The ups and downs of private debt in Germany

Germany has an abundance of attractive businesses, say market observers, including many in the Mittelstand, the mid-sized German business sector lionised by international commentators. The Mittelstand yields good borrowers for several reasons. Eric Gallerne is a Paris-based partner at Idinvest Partners, a French private equity and debt investor that opened an office in Frankfurt in 2017 to exploit local opportunities. He notes the wealth of innovative business-to-business companies in the country that are less sensitive to the ebbs and flows of GDP growth than their consumer-focused counterparts. Many of these businesses also have very long track records.

“In our portfolios, the average company age is around 50 – many are second or third-generation businesses,” says Daniel Heine, head of private debt at Patrimonium, a Lausanne, Switzerland-based alternative investment manager specialising in the German-speaking region. “If there is an economic downturn, of course our companies are affected,” he acknowledges – but he also points out that businesses of this pedigree have weathered many economic cycles. Many of the Mittelstand have another advantage, says Heine: as manufacturers, they have hard assets that can be used as collateral. These businesses are further strengthened due to Germany’s underlying economy. “Germany is a very stable economy,” says Alexandra Hagelüken, partner in the Frankfurt office of law firm Latham & Watkins, and vice-chair of the firm’s global finance department. “That’s one attraction.”

The strength of Germany’s businesses and its economy can also be a disadvantage for private lenders. Most borrowers have “no trouble at all” borrowing from the banks, says Britta Becker, partner and head of capital and debt advisory at Ernst & Young Germany in Hamburg. Becker typically deals with client that have turnovers of between €250 million and €1 billion.

“Banks haven’t reduced their lending at all in the past three to four years and this is expected to continue because the forecast for the German economy in the next two to three years is amazingly optimistic,” she says. The economy has also benefited from continuing growth in China, an important export destination, and from Germany’s strong fiscal position. Becker notes that even borrowers with low investment-grade credit ratings in the triple-B range generally find it easy to borrow from banks, adding that the banks are even willing to lend at quite high leverage levels in some sectors. She describes raising money for a customer in the infrastructure sector at an overall net debt to EBITDA ratio of more than five.

Companies in other industries, such as pharmaceuticals and life sciences, can also borrow at similar ratios. “The German banking market is highly competitive,” says Jeremy Golding, head of Golding Capital Partners, a pan-European debt fund of funds manager headquartered in Munich. “The owner of a company that wants financing can walk down the high street and find at least half a dozen players willing to lend to them. This has made it very difficult for private debt funds to compete.” He notes that German banks “remain very active” even in leveraged lending to sponsored companies.

“In the last four or five years there have been a lot of new market entrants in Germany,” says Alexandra Hagelüken of Latham & Watkins. “You had the feeling almost that with each week there was a new private debt fund coming in.” While there was only a handful of debt funds active in Germany in 2010, says Hagelüken, “now we have more than 60, from what I see”. She adds that private debt funds entering mainland Europe often choose Germany as their first country of activity because of its economy.

The more competition there is for deals, the more competitive managers need to be on pricing. However, Heine of Patrimonium, which focuses on non-sponsored deals, thinks the supply-demand dynamics vary widely depending on the market segment. “You have to address the difference between the sponsored and non-sponsored world,” he says. “Ninety percent of the money goes into funds focused on sponsored deals; within that universe you see a lot of dry powder, and this dry powder has driven margins down so that valuations are extremely high.”

Another way of dividing the market is by deal size – and Heine says that larger deals mean more competition. “If you look at the large end of the mid-market, those businesses with €1 billion or €2 billion in revenue are international, and when they borrow, their debt is – you could almost say – auctioned on an international basis.” Private equity sponsors are adept at playing potential lenders off against each other to secure the best deal.

A radar screen will not detect and display a tiny fish; much the same can be said for the metaphorical radar screen used by international lenders. “When deals are above around €50 million, our friends in the UK will also look at the transactions,” says Heine. This means that for the smaller loans Patrimonium makes – many of them clustered at around €20 million – competition is less severe.

Gallerne of Idinvest comes up with a similar threshold, though he differs from Heine in placing greater priority on sponsored unitranche rather than non-sponsored deals: “For unitranche deals of €20 million to €50 million the market is not so crowded.” As a result, says Gallerne, his firm gets access to good conditions, terms and pricing. Becker is more sceptical about the volume of opportunities. She acknowledges that sometimes a company wants to borrow for a longer period than many banks will countenance – a seven-year loan can be harder to source, for example. But she notes that for these long loans, they can raise finance through Germany’s large Schuldschein markets, where companies issue promissory notes and sell them through private placement.

However, Becker does still see opportunities for private debt funds in two areas. The first is where a non-investmentgrade company is restructuring, and banks decide this is too risky. The second is where a company is seeking high overall leverage. When prospective leverage is above four, “that’s a situation where a debt fund might step in”: banks may be less likely to lend. However, even in these cases, she says that banks will not always rule out lending. “Debt funds can compete through offering longer maturities, non-amortising loans or flexibility in complex situations, such as dysfunctional ownership structures, cyclical revenues and volatile businesses,” says Matthias Unser, Munichbased Member of the Executive Board at Yielco Investments, the alternative investment fund of funds manager.

From a legal point of view, “the main reason why Germany is challenging is because under German law lending generally requires a banking licence”, says Axel Schiemann, partner in the finance department at Latham & Watkins’ Frankfurt office. “In addition, the German regulatory authority holds the view that you are not only required to hold a banking licence if you conduct banking inside Germany; the licence requirement is also triggered if you provide lending services on a cross-border basis and actively approach the German market, even if you don’t have a physical presence in the country.” Schiemann adds: “A banking licence is not really an option for debt funds because you then become subject to the regulatory requirements for banks.”

These include requirements for capital, risk management and liquidity. Another disadvantage for lenders is that the legal regime is not as creditor-friendly as the UK. Hagelüken of Latham & Watkins notes that although the lender can negotiate contracts with the borrower that give the lender the right to terminate the loan, unlike in the UK this is still subject to the principle of “good faith”.

If the court decides that the lender has not acted in good faith, the lender cannot terminate. Secondly, to enforce German share security on a loan, the lender must put the collateral up for sale through a public auction process rather than relying on a private sale. This is not only time-consuming, it also means that commercially sensitive information might be revealed to customers, suppliers and competitors, says Hagelüken.

Lawyers have in fact worked out ways of structuring deals to allow private debt funds to avoid the need for a banking licence. Schiemann of Latham & Watkins gives a couple of solutions. “In many instances the lender can rely on the freedom to provide passive services if not actively targeting the German market,” he says, pointing out that in the sponsored market “the lenders are often approached by the borrowers, rather than the other way round”.

Another way is for the private debt fund to partner with a bank. The bank makes the loan and the debt funds holds the loan receivables. Schiemann notes that private debt funds have become so accustomed to solutions not involving a banking licence that when the legislature created an exemption for those vehicles classified as alternative investment funds, there was no rush to create them. “Private debt funds have certain challenges, but the market has got used to that and found ways of dealing with it,” he adds.

Hagelüken says there is a lot of clarity in the legal system when it comes to the treatment of debt funds, the enforcement of security and other issues, because these concepts have already been well tested in the courts. The legal system is also more creditor-friendly than France, Spain, Italy and eastern European countries. Other observers point to the scrupulous nature of Germany’s legal system, when compared with some southern European countries.