Return to search

Weathering the storm

Private equity firms held their breath when IKB Deutsche Industriebank AG became the first European bank to own up to large US sub-prime losses, prompting a rescue by other German banks. SachsenLB, a regional, state-backed lender was also hit and had to be bailed out.

The fear was that bad press surrounding sub-prime would turn off the supply of the following: loans for leverage; funds from investors; and deals, particularly from Mittelstand mid-market companies that traditionally looked elsewhere for finance.

Think again. “Sub-prime – they should really call it junk bonds – hasn’t really had a large effect on Germany because we did not have so many large transactions,” says Rolf Christof Dienst, chairman of Bundesverband Deutscher Kapitalbeteiligungsgesellschaften (BVK), the German Private Equity & Venture Capital Association.

Private equity firms acknowledge that covenant-lite loans are over, underwriting is now ‘club deals only’, and that debt multiples are down. But the effects are being felt disproportionately by the financial engineers, who can no longer afford high prices.

Large private equity-backed buyouts only hit their stride in the homeland of Grimms’ Fairy Tales from the late 1990s onwards as large corporates hived off non-core assets and deregulation and privatisation underpinned deal flow. Then they declined.

By 2007, there was only a handful of €1bn-plus deals per year. Then along came sub-prime to chop down the magic loans beanstalk, leaving the giants stranded in the clouds, dreaming of better times ahead … maybe.

2007 has not been a complete wipe-out higher up the scale. Allianz Capital Partners, 3i, and Bain Capital Beteiligungsberatung were all involved in billion-plus deals just before, during and after the peak of the turmoil. Charterhouse Capital Partners and EQT had already scaled the billion barrier in the first half.

But with the international syndication needed for bigger deals currently hard to come by, the real story in Germany now lies more firmly than ever in that fertile forest of the German economy, the hallowed Mittelstand, the mid-market.

Life goes on for mid-market private equity players with their feet on firm ground bound with the deep roots of banking relationships, specialist sectoral knowledge, and business culture and language shared with the companies they back.

Estimated transactions in this segment of the market rose from 25 in 2005 to 34 in 2006, ensuring that all-time highs were reached four years in a row, according to an analysis published this year by Frankfurt-based Deutsche Beteiligungs AG, a listed mid-market buyout company that has seen trends come and go over nearly 40 years in business.

It estimates investors poured around €4bn into majority takeovers alongside management in the €50m to €250m range, debt-free. This was €1bn more than in 2005, though estimated average transaction values remained around €120m.

Fifteen of the 34 transactions emanated from larger companies offloading peripheral activities. Secondary buyouts accounted for 14. There was one public-to-private deal, and the remaining four solved succession issues in once family-run companies.

Estimates are not yet available for 2007, but some players suggest mid-market deals are on the same track, emanating from companies seeking finance to expand, restructure and deal with pressing succession issues among Mittelstand firms.

“I don’t see any decrease or increase. It is a constant incoming flow of deals,” says Peter Blumenwitz, partner at Buchanan Capital Partners, a Starnberg, Bavaria-based private equity firm focused on mid-sized German growth companies

Mittelstand owners have been famously reluctant to approach private equity ahead of other sources of finance in the past, caution attributed to their wariness about opening up the books and nervousness over valuations.

But public controversy over the role of private equity in German business has generated greater awareness of its uses, arguably contributing to raised interest from the Mittelstand, albeit on a slowly rising path.

Perversely, sub-prime’s fallout could have an upside too, believes Blumenwitz.

“What is positive is that the enemies of private equity in the mid-market – mezzanine providers and so on – are having quite a hard time getting financing. So I think the competitive position of private equity is strengthened. Companies may turn earlier to private equity.”

While conceding that banks are “not exactly beating themselves up” to get involved, he insists that there is no credit crunch in his area. “Banks are extremely supportive: they’re really keen on doing business.”

Rolf Christof Dienst, BVK chairman and general partner of Munich-based venture firm Wellington Partners, relates the experience of a friend discussing a significant refinancing in late September/early October.

“He had zero problems financing exactly as before and at rates that were absolutely competitive. So my feeling is that the problem is with very large buyouts with syndicated loans. The banks don’t write them because they don’t know if they can sell them. It’s more a sort of distribution problem. The money’s still there.”

Funds aplenty

Nor is raising funds an issue, according to Wilken von Hodenberg, spokesman for the board of Deutsche Beteiligungs AG.

“I don’t thing the sub-prime crisis has done any harm to raising new funds [for the mid-market],” he says, one reason being that private equity is still building up as an asset class in Germany. “A good manager may have problems in allocating over-demand.”

For mid-market players with deep pockets, opportunity beckons. “Our mood is to look for further new investments,” adds von Hodenberg. “We’ve been doing a lot of exits and had a very significant cash flow over the last two years, so we are sitting on a very big net cash position.”

In uncertain times, relationships are proving invaluable as the mid-market private equity players keep the show on the road.

For example, Buchanan Capital Partners faced stiff competition before acquiring a 51% stake in time:matters, an ambitious logistics company, from Lufthansa for an undisclosed sum.

What swung it for Buchanan was an owner buyout, the PE firm’s existing network in the logistics industry, and its previous experience of buy-and-build.

“Structure and chemistry can beat valuation,” observes Buchanan’s Blumenwitz.

And now that the buy-and-build strategy for time:matters is being executed, the debt-providing bank is keen to keep pouring in acquisitions financing: a feature of this strategy that commends it in times of tighter credit.

In the Mittelstand, many owners value retaining a stake in the family business and are also keen to sell to ‘the right people’, which may come down to a simple question of whether or not they ‘like’ the buyer.

That said, German private equity firms do not have the marketplace to themselves.

“I’m fairly bullish on the whole German situation,” says Martin Block, partner at London-headquartered HgCapital and head of its German team, operating from Munich. “The quality of companies has always been high. That is a huge mitigant for credit crunch uncertainties.”

In an active year so far, HgCapital took a majority stake in SLV Group, one of the fastest growing manufacturers of innovative lighting systems in Europe; sold Schenk Process, a global market-leader in industrial weighing, feeding, screening and automation, to Industri Kapital; acquired a French wind farm portfolio from Germany’s ENERTRAG AG for €69m; and disposed of Hirschmann Car Communication GmbH (HCC) to its management.

German mid-market players nevertheless say they do not currently see much competition from pan-European funds, most of which are based out of London. Small wonder given the scale of deals, the distance from the UK, and language issues.

Internal competition is escalating though, as rising professionalism and internationally experienced staff raise the game at those mid-market firms that traditionally came out of banks or semi-governmental financial institutions.

It is almost impossible to find an exclusive deal. Almost everything is an auction, with at least two or three competitors, and the prizes go to those who can offer not only the right prices but the best solution.

So far, there is little or no sign of US funds preparing to mount a meaningful invasion in the mid-market.

“But I think that may change,” suggests Martin Block. “We’ll maybe see the big firms come down towards mid-market. But let’s see. They’ve said that before and it hasn’t happened. I think the competition will remain the core players on the ground and who have teams in London that come out regularly.”

Where are the hot-spots? According to the BVK, in 2006 investments in general were clustered where buyout groups are based and the Mittelstand is prominent, hardly a coincidence.

Bavaria claimed pole position with 50.5%, followed by Baden-Wurttemberg with 13.6%, Hesse with 12.9%, and North Rhine Westfalia with 7.7%.

Service businesses were most favoured (42.7%), ahead of mechanical engineering (18.5%), iron, steel and light metal (5.5%) and computer (4.3%).

High-tech industries, such as computers, communication technologies, biotechnology, and medical-related, received only 12.9% between them, a fall from a 28.2% share in 2005. The decline in relative share was down to big buyouts in other sectors and high-tech did at least account for a third of financed companies.

Within these categories, retail is well favoured, as evidenced by EQT’s €1.5bn acquisition from Apax and Cinven of CBR, and Advent International’s €770m purchase from Permira of a majority stake in discount fashion retailer Takko.

Better economic conditions are one reason; but there is also recognition that German consumers are less prone to buying on credit than their UK counterparts.

“Germany has that lovely, slightly old-fashioned feeling that you buy it with cash, you tend not to overgear whether it’s for furniture, holiday, car, or whatever,” says Martin Block.

Cleantech and renewables are also in fashion, and there is expectation of more to come in healthcare on the back of much discussion about reform.

As for exits….

Successful IPOs this year included the partial flotation in July of Homag AG, a maker of woodworking machinery that was in the portfolio of Deutsche Beteiligungs AG.

But market uncertainty during and after the debt crunch has produced a more cautious mood among private equity firms.

“IPOs are a little bit tough,” says Peter Blumenwitz. So the markets need to hear and believe a good story. “Is it a sexy story to bring to the market or is it the fifteenth biodiesel firm that you’re trying to get rid of,” he laughs.

Secondary sales were a notable feature of a big change of ownership over 18 months, last year and going into 2007. But there are no prizes for guessing what has happened in the current climate.

“It’s slowed right down,” notes Martin Block at HgCapital. “I suspect it will speed right up again, probably not in the next six months, but possibly in the next nine to 12.”

Trade buyers buoyed by improved economic conditions remain active and are expected to take up more of the running as falling debt multiples dent private equity’s ability to outbid them.

Good mid-market German companies that have sharpened up through the private equity process will offer good value to trade buyers who can find synergies, but only assuming that the price is right. Some observers see a Mexican stand-off developing.

“I’ve not seen pricing come down yet,” says Martin Block. “I think it’s because the deal pipeline is drier. But I don’t think that’s because of lack of deal flow. It’s that little bit of caution, no-one knowing how bad it will get. A sort of pause. We’ve seen the debt down and that’ll drive the prices down, but we haven’t seen it yet.”

While mid-market players are bullish, they still have work to do to attract more from institutional and fund-of-funds investors, who remain focused on big ticket deals.

It rankles with them that German investors have not showed more willingness to invest in the backbone of the German economy.

One reason is that returns had not always impressed. But rising professionalism and experience among German private equity firms augur well on this front.

There is also hope that as returns from mega buyouts decline, the mid-market will see more funds flow in. Blumenwitz says that in the news flow reaching the ears of investors through the German media, mid-market is becoming the flavour of the day.

Whether it is wishful thinking or the mood music of a new dawn from the country’s mid-market private equity firms is too early to say.

Fighting back

As if the industry did not have enough to contend with, it is dealing with constant political and trade union sniping and is having to swallow disappointment over the tax and regulatory environment in which it finds itself.

Stung into action, 10 major firms launched in June a large buyouts division of the BVK to complement existing groups for early stage, later stage and publicly supported private equity firms.

This group – Blackstone, Allianz Capital Partners, Apax Partners, Advent International, Bain Capital, BC Partners, CVC, KKR, Permira and TPG – is mounting a PR counter-offensive.

It has also commissioned detailed research to support its view that an industry backing 6,000 German companies with about 1 million employees deserves fairer treatment and a level playing field for German private equity firms to compete internationally.

But they appeared too late to head off new laws approved in draft in August, which critics claim will damage some venture capital firms, hasten an existing brain drain to surrounding countries, and do nothing to place German private equity on an internationally competitive footing.

A last-ditch hearing on the legislation was being held in mid-October, but the industry was not expecting a change of heart from Government.

“I am now very cynical about politicians,” said Rolf Christof Dienst at the BVK. “We can have as many hearings as we want, but nothing is going to change. This will happen and then we must [place our] hope in the next Government.”

On a more positive note, hopes were raised that the Ministry of Finance would back down on a previously issued instruction to tax officers to slap 19% VAT on management fees for new funds, even if fees were in the form of profit sharing. The industry argued that the diktat broke European VAT law.

One sweetener amid uncertainty will come from company tax cuts as of January 1 next year. It will reduce the current effective rate of about 39% – once local and national ‘solidarity’ taxes are added to corporation tax – to about 30%.

However, the tax deductibility of debt will also be reduced. “We don’t see that being a headache for any of our portfolio companies,” says Wilken von Hodenberg at Deutsche Beteiligungs. “[But] it could become a headache if profitability goes down, because the law doesn’t look at EBITDA versus debt levels at the time of taking up financing. The law will take an annual view.”

Thus if a business gets into difficulties, it will be punished not only from a market point of view, but from a tax point of view, because suddenly part of the interest is not tax deductible, he explained.

“But overall, given the significant decrease in corporate income tax next year, then even for investors who put more leverage in their deals, it should not be negative,” concludes von Hodenberg.