Is private equity good for Germany? In the summer of 2005, it looked as though a large number of important Germans had decided it was not.
Branded “locusts” by electioneering politicians, financial investors came under intense pressure from trade unionists and journalists alike. “Anglo-Saxon”, the adjective used to remind people that most of the “locusts” had their nests in Britain and America, became something of a dirty word as well. Efforts by private equity-backed companies such as Grohe, the bathroom equipment maker backed by Texas Pacific Group and DLJ Merchant Banking, to rationalise operations in their domestic market prompted fierce public protests and a barrage of scathing press coverage. At the time, regulatory changes designed to stem the flow of international private equity capital into the country appeared a distinct possibility.
A year on, no adverse regulation has materialised, and much of the noise surrounding the locust debate has died down. Paradoxically perhaps, 2005 set a record of new LBO financings by number, and further growth occurred in the first half of 2006: “The market this year has been sound so far, with activity in terms of deal value in the first two quarters of 2006 greater than 2005 year on year,” notes Jochen König, head of leveraged finance for Germany at Royal Bank of Scotland in Frankfurt.
Widely seen as a watershed – and described as ironic by many given the events of 2005 – was the decision of the German government in April to sell a minority stake in Deutsche Telekom to the Blackstone Group. Blackstone was one of the groups being attacked last year; less than twelve months later, the firm was invited to take an equity piece worth billions of euros along with a board seat in one of Germany's most high-profile corporations, and to help run the business alongside its largest shareholder – the German government.
Another indication that attitudes towards private equity have changed substantially was German chancellor Angela Merkel's state visit to the US in May. During a stop in New York, Merkel made time to meet with a select group of senior LBO practitioners including Henry Kravis. Merkel's unusual agenda item only added to the perception that Germany, instead of attempting to keep private equity at bay, was open for business.
So has there really been a change of sentiment? And if so, why? Market practitioners say that a year after the locust debate, there is now greater awareness of how private equity operates and what it tries to achieve. Thomas Pütter, head of Allianz Alternative Assets Holding in Munich and current chairman of BVK, the German private equity and venture capital association in Berlin: “There is now a growing appreciation of the methods, tools and value drivers we rely on, because people have been seeing more examples of private equity at work.”
The point is echoed by Jens Hardekopf, a managing director at Deutsche Bank in Frankfurt with responsibility for financial sponsors coverage in Germany. He says: “Companies coming out of private equity ownership are generally in better shape than they were at the beginning of the process. This is being recognised and has led to a more rational debate about the industry in Germany.”
As a case in point, an advisor to private equity firms in Germany points to Wincor Nixdorf, the cash machine maker that was controlled by KKR until it went public in May 2004: “The company has been doing well since, setting one quarterly record after another and expanding globally while still creating jobs in Germany.”
Those in favour of greater private equity activity taking place in Germany make a straightforward case for it: it is needed, quite simply, to help the country overcome the economic difficulties it continues to experience.
Although business confidence as measured by Ifo, an influential research institute, rose sharply earlier this year to close in on levels last seen just after reunification in the early 1990s, growth remains sluggish and unemployment sky high, with roughly 5 million people out of work. Angela Merkel, using unusually blunt language in a speech to trade unionists in June, described the country as a “financial basket case”.
This is the climate in which private equity is winning mindshare among those who recognise it as a mechanism capable of providing some of the sparks needed to revitalise Germany's economy.
The supporters want to see private equity at work in all layers of the economy. Large corporations, it is argued, need to rationalise their often convoluted business models; in addition, Germany's consensus-driven approach to corporate governance is considered outdated (see On the Record, p. 80). Private equity is deemed capable of delivering both. “I think it's telling that Blackstone was asked to buy only part of the government's Deutsche Telekom stake rather than the whole thing,” says one insider. “Clearly the majority shareholder is holding out for an up-tick in value.”
A similar argument applies to the Mittelstand, Germany's vast corpus of small- to medium-sized and typically family-owned businesses. It states that the Mittelstand needs private equity as a partner to help it replace the traditional sources of growth capital that have dried up ever since new capital adequacy rules have dramatically changed the dynamics in the banking system. Admittedly, private equity's foray into this segment of the economy, though long hailed as a potent source of deal flow for the industry, has been slow. However, it is still widely assumed that sooner or later the Mittelstand will have to embrace private equity-style funding techniques in order to secure a viable long-term future.
The third area where private equity involvement is seen as critical if Germany is to maintain its status as an economic power of note is in the technology sector: the German venture capital market is simply not large enough to foster the monetisation of the abundance of intellectual property the country produces. (24,000 new patents are registered in Germany every year, more than in any other European country.)
To illustrate the urgency, Pütter at Allianz cites the example of a piece of MP3 compression technology developed by the Fraunhofer Institute, a large research organisation based in Bavaria dedicated to applied science. Because the technology could not be funded domestically, it was sold to investors based in the US. Today, says Pütter, it resides in every MP3 player sold around the world – a lost opportunity as far as German industry is concerned.
“Germany is still one of the leaders in intellectual property creation,” Pütter says. “What we need is a venture capital industry capable of helping to commercialise it.” (See also p. 58.)
To nourish private equity's and venture capital's development in all three industry segments, change is needed on a number of fronts. Most importantly perhaps, any uncertainty over the tax status of private equity funds operating in Germany must be removed. In June, rumours circulated that the Ministry of Finance was mulling changes to corporate taxation that could destroy the appeal of German private equity funds and funds of funds to international investors. The Ministry has stated that no concrete plans to move in this direction are currently in its drawers, but industry professionals say more clarity in this area would be welcome.
It's telling that Blackstone was asked to buy only part of the government's Deutsche Telekom stake rather than the whole thing. Clearly the majority shareholder is holding out for an uptick in value
An equally important fiscal issue, the market insists, is a need to simplify the treatment of share options in Germany-based investee companies so as to more effectively attract and incentivise managerial talent.
Another major fillip to German private equity would be the relaxation of the regulatory hurdles that continue to make it difficult for German institutions such as pension funds to invest in private equity funds. If, instead of prescribing which types of risk, and how much of it, German investors ought to be taking on, something akin to the Prudent Man Rule was adopted, more German capital could participate in, and benefit from, the activities of private equity funds and venture capitalists in the country. This would in turn make it easier to demonstrate the industry's capacity to generate superior investment performance to a wider audience, and hence improve its overall public standing.
Pütter says that at the moment, things are moving in the right direction: “Private equity is in the business of mobilising private capital to invest in non-public companies. It's a powerful tool, and the key question for policy-makers has to be how can we get private equity investors to practice their trade in Germany. I am heartened about the growing awareness of the benefits of private equity.”
The creation of a more favourable investment environment will of course take time. In the meantime, arguably the most important challenge to the industry is to make sensible investment decisions in an increasingly exuberant market.
In the LBO segment for example, just like anywhere else in Europe, signs of overheating are difficult to ignore. Says Jochen König at RBS: “Liquidity is higher than ever, we're no doubt at stretch level at the moment. Interest rates are of course rising, but that will help stabilise rather than hurt the market. Financing costs are not really a deal breaker, because hedging is in place and loan costs are tax deductible, which helps to limit the cash burden. But we do have concerns about overoptimistic business plans. We have seen some that are not linked to the trading history of the underlying businesses – that's worrying.”
Sponsors, in other words, will need to tread carefully. A high-profile blow-up, just when private equity is making new friends in Germany, would be counterproductive.