Germany roundtable: Europe’s engine room

Volatility in the European Union hasn’t exactly made the last few years easy for German fund managers and investors. And incoming regulatory changes have added to the pressures. But, when PEI travelled to Frankfurt last month to meet four German private equity market veterans for a roundtable discussion, the overriding sentiment was that Europe’s largest economy is fuelling the region’s growth and providing plenty of attractive private equity opportunities.

THE MACRO PICTURE

PEI: Are macro concerns still dominating the German PE landscape like they were at this time last year? 

Mark Nicolson: Certainly the macro colours every discussion that we have, [but] private equity as an asset class is designed to generate outperformance versus listed markets and other asset classes and certainly rates of economic growth. If you consider the macro in the broader context, the difference between a recession and a growth period is maybe a delta of 2.5 to 3.5 percent, whereas private equity is typically targeting gross returns of 20 to 25 percent IRR. So the fact that private equity managers are continuously able to source deals that produce these sorts of returns through economic cycles lends itself to the view that, whilst the macro is important, it’s not the biggest factor influencing private equity returns. 

Christian Hollenberg: We’re not in the macro business. It is important to understand what could kill your portfolio company – there may be certain macro things that could do that. But in general, I think the range of outcomes when you look at an investment is so huge, that the macro is just a small portion of that. 

You’re more in control of your own destiny in private equity investments than you would be, say, in the stock market or the bond market where you’re a passive spectator. There are certain decisions that may be driven by the macro picture, but as such, the impact of it is fairly limited. Also we are mostly German-based in our investment strategy, so from the macro point of view I’d say that’s pretty much the place to be for the moment anyway, so we have a little less concern than maybe some other [European GPs] may have.

Then you don’t accept that buying into Germany is buying into the region?

Hollenberg: Buying into Germany into a successful company essentially means buying into the world market. Even small companies: we have some relatively small businesses in our portfolio that have a 70-80 percent export ratio, so you’re essentially buying into the world economy. You’re betting on the relationship between the euro and some key other currencies, in Asia for example, but you’re not buying into Greece, Spain, Portugal, or to a very small extent.
Nicolson: I’d totally agree with that. Germany is the second-largest exporter in the world. The world-class industries and expertise that Germany has means a lot of the companies are export-driven; so buying into Germany is really buying into a powerhouse economy. This coupled with near-to-full employment and consistently low wage inflation has meant that Germany has and will continue to be the engine room for European growth. These factors contribute to Germany being one of the most attractive private equity markets to be in. 

Georg Helg: We’ve been investing in Germany for over 10 years. Though we opened our Frankfurt office only two years ago, if you looked at our portfolio at that time it was already approximately 50-50 Germany and Switzerland. We mostly invest in global niche market players that have a substantial portion of their sales in foreign countries. As others have mentioned, it’s about investing in the world through these global niche players headquartered in the German-speaking region. 

WHERE TO FIND OPPORTUNITIES 

Are some sectors more interesting than others?

Nicolson: From within our portfolio and our monitoring of the wider German private equity market, the deal flow’s been largely within the traditional heartland of industrial and manufacturing businesses. There’s also been a number of pharma and healthcare related deals, tapping into the robust nature of the German governmental allocations to those areas.

Hollenberg: We have a hard time mentioning specific sectors because we tend to look for niche markets. Germany tends to be very good when it operates in a certain niche, not so good when it’s headed towards the general competition of the whole world, because we do have a cost issue in the country and staying niche, for us at least, has proven to be the best strategy. 

That makes it difficult to mention which areas we want to be in because with some of these niche businesses, they are so arcane that you need to spend three or four sentences explaining what it is that the company does, rather than being able to point to a certain sector. 

Helg: We’re also more of a generalist than a sector specialist, but looking at the last two transactions we made, one was a medtech company – a quite interesting sector these days. And the other was an attractive tourism company. Both companies benefit from mega trends.

Has it become easier to persuade German business owners to sell to private equity?

Nicolson: There’s always been the impression that there’s suddenly going to be a flood of deals from the German Mittelstand [SMEs in German-speaking countries] given the sheer number of SMEs in Germany. However, I don’t buy into that. Our experience has been that, broadly speaking, there’s always been a steady flow…so it does seem that GPs are able to convince German entrepreneurs [to sell] albeit at a fairly consistent rate. However, I think there’s probably been a bit of pent up demand through the downturn in terms of succession issues within the Mittlestand and other vendors wanting to sell but waiting for prices to recover. Another source of deal flow going forward will be the entrepreneurs from the ‘80s and ‘90s looking to realise value for their life’s work – these businesses have different characteristics to those within the traditional Mittelstand, with fewer likely to be passed on to the next generation as a matter of course.

Helg: About 40 percent of our transactions come from entrepreneurs with succession issues or needing growth financing. The remainder, I would say half-half, come from corporate carve-outs and also secondary buyouts. 
But in terms of the entrepreneurs I don’t think it’s become easier to convince them to sell to private equity. Family offices have started to emerge in the last five to 10 years looking at smaller transactions. Some of them market the fact that they do not need to sell companies in a couple of years like private equity firms do. But if you look at it in detail, most of them seem to sell in the same way as we do and I think we have a much more professional skill set to bring to the companies. 

Hollenberg: I have a slightly different view on that, different experience. There are two very distinct questions; the first one is: ‘Is it okay for people to be selling to private equity once they have decided to sell?’ There, clearly I think the answer is yes; the days where we were regarded as evil financial investors are pretty much over. 

We have some anecdotal evidence of that: we once tried to buy an ailing newspaper in distress in Germany and we were in the end outbid by, if you please, the Social Democratic party of Germany. Of course they were considered the saviour of this and what did they do? They sold most of it after two years, even sooner than we would have, and more than half of the people were fired. I think that shows there is no issue with private equity. 

The second and more difficult one is the issue with selling in the first place. Today, it is extremely difficult to find any entrepreneur willing to sell a business if he or she really doesn’t have to sell; why would they? In the old days, they would get six to eight times earnings for their business tax free and they would take their money and deposit it in the bank and they would get like 6 to 8 percent (factor 12 to 17, if you will) for their money in terms of interest and they could live comfortably off that. These days, regardless of how much you pay them, their interest rate at the bank is close to zero. What that means is a lot of the people who are willing to sell are really in desperate situations. 

Andreas Rodin: One has to distinguish between growth capital and buyout investments. I think as far as growth capital investments are concerned, our practical experience from our transactional work is there’s a high psychological barrier to share management rights with a financial investor and to accepting certain terms pertaining to equity rights mechanisms, how to get out, how to divest the rights in case the business plan does not turn out as expected. That continues to be a major problem.

As far as buyout transactions are concerned, an entity that has taken the decision to sell doesn’t have any problem whatsoever to sell to a private equity firm. Based on the statistics for 2012 from the German private equity association’s annual survey, I think it’s amazing – well not amazing, but it supports the ideas just presented – that 71 percent of all German buyout fund respondents said secondary buyouts remain important investment opportunities. That is also highlighting the situation that once a company has become the subject of a transaction, it will become the subject of secondary transactions. 

Nicolson: Just to develop on that point, I think the sourcing dynamic in the German market is one that is particularly attractive when we’re comparing it to other countries in Europe because of its fragmented nature, both in terms of intermediaries and the regional cultures and traditions which are still, to some extent, respected. This isn’t the UK, where the market is heavily intermediated and the lion’s share of deals is covered by a handful of advisors – in Germany there are dozens of credible intermediaries, most of which operate on a local or regional basis. The fragmented nature of the market also provides significant potential for off-market deal flow.

THE LENDING MARKET

What about financing – is credit now available?

Helg: From our perspective it hasn’t been that bad over the last two to three years … you find good financing for good assets. In recent months, some investment banks have become more aggressive and conditions are slightly improving; the debt multiples are improving for the right transactions. From our point of view, with quite low interest rates at the moment, it’s quite a good environment. Recently for good investments we have seen deals done at 4x-5x EBITDA, which we consider good.

Hollenberg: The larger the deal, the easier it is to get the financing. With our [special situations] strategy, typically the companies we invest in are not doing well enough to support a large debt load, and it tends to be more difficult to find banks for that. There seems to be some basic appetite from banks for doing these deals but the number of them that are willing and able to do it, especially in the small deal arena, has come down significantly. So it’s a much more difficult market than it used to be. 

Nicolson: I would echo that. From talking to GPs, it seems a number of deals are being completed utilising debt but I would say that 4.5x EBITDA is at the top end, with debt levels more typically at between 2-3x EBITDA. As we’ve seen across Europe, banks are being very selective in the companies that they’re funding and so only the highest quality assets are receiving debt packages. In terms of quantum it’s typically been €25-40 million max per bank and so clubs have been required for larger deals but there have also been a number of all equity deals with a view to refinancing at some point in the future. Obviously rates are down so debt is relatively cheaper but we’ve yet to see in Europe the seemingly abundant amount of new debt that’s been available in the US market, for example. Certainly at the smaller end, we’re seeing managers struggling to get debt into the businesses that they buy and therefore they’re considering other sources including private debt funds and mezzanine. 

Hollenberg: There’s the opportunity, at least in the German market, to place bonds. That’s new. It may be a window of opportunity that could be gone next year, I don’t know, but right now I think that’s something to look at. 

Nicolson: We’ve seen that across our portfolio in Europe. There have been a number of high-yield bonds because it has the clear advantage of consolidating debt lines and being covenant light out to its bullet repayment. There’s been a good level of demand for corporate bonds as investors begin to feel more confident and seek higher returns. 

Hollenberg: It is not suited for new acquisitions because of the process; you’d normally do it for existing portfolio companies. That’s something we’re looking at because some of the deals we do need to be all-equity because of the shape the business is in when we buy it, but a year or two years out may be ready for something like that. 
Helg: And these bonds often seem to be mispriced, at least from our perspective.

Hollenberg: Very much so. There is some really crazy pricing, a very unsophisticated market – which is a little bit of an issue. Do you really want to play in such a market? It could really taint your reputation if something goes wrong. We would want to make sure that any offer we make in this market is reasonably and fairly priced.

THE FUNDRAISING MARKET

What’s today’s fundraising climate like?

Nicolson: Certainly in Germany – and the UK, too, for that matter – the number of GPs that have been coming back to market in the last 12-18 months has been higher than in previous years for obvious reasons. Because of the large number of funds raised round 2007 and 2008, there’s been pent-up demand; there’ve been extensions to investment periods and there’ve been delays to GPs kicking off their processes to allow more value to come through in their portfolios. And so in terms of the actual number of funds in the market, activity has been relatively high. 

In terms of fundraising, in the past the LP bases in most German funds have mainly comprised German insurers and German banks. However, because of regulatory issues and directives, many are selling their positions on the secondary market and not making any new commitments. That’s created an issue for some GPs, however… one other interesting point is that we’ve seen more North American capital coming in to German funds. A number of US investors that have traditionally committed big cheques to large and mega buyout houses are reducing commitments or passing on funds altogether and are looking for exposure to small and medium-sized managers in Europe as they believe they will deliver additional performance above and beyond what they’ll get from the larger funds.

Hollenberg: To simplify, I think you can say fundraising has become totally ‘digital’: it’s either oversubscribed or it doesn’t work. If a fund’s oversubscribed, it has to have certain characteristics: it has to be an interesting geography; it has to be a niche strategy; it has to be a small fund. What many of the US investors seem to be thinking is, ‘We love your fund, but it shouldn’t be larger than €150-200 million, and by the way, we need to place at least €50 million but we cannot be more than 10 percent of your fund’. 

US investors are all realigning a little bit more towards the smaller funds away from the big funds, but there’s a big complication in taking on US investors. To be honest, we only have one US relationship that dates back many, many years, other than that we’ve been focused on European investors because we find the complications to be less, what with the whole FATCA thing [the Foreign Account Tax Compliance Act] and a lot of the bureaucracies involved in taking on US investors. 

POLITICS AND REGULATION

What kind of red tape pertains to US LPs?

Rodin: UBTI [unrelated business taxable interest] and ERISA [the Employee Retirement Income Security Act] have always been problems, but I think the German industry knows how to successfully manage them. FATCA has been a big, big question mark. But because of the most recent development – that the US and Germany entered into a treaty – there is a hope that this will simplify the procedures. Because in the absence of such treaty, to be FATCA-compliant is very, very complex and complicated regardless of whether you derive income from US sources.

Are the upcoming elections expected to impact private equity?

Hollenberg: Not directly I would say. It’s not easy to predict what will happen because one of the things one needs to understand is that what’s in the party programmes is going to be totally different from what will be real-life politics afterwards. Also there’s a high likelihood that not much will change when you look at the polls right now. There’s also little likelihood there’d be dramatic change to the private equity landscape tomorrow. 

Rodin: With one exception: the 40 percent exemption for which carried interest is eligible at the moment. There is a serious concern that this will be abolished in the future and that proposals already tabled will become relevant once elections have taken place regardless of the outcome of the elections. 

What other regulatory issues must German investors worry about?

Helg: For us, it’s not so much a specific law that we are worried about, but regulatory compliance is an increasing cost that we need to build into our funds. We’ll probably need to bring an additional 1-2 people on board to take care of all these regulatory issues.

Nicolson: We’re adding to our team as well due to the stream of new regulations that are coming in. The Alternative Investment Fund Managers (AIFM) directive is obviously one. There was a time when market participants in Germany were worried about the potential implications of the initial draft, but I think it’s reached a satisfactory compromise that’s far better than what had initially been feared. 

Rodin: For the first time in history from [late July] onwards, German private equity managers will be subject to regulation. This is new. For two reasons, the number of German managers that will be subject to full regulation is probably limited. Full regulation is triggered if the total amount of assets under management exceeds € 500 million. In Germany, however, there is a very strong focus on the medium-sized private equity firms, whose total assets under management typically would not exceed the €500 million threshold. 

The second reason why manager activities within the meaning of the European directive will probably be relocated from Germany to other countries relates to a tax issue. We still struggle with the position taken by Germany that compensation paid by the fund for management is subject to VAT. Other continental European countries like France, Italy and Luxembourg rely on an exemption from VAT under the European VAT rules. Since 2007, we have been disputing with the German finance ministry whether private equity funds fall under that exemption. The position taken by Germany is inconsistent with the interpretation applied by other continental European states. It’s always amazing how different states will interpret European law, but we cannot change it.

The German VAT issue can only be solved if the fund is managed by a non-German (e.g. Luxembourg) manager and the activities of the German private equity teams are “down-graded” to the performance of advice, which is rendered to the non-German manager. These are the reasons why the impact of the AIFM directive will probably be fairly limited on the German industry; many German private equity firms are too small to fall under the scope and others will restructure their set up and will establish in Luxembourg the fund’s manager to be eligible for the VAT exemption.

Nicolson: VAT on fees certainly makes German private equity funds more expensive than most of their European peers. If you’ve got a 2 percent management fee and add VAT at 19 percent on top of that, it becomes significantly more expensive. But of course, that’s just one element of the overall value equation. However, with VAT and the business/non-business legislation, the Luxembourg solution is one we’ve seen a small number of managers take, with some of the team based in Luxembourg to give it real substance. Over the next 5-10 years we may see more German GPs move their structures there or to similar jurisdictions. 

How have some of the GPs handled this?

Hollenberg: We’re in Guernsey and have been since the beginning of our activities. It’s a costly structure and does require real substance there; you need to have people who can take decisions there, and you have to travel, which is more difficult to Guernsey than Luxembourg. But overall it’s been worth it because the additional side benefit is you get an excellent service infrastructure in Guernsey. They know how to run these funds and they have the requisite software for that, plus you’re in the UK/US law environment, which makes everyone’s life a little easier. 

Roundtable Participants

Georg Helg, Capvis Equity Partners
Helg has been a managing director in Germany for Capvis since 2011. He previously spent 20 years in management consulting and investment banking for ABN AMRO and Royal Bank of Scotland.

Andres Rodin, P+P Pöllath + Partners
Rodin is a founding partner of law firm P+P and a leading private fund formation lawyer in Germany. Rodin and his colleagues have advised more than 300 private partnerships. 

Christian Hollenberg, Perusa
Hollenberg co-founded special situations firm Perusa in 2007, having previously co-founded fellow Munich-based turnaround investor Orlando Management. He has more than 20 years’ experience as an investor and entrepreneur in SMEs.

Mark Nicolson, SL Capital Partners
A partner at SL Capital, Nicolson oversees the fund of funds’ UK and Germanic market activities. He joined the firm in 2007, having previously spent seven years doing mostly buyout-related advisory work with KPMG and Ernst & Young.