenberg: Absolutely. We’ve recently become a member of the BVK, after years of not joining. There is certainly education that needs to be done. In Germany, it depends on how the economy is doing. If it’s doing poorly, Germans tend to be quite pragmatic people. If it does well, they come up with all sorts of ideological ideas, which is what we’re seeing now. The periods where the economy seems to be doing well tend to be the more hazardous ones to the long term economic health of the country. My concern is the way the way they interpret law. Germany has a history of transforming EU Directives in the most restrictive and bureaucratic way possible, to present itself as the absolute super-executor of anything the EU designs. So we’ll have to wait and see how we implement the AIFMD, but my hope is that the BVK will have some influence on that.

What we’re fighting here is a general anti-finance, anti-industrial sentiment which is always under the surface in Germany. It comes to the surface as soon as the country thinks it can afford such a thing.

Flaig: Here in Germany, there’s been a bit of a slow start in terms of educating politicians. We underestimated the danger of it from the Regulatory side and we also had this heated local debate about locusts.

Banks have taken a lot of the flak. We have other problems. People are starting to understand the difference between a huge multi-billion euro hedge fund influencing the entire banking system and exchange rates and a private equity firm which buys a company for a few hundred million. People realise there are different types of funds.

Hollenberg: We have been somewhat successful at making the point that we’re not part of the problem, but rather part of the solution.

That needs to be sold more aggressively and I think Germany can do it better than the UK. Pyschologically, in the UK, everything is centred in London. The banks are all there so the epicentre of the financial crisis was there too. So are the hedge funds and private equity funds, and for the general public who aren’t knowledgeable about these things it’s difficult to differentiate between the various institutions. In Germany it’s more decentralised. The banking crisis was somewhat concentrated in Frankfurt, the private equity industry is clustered in Munich and Frankfurt but the target companies are literally everywhere. So it’s more decentralised.

Burton: As to whether private equity will ever be truly embraced by policy-makers, I don’t think it will ever be a passionate embrace, but the best case is probably mutual tolerance based on sound economic principles. I think it’s clear it’s unlikely to be a vote-winner for a politician.

Flaig: The next election is in two years. If we see a complete swing to let’s say a Green / Red government, this will cause a lot of uncertainty. Maybe they won’t do so many bad things – coalitions tend to be pragmatic – but the uncertainty will be high and this will hinder the country.

PEI: How would you sum up the German private equity outlook then for the next 12-18 months?

Burton: I think the next 18 months will continue to be good in economic terms, although I expect us to come down from the 4 percent growth rate to something more sustainable. My hope is that we’ll see more primary opportunities, more companies coming onto the market from both the mittelstand and from corporates. I think exits will continue to be made in numbers and the environment will remain good for those.

Hollenberg: I agree with that as long as nothing happens in the world. But the world being so closely interconnected as it is, I think there’s not better than a 50 percent chance of that. I have some ideas of what might happen, each of which would completely throw off our prognosis. It could be something from the raw materials / oil markets, it could be Chinese real estate, it could be another banking crisis somewhere. There are plenty of opportunities to mess up a good trajectory to a better future. So I expect no better than a 50 percent chance that the good times will continue.

Flaig: Volatility in the world is much higher than it used to be, so the risk of a downturn, especially a surprising one, is much greater. For the German-speaking region, it is a very positive outlook, but when you do investments right now you have to think about the possible black swans on the horizon and you have to put in place a structure which means you can survive such incidents. But in the long run I’m very positive.

Hollenberg: Our chances of surviving to see the long run are much higher in this industry than in the hedge fund industry – we don’t need to mark down to market day to day, we can’t be easily driven out of our investments if we’re prudent with leverage, we can position our companies to survive something like that, and most importantly we can behave anti-cyclically, which many investors cannot.