Truffle hogs

Germany's weakened economy remains difficult territory for financial sponsors to negotiate. Incumbents dig deep to come up with the goods. Is the hard work paying off, asks Philip Borel

At this point in the cycle, private equity providers active in Germany may spend much of their time in capital deployment mode, but in recent weeks, exits are very much the fashion.

In mid-May, the country's IPO market, having shut in November 2002, finally reopened, and although no one is willing to predict how long this will last, a number of private equity houses are determined not to miss the opportunity that it affords.

German market participants hope that the successful IPO in May of cash machine make r Wincor Nixdorf, majority-owned by KKR and Goldman Sachs Capital Partners, will pave the way for further listings. Priced at the very bottom of the book building range, the deal was by no means easy to get away. Lead arrangers Deutsche Bank and Goldman Sachs reportedly lobbied hard to persuade institutions to buy Wincor's stock.

Still, the shares were finally placed and got off to a promising start in early after-market trading on May 19. As things stood at the time of this article going to press, the financial investors, who retained part of their respective stakes in the company, could expect to double their money from the deal.

It may be the door opener that private equity houses with German assets in their funds have long been waiting for. Doughty Hanson, owner of Auto-Teile-Unger (ATU) that operates specialised automotive parts stores and repair shops across Germany, is currently preparing to take the company public, hoping the market will value the business at &€1.5 billion.

Other equity sponsors with sizeable assets in the exit pipeline are not far behind. BC Partners is reportedly mulling plans for a return to the stock market of Grohe, the sanitary goods maker it took private in 1999; Apax Partners is keen to exit Autobahn services group Tank & Rast, privatised in 1998, as well as Nordsee, the fast-food chain it bought in 1997; Tenovis, a Frankfurt-based telecommunications business that KKR acquired in 2000 for $400 million from engineering multinational Bosch, is also readying a float at present.

And there are many more. According to the BVK, the country's Berlin-based private equity and venture capital association, 56 of 111 German private equity firms participating in a recent survey said they owned at least one candidate suitable for a public offering. In total, 132 portfolio companies were described as “ready for the stock market”, although 75 respondents also registered a concern that small and medium-sized companies would find it difficult to list however benign market conditions, because the German equity market's current segmentation, particularly following the demise of the Neuer Markt, was not receptive to all but the largest stocks.

And even large-cap companies are by no means certain to be given a warm stock market reception in the current climate: the market is considered highly volatile, and offerings for chip-makers X-Fab and Siltronic, which were pulled earlier this year, before Wincor made it over the finish line, were a reminder that German investors continue to take a selective approach to evaluating new offerings.

But if a string of successful private equity-backed floatations were to succeed now, it would certainly be a welcome boost not only for the sponsors involved, but also for the industry as a whole. ATU, Grohe and Tank & Rast rank among the best-known private equity-backed businesses in the country. A demonstration that private equity is capable of making money for investors and releasing these and other household corporate names as healthy, growing entities from under its stewardship would not just yield financial benefits.

Private equity's public image continues to leave much to be desired in Germany. A string of showcase exits could also help soften attitudes towards an industry that, according to one German professional, is still widely regarded as populated by financiers to whom the business of buying and selling companies is little more than a “rich man's” pursuit.

An article published in April on the website of Der Spiegel, Germany's leading current affairs weekly, denounced in its trademark stark language KKR's restructuring work with Tenovis as an example of cold and calculating asset stripping, carried out with little empathy for the company and its employees. Although the story's impact would have been greater had it made it into the magazine's print edition, it came as a reminder that private equity has not succeeded to persuade the public of its merits.

Indicative of a similar negative attitude was a recent survey of 3,500 German managers, cited by The Economist in an article published in May, 50 per cent of whom categorically ruled out the possibility that they would ever work with a private equity provider.

From an industry point of view, this doesn't sound great. However, it is a sentiment to which buyout professionals practicing their trade in Europe's largest economy are well accustomed.

Many allow that the 2002 catastrophes of Apax Partners' overly optimistic bet on Authentos, the formerly state owned printing house, and of Fairchild Dornier, the aircraft maker owned by New York's Clayton, Dubilier & Rice and Allianz Capital Partners, were events that didn't help improve private equity's reputation in the country.

But professionals also question whether public scepticism does in fact matter much at a time when private equity is already a key force in helping German companies, particularly the large corporations, find solutions to a wide range of strategic challenges. “We might be resented,” these people say, “but we're needed nevertheless.”

Given that restructuring-driven deal flow at the top-end of the market appears to be holding up nicely, this attitude seems justified. According to Jochen König, head of leveraged finance in Germany at The Royal Bank of Scotland in Frankfurt, deal flow this year is as solid as it was in 2003, when the bank had its strongest year since moving into the German market in 1999.

Among the large German LBO highlights so far this year were the &€3.1 billion public-to-private transaction forced through by the newly established Hamburg office of The Blackstone Group; the &€2.7 billion bolt-on acquisition in April of cable assets not already owned by market l eade r Kabe l Deut s chland, a company backed by Apax Partners, Providence Equity Partners and Goldman Sachs Capital Partners; the KKR-led &€2.25 billion purchase of Dynamit Nobel, a deal comprising the chemical s as set s sold by Frankfurt-based MG Technologies; as well as Permira's latest engagement in the market, the &€640 million purchase of telecoms company Debitel from Swisscom in April.

König, who tracks transactions with an enterprise value of &€100 million upwards, is confident that a number of big-ticket private equity transactions will be added to this tally later this year. What is less clear, he says, is how business in the middle market is going to develop: “We would certainly welcome greater demand in the mid-cap segment.”

Most private equity sponsors operating in that market segment stress that finding and executing good deals remains a challenge. “In the mid-cap sector, both companies and banks are still reluctant to do much. Confidence of closure can be difficult to achieve,” says Peter Schiefer, partner at Munich-based GI Ventures, which is currently in the process of raising and investing a &€100 million first-time buyout fund dedicated to German Mittelstand companies.

However, incumbent mid-market investors typically welcome the fact that deals are a little hard to come by and that they require some risktaking on behalf of the equity sponsor even before a transaction closes. As Schiefer notes, greater inefficiencies translate into a greater return potential compared to the more professional, heavily intermediated large buyout segment. This in turn requires mid-market funds to act as the market's “truffle hogs” he says, digging deep in search for investment performance.

Most truffles continue to be found in the front- or backyards of large corporations that are streamlining their operations. GI Ventures' latest investment was the &€100 million purchase in January of the wind power division of ABB, the engineering group. A senior debt package worth &€80 million took less than six weeks to assemble and syndicate, Schiefer says, evidence that the debt market is prepared to support midsize transactions provided it likes the structural features and the underlying business.

One major influence on the current stream of assets coming to market is Germany's current macro-economic predicament. After a decade of economic stagnation, the country's prospects are still far from bright. Big government and big bureaucracy, an over-regulated labour market, legacy issues stemming from the reunification in 1990 as well as inflationary pressures associated with the introduction of the euro are among the most widely discussed problems facing Germany's economic base at this point.

At a time when the totality of these factors is having a depressing effect on corporate earnings, owners of assets are not particularly eager to transact, a phenomenon recently found in other markets too – unless, of course, the pressure on a potential vendor becomes too great to withstand. To some, therein lies a significant opportunity.

However, the number of turnaround specialists that have raised funds dedicated to working with highly motivated sellers such as Orlando Management and Nordwind Capital in Munich, and CMP Capital Management- Partners in Berlin, remains relatively small. But speak to those that are in business with this kind of strategy, and you won't hear of too many complaints about the quality and quantity of attractive assets coming their way.

Illustrating trends in the market that he specialises in, Christian Hollenberg, CEO at Orlando, says: “It's not unusual in the current market for us to see things twice, sometimes three times. First time around it might be in relatively good health, next time it might have slipped into a crisis, then it comes back via the receiver.”

Hollenberg, whose &€163 million fund acquired Solvadis, a non-core chemicals business sold by MG Technologies, in May, also notes that this phenomenon of gradually deteriorating financial health of quality companies has not gone unnoticed among the large LBO funds: “In the current climate, even the big buyout firms are now looking into more troubled businesses which at other times would not necessarily be of interest to them.”

GI Ventures' Schiefer confirms this: “The big guys have been fishing closer to the bottom for some time now,” he says.

One already completed transaction that practitioners cite as evidence of this is Advent International's acquisition in December last year of Moeller Group, an industrial electronics business headquartered in Bonn that needed to raise capital to appease a consortium of creditor banks.

Also increasingly active are US distressed debt specialists such as Cerberus Group, Fortress Investment Group and Lone Star Funds. Pursuing investment strategies that don't have much of a history in Germany at this point, these groups have so far been operating discreetly and maintaining a relatively low profile. Says one observer: “These firms are doing deals, but given the size of the opportunity, it is still very early days.”

The timing of the distressed pioneers looks good. Matthias Moser, a Frankfurt-based financier who until recently was part of Terra Firma Capital Partners' Germany team before joining Fortress, says his firm currently has approximately &€20 billion of non-performing property- backed or direct corporate loans on its radar. These loans are unlikely to be sold off in a hurry, Moser believes, but a distressed market place is gradually emerging: “There is still a big gap between buyers and sellers in terms of price expectations, but both sides are currently going through a learning curve.”

Equally optimistic predictions have been attributed to Cerberus. Earlier this year Ralph Winter, a ([A-z]+)-based executive at the New York firm, was quoted in a German newspaper as saying that his group had plans to invest up to &€4 billion in the country over the next two years.

These are big numbers. Meanwhile the economic downturn also affects the investment activity of the more mainstream equity providers targeting the mid-market.

Two pressing issues currently facing German corporates generally are particularly relevant to midmarket sponsors. The first, high labour costs in their home market – Germany's cost of labour is second only to Norway's – combined with lacklustre domestic demand, is forcing German businesses to expand abroad, both in terms of production as well as sales.

“The key is to avoid investing in companies with excessive exposure to domestic demand and limited production capacity in low-cost labour markets,” says Karsten Hartmann, a member of Hg Capital's mid-market focused Frankfurt team. Where private equity does target companies that fall foul of these criteria, the challenge – or rather, the opportunity – lies in working with management to modernise accordingly.

According to Hartmann, Hg's recent investment activity is a manifestation of this strategy. Last year, the firm took private W.E.T. Automotive Systems, a Bavaria-based maker of seat-heating systems, in a &€169 million transaction. Under Hg's stewardship, W.E.T., which already generates approximately 60 percent of its revenue in the US, is working to further grow its international customer base, while placing similar emphasis on building production capacity abroad. The company currently has production facilities in Hungary, Malta and Mexico, and recently opened a plant in China. “Asia is a major topic for us and our portfolio companies, especially China and Japan,” confirms Hartmann.

The business plans Hg put in place for two other recent German investments, the 2002 acquisition of FTE Automotive GmbH, a manufacturer of clutch and brake hydraulic products, from Dana Corporation, and the &€115 million buyout of Hirschmannn Electronics, an electronics equipment maker, bought from Rheinmetall earlier this year, also reflect the firm's awareness of the need to operate globally.

Inevitably, internationalising businesses that remain embedded in the culture of their home market is challenging. In a country with currently 4.5 million unemployed workers, an all time high in the history of the Federal Republic, relocating jobs is an undertaking fraught with political obstacles and certain to incur the wrath of the country's still powerful trade unions. A balanced approach is therefore essential.

Another danger is for companies unde rgoing an export-driven makeover of their revenue base to be come overly vulnerable to exchange rate fluctuations. Nigel McConnell, chief executive of European mid-market investors Electra Capital Partners, which has an office in Frankfurt, points to the issue of currency swings, although he also says that the impact of the weakening US-dollar has been surprisingly limited so far: “We would have expected German companies to have been hurt more by the strength of the euro by now which is encouraging.”

The second aspect keeping Mittelstand executives awake at night is the systemic drying up of traditional credit lines. German banks, under pressure to adjust to changing capital adequacy regulations and to achieve better returns on their capital, are increasingly reluctant to lend. Family-owned small- and mid-cap enterprises in particular are aghast to find their Hausbanks turning their backs on banking relationships that in many cases stretch back generations.

The consequences are serious. Hans Reich, chief executive of KfW, the state-owned credit agency, said in an interview with German daily Handelsblatt in April that the disappearance of bank credit was reaching a critical level, as companies were struggling to secure enough capital necessary to fulfil their – often bursting – order books.

Benedikt von Schröder, Frankfurt-based partner in charge of German operations at European merchant banking boutique Augusta & Co, believes that of all the Standort Deutschland-related concerns affecting business sentiment in the country at present, lack of credit is the most pressing. “Financing has become a crucial strategic issue, and many mid-caps are having to rethink the way they access capital. Hausbanks will often offer a suit that barely fits, or not even be there at all.”

Several initiatives are currently underway to plug the gap, many of them based on a mezzanine concept. In March, KfW launched Unternehmerkapital (“capital for entrepreneurs”), a mezzanine programme designed to support small and medium-sized businesses. Commerzbank, DZ Bank, IKB Deutsche Industrie Bank and Dresdner Kleinwort Wasserstein, the latter in tandem with Anschutz, the US group, have also established subordinated debt programmes. In addition, Frankfurt-based start-up MCap Finance Deutsche Mezzanine is currently raising a &€150 million dedicated mezzanine fund sponsored by public-sector bank SachsenLB, while Muni ch-bas ed fund of funds managers VCM and Golding Capital Partners are progressing with a dedicated mezzanine product.

Augusta's von Schröder says that in addition to these new capital pools becoming available, he expects midcap companies looking for capital to turn directly to the institutional investment market by way of private debt and equity placements. A well-trodden road in Anglo-Saxon corporate finance, this approach is yet to gain a foothold in Germany.

However, one recent case of a Mittelstand business opting for a capital markets solution was the recapitalisation of Schoeller Wavin Systems, a family-owned returnable crates manufacturer, which Augusta advised. The company opted for a recapitalisation instead of an outright sale. In a complex deal, London-based Stirling Square Capital Partners bought a majority controlling position in the business on the back of which an LBO style debt facility was arranged by Augusta and underwritten by Dutch bank NIB.

Similar transactions may generate opportunities for other private equity houses too, although the approach requires flexibility. The ability to exercise control over an asset is a key instrument in private equity's armoury, and not every house will be open to sharing ongoing management or having significant minority shareholders in a portfolio company.

Still, given that the idea of ceding control remains an appalling prospect to many Mittelstand entrepreneurs, alternatives may need to be considered. Says von Schröder: “Private equity firms ought to think about whether they can present an owner with more options than to sell out totally. Investing in minority stakes can also provide solutions, provided corporate governance issues and the financial investor's exit strategy are addressed. Potential exit routes can include a subsequent owner buy-back, a recapitalisation or a public market solution.”

Incidentally, the latter option was the basis for Permira's agreement last year to acquire a 49 percent interest in Rodenstock, Germany's largest spectacle and lense maker. Under the deal, struck in order to prepare for an IPO according to a company statement issued at the time, CEO Randolf Rodenstock retained a 51 percent majority stake in the family business.

Given the current dynamics, Germany might be as far away from becoming an “easy” market for private equity as it has ever been. But those on the ground don't want “easy”, as that might trigger another influx of competitors into the market. In recent years, traffic was in fact going in the opposite direction, as a number of UK and US buyout firms scaled back or departed altogether.

Those who stayed are happy to have done so. Says Hartmann at Hg: “In 2001 and 2002, the market was indeed slow in terms of deal flow, but we're very pleased to have invested through the cycle while others left.”

Expect Hg, other mid-market specialists and the big LBO shops to keep up the investment pace going forward. And if the public market can deliver on the promise of an active IPO summer, some of the incumbent houses may well be able to take some significant money off the table too. If that happens, those currently not involved in the country's private equity scene may well decide those truffles made in Germany are worth another dig.