PRINT THIS PAGE

The giant engine who could?

The German private equity industry has struggled to live up to its much touted promise over recent years, but Brian Veitch of Electra Partners Europe believes that the market could finally be turning a corner. Here, Veitch examines the stumbling blocks that have held Germany back in the past and looks ahead to better times for those private equity firms prepared to roll up their sleeves and to really get involved in turning their portfolio companies around.

The German private equity market has endured a challenging couple of years after the flurry of management buy-out activity predicted at the end of 2001 failed to materialise. As we move into 2004, the German market is starting to show some signs of a revival. Much of the stimulus that the supposed “market engines” were expected to produce in 2002 and 2003 may have been slow in taking shape but the future is now looking brighter.

Many positive developments have taken place in Germany such as the enactment of a law to exempt corporations from capital-gains taxes, falling stock-market valuations and diminishing company profits. Other positive changes include tighter lending policies in response to Basle II and the impact this has had on credit ratings, as well as the increased pressure that has been exerted on companies to focus on their core business and to sell off non-core activities. But despite these positive changes, no one thing has made enough of an impact for market participants to really capitalise on available opportunities. And by that I mean opportunities for both sides – the private equity investors and the companies.

Is the German private-equity market a giant engine that can’t succeed?  
Again and again, pundits have forecast that private equity will start swinging some more weight around in Germany. But the only thing that these forecasts have accomplished is to foster a feeling of déjà vu among investors, who have started wondering what has to happen for this “giant” market to reach its full potential. One thing is certain: The “hard” market factors are – at least superficially – in favour of more private equity capital in Germany.

With the economic engine still spluttering, bankruptcies at record levels, industrial buyers pursuing cautious investment strategies and many banks saddled with large-scale loan defaults (not to mention the succession problems many SMEs are facing right now), private equity looks set to pick up speed in the foreseeable future. Hopefully it will take off – not only for our sake, but also for the sake of many German companies, both large and small.

Germany Needs Gutsier Managers
One of the main problems both for private equity in the German market and for the overall economy is the fact that many executives, especially those running SMEs, are still extremely risk-averse. There are companies that are willing to sell, but whose executives – and the employees they influence – are opposed to having any private equity companies invest in or take over their companies.  However, what really makes or breaks a private equity transaction is the company’s management. In other words, if the executives are not true entrepreneurs, it won’t matter how much capital is made available for financing. The deal will be dead in the water unless you have managers who express their whole-hearted support for the private equity transaction to their employees and outsiders alike.

It’s hard to fathom why some managers are so dead-set against private equity. It’s far too easy to just point to issues of status and job security. The real problems are much more complex and hark back to the tradition of having (more or less) unimportant employees manage the companies on behalf of omnipotent patriarchs. These roots are especially deep in the small or family-run companies that account for a large proportion of private equity transactions. While some managers have shown considerable initiative, there are just not enough of them to tip the balance. This uniquely German shortcoming is the very reason that many investors have chosen to give many deals a wide berth. 
 
Admittedly, any far-reaching cultural changes need time to be absorbed. Managers and employees need to accept the new structures and strategies that arise in the wake of a private equity transaction. But they can’t accept them without first understanding them. Unfortunately, many German managers simply don’t know how a company can be bought out of old shareholding structures, how this might benefit them and what partners would be able to give them the best possible assistance. We have often detected a pervading sense of fear – not surprising considering how many newspaper headlines decry the tactics of “raiders” and “vultures” that, in the eyes of the uninformed (see above), cast a shadow on the most reputable of private-equity investors. 

Ignorance of the Practices of Good PE Companies
Often, German companies refuse to accept debt financing through private-equity investors, although any industrial buyer would just as well avail himself of this type of funding. They also frequently overlook the fact that, many times, private equity offers better ways of retaining the corporate culture, jobs, market share etc. of a company than an industrial buyer, who is often only out to exploit synergies at the cost of the acquired company and its staff. The industrial buyer is often mistakenly viewed as the better choice – as a partner with more industry know-how and operational expertise than a financial investor.

One of the reasons for this attitude is the fact that the German private equity market, being relatively young, has still not embraced the practice of installing independent, seasoned executives to back up the current management team during the transition and beyond. Having access to such a wealth of experience and expertise is a boon for the bought-in company.

Handicap: Not Enough Financiers for Small Deals
While major corporations and medium-sized businesses have extensive enough divestment programs to keep the deals flowing, many companies in Germany are still too slow at identifying and responding to changes that turn a particular business unit into a non-core activity. So why is it that many deals, especially smaller ones, never see the light of day? Is it because executives have lost track of what’s going on in the company? Or might it just be inertia? One obvious answer is that economic forecasts are looking fairly grim right now, which has depressed the valuations of companies and company divisions and put the blatantly excessive prices demanded by potential divestors out of the reach of even the deepest pockets. Or maybe it’S just that banks are currently reluctant to finance any deals worth less than E100m. They’re mostly interested in large transactions that offer wider margins, fatter transaction fees and, they believe, lower risks of default.

Where Are the Visionary CFOs?
Yet another reason is the fact that most companies in Germany simply do not have a CFO in the classic sense of the word – a financial expert whose duties extend beyond basic accounting to help direct the company’s overall strategy from a financial perspective. This gap never fails to surprise us in today’s world, where international financial markets are becoming ever more interlinked and sophisticated. But would having more CFOs in Germany bring any benefits? We think so. Divestment solutions would be more forward-thinking, would be conducted at the best time, using the best procedure and with the best partner. Plus, private-equity investors would have a partner who knows that it’s no use generating profits if your cash flow isn’t positive and stable, no matter how the company is financed.

Looking Forward
The question still remains - will the German engine make it over the mountain? We think so. But it will be a different market, one that demands more of its participants in terms of results, flexibility and aggressiveness. It will be perfect hunting ground for private equity companies who aren’t just interested in buying low and selling high, but who are prepared to roll up their sleeves and put together a “perfect” team of current and outside managers to turn around the acquired company and ready it to tackle the challenges of tomorrow. On the other hand, private equity funds and other investors who aren’t interested in any long-term transactions in Germany will probably not get a real foothold in this market. In fact, some have already set sail for warmer climes.

Brian Veitch is a director in Electra Partners Europe’s Frankfurt office. For additional information please email bjv@electraeurope.de

Copyright © 2004 Electra Partners Europe