Horse-trading over private equity

Across the world, there are a number of countries where the greatest threat to private equity's continued progress is currently political. In Germany, the issue has been especially intractable. A debate over the merits and drawbacks of private equity investing has raged for two years – and still shows few signs of resolution.

After the furore of the “locust” debate in 2005, it had seemed as though private equity in Germany was mounting a steady recovery, mirroring the upwards trend in the economy as a whole. Understanding of the industry seemed to be increasing, while the government was making noises about much-needed improvements to the tax and regulatory environment.

But any hopes that private equity was about to find mainstream acceptance appear to have been ill-founded. The government's proposed changes will do nothing to help the industry; indeed, in some respects it will be worse off than ever. Clearly there is still unease about private equity at the highest levels of government – which is bad news for the industry's future growth.

Any discussion of private equity in Germany has to begin with Social Democrat politician Franz Müntefering – the man who, shortly before the state elections in April 2005, compared private equity to swarms of locusts, stripping bare the country's businesses.

Müntefering, in full electioneering mode, was attacking an easy target: as a manufacturing economy with strong trade unions and a largely protectionist mind-set, Germany had no natural affinity with private equity's “Anglo-Saxon” financing methods. In fact, most private equity funds operating in the country were, and still are, managed by foreign-based investment firms. The country has home-grown venture capital firms and a cluster of local mid-market investors. But there are no large LBO funds headquartered in Germany, with the exception of Allianz Capital Partners in Munich.

Müntefering's comments struck a chord. “There were people who were prepared to debate the issues objectively and without emotion,” says Thomas Krenz, a partner at London-based pan-European LBO investor Permira in Frankfurt. “But the locusts tag did stick in the consciousness of the wider public.”

The ensuing backlash was fierce, and the industry is still in the process of recovering. “There's still a reluctance to accept the industry, a sense of uneasiness about our behaviour, and a lack of understanding about what we do,” says Ralf Huep, head of German operations at Advent International in Frankfurt. “Some people don't understand the difference between private equity and the hedge funds that take a more short-term view”.

Helmut Schühsler, managing partner of US-German venture investor TVM Capital in Munich, is more emphatic: “The mixing up of private equity and hedge funds that is currently going on is a nightmare.”

The irony, according to many observers, is that private equity has much to offer the German economy. Many of the large and formerly stateowned companies require investment and restructuring, while many of the thousands of small and medium-sized companies that constitute the Mittelstand need third party capital to accelerate growth or to resolve succession issues as their first and second generation owners approach retirement. “There is an enormous mismatch between the importance of private equity to the German economy and the lack of recognition,” says Dörte Höppner, co-CEO of the German Venture Capital Association (BVK) in Berlin.

Others say the public debate has cooled, at least to an extent. Indeed, the painful process may even have had some benefits, according to Karsten Hartmann, Frankfurt-based partner at mid-market investor HgCapital.

One positive corollary of the debate is that management teams tend to be better informed about the pros and cons of private equity. “Management teams on average tend to be more receptive,” says Hartmann. “The debate has given the industry some free publicity – managers may take a positive or negative view, but the proportion that doesn't have an opinion either way is almost zero.”

Krenz at Permira believes the debate has forced private equity to communicate better. “The main effect has been that it has encouraged greater dialogue with the stakeholders in any investment – to clarify what is being done, and what the plans for the company are. It's definitely increased the willingness to engage, and not just with the vendor and the management team – with all stakeholders in the company.”

This has changed the landscape for doing deals in Germany. With plenty of capital in the market looking for a home, reputational issues are becoming increasingly critical. “Corporate vendors will look at a private equity buyer very carefully, perhaps even take references,” says Hartmann. “The decision is not just based on price, but also on reputation.”

The same is true of limited partners, according to Peter Laib, a Germanborn partner at fund of fund manager Adveq in Zurich. “One new development is that German investors don't just discuss returns now, but also the reputation of a firm and other ethical concerns.” These could include excessive use of leverage, a propensity for offshoring jobs, and over-generous incentives for management teams, he says.

One significant stakeholder group in Germany are the trade unions, who – as elsewhere in Europe – are playing a more active and influential role in the buyout process. To some, this is mainly a function of scale. “Trade unions are becoming much more important,” says Jochen König head of leveraged finance German of Royal Bank of Scotland in Frankfurt. “It's quite a natural development – target companies are much bigger, so the industry is now on the radar screen of the unions.”

Unlike in some other jurisdictions, including the US and the UK, trade union influence is built into the corporate governance of German companies. A supervisory board will normally contain a number of representatives from the ranks of the workers, who will have a say in the choice of buyer. “Unions do play a role – the labour representatives will argue hard for job security, and drive an aggressive selection of buyers,” says Hartmann. Managers with a reputation for jobcutting will find it more difficult to gain the board's approval.

Germany's unions have been critical of private equity, and more work is needed to foster their understanding of the nature and benefits of the industry (see box-out). But most participants said unions have not been a particularly disruptive influence – yet. As König says: “I can't think of a single deal that has been pulled because of union pressures. In most transactions they have been very co-operative.”

Activist unions may present a threat to the industry. But there is a more pressing concern: the government still seems disinclined to help the industry play a more active role in the country's economic recovery.

When it took power two years ago, the government briefly raised hopes by promising to review the industry's tax and legal framework and announcing plans to introduce a specific private equity law. However, the so-called “grand coalition” formed by chancellor Angela Merkel's conservative Christian Democrats and the centreleft Social Democrats has made for an uneasy alliance, and this has stymied decision-making.

There were initially encouraging signs: the government commissioned a study from academics at the University of Munich, which concluded that the private equity industry needed a lighter fiscal and regulatory burden. However, these recommendations have been largely ignored. Some say they have been deliberately misinterpreted.

Leading the ongoing legislative review is the Ministry of Finance under Peer Steinbrück, a Social Democrat. The current draft of the new law, published by the Ministry this spring, doesn't change the rules at all – except for seed funds operating at the smallest end of market, investing in companies with equity worth less than €500,000.

Industry practitioners argue that this is the wholly inadequate outcome of a political compromise. Says one of the country's most senior industry representatives: “The intention of doing something for Germany as a location for private equity is gone, we are now into party-political horse-trading. The difference being made here between venture capital and buyout is a political effort to distinguish between good and bad private equity.”

Venture capitalist Schühsler says any plan to promote investment into the smallest German companies only “betrays a fundamental lack of understanding of what building early-stage companies is all about”.

Buyout practitioners are even less impressed. “I can see why the Government wants to support seed capital,” says Hartmann diplomatically. “Since the breakdown of the new economy, the level of venture and seed funding has been very low – elsewhere it's recovered much better, while in Germany there's still an equity gap. But the law will not do much good for the [buyout market].”

Some of the changes to be introduced under the government's tax reform plan, which is scheduled to come into law next January, seem deliberately designed to undermine private equity. Most worrying is a law that limits the tax deductibility of interest payments – a cornerstone of the leveraged buyout structure – to 30 percent of EBITDA for that year. With similar moves already afoot in Denmark and Holland, the implementation of this will have buyout executives across Europe looking nervously over their shoulders.

On May 31, the Finance Ministry poured even more oil onto the fire when it published a document announcing that private equity funds based in Germany would have to pay value-added tax on the management fees they receive – an additional cost to domestic managers. This rule would be unique in Europe. “It is difficult to see why the Ministry of Finance would hand such a significant advantage to fund managers abroad. At the very least, we should be entitled to a level playing field,” protested the BVK in a statement on June 8.

Another key issue for many GPs is the lack of clarity in the proposed new framework. After all, this was the very issue that was meant to be fixed. “When they started to draft the law two years ago, we hoped it would at least make the legal situation clear, unambiguous and predictable,” says Krenz. “The old system had too much room for interpretation, so the industry wanted some clarity.”

Unfortunately, it hasn't got it. “The new law is so complicated that it will create problems for all concerned. There's still too much room for interpretation, and that might create insecurity and uncertainty,” concludes Krenz.

But perhaps the most worrying consequence of the new laws is the potential significance for German-domiciled funds. Says Hartmann: “There is still no reliability around the treatment of private equity funds as tax-transparent vehicles. As a consequence, there is a risk that profits made by private equity funds might be taxed on the level of the fund vehicles in future.” This would be on top of the tax investors already pay on the capital gains delivered by the fund, which Hartmann believes cannot be right. “This would deter foreign investors in particular from investing in German funds,” he says.

According to Laib, German limited partners would also be hit with a double tax. “At the moment the tax situation would be very good for German institutional investors looking to invest directly in German companies, or in overseas funds. But there would be an additional tax burden for German investors if they put money into German vehicles.” This cannot be the government's intention, he believes. “It can't be right that it's more attractive for German investors to invest outside of Germany.”

“The domestic funds domiciled in Germany would be hit much harder,” notes Hartmann. According to a recent survey by German trade body the BVK, almost 50 percent of their members would consider moving their funds or even their management companies out of Germany if the law comes to pass.

Strictly speaking, the law as it currently stands is still just a basis for discussion. But according to some GPs, the consultation process is no less opaque than the law itself. “The amount of consultation [about the legislative process] is very limited,” says Huep. “We (as a firm) know as much as we read in the papers.”

At this stage, it looks as though the government is going to miss out on an opportunity not only to improve the lot of private equity in Germany, but also to provide the industry with the stamp of approval that would accelerate its progress into the corporate mainstream. At the same time, it seems determined to strike a hammer blow at the heart of its domestic buyout market.

It is hard to see beyond the explanations offered by some in the industry that many of those in government have no understanding of the industry, or indeed business in general. “In Germany there are a lot of career politicians, who are not typically close to business,” says one. “That means there is less willingness to engage in an ongoing dialogue than there is elsewhere.” The politics of envy is clearly at work too. “There's always suspicion of people earning lots of money,” says another.

When the government takes this attitude, it is not surprising that the electorate follows suit. “The overall attitude of the government has become more critical, so it's hard to convince people otherwise,” says Huep. As a result, legislating in favour of private equity will never be a vote-winner – and with the balance of power so precarious, there is nobody in power with the authority to push through measures that are unpopular but may be good for the economy. “Germany needs a Sarkozy,” as one adviser puts it.

But how significant will the government's lack of support prove to be? The answer depends very much on one's perspective. Market participants representing funds incorporated outside Germany suggest there are more important things to worry about. “The political and tax situation is not a big threat,” says Hartmann at Hg. “I'm confident it will be sorted. There may be some small issues, but nothing terminal. More worrying is the upward trend in valuations. There's a flood of money chasing deals, and if you have 25 bidders in an auction, at least one is likely to act irrationally.”

This seems particularly true of the mid-market. “Pricing is still very stiff,” agrees Huep. “Things just continue like last year, where there was too much money chasing deals, but this can't last forever.”

Nonetheless, Germany still is attractive to private equity investors, Hartmann believes: “Germany is a very attractive market for private equity, and slowly but surely the country is becoming more open to the idea. So we expect to see aboveaverage market growth.” In relative terms, the size of the market still lags behind other European countries. According to figures from the BVK, private equity investment equated to just 0.12 percent of German GDP in 2005 – less than the continental average of 0.42 and well below the UK, the biggest market at 1.33 percent.

Krenz agrees. “Overall I'm very positive about private equity in Germany. 2006 was a fabulous year – we may not see quite the same level of activity this year, but we're starting from a relatively low base so there's still some further growth ahead.”

However, representatives of domestic private equity firms are very clear that the new law as currently pending could have a crippling effect on their circumstances. Those opposed to the notion of a successful German private equity industry might welcome such an outcome – although they should also bear in mind that whatever a German private equity law will end up prescribing, it won't have much effect on funds that are domiciled elsewhere.

In other words, the new law in its current guise won't stop private equity doing deals, but it could force local firms to leave the country altogether. Dr Christian Hollenberg, a partner at German special situations fund Orlando Management, says: “The tax situation could have a huge impact. It could drive German firms outside the country, and drive German investment money outside the country. That doesn't make sense.”

And Schühsler: “Everyone I know has something in their drawer in the event the law goes through. If the government doesn't want to be competitive [in private equity], they have every right not to be – but they will also have to live with the consequences.”