Click here for printer friendly page

German private equity: short-term pain for long-term gain?

Germany's wide-ranging reforms have long promised rich pickings for private equity investors. The problem is, many of the promised opportunities haven't yet materialised and Germany is now suffering as badly as other European markets. So what next for the world's third largest economy? A new report by AltAssets has some of the answers.

For years now there has been a huge interest in and speculation about the German private equity market. After all, it is Europe's largest economy and boasts some of the continent's most highly respected businesses. And since the middle of the 1990s it has been undergoing wide-ranging economic reform that has raised expectations of a flood of opportunities for investors.

The introduction of new tax rules, in particular, have raised hopes that from the start of next year there would be a huge upturn in buy-out activity and persuaded big international players to set up shop in readiness. Law firms like Ashurst Morris Crisp, Clifford Chance, and S J Berwin, were among the legion of new arrivals.

In other private equity sectors, there seemed to be a great deal of potential, too. Many of the country's large corporations, such as Siemens and Deutsche Telekom established corporate venturing arms, capitalising on the country's strong technology base, which had already enjoyed an enormous increase in venture capital from both domestic and international investors.

But the economic downturn, the technology crash, and most recently the effects felt in Europe from the 11 September terrorist attacks in the US, have left even the optimists rather less positive about the German market's prospects. The deal flow pipeline is empty, institutional investors have signalled a retreat, and venture capital investment has all but dried up.

So where does that leave the German private equity market? A forthcoming research report produced by AltAssets, Growth by transition: Overview of German private equity, gives a clearer idea of what to expect. One of the report's main messages is that Germany, along with other private equity markets, will suffer in the short term, but in the medium to long term, it should see continued growth and an increasingly developed private equity industry. ‘There is no escaping the widespread sense of disappointment with the way the German market has performed. It's been a classic case of too much too quickly. But the underlying promise is still there. Germany is still on track to become one of Europe's most exciting private equity markets. It will just require a little patience on the part of investors,' says Chris Davison, one of the report's authors.

Short-term view
In the short term, Germany will not be immune to the slowdown apparent in the US and European private equity markets. The last couple of years saw rapid a expansion in Germany in terms of the number of players, of funds being raised and of amounts being invested. Two-thirds of private equity firms operating in Germany are either new or new to the market. Funds raised for investment in Germany leapt from E2.6bn in 1996 to E6.1bn in 2000. The amount invested by private equity firms shot up by 51 per cent in 2000 from 1999's figures. All of this was fuelled by the establishment of the Neuer Markt in 1997, which provided an exciting new exit route for private equity investments.

But just as the Neuer Markt took off like a rocket, so it crashed with undignified speed, taking its cue from the NASDAQ. Exits have dried up, investor confidence has been damaged, and the private equity market has gone into a form of suspended animation. The amount of money being raised has fallen since its peak in 2000 and participants are predicting a wide-scale consolidation among players. In particular, the amount of money raised from outside Germany has fallen since 1999, a sign of the frustration among international investors with the slow pace of economic and cultural change.

Deal flow is the biggest concern among institutional investors. Many had been attracted by the promise offered by the Mittelstand (roughly translated as privately owned small and medium-sized companies) and by predictions of large-scale corporate restructuring in Germany. Neither of these prospects have materialised as quickly as investors had originally hoped. Owners of many Mittelstand companies have proved surprisingly resistant to the idea of selling to private equity firms as a way of solving succession problems or expanding their businesses.

Limited partners believe this is partly because of insufficient understanding about what dealing with a private equity firm would mean for the business and partly out of a fear of the effect that restructuring and job losses could have on the local community. ‘A lot of the companies and staff are well established in small towns and are very reticent about selling to anyone who will reduce the size of the workforce and embarrass sellers of the business. You can't do the types of things in Germany, because of the corporate law, that you can get away with in the UK,' says Ray Maxwell of Invesco.

The economy has also started to look distinctly fragile, hitting M&A activity as well as limiting the government's room to pursue the sort of ambitious economic reforms that might mitigate mounting external pressures. The effect has been to generate ‘a new super-strain of cynicism about Germany's prospects,' says the report. ‘Some US institutional investors in particular expressed doubts about whether German private equity would ever be as attractive as they had hoped several years ago. They said the country had missed the chance to exploit the value of its multitude of world-class businesses.'

Misplaced cynicism?
However, this cynicism about the longer term prospects for the German private equity is confined to a few overseas investors. Most investors are confident that the German market will be much more attractive in ten years than at present. Progress may have been a relatively slow, but there is a feeling that the Germany's economy and reform programme is still moving in the right direction and will continue to do so.

With support from the government, Germany has built a solid framework around which the private equity industry will be able to grow in the long term. There has been a new takeover law, the epic tax reform package, a basket of micro-measures aimed at boosting entrepreneurship and steps to improve conditions for small businesses and start-ups. And, in tandem with the European Union, the government has firmly committed itself to the cause of risk capital as a central part of its campaign to tackle stubbornly high levels of unemployment and promote the growth of small businesses.

Some of these measures will help unplug the deal flow bottleneck in the medium term but the most important factor will be a creeping change in attitudes towards equity financing at the expense of more traditional debt financing. There is every reason to expect the business culture will grow ever more comfortable with the idea of sourcing capital from private equity firms as pressure builds to restructure both large corporates and Mittelstand firms.

The private equity industry itself should emerge from a period of painful consolidation a stronger force. ‘Deep consolidation will be a key theme over the course of the next year as the less experienced investors are punished for their over-exuberance during the boom times,' says the report. ‘However, the longer term consequence will be a stronger private equity infrastructure.'

There may have been a measured retreat by foreign investors but the big domestic investors remain committed. German banks and insurance companies, relative newcomers to the asset class, are raising their allocations to private equity over the medium term as they seek better risk-adjusted returns and as part of portfolio diversification.

The German market will emerge gradually from the current downturn to produce a distinctly German model of private equity, one that is comfortably integrated within the country's existing business environment. The close relationships that already exist between banks, insurance companies and large corporates are expected to manifest themselves in the private equity arena, with all parties collaborating at the venture end of the market. Corporate venturing will become an increasingly important part of the German market, in a more pronounced way than is common in the anglo-saxon economies.

As the government's reform ambitions begin to bite and permeate the business consciusness, so private equity will become a more influential component of the economy. ‘I hope to see activity pick up, with a combination of the CGT cut, the push for corporate restructuring, and the global downturn pressuring conglomerates to pare back,' says Thomas Lynch of Wilshire Associates. ‘We are believers but we're not betting the house. Like everything else in Germany, it is a slow, slow process… The benefit is that when it does start moving it is going to be a continued process - a five to ten-year process with a lot of opportunity. I can't see it not happening. It's just a question of when.'

Growth by Transition: Overview of German private equity, published by AltAssets in early November, is available by subscription. For more information, please click here.