A time for long-term capital

Munich, June 2009. A stroll through Bavaria's affluent capital will never reveal it, but Germany is in the early stages of an economic downturn that many predict will be remembered for years to come. This year the economy will shrink by an unprecedented six percent, according to government calculations; for 2010, a rapid recovery is not expected. Unemployment, which in May stood at 3.5 million people, will hit five million next year, according to commentators including Deutsche Bank.

Many of Germany's financial institutions are fighting fires similar to those burning at banks and insurance companies around the world – nothing unusual there. The quintessentially German experience of the global crisis is that it is hitting the economy in the very part that in normal times is its main source of strength: exports. Global demand for goods made in Germany has fallen sharply, and countless manufacturers in many industries are experiencing intense pain.

The automotive sector, arguably the greatest success story of German industry, is the most high profile example of the current malaise. International car sales have collapsed, and the country's uneasy coalition government of Christian Conservatives and Social Democrats is desperately trying to prop up failing businesses in the sector, amid bitter disagreements among the political figureheads involved.

In May, ministers agreed to help finance a controversial rescue plan for Opel, a German subsidiary of General Motors that employs 50,000. The intervention came despite many experts questioning the industrial logic of saving the company. Why? Because in September the country will be going to the polls in a federal election, and politicians of all stripes and colours are determined to be seen as willing and able to protect jobs.

For private equity investors operating in Germany, the question of what to do in these difficult economic circumstances is fascinating. Investing into a negative growth environment is no-one's idea of an easy task. However, unlike other types of capital providers, private equity has the advantage of remaining open for business: at a time when banks are reluctant to lend, and corporate M&A activity is in the doldrums, German business owners in need of capital are increasingly cognisant of the fact that one source of funding that can still be tapped is private equity. For the industry, this bodes well.

With this in mind, four leading professionals with intimate knowledge of the German market joined PEI at Munich's Hotel Vier Jahreszeiten Kempinksi in early June for a frank exchange of views: mid-market investors Daniel Flaig of Capvis and Christian Hollenberg of Perusa; fund investor Jeremy Golding of Golding Capital Partners; and Sonya Pauls, a private equity-focused partner at international law firm SJ Berwin. How bleak is the picture at the moment, we asked, and what is the way forward for private equity in Germany? The debate was lively and engaged. What became clear very quickly was that here were four practitioners who were keeping a close eye on developments – and seeing good reasons for considered optimism.

PEI:Welcome to the Roundtable. Let's talk macro first. Suddenly there is all this talk about ‘green shoots’. Are we at the turning point of the economic crisis?

Golding: I don't think the recession has really hit Germany yet. But it will. The Dax has recovered some 40 percent this year, which is great, and if it makes everyone feel better, we should all benefit from that. But I fear the hard news still hasn't really hit home yet. The first real sign was possibly Qimonda going into insolvency, although I don't think the full implications of that have been appreciated either. Numerous automotive suppliers are having problems, but unemployment is still low. It will definitely go up. And in Germany the swing in mood typically takes much longer to filter through, both on the way up and on the way down. There is a lag factor, and we're seeing that now. The mood is still surprisingly buoyant but unemployment is going to rise, we will have a long recession, and today it has barely started.

Hollenberg: We have many factors in Germany that cause a lag in economic behaviour, foremost of which is a high degree of government intervention everywhere. It was in the papers only this morning that government spending as a percentage of GDP is approaching 50 percent again, which is higher than it was in Poland before Poland went off Communism, so this isn't really a market-driven economy and remains slow to react to positive and negative developments. The really bad news could come when we are in a position to raise taxes dramatically at a time when the economy is still very unstable, which is what I expect to be happening right after the election in September.

Pauls: Globally speaking, there has been talk in recent weeks about the first signs of green shoots, such as in the US residential mortgage market. These signs are more concrete than what we've seen in Europe, but there are also fears that we may yet see a double dip in the US – which for an export-dependent economy such as Germany has to be a concern.

Flaig: I have a cautious view on the situation. Yes, you don't really feel the impact of the recession on consumer behaviour here yet, but that is not surprising if you consider that Germany didn't experience the kind of excessive boom that occurred in other countries such as Britain, Spain, the US. There wasn't a real estate bubble, there is less leverage in the system overall, and consumers didn't leverage up either, which is why they aren't having to react to the downturn as, say, consumers in the UK. It's more stable, but I do fear we are going to hit the worst right after the election, because until then the government will do everything to keep unemployment low and subsidise industries, but the high level of spending on this will not be sustainable. So yes, we will go deeper into recession after the election, and I don't see a quick way out of it.

PEI:Given this complex macro picture, is it possible to do deals right now? Where are you looking?

Flaig: Three options, basically. What we think is interesting right now is either companies with a very stable business model, which haven't been affected by the downturn much – but as you may guess, these businesses are getting a lot of attention right now, so expect high prices. You can also go after companies that have been hit very hard but whose business model remains fundamentally intact; companies in this category haven't come to market yet, but if the pain continues, that may change. The third area is companies with exposure to markets that are still growing, such as parts of Asia.

Golding: I often think back to the dark days of 2002 and 2003. At that time investors complained about there being no deals, no banks etc. But the few deals you could find, where the price was right, where you were able to get reasonable financing and you had the courage to do it, well, they turned out to be some of the best deals on record. I agree that the economic situation is much more dramatic today, but since private equity investors operate with a 10-year time frame, they have the option to stay on the sidelines for 12 to 18 months and then re-enter when opportune.

Hollenberg: Our view is, we are among the last people to still have money, which is a great position nowadays. Also, Perusa is looking at a part of the economy in the mid-market that has seen storms before but has not been bailed out by government or some M&A-driven takeover activity. These are people who have learned to weather storms before. We are seeing quite a lot of companies that we believe will live through the crisis, that will still be there. We have the money to buy them, and it really is down to a technical issue whether we can finance purchases with debt or not. There are various ways of looking at that. One is, depending on the situation of the seller, you get a vendor note or an earn-out. If you cannot get that, you might muster the courage to buy it all equity and then refinance it later on an asset-based financing basis: you sell the receivables, you sell the factory, whatever – these are forms of financing that still work, whereas structured M&A financing may not work anymore.

We are among the last people to still have money, which is a great position nowadays

Christian Hollenberg

The bigger problem is that we are now flooded with people who have to sell and who are in hopeless business models, but anyone who has the slightest glimmer of hope and a fundamentally sound business that they may not have to sell in the current environment tries to avoid doing so. So we are still in a transitional period, which I expect to end in the autumn at the latest, because by then people will realise that things aren't going to get any better in a hurry. We have gone through cycles like this before, and when the recovery finally comes, it will be good for our investing. I absolutely agree that if we start riding cycles, seeing nothing but doom and gloom right now, and stop looking at opportunities, we will probably look pretty stupid five years from now when the economy has recovered and we have no portfolio.

Pauls: We know of negotiations that are going on right now where limited partners are putting pressure on general partners to concentrate on fixing problems in their existing portfolio companies, rather than going after new investments.

Hollenberg: We have had none of that, no intervention at all. Investors, I think, are having many problems of their own right now, unrelated to private equity. Our investors have been leaving us alone.

PEI:As Christian pointed out, private equity still has money to invest. Are you seeing new funds with a Germany focus coming to market at the moment?

Pauls: Yes. It's amazing, actually: German funds, along with emerging markets funds, are the most active areas in our funds practice at the moment. I'm not sure what the link is between them! (laughs) There are only a small group of German mid-market managers out fundraising, but we are seeing a number of distressed funds in the pipeline, including several being organised by first-time managers. We're also seeing new growth funds and venture funds forming. And the appetite for Germany in the international investor community appears to be there: the turnaround funds, including the first-time groups with relevant experience, are getting interviews; they are getting through the due diligence stage, which is of course encouraging. The same is true for the venture groups.

PEI:What about appetite for German funds from German investors? Is there much?

Hollenberg: We have no German investors in our funds. We have of course developed relationships, but the reality is, if you want to go through a reasonably concise fundraising process to establish a diversified investor base, chances are you simply will not end up with many German LPs in your fund, with the exception of German money coming in via funds of funds. The reason is that it is still difficult for most German investors to follow the rules that are standard pretty much everywhere else in the world. These rules can be criticised, but they are efficient. And we're not professional fundraisers – we want to get our capital raised quickly.

The interest in private equity has broadened in the recent years, with many of the smaller insurers and endowments now studying the asset class

Sonya Pauls

Flaig: We raised our current funds 18 months ago, and we really tried to bring in more German investors. We do have some, but on the whole German institutions, even those who invest in private equity internationally, seem to have a curious, largely negative view of private equity in their own country. ‘We haven't found a very good German team’ is something I have heard many times.

Golding: Our experience is somewhat different. We represent 80 German institutional investors, many of whom, incidentally, also have an implicit interest in gaining exposure to German investments. Dealing with these investors can be hard work though, simply because of the legal and regulatory requirements they face: tax, transparency, documentation, monthly NAVs, local language reporting – all of that is very important to them. They require a highly differentiated type of service, which, whilst demanding, is a means for groups like ours to provide substantial value-add.

Pauls: We represent some of the larger investors here, and their investment behaviour has tended to be quite brand-driven, with the big international private equity brands often being quite popular. German teams with comparable track records on the other hands have been finding it relatively difficult to attract these investors. On the venture side, there is still a great dependency of funds on development finance, as provided by agencies such as the KfW. That said, the larger mid-market funds that German managers have raised in the last couple of years did get the support from some large German institutions. More generally, the interest in private equity has broadened in the recent years, with many of the smaller insurers and endowments now studying the asset class.

Hollenberg: Meanwhile we're not unhappy with the situation though because it gives us a great argument in union negotiations for instance. When they try to come up with the old Heuschrecken story, we can tell them we're making international capital available to them that their companies have no access to. There are no lenders and no other providers of equity to step into the situation these companies are in right now, and what we can say to them does make a difference at times. People do listen.

PEI:Speaking of Heuschrecken: how has private equity's image in Germany changed?

Golding: I would argue that private equity in Germany has progressed from an emerging player to a fully fledged participant, even though the legal and regulatory framework is still lacking. Even politicians no longer see private equity solely as aggressors or destructive locusts but increasingly as key providers of capital and creators of economic value. The government is implicitly embracing private equity by asking sponsors to support important German companies. Consider CVC's investment in Evonik and Blackstone's in Deutsche Telekom. There is now recognition that private equity is an essential element of the economy and has a role to play in supporting German business, especially in the current environment.

Pauls: I find that there is new kind of pragmatism with which politicians and trade unions now look at certain issues in the economy, including the presence of private equity. The debate is now less driven by ideology, which is healthy.

Historically, the perception of German private equity has always been confused with the tools that it uses

Christian Hollenberg

Flaig: I am not convinced that the debate with trade unions, with journalists, with credit insurers really has changed fundamentally. The industry might be less in the limelight because we had the problems with banks, the bonus discussion and so on. There are other enemies now, but the perception of private equity has not changed that much. We bought a business recently and the credit insurance company downgraded it immediately, without even looking at the figures! We went in together with management to explain our case, but it was hopeless. ‘You are private equity, you are in that basket.’ Of course we can add value to the German economy, but I don't think that is already in the discussion. As for the unions, yes, they may be less aggressive, but they may just be waiting for the next incidence they can jump on.

Hollenberg: Historically, the perception of German private equity has always been confused with the tools that it uses. It was considered a leverage activity rather than an investment activity. Leverage is something Germans generally don't like. In addition, many Mittelstand companies have been highly leveraged historically and didn't need any more, and many of them have also had negative experiences dealing with banks. They're basically not keen on financial engineering, and as long as they confuse what a private equity owner will do to them with the tool set that this investor may use in an LBO situation, they will be extremely cautious. When we talk to business owners, we always stress that of the three deals we did last year, only one used any debt at all, at a very moderate level.

PEI:But after the global debt binge that has just ended, isn't it difficult right now to explain to owners the difference between funds relying on leverage and funds seeking to drive returns in a different way?

Hollenberg: Right now we don't need to explain this to them. Where they have used leverage in the past, they're explaining to us that their capital structure is in bad shape and unlikely to get better any time soon, and they ask us whether we can help. In other words, people are beginning to appreciate the difference between genuinely long-term capital, of which there are very few providers right now, and a bank loan that has just been called. This is a painful experience that many people are making right now, and I think it is leading to a shift of how they perceive financial investors. People are beginning to realise that the only source of long-term capital is probably private equity. I wouldn't know where else you could get it from.

PEI:So there is a sense here that the banks have abandoned Germany's businesses?

Hollenberg: Definitely.

Flaig: Going into an overleveraged business to clean up the balance sheet is different though from trying to buy a business that hasn't yet much debt in it. There you have to explain how the financing is going to work, that using some leverage is actually efficient, and that we aren't locusts. That is still taking a lot of time. I don't think Germany is already at the stage where this is getting easier.

Pauls: Also, I'm not sure German GPs can isolate themselves in terms of the financial tools they use. An investor can always choose between investing in a German fund or an international fund, and if there are certain returnenhancing tools in use internationally, then there will always be pressure on German managers to follow the trend.

Hollenberg: Absolutely, and we will always use the maximum amount of leverage we can get. The question is, how do you think about it. Is that your basic investment case and if it doesn't work then you abandon the investment? Or do you say, ‘this is a quite a lot of leverage and we know it, but if it doesn't work we can put in more equity and it will still be a good investment’. That's a huge difference.

Whatever regulation will hit us we will be able to deal with. The only thing I am concerned with is the uncertainty of the tax situation

Christian Hollenberg

Pauls: At the large international firms we're seeing a lot of reshuffling of the teams going on. GPs are changing their carried interest entitlements to incentivise people with operational know how and restructuring expertise. Financial engineering is clearly less important now.

PEI:Another big talking point in the industry today is the prospect of more regulation. In this context, are you focused on what might be coming out of Berlin, or do you look mainly to Brussels?

Flaig: For us EU regulation is the issue. What the EU is now proposing for firms above the €500 million under management threshold in terms of disclosure and the many other things on what is a very long list means that we will need to be more transparent than any public company. In transactions, this could well put us at a disadvantage vis-à-vis other bidders.

Hollenberg: As a small niche fund, I am not worried about the EU at all, and I don't worry about regulation. Whatever regulation will hit us we will be able to deal with. The only thing I am concerned with is the uncertainty of the tax situation. That is still a very severe problem because it impacts our daily activities. It means certain things we as fund managers want to do, such as being able to run a portfolio company as a Geschöftsführer, we just cannot do. We have to design structures that do not add a lot of value for no other reason than a completely theoretical tax regime. Tax is forcing you into structures that are totally inefficient.

Pauls: Yes. The question of how your fund vehicle will be treated and how carried interest will be taxed is still a big headache. And now we have VAT on the management fee, which doesn't help. So in negotiations of international investors coming into a German fund, taxes and the uncertainty surrounding German structures remain an item. In terms of regulation, what people forget is that there is virtually no regulation of private equity in Germany. Guernsey and Jersey are more regulated.

PEI:Is the tax situation likely to improve at all in the coming years?

Pauls: The tax authorities now have a much better understanding of how private equity works as compared to the situation a few years back, which is of course positive. And as unfortunate as the locust debate was, it may actually have helped in educating people about private equity on a broader scale. But in terms of the fiscal framework changing, we don't see any development. The tax authorities seem to believe that the criteria applied to private equity work, even though the industry finds it extremely difficult to even define how these criteria can be worked. The uncertainty will remain for the foreseeable future.

Flaig: This really is a stumbling block for Germany, not just for private equity. You come up with an acquisition structure, and you have no idea whether it works from a tax perspective right until the end.

Golding: It's a pity, it's ironic, and it's a lost opportunity. At the end of the day, one will invariably find a structure to provide the required solution, but smaller institutional investors without the resources will inevitably lose out.

PEI:Could the federal election in September make a difference in terms of how private equity is being treated?

Golding:There are bigger issues than private equity at stake. Opel, Arcandor, that's where the political focus is right now.

Hollenberg: I have a concern though that we will see a scheme being implemented after the elections whereby VAT will increase by two percent a year until it hits 30 percent or so. That would make it very difficult to sell businesses, because a buyer will say, ‘of course you're doing great – customers are buying because everything will be more expensive tomorrow; but what does your performance look like on a normalised basis?’

PEI:You see that as a genuine possibility?

Hollenberg: Yes. We have seen the principle applied to the mineral oil tax, where it hasn't worked. But VAT moves a lot of money, it's one of the most efficient ways of taxation, so this is definitely something the government might consider.

If firms like us can be creative in terms of providing financing, we should be able to play a larger role

Daniel Flaig

PEI:Despite this and the other obstacles we touched on: can private equity, as a provider of funding to businesses, be expected to grow further in Germany?

Golding: Despite the short term difficulties, we nevertheless maintain a positive outlook. Given the size of the economy and its fundamental strength, Germany is extremely attractive for deals. Both for international and German investors. We are seeing interest from our investor base that is higher than it has been for some time, and we're ramping up resources so that we can deal with the new requests and projects coming in. Over the next three to five years, we're definitely optimistic.

Pauls: Over the past couple of years, the amount of work coming out of Germany for us has increased disproportionately, which is clearly significant.

Hollenberg: I am generally very positive about the private equity industry as it exists in Germany today, but this doesn't translate into an expectation of strong growth. Nothing dramatic will happen, because there won't be many large deals, and the mid-market will remain the domain of niche players because industries are still very fragmented. Unless you believe that there will be a lot of consolidation in the coming years, which we don't, the opportunities residing in the many smaller mid-market businesses will not be accessible to larger private equity funds, at least not on institutional terms.

Flaig: In addition to the fundamental factors that are driving the development of the industry in Germany, some growth for private equity could come out of the current banking crisis. If firms like us can be creative in terms of providing financing, we should be able to play a larger role, and therefore to grow the industry.

Pauls: And this is of interest especially to local players. To solve the issues currently at hand will require knowledge of how Germans work and operate, and you also need dedication to the market. Therein lies a great opportunity for locals.

AT THE TABLE
Sonya Pauls, partner, SJ Berwin

Active in private equity since 1996, Pauls joined SJ Berwin in 2000 and is part of the firm's German private equity practice in Munich. Representing German and international fund managers as well as LPs, her areas of expertise include fund structuring and carried interest arrangements.

Daniel Flaig, partner, Capvis

Zurich-headquartered Capvis is a leading private equity provider in German-speaking markets, with deals worth more than €3 billion in enterprise value to its name since 1990. Flaig, who joined the firm in 1995, is one of five partners. Capvis' current fund closed in 2008 on €600 million.

Jeremy Golding, founder and managing partner, Golding Capital Partners

Golding Capital Partners, with approximately €1.5 billion under management, invests in private equity on behalf of predominantly German institutional investors. Based in Munich, the firm opened an office in San Francisco in 2004, and another in Luxembourg in 2007.

Christian Hollenberg, co-founder, Perusa

Hollenberg is one of Germany's foremost turnaround specialists and one of three founders of Perusa, which opened for business in 2007. The firm is currently investing a €155 million debut fund. Prior to Perusa, Hollenberg was one of the founding partners at fellow Munich-based investment house Orlando Management.