Germany roundtable: "There’s confidence out there”(3)

The storm over Europe is tearing into investment strategies across the continent. However, the private equity opportunity in Germany, according to three market insiders, remains intact.

In June, three seasoned practitioners joined us in Frankfurt for an in-depth discussion of private equity trends in Germany. Front of mind, of course, was the uncertainty afflicting Europe’s single currency and its implications for investors in Germany-based businesses. At the same time, the outlook Daniel Flaig of Capvis, Andreas Rodin of P+P Pöllath + Partners and Permira’s Martin Weckwerth chose to explore was resolutely long-term. 

For all the current difficulties, they suggested, there was still more to the story of investing in Europe’s largest economy than the troubled euro – and attractive opportunities remained for private equity to help German businesses remain agile and competitive.

PEI: The euro crisis continues to cast a dark shadow over the European economy, Germany included. How is this affecting your thinking as private equity practitioners?

Flaig: The difficulties with the euro, with Greece, the Spanish banks – there’s not much new about these problems. It looks like we’re now getting closer to a decision point, but we still don’t know when the political decisions will actually happen. So there are big uncertainties, certainly in the short-term, and they make it difficult to invest. On the other hand, we see strong economic performance in the German-speaking region, and as long as the euro remains weak I think the German economy will be booming. In that sense, it’s a good environment and we are still looking for new investments in this country, ideally ones with an international, export-driven angle. Even domestically, Germany is in good shape. So if you’re going to invest in Europe, where else would you go?

Does Permira have a house view on whether the euro will stay?

Martin: No, there is no official view. I think we all agree about the uncertainty, and nobody can tell you how long it will take until a political solution is found. Personally I think it’s less likely the euro will fall apart because there’s just so much economic value at stake for everyone in the eurozone. In the meantime we clearly see Germany in a strong position because of the weak euro and low unemployment. Yes we are in a highly volatile environment; things can change fundamentally and very quickly. But relatively speaking, Germany is in a good position and we think investing here in the next couple of years will be attractive.

Strictly speaking, when you invest in Germany you don’t necessarily acquire exposure to the German marketplace. You’re effectively buying into regional if not global markets, albeit via businesses that happen to be based here.

Flaig: Yes and no. We look into regional market leaders, typically service-based  companies with a strong position in the domestic market; but we also invest in global champions in niche markets with an enterprise value of up to €300 million, and exposure to the emerging markets in particular. We recently did an analysis of direct sales of our portfolio companies and found that 80 percent or so actually come from German-speaking markets. Obviously we can’t really measure our indirect foreign sales exposure coming from German companies selling to other German companies, which then export. But still, we think 50 to 60 percent of our revenues come from
within Germany.

Capital challenges

What does the macro uncertainty mean for private equity fund formation in Germany?

Rodin: From a GP perspective, fundraising is still difficult. But for a variety of reasons, the number of fund closings is increasing at the moment – less so on the venture side, but certainly in buyout. As far as our LP advisory business is concerned, we still see subdued appetite for private equity from regulated investors such as insurance companies and pension funds – mainly because of regulatory issues such as Solvency II, but also because private equity doesn’t quickly generate cash that can be reported as the return required by the law. As a result, it can still take a lot of time to get a German institution into the fund – not because the asset class isn’t interesting per se, but because of reasons to do with their own situation.

How are tax issues affecting fundraising in Germany?

Rodin: For investors tax isn’t an issue, but for GPs it is. We’re still having to deal with uncertainty around taxing the management fee and carried interest, and there’s also the question of tax deductibility of acquisition debt. The latter subject has recently been picked up by the Dutch government, which is ironic; we had just moved it off the table here in Germany, and now it pops up in the Netherlands, an important holding country. 

In Germany, uncertainty around tax has been a fact of life since 2007, and it has obviously affected our work as fund structuring lawyers in terms of the solutions we’ve been able to come up with. Putting in place an off-shore structure alone is typically not enough; from a tax perspective, there has to be some substance in the off-shore jurisdiction too. Besides, if you’re considering setting up a fund right now and establishing it in Guernsey, you run the risk of coming under the EU’s manager regulation – which will happen.

Moving on from the locust debate

In terms of competitiveness, Germany was not long ago labelled the sick man of Europe, and regulatory reform was seen as long overdue. Is that still the case?

Rodin: Market reforms were indeed badly needed after the last years of the Kohl government, but not anymore. In fact, one reason why Germany is performing strongly today is that under Kohl’s successor Gerhard Schroder, the reform of the labour market under the so-called ‘Agenda 2010’ was highly effective. Another reason is that company management, often as a result of private equity ownership, has improved and become more efficient. Of course, the industry doesn’t get a lot of credit for this: people are still talking about deals that went wrong as examples of ‘locust’ investing. 

But this cannot obscure the fact that private equity financing has been instrumental in deconsolidating the Deutschland AG, i.e. the old web of crossholdings of the country’s largest businesses; and today’s government understands this exactly. Moreover, private equity has also been important for German mid-sized companies, again helping them with professionalizing management and so on.

Martin, what has your experience with sensitive investments in Germany been?

Weckwerth: With both ProSieben.Sat1 and also Hugo Boss, the general public were very interested in why the investment was made, how we structured it, what the idea behind it was. Clearly we invested around the same time as the locust debate and that did not help with people’s expectations of what would happen to these businesses. Our challenge was to create an understanding among all stakeholders of what we would do and how it would benefit the business. But in both cases, together with management, we did manage to explain to the unions, the workers’ representatives, other stakeholders and the public the rationale of the actions taken. And today, the outcome actually shows that the companies benefited.

How so?

Weckwerth: At the beginning of the investment Hugo Boss had sales close to €2 billion and EBITDA of €275 million, with an EBIT margin of roughly 17 percent. Last year sales grew by 19 percent while EBITDA grew by 34 percent to €470m. At the same time cash conversion improved significantly. Looking ahead, the business is forecasting sales of roughly €3 billion, with EBITDA of €750 million, for 2015. I think that shows, even to the sceptics, the significant improvements that have been made in the business.

There is a world-class management team in place, led by Claus Dietrich-Lahrs, and they have considerably strengthened the brand positioning and set the company up for growth, especially internationally. To be sure, it took time for the operational changes management made to show in the numbers but Hugo Boss now has a growing international profile. A few weeks ago the company had a big fashion show in China, which clearly from an Asian perspective is very important. Overall, we think Hugo Boss makes a very good case study, because people can see that this business is in much better shape than before and management can easily explain what they did with our funds’ financial backing and why they did it.

How closely is private equity in Germany being scrutinised now?

Flaig: Private equity is not in the headlines as much anymore, because it’s become clear that it doesn’t create systemic financial risks. People have learned that systemic risk is related to hedge funds and overleveraged banks, but not private equity. Unfortunately for us, regulators have taken a long time to understand the differences between private equity and, say, hedge funds; it’s only now that we’re beginning to see regulators differentiating more clearly. And there is still a lot of work to do to explain the private equity approach. When we talk to a family owner, for instance, we still have to make it clear to them that we will make an adequate return only if we grow the business.

Assuaging owners

How troubled are family owners by the fact that private equity has to sell again at some point?

Flaig: I think this is one of the two greatest challenges in the discussion with owners. The first question they ask you is: ‘If I sell you my company, what should I do with my money in this uncertain time? I have a good business and I know what I’m doing – am I not better off holding on to it?’ It’s very hard to give people advice on this, especially in the current environment, and I have real sympathy for this concern. 

The second problem is that yes, as a private equity owner you will need to sell again. It is true that holding periods in the industry are getting longer, but in the end, five, 10 or even more years from today, there will be the need to find a new owner – and we obviously cannot know at the outset who that owner might be, because the company will have changed completely, and the market, too.

Martin: I think the key here is to demonstrate how during the investment period we can help create attractive opportunities for the business, maybe by way of consolidating the sector, by building structures that allow the business to grow internationally, by bringing in high-calibre management to create real market leaders. This can be persuasive, especially when the family owner retains a stake in the investments and become a partner who can contribute their knowledge of the business and ultimately participate in the success of the investment. At that stage, when it comes to making the exit, selling to a strategic buyer can still be the most sensitive of the three routes that are available – an IPO or another sale to private equity being the other two. Because it is rare for a family entrepreneur to see a trade buyer as neutral.

Rodin: Clearly these situations are psychologically driven, and in my view mindsets in Germany have changed in important ways over the past 15 to 20 years. The current generation of owners is more flexible than the previous one, to whom selling or partnering with an outside investor would often have been unthinkable. Now owners realise these things aren’t as black and white. They also realise that when a private equity owner looks to exit, it typically comes when the business plan has been achieved and when the time has come for someone else to take over and drive the business forward.

PEI: Has there been a dearth of exits in Germany?

Flaig: Generally speaking, since the financial crisis of 2008 the numbers of all types of transactions has dropped dramatically, including exits. Deal flow stayed strong, but a lot of businesses were being prepared for transactions that were then postponed for all sorts of reasons: price, lack of financing, uncertain markets, structural problems with the companies internally and so on. For private equity, the need to exit investments does exist, and postponing exits can of course be more of a problem for a fund than for a family, who can postpone for a long time, or even a corporate. But as the pressure to sell increases, so will the number of completed transactions.

Generous leverage

Capvis has just bought Hessnatur, a natural clothing distributor based near Frankfurt. Is there any way in which this investment was directly affected by the difficult macro climate?

Flaig: Not really. The company is in an unconsolidated sector and became available as a result of a bankruptcy a year ago. We financed the purchase with equity only; that might be a flavour-of-the-day aspect, if you like. We did it because we see it as a growth business that we will continue to invest in, and so leverage wouldn’t really add a lot of value – and in any event, once you start talking to banks, you can be sure what you’re trying to do will leak to the market. But we could have got leverage had we wanted to. In fact, I am surprised how generous or aggressive borrowing multiples have become again. We’re talking senior debt at 4.5x, total leverage up to six times; that’s what I see 
in the mid-market segment.

Weckwerth: In the large-cap segment, multiples can be aggressive but lenders are also more selective, risk-conscious and focused on cash flow stability. In growth situations, for instance, leverage ratios are lower than they have been before. As a sponsor, having flexibility in your capital structures in downturns is clearly important. If you look at what Permira has done in the past three years, we have significantly deleveraged the portfolio and gone into a lot of discussions about amending and extending our structures. Today none of our businesses are having to deal with difficult covenants or refinancing situations; we basically have green flags on the entire portfolio.

Flaig: Sponsors do have to be more careful with structures compared to the peak, but again, it’s striking how quickly the overall leverage volume has bounced back. There was virtually nothing available in the second half of 2011; the market was completely dried out. But then somebody switched on the light at beginning of this year, and somehow money flooded backed into the system; now the banks are back. I am surprised how quickly these cycles go through and maybe how little some people learn. It reminds me of a professor of mine, who used to say banks are organisations without memories.

Opportunity in change

How is the industry changing on the equity side – are you seeing new groups coming to market?

Rodin: Yes we are, but for first-time managers life remains difficult. Recently we’ve been doing quite a bit of work on pledge funds and structures that enable deal-by-deal funding of investments, rather than first-time funds. But as far as our fund formation practice is concerned, private equity remains an important source of business for us. We’re also seeing a lot of interest in cash-intensive segments such as infrastructure and energy.

To conclude: what is the outlook for private equity in Germany in the coming years?

Weckwerth: We see profound change in many sectors, which will create opportunities. All the signs are that private equity will have to approach them constructively: if you position yourself purely as a financial player, it probably won’t be good enough. You’ll need to be able to actively contribute to operational improvement.

Flaig: In the mid-market, it’s never been enough to be financially smart, and it won’t be enough going forward. We have to be able to change companies, grow companies, make them better. As a private equity firm you probably don’t have the muscle to influence an entire industry, but we can certainly pick companies that are in a good position to benefit from trends in their sector. That’s where I continue to see a big opportunity.

Rodin: I’m also optimistic. Ultimately private equity has to deliver returns to its investors, but it isn’t just a financial product as many others. It’s a catalyst for change in business, and for as long as Germany retains its focus on industry and innovation, there will be plenty for private equity to do here. 

Roundtable participants

Daniel Flaig, Capvis
Swiss mid-market house Capvis is investing its third fund in German-speaking markets. In May, the firm opened an office in Frankfurt. Daniel Flaig is a partner.

Andreas Rodin, P+P Pöllath + Partners
Andreas Rodin is a founding partner of P+P and a leading private fund formation lawyer in
Germany. To date, Rodin and his colleagues have advised over 300 private partnerships.

Martin Weckwerth, Permira
Permira was an early mover in German private equity and retains a lead role in the market. A partner since 2002, Martin Weckwerth has worked on many investments in the country including Hugo Boss and Valentino.