Buyouts: still awaiting a boom

December 31, 2001 is not going to ring in the new for Germany’s corporate financiers and their private equity cousins in the way that many of them have long hoped.

While the eagerly awaited simplification of Germany’s tax system kicks into effect at the start of next year it’s going to bring little excitement to the private equity market.

“The tax changes are targeted at conglomerates, like the big banks and insurance companies, to help unwind their cross holdings,” says Nils Stoesser, London-based investment manager with Candover. The majority of these cross holdings are in fact minority interests and as such they are not attractive to private equity investors.

Alex Insam, who works across Legal & General Ventures London and Frankfurt-based teams, notes that it’s more likely to be institutional investors, such as Legal & General Ventures’ parent company that would be interested in taking on these unwound holdings. And, Insam believes this unwinding activity will take time. “Deutsche & Allianz, for example, won’t sell everything immediately as this would swamp the market. But I think by 2003 we could well see a wave of this type of activity,” he says.

Perhaps the most interesting point about this activity, from the perspective of the private equity investor, is that it will force a focus on core business and core competencies and bring transparency to many of these hard to penetrate German institutions. These changes coupled with the fact that the acquirers of these unwound cross holdings will in many cases be non-domestic, and as a consequence less sympathetic, shareholders is likely to increase pressure on maximising shareholder value. This in turn may eventually result in corporate spin-offs and divestments, which, if in sufficient quantity, would be low hanging fruit for buyout firms.

Of course such a scenario includes the all-other-things-being-equal clause, which cannot be relied upon as events of September 11 amply demonstrated. Since that date, and the commencement of military action against Afghanistan, there are few willing to offer a view much beyond a period of four to six weeks of uncertainty. In fact in relation to the debt market, upon which the buyout market is so dependent, there are already clear signs that if market confidence does not improve the market will need to realign for the majority of deals to be done.

Prior to September 11 it was possible to get bank debt to four or as much as five times the equity injection. Estimates are that this may now have dropped back as far as three times. Of course not all this can be blamed on September 11. The bank market thanks to the soft fall of the US economy, the collapse in technology stocks and bad debts resulting from some disastrous Internet investments was already tightening and in Germany, in particular, there had for some months been talk of a slowing in the domestic economy.

While Germany is known for its strong banking community and financial power houses, like the German insurers, it is not these players that are leading the way in LBO and MBO debt financing in the country. The LBO debt market is quite heavily influenced by the Anglo-Saxon banks that are leading transactions and also setting documentation down in a way that suits the Anglo model. “This is because you need to reach a big market to syndicate and Germany just doesn’t have the market to place these kind of deals on its own,” says Insam.

In some ways the tightening of the bank debt market is the least of the problems facing Germany’s buyout market. For one thing those aiming for the mid market (Mittlestand) rather than the mega LBO end of the market have to decide where to concentrate their efforts. Many buyout firms have set up offices in Frankfurt but this is really a banking community and the headquarters of the country’s large corporations.

The Mittlestand is by contrast spread around the whole of Germany meaning in terms of tapping into the local deal scene a presence in Munich or Dusseldorf may be more productive than locating in Frankfurt.

But that’s less of an issue than the fact that the buyout isn’t necessarily seen as an obvious solution by German corporates. One investor notes that it is difficult to envisage the scenario where British Airways promoted the management buyout of its Go subsidiary, which was backed by 3i, happening in corporate Germany. Stoesser also notes that in Germany there is a perceived responsibility to the corporate parent, in the case of a divestment, or the family, in the case of a solution to a succession issue, which can get in the way.

“The market in terms of the perception of private equity is still relatively reticent. If you were to compare German management teams to those in France, for example, if you talk about a buyout, the managers don’t respond to that as energetically as you would expect in Germany. Whereas in France managers would be very enthusiastic,” says Stoesser.

Some of this reticence might be attributed to the corporate environment in which Germany operates. “Managers are sometimes afraid to discuss certain matters because they think they will be blocked immediately by the union representative,” says Insam. Another factor that could be a cause for concern is that investors are in the first instance likely to squeeze a company’s assets rather than employ more personnel. This sits at odds with a survey on the economic impact of buyouts on the economy conducted by 3i on behalf of the European Venture Capital Association. This found that in fact the businesses surveyed found around two-thirds experienced increases in employment levels post-buyout. The difficulty in Germany is that on average it takes in excess of six months to lay employees off and in addition can be costly.

Insam notes a further obstacle. “In the UK a financial investor has more opportunities to inject money into a business and to still enjoy the position of secured creditor if an agreement is reached with the banks over ranking. In Germany the equity is always at the end of the queue so there is no incentive to put more money into a business,” he says.

While there are certainly aspects of the German market that mean the buyout mid-market or otherwise isn’t going to explode, that’s not to say the wallflower doesn’t have an army of suitors waiting in the wings. “In general the German market shows very positive signs. It has a population of 80 million, it’s the biggest EU country, it’s a very trade orientated country, its companies are well invested in, and there is some strong middle management and a high level of expertise in areas like chemicals, engineering and the banking community. So, from a private equity point of view, Germany has a lot of assets,” says Insam.