Why it’s important to get heavy in the German market

Fund managers attempting to penetrate the Mittelstand need to target asset-heavy businesses to compensate for weaker credit metrics. Daniel Heine of Patrimonium explores the landscape.

The German market is opening up to private debt but it is not the easiest of markets to operate in. PDI caught up with Daniel Heine of fund manager Patrimonium to find out more about the market’s dynamics – including why partnering with banks is a good way forward.

How would you define the lower mid-market – and what is the significance of that in terms of types of companies targeted?

We narrow it down to the German-speaking markets, with around 90 percent being Germany and the rest Austria and Switzerland. The companies we target typically have EBITDA of between €10 million-€50 million, with revenues of around €100 million-€300 million. Above that – where you have companies with revenues of €500 million or more – we would consider to be the mid-market.

The mid-market is already able to access public instruments in Germany. It has a well-developed Schuldschein market and mid-market companies use that to access financing from mainly insurers and pension funds.

The lower mid-market represents the backbone of the German economy in terms of volume of companies and number of employees. These are businesses that don’t make the cut when it comes to issuing public instruments as they are too small. In the past, they have been fully dependent on the traditional providers of finance, especially the banks.

Following the financial crisis in 2008-09, the traditional lenders have retrenched. They retrenched first at the weak end of the borrower base – the weaker quality credits and the lower ratings. Germany is still an overbanked market but it’s now starting to bifurcate. Companies which qualify for a banking solution can get that on very favourable terms. But if their rating is too weak then they get rejected and fall into our direct lending/sponsorless universe.

How much opportunity is there in Germany? 

From a value perspective it’s a fantastic universe, as Germany is such a developed and broad market – it’s the world’s fourth-largest economy. It is currently around five years behind the UK in terms of the development of its private debt market. UK banks are further ahead in having recapitalised their balance sheets but I would expect Germany to catch up to where the UK currently is over the next three to five years.

What are the main considerations when making an investment in Germany? 

There are three key characteristics. One is that the German market is essentially sponsorless. Traditionally there have not been many private equity deals and companies are family owned and generally not up for sale. The good news for the likes of us is that it’s very much a credit culture.

Two, if a company qualifies for bank finance then that finance will be significantly cheaper. If you’re looking for an alternative finance solution then your credit metrics will be weaker. As a fund manager, what’s the remedy for accepting weak credit metrics? You have to be compensated by hard asset collateral, and that’s something many German companies provide. There is a tradition of asset-heavy businesses.

Three, you are dealing and working with family companies and there is a question of mutual trust. They want to know their counterparty and you have to provide them with convincing references, as they are afraid that you will want to take over the business. The more deals you do in the market, the more references you can provide and the more trust you can earn.

How should fund managers be preparing themselves for a turn in the cycle?

We have been around since before the GFC and went through it with a mezzanine portfolio, so the experience is still fresh in our memory. That is important because everyone who has been in the market for more than a decade knows this cycle will come to an end.

How are we prepared? With the current portfolio, the best remedy is to look for risk/return profiles where there is very solid downside protection. If the worst comes to the worst, you want to be able to liquidate the collateral and have a strong recovery.

Parallel to our direct lending fund we also have a special situations fund and it’s important to have capital commitments in place, as when the cycle ends, opportunities for special situations will increase. If the capital is ready to deploy, you can make some very interesting investments.

For example, we have entered into a sourcing partnership with HSBC in Germany,  one of the largest providers of “insolvency money” i.e. pre-financing of company salaries for a three-month period guaranteed by the state as a subsidy for companies in insolvency, to make additionally available a super senior loan which is what insolvency administrators often need to orderly run off the business and either sell the assets or the shares of the insolvent company.

This additional loan pushes all the other lenders down and typically displays a very strong risk-return profile due to its super seniority. Under Basel III, the traditional financiers struggle to provide such an instrument to a company in insolvency. We have set it up and it’s well placed if the cycle really ends and is a good example of a  sourcing partnership with a bank.

How much competition is there?

Competition is definitely increasing from various ends. Funds from the UK are more focused on larger mid-market sponsored deals, but there is a bit more of a tendency for them to lower their thresholds and do smaller deals. Our deal tickets are typically in the €20 million-€30 million range and the UK houses more like €80 million-€100 million but thresholds are certainly being lowered and the sponsor world is pushing into sponsorless. There are also new teams spinning out from both existing funds and banks. Germany is becoming a focus, and more competition will undoubtedly come.

Do you have a sector preference?

We are sector-agnostic. The important thing to bear in mind is that the moment a company has flawless credit metrics, they qualify for bank finance – and we can’t compete with that. To come back to the point made earlier, we are at the weaker end of the credit metrics spectrum and we want to be compensated by collateral. So we naturally focus on asset-heavy businesses, and we are somewhere between cashflow and asset-based lending.

Are partnerships between funds and banks the way forward for private debt?

I have been saying for many years that banks and funds are natural partners, and today that idea is materialising. You have been seeing relationships based just on sourcing, like the example above, but now you are also seeing even stronger partnerships.

We have a cooperation agreement with Credit Suisse and we are in the process of launching a fund, the Private Debt Co-Investor Fund, to target a hybrid universe of companies which are still bankable – mainly B and BB rated. They qualify for bank lending, but the banks are typically restricted by the regulators to maximum hold levels on those credits. It’s important for the banks to continue to lend to those businesses and, by having a partner, they can split the exposure.

The banks want to continue to run the relationships with corporates and they have different services to offer. We only have capital, so we are not competing with the banks. In our Private Debt Co-Investor Fund we are launching, we can split the exposure. It’s a very modern product with full alignment of interest between the bank and the fund and proves that the partnerships we have been talking about are really happening.  n

Daniel Heine is founder and managing director of private debt at Patrimonium, a Swiss alternative asset management company managing today approx. CHF3.5 billion with around 60 employees.

This article is sponsored by Patrimonium.