How to keep a promise never made

More than enough has been written about the broken promise that was Germany's private equity market. The problem is: who made that promise? Not the local practitioners who continue to build out the franchise of the asset class not so much in spite, but because, of the tough times the economy is experiencing. Philip Borel visited Germany to find out who's doing what and why.

Buyout practitioners active in Germany are tired of being asked when their market will finally make that sudden great leap forward that has been predicted time and again over the past decade. ‘Predicted by whom?’ they shrug, implying that much of the commentary published in recent years on the German market's growth potential has been so much nonsense, circulated by poorly informed outsiders. “Germany is the country of the great undelivered private equity promise it never made”, says Thomas Pütter, chief executive of Munich-based Allianz Capital Partners, the European direct investment arm of insurer Allianz, and this is a view shared by many of his peers.

What local private equity investors operating in Germany find irritating about all the talk of the supposed disappointments of the past is that it distracts from the fact that private equity as a financing tool has steadily grown over the past decade, and in doing so has secured a permanent – and increasingly prominent – place in the lexicon of German corporate finance. “There is no question that private equity has become established in Germany”, says Peter Gangsted, head of European large-cap buyout investor Cinven's Frankfurt office. Pütter agrees: “Investment banks will now invite private equity to a transaction as a matter of course – that is a newer development.”

Full prices
Practitioners will also note that investment banks, especially the US houses that had moved to Germany in the second half of 1990s and quickly assumed dominant positions in German M&A, might in fact have gone too far at times in promoting investment opportunities to financial sponsors. In 2000 and 2001, many domestic and international private equity funds that had raised capital specifically for the purpose of doing deals in Germany were under pressure to invest. “The investment banks knew that and fed the machine”, says Nigel McConnell, managing partner at Electra Partners Europe, which has an office in Frankfurt. As Jens Tonn, a director at Candover specialising in Germany, points out, some of the investment propositions circulating at that time were using growth projections that looked “as if they had been based on Anglo-Saxon or US comparables”, that is, reference points that were hardly realistic in the German context.

Unsurprisingly, a number of transactions that were completed on the basis of such overly aggressive performance forecasts are thought to have proven disappointing to their sponsors. “There have been a number of recent transactions where sponsors have had to put more money in”, says McConnell. “I expect these deals to pull through, but I'm not sure they will be very profitable.”

Perhaps partly as a result of these developments, a number of European buyout firms have recently concluded that to consistently make money in Germany is too difficult to be worth their while. Earlier this year UK turnaround specialist Alchemy Partners closed its Frankfurt office. Mid-market investor L&G Ventures did the same, citing excessive competition for what it considered limited deal flow. London-based Botts & Company is currently in the process of closing its Munich office, while London-based Duke Street Capital shelved plans to open an office. So did US LBO specialist Clayton, Dubilier & Rice (CD&R), following the high-profile collapse of Fairchild Dornier, the Bavarian aviation group CD&R had acquired alongside Allianz Capital Partners.

Pending or completed withdrawals from the market notwithstanding, German asset prices have remained robust. “It seems surprising that pricing is still fairly demanding even though a number of private equity players have withdrawn from the market”, says Dietrich Stoltenburg of Bank of Scotland Corporate Banking, one of Frankfurt's most active providers of debt to German leveraged buyouts. “However, this is very much related to the fact that competition is still intense and enough money is available to invest.”

Neither have Germany's economic downturn and the fact that trade buyers' appetite for acquisitions is still at a low had much of an impact on prices. Germany is technically in a recession following a prolonged and ongoing period of negative growth, but company valuations have not softened as a result. Says a banker: “If you look at the multiples of recent large LBOs such as Viterra Energy Services [the metering business sold by German utility group E.ONg to CVC Capital Partners in April this year] or Bertelsmann Springer [a publishing business acquired by Cinven and Candover in May], you find that the economic situation was not reflected in the pricing. These are robust, internationally operating businesses, but prices were still surprisingly full.”

Fullness of pricing stems in part from the fact that deal flow, while steady, remains limited. According to data compiled by the Centre of Management Buyout Research at the University of Nottingham, Germany over the past five years produced an annual average of twelve buyouts with a transaction value of less than €100m, six transactions in the €100m to €250m bracket and six large leveraged buyouts worth more than €250m. That's not many deals per sponsor, notwithstanding the reduction in their number. Ralph Huep, Frankfurt-based general manager at Advent International, which invests up to €200m of equity per buyout, says there are still some 30 financial investors competing in the firm's target segment. In the early 1990s, when Advent first moved into Germany, there were less than a dozen competitors, he recalls.

The many houses that remain committed to the market maintain that what motivates them is the prospect of investing in high quality, often world-leading businesses run by managers that traditionally have often concentrated more on their product and less on financing.

Of all the assumptions about Germany's potential for private equity investment that are currently in circulation, the idea that many German managers are still relatively unfamiliar or uncomfortable with private equity as a corporate finance instrument is arguably the most accurate one. (On the other hand, the frequently made claim that German executives are somehow less interested in personal wealth and hence make less suitable candidates for MBOs has always been dubious, although there is the more plausible notion that Germany has something of an ‘envy culture’ which makes the rich deal with their personal wealth more discretely than commercially successful individuals in other capitalist societies might.)

In 2002, according to the European Private Equity and Venture Capital Association, private equity investment as a percentage of German GDP accounted for 0.11 per cent, against 0.14 per cent in Spain, 0.21 per cent in Italy, 0.39 per cent in France and 0.63 per cent in the UK. Therein lies what many consider a significant and still largely untapped opportunity for private equity.

Many are quick to acknowledge that managerial attitudes are changing. A new generation of executives in Germany, many of whom have spent time studying and working abroad, is more likely to apply the kind of cash flow focus and financial understanding that financial investors require operational management to exercise.

To be sure, divisional executives at a large corporation, upon hearing that their unit is no longer core to its parent's strategy, may still not as a first thought realise that this presents an opportunity for them to buy the unit out. But what practitioners say is changing is the old preconception that for a business to be sold, its management must have somehow failed. Large scale privatisation undertaken by the trust organisation Treuhand Anstalt, on behalf of the government following the country's reunification in the early 1990s, helped make M&A acceptable in Germany -a change that incumbent private equity investors believe they will benefit from going forward.

Tomorrow's deal flow
Today however, privatisation, even though the federal government has announced plans to raise several billion euros from asset sales in order to fund fiscal reforms, is unlikely to create much deal flow that will attract private equity investment.

Neither is the Mittelstand, Germany's famous network of small- and medium sized privately owned businesses, likely to suddenly see a jump in company sales to financial sponsors any time soon – at least not at the rate the some have forecast. “The importance of the Mittelstand is often overrated”, says Allianz' Thomas Pütter. “There may be about 2 million Mittelstand companies in total, but only 3,000 to 5,000 have the potential to undergo a private equity funded change of ownership.” Another practitioner, representing a pan-European investment house, quips that over-enthusiasts working with very big numbers when assessing the Mittelstand opportunity “probably never read the small print about how big most of these companies really were.”

Stefan Winterling, associate director at Hg Capital in Frankfurt, which in May of this year tendered a recommended €169m offer for W.E.T. Automotive Systems, a seat-heating manufacturer, says that although there are very attractive businesses in the mid-cap segment, some deals are more difficult to execute than others: “Mittelstand transactions are not as abundant as many people have expected, and due diligence can be tricky since owners might not want interested parties to talk to customers, managers, or suppliers. Public-to-privates need to follow clear and stringent regulation and take time. Corporate disposals, on the other hand, tend be more straightforward auction processes. But if we like an opportunity, we are prepared to commit the necessary resources.”

It should be noted too that a number of other European private equity firms are determined to remain active in the mid-market, such as Barclays Private Equity in Munich; Industri Kapital in Hamburg; Electra, Bridgepoint Capital and NIB Capital Private Equity in Frankfurt; as well as Leman Capital, which operates from its Geneva base.

Pressure to divest
Most German private equity investors, Hg's Winterling included, continue to expect the bulk of investment opportunities to come out of the restructuring of the corporate sector. Cinven's Peter Gangsted estimates that about 80 per cent of the deal flow for larger transactions of the past few years has come from large corporations disposing of non-core businesses. This is a process that has only just begun: only a select group of large publicly listed conglomerates including Siemens, Degussa, E.ON and Hoechst have begun to sell off assets in a series of large transactions. “Everyone else is talking about it, but very few are doing it yet”, describes Jens Tonn at Candover the mood among Germany's corporate heavyweights.

It seems surprising that pricing is still fairly demanding even though a number of private equity players have withdrawn from the market

But no one doubts that more household names are going to join in Deutschland AG's restructuring process. A survey of 28 M&A professionals at some of Germany's largest corporation, published in August by German trade magazine Finance in conjunction with 3i Germany, Linklaters Oppenhoff & Rödler and Deloitte & Touche, found that 71 per cent of those surveyed had plans to continue or accelerate their divestment programmes. 75 per cent expected that private equity funds would play a greater role assisting in this process than in previous years.

One group of market participants driving this process, according to Jochen König, head of leveraged finance at the Royal Bank of Scotland in Frankfurt, are the credit rating agencies, benefiting from a growing recognition of the importance of shareholder value among German corporates: “Ratings agencies, especially once interest rates pick up, are bound to put more pressure on corporations to pay down debt and streamline their businesses,” he predicts.

At the same time banks, facing greater international competition and regulatory pressures such as Basle II to risk-adjust their lending, will further reduce the availability of the cheap loans that have long been the traditional source of funding for German businesses. According to data compiled by HypoVereinsbank, German companies today still satisfy an extraordinary 71 per cent of their funding requirements using bank debt and procure only the remaining 29 per cent in the capital markets. In the US and the UK, capital markets account for 82 and 90 per cent of corporate funding, respectively – a differential that will undoubtedly narrow, if not close altogether. From the point of view of corporate borrowers, the resulting funding gap will have to be plugged somehow, and providers of equity capital look set to be among the beneficiaries of this trend.

Trend towards turnarounds
That said, for a growing number of German businesses toiling in the face of adverse economic conditions and increasingly elusive bank credit lines, a plain vanilla private equity solution might already come too late. Bankruptcies are on the increase, and a growing number of turnaround specialists are looking to cater to businesses in need of a more drastic response prior to an insolvency than what mainstream private equity investors can typically provide. Munich-based Orlando Management has raised €163m for a special situations fund, while Nordwind Capital is currently in the market with a similar vehicle. In Berlin, CMP Capital Management Partners, with €125m under management, is also pursuing a turnaround strategy.

Accountants and management consultants, who are often ideally positioned to detect potential problems that may be in need for treatment further down the line, are looking for ways to participate in what they too perceive as a growing restructuring opportunity.

US turnaround consultants such as Alix Partners have also arrived in Germany, and there is even talk in Germany's main private equity centres of Frankfurt, Munich, Hamburg and Düsseldorf that US distressed investors like Apollo Management and Cerberus are wondering whether the time may be right to bring one of Wall Street's most aggressive investment techniques to bear on an economy that traditionally has favoured a more consensus-driven model.

These specialists may yet decide against setting up shop in Germany at this point, but the fact that they have been considering their options is more proof still that significant change in German corporate M&A is currently underway.

Whether this change will also trigger yet another wave of international private equity groups looking to enter the market also remains to be seen. Rumour has it that The Blackstone Group is looking to open an office in Hamburg to boost its presence in large-cap LBOs, while a number of US mid-market houses are also thought to be toying with the idea of doing more business in Germany.

Regardless of how many, and what type of, newcomers will ultimately arrive, one thing seems certain: the German buyout market will continue to expand gradually. What it won't do is mutate overnight into an environment where a multiple of today's transaction volume will occur. Incumbent players as well as a number of savvy new entrants will be doing nicely as German private equity develops. But to overestimate its short-term potential would be a mistake. As Peter Gangsted at Cinven puts it: “There is no way there will be a boom all of a sudden. Germany is not like that.”