PE firms to profit most from German tax reform

Expect an M&A frenzy when Germany's corporate tax reform kicks in next year, but don't just go for the big industrials. The real action is in the smaller deals, according to German bank Commerzbank, and this means that the smart money will go straight into private equity funds.

“Germany is the Eldorado of private equity,” says Rolf Elgeti, analyst at Commerzbank. “There is lots of opportunity; forced sellers, which means good prices; and all the profits you make are non-taxable.”

Here's why. The generation of Germany's Mittelstand (made up of small-to-medium-sized businesses – SMEs) bosses is ready to sell up. But the mass of deals has been dammed behind prohibitively high tax levels.

“The succession issue has been talked about in the press for four or five years,” says Elgeti. “But nothing has really happened because in order to do these deals, people would have been really hit by the tax.”

The reform will open the sluices on these deals. It will also allow about E600bn of non-core assets to be demerged. And deals of less than E1bn will account for 83 per cent of that figure.

In Germany, the succession issue means that private equity deals are often MBOs or MBIs. Deals are typically small – worth less than E1bn – and the equity portion comes to between 20 per cent and 50 per cent , with the balance coming from debt-financing.

“Many of these businesses were founded after the war, by returning prisoners of war aged about 25,” says Elgeti. “Forty years on, these guys are too old. Not only that, but many have run their businesses in a patronising way – they are one man shows.

“In addition you have the Machiavellian problem of secondary succession,” continues Elgeti. “Their children are only interested in the companies as a means of buying a new Porsche. What these businesses need is external management and finance.”

Step forward private equity funds. They are “the ultimately direct way of buying into this growth market”, according to Commerzbank's research note. For investors, says Commerzbank, underwriting private equity funds is a better option than buying banks because German banks have relatively little exposure to private equity.

Furthermore, some of these banks may be planning to spin off their private equity divisions. Rumours persist that Deutsche Bank wants to sell Morgan Grenfell Private Equity, one of its private equity vehicles. Speculation is also mounting as to what the Dresdner group's merger with Allianz means for Dresdner Kleinwort Kapital.

Many investors might be tempted to buy into the German Mittelstand directly. But Commerzbank believes this is difficult to put into practise because the companies are small, often unquoted and therefore not easily accessible for institutionals.

So private equity it is. It may seem like a compromise, but it's the best way to invest because it lets you direct your cash into Germany. Commerzbank is not alone in reaching this conclusion – foreign investors are also cashing in. Commerzbank believes German investors provided less than 50 per cent of private equity capital in Germany in 2000, down from 54 per cent in 1999.

Many of these investors are American. “Private equity was virtually non-existent in Germany five years ago,” says Elgeti. “At that time, by pure coincidence, US firms began setting up offices in Munich and Frankfurt and started hiring people.”

The Americans bring hunger and experience. “You need two skills for successful investing,” says Elgeti. “You need local knowledge but you also need know-how and experience in the Anglo-Saxon banking world. And you need greed.”

However the greedy Americans have not yet cornered Germany's private equity market – far from it. “The market is a very long way from saturation,” says Elgeti. “It will take 10 years at the very least to resolve the succession issue. It will take at least five years to redistribute the non-core assets of conglomerates.”

And once these assets are sold, there is no reason why they can't be resold. “Business models change,” says Elgeti. “Private equity has a perfect role to serve as a catalyst for allocating capital more freely. And its tax free – there is no better way of doing it.”