Mind the gap

One of the hot issues in the run up to this year's elections in September is the funding gap that is emerging between banks and corporates. It threatens the country's privately held Mittelstand businesses, the backbone of Germany's already flailing economy.

The fringes of Germany's private equity community, away from the mainstream buyout funds, may do well to bridge the gap as bank debt and credit tightens and no easy route to the capital markets looks set to open up imminently.

?Young, successful and redundant? ran the recent headline on the cover story of Der Spiegel, one of Germany's current affairs magazines. Nothing surprising in a downturn, especially one in a country where the labour laws favour the old and the needy when the axe falls on jobs. The difference this time is that the severity of the economic decline is finally hurting Germany's professional classes.

Thousands of bankers are being culled, as the German banks try to survive Europe's biggest economy all but grinding to a halt. And the worst is yet to come. Deutsche, HypoVereins, Dresdner and Commerz, the country's four biggest banks, are all taking a pessimistic view on their bad loan provisions, which already run into billions of Euros. The banks know that insolvencies only hit a peak as the economy is well on the road to recovery.

Meanwhile the banks pursue aggressive cost reduction programmes, taking a fine-toothed comb to their loan portfolios, partly in readiness for the capital adequacy requirements of Basle II, but mostly because they cannot afford the low to zero margin business. The banks are focusing on risk and they are starting to price it appropriately.

Ratios of total debt to EBITDA (earnings before interest, taxation, depreciation and amortisation) on leveraged buyouts are significantly down in Germany compared with the UK, France and the Netherlands, according to a recent report by KPMG, the accountants. Debt providers will lend around 4.4 times EBITDA in those countries compared to just 3.8 times EBITDA in Germany. Senior secured debt considered alone is a similar story.

What is a private equity house to do?
Despite these gloomy indicators, there are early signs at the top end of the market that deals are getting done, following a year of quiescence in the face of turbulent markets. Half a dozen big buyouts by foreign players boosted the private equity investment figures for the second quarter of 2002. Deals like Nordic private equity house EQT's €1.66bn acquisition of Haarmann & Reimer, the flavours and fragrances unit of Bayer, have helped swell the numbers. Doughty Hanson, the pan-European private equity firm, is said to have spent €700m for its majority stake in Auto-Teile-Unger, the largest auto parts supplier in Germany.

But the competition is fierce and it keeps prices firm, to such an extent that the private equity investor that wins at auction is often suspected of over-paying. At the same time, some foreign firms have yet to do a deal in Germany and the dark mutterings from head office suggest time is running out.

The good news is fresh opportunities to do business are emerging.

Frank Golland, head of KPMG's private equity practice in Germany, says: ?There are great opportunies given the state of the economy for secondary buyers and turn-around funds. There are already three or four new turn-around funds in Germany. We will see more and more of these special situation opportunities.?

Already Orlando Capital Partners, Nordwind Capital, EMC and CMP in Berlin are staking a claim in the new order. Munich-based GI Ventures, in a move backed by HypoVereinsbank, is raising a €100m buyout fund looking to capitalise on buyout opportunities in the Mittelstand as well.

At the secondary end of the market, says Golland, private equity investors, banks, insurers, pension funds and corporates have all been stung by the decline of the German economy and some of them are looking for ways to take an early strategic exit. He says: ?For others it is a brilliant opportunity to buy a whole portfolio at a discount. The Neuer Markt, the growth segment of Germany's stock exchange, is worth a tenth of its peak value and a secondary buyer will take a discount on top of that.?

This strikes at the heart of the main obstacle to successful secondary sales of any kind in the straitened conditions of the last 18 months: valuations. Golland concedes that this is where it can become complicated, when, for example, a VC fund has reached the limit of its capital commitment to a specific investment. Many funds have a cap on the amount any one individual investment can draw from a fund. Or the fund may not have banked on holding the investment for as long as the current markets have forced them to. In such cases the investment can be sold on for a nominal price and the seller takes an earn-out, cash on the eventual sale of the asset in return for their continuing involvement in the management of the investment.

The turnaround proposition
Alternatively in turnaround buyouts of struggling corporate subsidiaries, vendor loans or seller's notes are also ways for the seller to participate in any upside and a convenient means for the buyer to leverage a deal without having to rely entirely on bank debt and credit.

Looked at crudely the turn-around fund is not so far removed from the secondary market in Germany in its central conceit: buy an asset at a discount, fix it and sell it on for a profit. In a secondary portfolio sale it may be the seller that is distressed; in a turnaround it is the asset that is squealing. If the emergence of secondary and turnaround strategies is an expression of an increasingly mature German market, then it is perhaps ironic that at their heart is the old-fashioned private equity discipline of spotting an opportunity to buy low and sell high.

Christian Hollenberg, a founding partner at Orlando Capital Partners, has raised a €163m turn-around fund. He says: ?It goes back to the original roots of private equity. The mainstream market has degenerated into a bidding game and the returns have become the same as those from the markets plus a premium for illiquidity.? That is fine, he says, but it may not be the reason the investor moved into the asset class.

Hollenberg, who prefers the broader term of special situations to describe the kinds of opportunity that the fund targets, had initially targeted a final close of €125m for the fund. Raising the bulk of the capital outside Germany, strong investor appetite for an alternative to the private equity mainstream meant the fund was oversubscribed by a third.

Hollenberg says the type of companies he and his team are looking at may have a variety of problems: poor profitability, an even worse balance sheet, a one-time management error that needs correcting. He is adamant that Orlando will not touch the ?eternal turnaround,? firms with a poor product or a poor market position, because it makes the time-frame difficult to calculate. They prefer to leave those to die or to go to strategic buyers with time to spare.

Also he says: ?We tend to stay away from large scale mass staff reductions, unless it's an insolvency procedure. The reverse selection of people – where you have to retain the older and more dependent staff – may be fine from a social perspective, but it is disastrous from the perspective of the company.?

Tobias Hans, a senior executive in Golland's team at KPMG, says the German insolvency procedure is very highly regulated and for most turnaround funds it makes sense generally to step in before or after the procedure. Golland says: ?It is difficult because in Germany we don't have that many top performing managers who have the experience in restructuring companies.?

Hollenberg is not shy of tackling an insolvent firm: ?In the US you can implement drastic and far-reaching measures swiftly. The only place you can do that in Germany is in insolvency proceedings.?

But he notes that in Germany even then it is costly and timely. By and large he prefers companies with an isolated problem and a good core product and market. In fact exactly the kind of company the funding gap may throw up.

The relevance of mezzanine
Jochen König, who runs the Royal Bank of Scotland's leveraged finance operation in Frankfurt, is keen to work with a particular breed of business manager: ?The German entrepreneur has been focused on a very modern asset base – his operative target – and tax minimisation – his financial target. They fit very well together – you can invest and reduce earnings and tax liability.?

But it is exactly those concerns that can take the business manager's eyes off managing the cashflow and balance sheet. Hollenberg at Orlando says: ?We see that frequently. The banks have been willing to lend for decades and now they are not and many companies cannot adapt to that.? Funds such as Hollenberg's can move into the funding gap, recapitalise the company and move the business plan to a more cashflow friendly model.

Orlando Capital Partners have no need for debt. In most cases, when they invest they will buy the company's debt from the bank and what they do not buy they try and reduce.

Of course most Mittelstand firms would rather have no need of turnaround specialists. Those struggling as the banks call in their loans may instead to turn to the mezzanine houses to fill the funding gap.

Both Jochen König of RBS and Thomas Krausser, director of mezzanine provider Pricoa, say though that the sponsorless mezzanine transaction is just a side-show to the main mezzanine event, the LBO. König says cheap money is still available to Mittelstand companies that want it and that the German banks are not much further forward in cleaning their loan portfolios than they were a year ago. The progress they have made is only just keeping up with the deteriorating economy. The debt and credit crunch will only really bite in a year or so.

Even then it will be easy to overstate the impact of the sponsorless mezzanine transaction, mainly because it is driven by issues that are not time critical. The main and oft cited ground for such a deal is succession – a capital replacement to buy out a shareholder. König says that a deal like that can take anything up to five years.

Krausser says the volume of sponsorless mezzanine is very modest. Pricoa built up a small portfolio in the early 1990s, before it jumped on Europe's LBO train. As a strategy its appeal is greatest when the buyout market is most stagnant.

Krausser concedes there is an opportunity in bridging the funding gap, but he says you need to dedicate significant resources to it: ?You need the chemistry. You need to clarify control issues and define an exit strategy. You are not far from doing all the work of the private equity investor.? Only the few that take that systematic approach will succeed.

Both mezzanine providers are happy with their strategies to hitch their wagons to the buyout train. Business has been quiet, but is starting to pick up. And even in a slack market, mezzanine was taking a bigger slice of the financing structure as an alternative to the high-yield markets. As Krausser says: ?Mezz has a few unbeatable selling points. It is flexible; you can structure it as you wish. It's private, there is no roadshow, and it is always open.? It's a sales pitch that sounds ideal for the Mittelstand, but it leaves out the cost. And that is significant, particularly when compared to the cheap credit the private companies are used to.

Meanwhile the funding gap is set to grow. And while it might cause a few finance directors to suffer the odd sleepless night, most observers believe it will be to the benefit of the German economy if its backbone of Mittelstand companies becomes less reliant on bank debt. For the country's maturing private equity community, this offers a genuine opportunity. Mind the gap and bridge it.