Storm clouds gathering

It would be easy to dismiss Germany as being of little interest to private equity and venture capital investors right now. After all, the official data suggests that its economy shrank by 0.5% in Q2 versus Q1. And contrary to earlier expectations that it would ride out the credit crisis, the economy appears to be stumbling, with some economists warning it could even slip into recession.

Furthermore, the private equity sector is comparatively under-developed in Germany. According to figures from the country’s private equity and venture capital association, the BVK, private equity investors operating in Germany raised just €4.2bn in 2007. This is one-tenth of the €36bn raised by UK-based houses in the same period.

The perceived inadequacies of Germany’s legislative framework, its labour laws and its ‘social market’ culture can also be problematic for private equity players. The Federal Government and national regulators seem to have few qualms about imposing onerous regulations on legal and tax structures, and they also have a habit of changing these with little warning.

Industry players hopes were raised when the coalition Government of Chancellor Angela Merkel said it would clear up some of the confusion with a string of legislative changes last year. However, given the morass of ‘gold plated’ legislation that has emerged from the Bundestag, some believe these attempts have misfired. The resulting legislation has been variously described as a “botched job” and a “missed opportunity”. The Bundesverband Alternative Investments (BAI), which lobbies for hedge funds and private equity investors, believes Merkel’s package will actually make Germany less attractive to international investors.

Locust repellent

This leads onto the issue of perceived nationalism and protectionism in Germany. Another recently enacted law, effective from January 1, has been portrayed as making it more difficult for non-European buyers to acquire German assets. Forming part of the Federal Republic’s foreign trade law, it effectively gives the Government the right to block the acquisition of anything more than a 25% stake in a German business by any acquirer that is based outside the EU or European Economic Area.

Rather than applying only to deals involving defence companies, the act was extended to cover those that might threaten German “public order or security”; and interventions are permissible even three months after a deal is signed. The measure was apparently introduced to allay public fears about incursions by Middle Eastern sovereign wealth fund, and affected sectors are likely to include oil, energy, telecoms, public transport and logistics.

The BVK, the German venture capital and private equity association, warns that the new law is going to put overseas bidders at a clear disadvantage. “In auction situations, any uncertainty about a possible refusal, over a longer period, can constitute a significant disadvantage for a particular bidder vis-à-vis other bidders, even if an actual refusal is unlikely,” says Dorte Hoppner, managing director of BVK.

Then there is the whole “locust” debate, initially sparked by former Social Democratic Party chairman Franz Munterfering in April 2005, but still reverberating around the industry today. Munterfering spoke out after it emerged that the bathroom and kitchen plumbing manufacturer, Grohe, owned by TPG and CSFB, was planning to lay off more than half its workforce and transfer some of its production to Asia.

Another major disappointment has been that the Mittelstand – often seen as the economic backbone of Germany, and made up of thousands of family-owned firms which together employ more than 70% of the German workforce – have proved much more resistant to the allure of private equity ownership than some had expected.

“That was the big idea five or seven years ago,” says Christian Hartmann, a partner with HgCapital in Germany. “But that sector has not been nearly as explosive people had hoped. The owners of many of those businesses quite like the idea of being big fishes in small ponds [of their local communities].”

A further reason the industry remains under-developed in Germany is that institutional demand for alternative assets is much lower than in other markets, partly as a result of the structure of the country’s state-sponsored pension system. This has been exacerbated by an aversion to equities among German institutional investors, which translates into low allocations to alternatives. Peter Laib, managing director of Zurich-based fund-of-funds Adveq Management, says: “In Germany you have 600 to 700 institutional investors who are potential investors in private equity. We did a market study that showed they are allocating an average of 2% of their assets in private equity. That is pretty low compared to countries like the UK or the Netherlands.”

He says the position is exacerbated because limited partners with fixed percentage-based allocations to private equity have recently been obliged to cut their allocations to the asset class, simply because the values of other parts of their portfolios have been affected by the bear market.

Legal improvements

Taken together it would seem to add up to a pretty bleak picture for private equity in Germany. However there are some substantial chinks of light. Also one could argue that is wrong to look at a market such as Germany through the prism of Anglo Saxon attitudes; the subtle nuances of German capitalism might get ignored.

For example, the perception that Germany is pulling up the drawbridge to foreign investors may have been reinforced by the new foreign trade law, but it was surely countered on August 21. That was when the Government announced it was selling stricken lender IKB Deutsche Industriebank, which the Government and others were obliged to bail out in July, to Dallas-based private equity house Lone Star Funds. The Texas-based group is buying a 90.8% stake in IKB, one of the first casualties of the credit crunch, for the knockdown price of €150m.

On the foreign trade law, industry players also point to the fact that Washington DC has had similar powers in place for 20 years and that the US Government can use these at any time to block contentious overseas takeovers of “strategic assets” particularly if these could impair US national security.

Christian Cornett, a partner in SJ Berwin’s Frankfurt office is “relaxed” about the new law. He says it “could potentially cause delays to some auction deals. It could also introduce an element of conditionality into refinancings in particular sensitive areas. And it’s fair to say that, if the legislation were to be interpreted too literally, it could be catastrophic for the private equity industry. However, we feel certain that this will not be too big an issue, because of the wide administrative discretion involved and because of the way in which the law is likely to be administered.”

In general terms Cornett believes Merkel’s Government is making good progress in improving the legal framework for private equity and commercial activity. He points to a court ruling on management participation in buyout structures, the establishment of a Real Estate Investment Trust (REIT) vehicle and the new private equity law. He says other positive signs include a German corporate governance code, new transparency rules, the ability to use International Accounting Standards and the updating of the legal framework for the GmbH, the German private company.

However, Cornett acknowledges that fund structuring remains a thorny issue. “Those structuring onshore private equity funds still encounter significant hurdles, with no real solution yet in sight.” He believes that private equity funds are going to be structured as foreign structures for some time to come. The most common approach is for funds to be domiciled the Channel Islands and only to have an advisory firm based on German soil.

Recession fears

On the economic front, the picture is perhaps less anaemic than the latest batch of business and consumer surveys would suggest. Holger Schmieding, chief European economist at Bank of America in London, is confident that Germany will not actually suffer a recession, believing the weakening euro will offer respite to exporters, and that the weakening oil price will relieve inflationary pressures.

“Germany has entered a period of stagnation, not a recession,” says Schmieding. “Germany doesn’t have the same real estate problems and has less financial market exposure than certain other markets such as the United Kingdom. The country can therefore be expected to get off more lightly than the UK.”

Schmieding is forecasting stagnation in the second half of 2008 and first half of 2009, followed by a resumption of growth in the second half of next year, so long as the oil price continues to fall and the euro comes down in value.

The strength or otherwise of the euro – a currency which has been driven up by the ECB’s hard-line response to the threat of inflation since the credit crunch – is going to be critical to Germany’s economic future. This is because the country is so heavily dependent on manufactured exports: it prides itself on making the sort of high-value products that consumers in other countries want.

This leads on to the investment side. Hartmann says the main stamping ground for private equity investors continues to be “classical industrial” companies, adding that around 60% to 70% of private equity deals in Germany involve manufacturing and engineering firms.

“Some of the mid-size companies have good technology in sectors where the barriers to entry are high and they are already selling worldwide.” In regional terms, most such firms are clustered in Germany’s former industrial heartland – Baden Württemberg and the Rhineland.

Adveq’s Laib is particularly enthused by the small cap segment – companies with annual turnovers of less than €100m – seeing them as keen to secure private equity backing as they seek to expand their customer base into new regions such as Asia. “Private equity managers focusing on the small cap segment now have a unique opportunity,” says Laib. “There are some really nice transactions in that space, earning multiples of four to five times and okay potential for revenue growth. Some managers in that segment, such as EquiVest, are achieving incredible returns.”

Another reason Laib is so enamoured of this market segment is that German private equity players in it tend to have a clear run with little competition from foreign private equity houses. Apparently this is because owner-managers of small entrepreneurial firms are unlikely to speak English, and might have cultural reservations about selling out to non-German investors.

End of the easy ride

According to BVK figures, private equity companies operating in Germany invested €4.12bn in 1,078 separate companies during 2007, a 13% rise from 2006.

In overall terms, it seems that just as elsewhere in the world, Germany’s private equity market is undergoing some profound changes at the moment. The credit drought is meaning that only managers with deep-seated operational abilities are likely to survive long-term.

Laib says that managers who unwisely overpaid for assets at the height of the credit bubble may find themselves out of job. “Until the middle of 2007, valuations were based on multiples of EBITDA (earnings before interest, taxes, depreciation and amortisation) and earnings expectations. This enabled some mid-market players to generate excellent returns and raise money very easily. Debt was so readily available that even poor mid-market players were able to generate IRRs of 20%-plus without much effort. It was almost unavoidable that they would make money.” However, Laib says that as both multiples and earnings are being squeezed, some managers are going to feel the pain. “The easy ride is over. Now they really have to add value. It is the operational expertise of managers that is really in demand.”

“The problems will be intensified if they invested a significant proportion of their fund in 2006 and the first half of 2007. However if they had the self-discipline to not do deals in that period, they’re going to be much better off.”

SJ Berwin’s Cornett agrees. “Some of the funds that bought real estate and certain other assets when prices were elevated at the top of the cycle in 2006 and the first half of 2007 may now have reasons to be very worried. They may face difficulties with regard to their exit strategies, as currently they can’t sell at the hoped-for prices, and valuations and higher interest rates mean they can’t do refinancings either. They may well have to wait a long time before they can exit, which may have implications for their ability to raise new funds.”

He believes the industry is changing for the better. “When I started in the private equity sector in 1998, it was first and foremost about stable cashflows, convincing the management to sell, and then buying a business using as much leverage as possible. You would then carry out a restructuring and prepare the company for sale, which would often happen about five or six years after you had bought it. While the basics are unchanged, nowadays in addition, private equity has become more like a science, for example due to more sophisticated mechanisms and models, in particular tax structures, financial modellings and refinancings. This brings higher fees for professional advisers such as lawyers. From my perspective it’s become more interesting.”

Feeling the crunch

Overall the number of good acquisition opportunities remains much lower than in previous years, partly because many vendors remain in denial about the true value of their assets – and so some deals are being withdrawn as soon as first-round bids come in. Hartmann says there are probably 45 deals in an average year in the €100m to €500m enterprise value range. However he expects this will fall to 25 in the current year. “Sellers still have somewhat unrealistic pricing expectations and buyers are waiting for these expectations to come down. Some vendors have tested the waters but put transactions on hold when first-round bids came in lower than expected.”

Given the uncertainty over valuations and the weakness of the stock market, the prognosis for exits is not particularly good either. Hartmann says: “Although it is okay for quality assets, it’s very difficult to get rid of a shaky asset at the moment.”

Larger buyouts had only just started to become a bit more prevalent in Germany when the credit crunch intervened to cut them off in their prime. Leaders in this field in Germany include KKR, which had closed deals worth about €12bn by July 2007; and Permira (a total of €8.5bn invested). However Laib points out that large buyouts remain a rarity in Germany and that just one has exceeded €5bn in value – the acquisition of Viterra, a property portfolio, from E.ON by Terra Firma for €7bn in May 2005

In the past 12 months, only two German deals have come in at above €1bn. These were PAI’s €2bn acquisition of the construction materials group Xella, and CVC’s acquisition of a 25% stake in the industrial conglomerate Evonik Industries. CVC bought its one-quarter stake in Evonik for €2.4bn – having seen off competition from Blackstone, KKR and Bain Capital. However, it is worth noting that CVC was obliged to stump up half the acquisition price in equity.

However Cornett does not believe that the mega-buyout houses will give up on Germany. “In my view they are still on the field, they are just not picking up the ball at the moment.”

The locust debate, although it briefly gave the industry a bad name, might even have been beneficial for the sector. It has, for example, forced private equity players to become more transparent about what they do, and to become a little bit more grown up in their dealings with trade unions. Hartmann says: “At least when the managers of Mittelstand companies are now considering selling a division, they will be much more likely to be clued up about private equity – and, on average, I think they will more comfortable with the idea.”