Frankfurt: the heart of the German buyout

Firms don’t come to play in Frankfurt, it is the whole of Germany they want when they set up here,” says Andreas Kochhauser, of 3i, which has been based in Frankfurt since 1987. “Frankfurt is not that much of a region in terms of deal flow, but it is one of the most cosmopolitan cities in Germany with a strong financial services industry, which is what you need as a private equity investor. From Frankfurt, we are able to do deals across Germany.”

Frankfurt is the heart of the dynamic Rhine-Main region. With a population of 4.8 million and a workforce of 2.2 million, the area generates an annual gross domestic product of over EURO143 billion. Among the 320,000 companies based in the region there are also the headquarters of a large number of major international and national corporations. It is a well-developed region with a combination of manufacturing and service industries offering an ideal environment for businesses of all sectors and sizes.

While the region is primarily home to the later stage players and buyout houses, there are over 2,200 high tech companies, which illustrates a potential for earlier stage investments. Biotechnology is increasingly gaining in importance. Harmut Schwesinger head of the Frankfurt Business Development Board is currently pushing biotech very strongly in the region and the city’s well-organised university infrastructure is also a critical factor in this respect.

As a leading financial marketplace in continental Europe, Frankfurt is the seat of the European Central Bank and at the centre of European monetary policy and the European Monetary Union. Wholesale and foreign trade have an important role in Frankfurt and the city benefits from an efficient telecommunication and transportation infrastructure. Frankfurt airport offers excellent connections within Europe and abroad and the city’s transportation network ensures a seamless connection to all road, rail and water links. The city’s appeal to the private equity community also lies in its status as an international meeting point and city. Trade fairs have a long tradition in Frankfurt. Around 50 fairs a year are held at the Messe Frankfurt Centre with 42,500 exhibitors and over 2.2 million visitors.

Unrealised potential?

The past two years in the German buyout market has seen some exceptional deals such as Messer Griesham and Cognis and although this year’s investments will not reach the same level they are still up on 1999’s figures, according to the Bundesverbandes Deutscher Kapitalbeilteiligungsgesellschaften (BVK), the German venture capital association. This year’s lower valuations mean that even if the same number of companies were invested in, total investment could not reach the same volume and so the year’s total investment figure is likely to be down on last year’s. Torsten Grede of Deutsche Beteiligungs, which has just managed a first closing of its fourth buyout fund at EURO120 million, comments: “In my opinion, we have seen an unusually high number of deals in the larger spectrum over the last three years. We have seen close to ten each year and this probably won’t continue. The source of this size of deal is bound to dry up.”

However, BVK figures do reveal an increase in buyout activity. In the second quarter buyouts accounted for over half of the total amount invested (EURO372 million), compared to less than 20 per cent in the first quarter, reflecting a move away from early stage and back towards buyouts. Investments in traditional industries outweighed commitments to the technology sector. The machine/equipment sector received EURO174 million of investment in the first three months, electronics accounted for EURO110 million and construction took EURO34 million, all up on the first quarter.

Of the seven major German buyouts so far this year, six were completed in the second three months. This may be the effect of the much-lauded 100 per cent relief from capital gains tax which was hoped to provide the impetus for an MBO explosion. But certain players beg to differ, stating the effect of the reform is minimal. There is even a fear that following September’s general elections there will be a reintroduction of capital gains tax see box.

The German mid-market still doesn’t look set to see a boom because most owners of Mittelstand companies are not prepared to sell the majority stake that most funds operating in the region are looking for. Jochen Knig, managing director of German Leveraged Finance at Royal Bank of Scotland, says: “There hasn’t been an explosion of deals within the last two years. The tax reform has had no effect and succession issues within Mittelstand companies have had very little effect. But there should be an increase in transaction size in 2003. Restructuring and spin-offs from large corporates are the main drivers.”

He adds: “The market is not as bad as many people say – it is comparable to 2001 where we saw nine transactions valued at over EURO100 million. We are up to eight transactions in 2002, which is not so bad. Volume is on track, but value isn’t – we are slightly below last year – the main reason is because the deals this year such as Demag and Haarman & Reimer are not really on a level with the jumbos of 2001 such as Messer and Cognis.”

Where it’s at

“Frankfurt is the place to be for buyout funds, but it is not where the actual targets are. Funds that sit in Frankfurt will travel around. One good thing for the PE houses in Frankfurt is that they are very close to the large intermediaries,” says Hassan Sohbi of international law firm Osborne Clarke.

Stephan Illenberger, managing director of AXA fund-of-funds, which set up in Frankfurt in May this year, agrees: “Frankfurt is the home for later stage players because the banks are there. There is also a very efficient infrastructure and communications network.” Helmut Pitsch, who alongside Stephan Illenberger is the managing director of Axa Private Equity in Frankfurt, says the firm’s ultimate intention is to cover the whole of central Europe. We see Germany as the biggest market for us to do deals in, but Spain and Italy are also very interesting and we are currently selecting co-investment partners there,’ he says.

Axa’s decision to set up in Germany came swiftly after Candover, the listed UK private equity firm, said it had hired Kurt Kinzius to set up its first German office, in Dusseldorf. Why Dusseldorf? When Candover was looking to set up an office in Germany most opportunities were to be found in the Dusseldorf area and the surrounding region, said Kinzius. Bridgepoint and HSBC also have offices Dusseldorf. He says: “Of course it is important to be close to financial institutions, but Frankfurt is now less than two hours from Dusseldorf with the new high speed train which is every hour on the hour. Getting to Frankfurt is not a problem and a lot of our advisers are based in Frankfurt, but are also happy to travel to Dusseldorf.” The need to travel to get the deal done is firmly embedded in the German culture, he says.

As far as the majority of buyout funds are concerned, Stephan Illenberger says most are based in Frankfurt, but it is not overcrowded yet. He predicts probably in two years’ time the market may need to be thinned out. “There is a theory that too much money is chasing too few deals at the moment. I think for the size of Germany there will be a thinning out, the main question is whether the current funds investing will get the second generation of funds. We ourselves are very cautious with investments.”

“In our direct investment business we have not completed a single deal this year [in Germany]. The opportunity is there, but it’s very resistant,” he says. There are ten people on the AXA team in Frankfurt including the fund-of-funds business, which has six on the team.

Professor Stefan Jugel of the University of Wiesbaden, who sits on several fund advisory boards and does investment ratings for fund-of-funds, says: “Fund raising has been pretty difficult due to different reasons – there is still an over-capacity of money in the market, which is not invested yet. A poor flow of good deals and an overhang of funds is contributing to a slow year for private equity in Germany.”

Hassan Sohbi of international law firm Osborne Clarke adds: “The funds we speak to in fund raising mode are having trouble getting money out of institutional investors some will close but it will be difficult. Buyout funds are finding it easier VC funds will have more trouble.”

The main point Jugel touches upon is quality. “Good funds in Germany in the past had good deals and so had good results, and they will continue to do so in the future.” The down-period he says is due to the hype of inexperienced funds that entered the market in the boom period of 2000. “There are many funds who won’t get a second fund. Investors now discuss more deeply and consider more seriously who to give their money to – they want to see good performance.”

On the look out for suitable candidates is Swiss fund-of-funds specialist Adveq, which opened an office in Frankfurt a year ago. The German division is responsible for the management of PEEUP II Beteiligungs GmbH, which closed this year at EURO252 million. The new fund-of-funds will target investments in European buyout funds and Adveq has been busy with a similar US model planned to launch by the end of this year.

“With the new subsidiary we are able to serve our institutional investors in a more direct and qualified manner,” said Bruno Raschle, founder and managing director of Adveq Group. In the past Adveq has concentrated all of its operational activities in Zurich. Germany will be one of the dominant markets for the firm in the future.

A first-time fund battling on to reach its target is Frankfurt-based Cornerstone Capital. The fund has reached a first closing of EURO40 million since its launch a year ago. Pieter Von Harlem, managing partner, said: “We had an original target of EURO100 million, but the current market environment is difficult especially for a first time fund.” The firm’s management team with over 20 years’ experience in the private equity industry should stand it in good stead. In spite of the difficulty fund raising, the team is getting the deals done and has made seven investments so far, mostly in Frankfurt and the surrounding region, focused on mid-sized buyouts in technology-related industry sectors.

Hungry for deals

The number of spin-offs from large corporates will increase in future. Andreas Kochhauser, managing director in 3i’s Frankfurt office, says that at the moment spin-off activities and general M&A activity is the main source of deal flow more than the over-hyped Mittelstand. The boom in buyout activity promised by the Mittelstand has yet to be witnessed. Kochhauser says that it will happen at some stage, but not yet. “It’s a long-term thing, not a quick-fix,” he says. “The figures four to five years ago on the Mittelstand were misleading and included all sorts of companies that a private equity house would never consider a buyout target such as a small local businesses with only several employees.”

There are great opportunities coming from corporates at the moment, says Kochhauser. Two recent examples are Advent International’s EURO215 million buyout of the Rhein Chemie Group of companies from Bayer and Covidence, a 3i investment and spin-out from Aventis. Covidence was formerly a clinical development department of Aventis Pharma and as a spin-out will be building upon a sound track record of successful drug development programmes.

The recent announcement that Frankfurt’s Neuer Markt is to close see EVCJ October News, page 16 is, suggests Jochen Knig of RBS, no great loss with the state of the market as it was. He said: “With the disappearance of the Neuer Markt, an exit channel has also disappeared. But we are not losing an exchange we had already lost it.” The disappearance of the Neuer Market is part of Deutsche Brse’s plans to divide the entire listed market in Germany into two segments that differ to each other with regards to their transparency standards. The two segments are Domestic Standard and Prime Standard and the latter will house the Neuer Markt. The move to Domestic Standard and Prime Standard will be voted on by the end of November and is expected early next year.

Hassan Sohbi of Osborne Clarke says: “There will still be opportunities to list on the stock exchange in Germany. But there are other alternatives. Instead of going for an IPO, private equity players are quite happy to do a trade sale or pass the deal onto someone else as a secondary investment. Players are also holding onto their investments for longer.”

As far as public-to-privates are concerned, the market has not been a real success story in Germany as there have not been that many opportunities, says Jochen Knig. “It may be that valuations were not right at the beginning of the year, but we have had some big public-to-privates like Grohe and Gerresheimer years ago so it is not any legal restrictions, like the takeover code that is holding back this market.”

Hassan Sohbi says there are more and more players testing the water in the public-to-private market and also more examples of private equity firms taking a stake in public companies. This does not necessarily mean delisting a company completely, says Sohbi. These might be minority stakes which wouldn’t require any takeover act. “Private equity players, provided they are not prohibited by their fund statute, are increasingly looking at public equity deals.”

Osborne Clarke is currently looking at two such deals. Sohbi mentions a recent investment by General Atlantic Partners in Munich-based, Neuer Markt-listed IXOS SOFTWARE AG, a global provider of solutions for eBusiness document management. General Atlantic will become the largest investor in IXOS following its acquisition of a 25.1 per cent stake in the company, or 5.4 million shares. The purchase price agreed with General Atlantic is EURO5.90 per share. The Frber and Strack-Zimmermann founding families have also signed stock purchase agreements with General Atlantic, under which General Atlantic will acquire 1.8 million shares from each of them. The Frber and Strack-Zimmermann families will then hold 945,673 shares (4.4 per cent) and 1,028,516 shares (4.8 per cent) in IXOS, respectively.

A tight debt market

Tapping into the German debt market is not an easy prospect in the current climate. German banking is experiencing tough times. Three of Germany’s major banks Commerzbank, Deutsche Bank and HypoVereinsbank are all trading at well below their net asset value with shares for each down over 30 per cent since August. Deutsche Bank is looking to cut EURO2 billion from its operating cost base by restructuring its retail and private banking businesses and reducing its private equity portfolio to focus on its core businesses. The bank is seeking buyers for part of its private equity arm, DB Capital, which has around EURO6 billion under management. The direct investment portfolio, which has a book value of between EURO3.5 billion and EURO4 billion is reportedly on the sales block.

In spite of a general pessimism among the German banking community Jochen Knig is upbeat about lending prospects in the German market. “I think that there is still a huge appetite for banking finance. Banks are being a bit more selective and are looking for diversified businesses with a stable cash flow such as robust industries like food and beverage. If deals show these characteristics, banks are still motivated to leverage these assets.” He adds: “Competition is healthy, but we do have to fight for deals. [As a lender] if you are prepared to offer tailor-made structures with senior and mezzanine out of one hand for example, then you have a very strong position in the competitor’s group.”

There are two market segments in Germany – the mid-market and the larger buyout segment, says Torsten Grede of Deustche Beteiligung. Players such as KKR, Carlyle, CVC and Cinven target the larger buyouts for example KKR’s recent buyout from Siemens and EQT’s acquisition of two flavour and fragrances manufacturers, Haarman & Reimer and Dragoco Gerberding from the Bayer group. “These deals are quite complicated in particular to secure the debt financing,” says Grede.

KKR’s EURO1.69 billion buyout from Siemens of seven businesses with a combined turnover of EURO3.5 billion is a complicated lending prospect. However, the financing has found support at senior level, in particular from Landesbanks that have relationships with Siemens and its subsidiary companies. The seven businesses will be sold into holding company Demag Holding, which will be 81 per cent owned by KKR, with Siemens retaining the 19 per cent minority.

Grede says: “Debt financing is something where we rely on long lasting relationships. It is very important in more difficult times to have this sort of relationship. There are less banks at the moment who are willing to finance deals in the uncertain economic climate. I would not be surprised if some of them come to the decision to exit this field. At this moment in time, banks are very defensive with regards to what deals they provide debt financing to.”

But a tight senior debt market is creating more opportunities for mezzanine, according to Steffen Lehmann of Mezzanine Management’s Frankfurt office. “There is an increasing demand in Germany for mezzanine in reasonably priced transactions due to the fact that senior debt providers are not as aggressive as they have been.” This he says is partly because a number of senior debt providers have been badly burnt by exposure to large buyouts which haven’t performed as well as expected. The mid-market is the preferred sector of investment for mezzanine players. “In very large transactions the high yield bond is the preferred instrument as it tends to be cheaper, but it does have some disadvantages, mainly because it is a public product.”

As for what the future holds, Stefan Jugel says: “There are good deals at good prices in Germany. So what is holding back the market? This down period is mainly due to a lack of knowledge of the private equity industry in Germany, and not a judgement on the market itself which is still attractive and can still bring high multiples.”