Private equity firms operating in Germany have reasons to be optimistic: the economy has held up well so far despite global pressures, while the asset class appears to be successfully challenging negative stereotypes. Nonetheless, things could yet take a turn for the worse. Andy Thomson reports from Frankfurt.

In the office of Peter Smeets, a corporate partner in the Frankfurt office of law firm Paul Hastings, a large painting hangs from a wall. On it, two young children sit next to each other. With their rosy cheeks, neat hairstyles, t-shirts and shorts and shiny buckled shoes, they appear at first glance to be symbolic of youthful innocence and good health. Linger beyond that fleeting observation and it's surprising to discover that both are clutching cigarettes.

In the German private equity market, too, appearances can be deceptive. Compared with the mood in most of Europe, where economic fears and the continuing lack of financing options continue to undermine confidence, Germany is cited by some as a comparative idyll. Will Allen, joint head of the European debt advisory unit in the London office of investment bank Houlihan Lokey, says German banks (and some international banks as well) are still prepared to underwrite large amounts of debt for private equity deals in the country. Single underwrites of E200 million to E225 million are “within the comfort zone of a number of banks that remain prepared to underwrite” he says.

The result is that multi-billion euro deals are still possible – as evidenced by CVC Capital Partners' E2.4 billion ($3.6 billion) acquisition of a 25 percent stake in Evonik Industries, a chemicals, energy and real estate group, in June this year. The deal saw an eight-strong syndicate of banks club together to provide a combined E1.2 billion of debt finance, led by WestLB and including three German Landesbanks. While many of the banks that have traditionally lent to the German private equity market remain open for business, observers highlight the large number of ‘second-tier’ banks that have also stepped up to the plate recently.

The continuing availability of debt finance for reasonably large deals contributes to the sense that the German private equity market has managed to fend off the ill effects of the credit crunch rather more effectively than most European counterparts. Observers of the German economy have also no doubt experienced this feeling of relative buoyancy, given that it grew by a robust 2.5 percent last year and then delivered 1.5 percent growth in the first quarter of 2008.

That first-quarter result “surprised macro-economists who had been expecting a slow down”, in the view of Helmut Vorndran, chief executive of Ventizz Capital Partners, a technology-focused buyout and growth capital investor based in Düsseldorf. Vorndran himself is no stranger to producing pleasantly surprising results. In June this year, Ventizz sold a stake of just over 50 percent in Ersol, a solar energy firm, to Robert Bosch for more than €546 million. In 2004, Ventizz had viewed Ersol as “a medium expansion capital deal” but, by August 2005, had acquired a stake of around 80 percent following a series of equity increases. “It passed three or four milestones where we saw the potential for further development each time,” says Vorndran. In September 2005, the firm's listing on the Frankfurt Stock Exchange was 50 times oversubscribed.

According to Vorndran, Ersol has delivered eight times the total capital of Ventizz' E67 million second fund, which closed in 2004. This may help to explain why Ventizz went on to raise a E125 million fund in 2006 and then a E450 million fourth fund earlier this year (Vorndran says there was appetite for between E800 million and E1 billion for this latest effort). What's more, it will presumably have done no harm at all to the image of private equity in the eyes of German management teams. Ersol chief executive Claus Beneking, who said at the time of the recent sale that he would be standing down within a few months, had seen his company's sales grow from E127 million in 2006 to E160 million last year, with a forecast of more than E300 million for 2008.

Might outcomes such as this help private equity to achieve what some see as the Holy Grail of gaining acceptance from the swathe of medium-sized family-owned businesses known as the Mittelstand? In fact, Andre Magnin of listed mid-market GP Deutsche Beteiligungs argues that the image is already favourable: “Mittelstand business owners see private equity as a useful and helpful alternative to an IPO. This perception is helped by the fact that most private equity deals have performed very well.” Although progress made by private equity in penetrating the Mittelstand has been slow, some attribute this simply to a traditional reliance on bank loans to grow businesses rather than any fundamental objection to working with private equity (although there's a view that it helps if you're a locally based fund).

We had to close quickly because regulations governing the sector were due to change. Regulatory approval would normally have taken three months, but we got it within a week. And German regulators are not normally very flexible

Thomas Schmitt

Certainly, signs are emerging that private equity is beginning to be perceived as a valuable contributor to the German economy. In 2003, Thomas Schmitt and Günter Skrzypek launched Augur Capital – initially an adviser to private equity investments in the financial institutions sector, which is currently raising a debut sector-focused fund with a target of E250 million (around E150 million had been raised at the time of going to press). Schmitt says the firm is finding myriad opportunities to invest in the wake of the credit crunch. Furthermore, it claims to have been helped by an extremely productive relationship with the regulatory authorities.

Schmitt reflects on the buyout of open-ended mutual fund trader Schnigge Wertpapierhandelsbank, a deal Augur was under pressure to wrap up last December to safeguard tax benefits: “We had to close quickly because tax regulations were due to change by year end. Regulatory approval would normally have taken three months, but we got it within a week. And German regulators are not normally very flexible.” He adds with a smile that, since then, Augur has been granted verbal approval for a deal before it even having been signed.

Skrzypek points to a number of reasons why Augur appears to have been viewed favourably: “The fund is tailor-made for investments in financial institutions and it's regulated in Luxembourg; we've worked with the regulators for many years as operational managers [both men had prior careers in insurance and asset management with the likes of Winterthur and AXA]; and we have staged workshops with the regulators to help them understand our thinking.”

Schmitt adds: “We're far removed from the locust image. We're playing a role in consolidation, which is needed. And we try to add value through our strategy by way of things like operational changes and roll-ups.”

It is, indeed, hard to reconcile this with the locust image that has cast a cloud over German private equity for the last couple of years. There again, as we reported on page 25, that powerful image was recently subverted by an advertisement placed in a leading German newspaper by Evonik following its tie-up with CVC Capital Partners which humorously described the private equity firm as a “locust of joy”.

Christian Wildmoser, a partner at CVC, says some hard work has been put into shedding private equity's negative associations. “The industry has finally done its homework,” he says. “The large buyout groups have now joined forces within the BVK [the German private equity trade association]. The trade unions have always been very organised whereas private equity firms had previously acted independently. I think the days of running through picket lines at conferences have gone – the debate is more informed and intelligent now.”

Wildmoser does admit however that “lingering suspicion” of private equity's motives remains – suspicion that has been stoked recently by some fairly sceptical comment about certain private equity deals in the German press. Permira-owned Hugo Boss, for example, has been in the spotlight following reported disagreements between the London-based private equity firm and its portfolio company's supervisory board.

Regardless of the accuracy or merits of such press reporting, there are other reasons for believing that the apparent resilience of the German private equity market referred to earlier – together with its improved image – may be a little fragile. Figures from research firm Dealogic, show new deal activity declining over the last couple of years from 104 deals worth $32.7 billion in 2006, to 90 deals totalling $20.5 billion in 2007, and then 39 deals worth $8.3 billion in the first half of this year.

Partly this is because of the rarity of large deals, though one or two remain in the pipeline. Notably, much attention has focused on the auction of building materials group Xella, a firm that has attracted private equity interest and which is believed to have a price tag of around E2 billion. At the time of going to press a source close to the deal expressed confidence that, contrary to some press speculation, it would reach the finishing line – an outcome that “would give the market a confidence boost” according to the source. However, he added that the test would then be whether the financing for the deal could be successfully syndicated.

But the decline in activity also stems from the mid-market, where the price expectations of sellers and those of prospective buyers appear to be increasingly out of kilter – with the result that deal completions are proving difficult. “Pricing is a disaster compared with a year ago,” says Christof Namenyi, a managing director at AXA Private Equity in Frankfurt. “Deals have gone from very cheap to very expensive. Private equity firms have a lot of capital to invest and are keen to do business, so it's understandable that owners will be reluctant to lower their prices.”

Furthermore, the decline in new deal activity is being accompanied by fears that the apparently benign economic outlook hinted at in the statistics earlier this year was merely a temporary suspension of reality rather than a sign of enduring strength. The German Government recently said it expected growth to have “dampened” in the second quarter and that only moderate upward movement could be seen for the remainder of the year.

“The upward force of the German economy is facing persistent headwind, primarily from the world economy,” the Ministry of Economy and Technology said in a statement. “Recently, huge price increases in energy and food have primarily impacted demand in the domestic economy. In addition, less demand in industry – especially abroad and in the euro zone – contributed to this.”

Deals have gone from very cheap to very expensive. Private equity firms have a lot of capital to invest and are keen to do business, so it's understandable that owners will be reluctant to lower their prices

Christof Namenyi

Specific examples are hard to come by but, anecdotally, it appears that increasing numbers of German portfolio companies are beginning to feel the pinch. Back in the office of Paul Hastings in Frankfurt's Eschersheimer Landstraße, Peter Smeets reflects that “much more work is being done on portfolio companies where the financing is under pressure and restructuring is needed”. He contrasts the marked increase in these “financial restructurings” – “where the company is fundamentally okay, but the leverage is too high” – with “deep restructurings” where companies are essentially on their knees. There is always, he says, a small but steady flow of the latter type, regardless of up- or down-cycles.

With signs of trouble emerging, it brings into question whether the German private equity market can continue to make generally smooth progress. There is some evidence that the asset class has made a significant step forward in being seen as a useful – even friendly – partner to Deutschland AG. But this may yet change if cold economic winds bring a chill to private equity-backed German companies – all the more so if one or two large, high-profile corporate brand names are laid low. The image war is not over yet.