FW moderates a discussion looking at private equity in Germany between Jörg Kirchner, a partner and vice chair of the Global Corporate department at Latham & Watkins, Peter Memminger, a partner at Milbank, Tweed, Hadley and McCloy LLP, and Steve Roberts, private equity leader at PwC.
FW: How would you describe Germany’s private equity market over the last 12-18 months?
Kirchner: In general deal flow was patchy. The German market has seen very few larger buyouts with deal volumes exceeding €500m. Moreover, the German market has not seen a stable deal flow during the last 12-18 months. As in prior years finding the right purchase price has been difficult due to the eurocrisis and the instable economic outlook. The exit of portfolio companies by private equity funds was an important driver of the thin deal flow. Only a few targets resulted from carve-outs by corporates, which only divest for urgent strategic reasons or to refinance major acquisitions. Why sit on a pile of cash when there is no lucrative way to reinvest the cash? The private equity market in Europe generally faces consolidation, which of course also affects international and national funds that are active in Germany. It is generally more difficult for funds to raise funds, and even the successful funds receive a substantially higher level of scrutiny from investors. In the mid to long-term this will lead to a consolidation in the market with only those funds surviving that have a solid track-record and a solid business and investment approach.
Memminger: The market was neither good nor bad. Before 2012 started there was the expectation that we might have a very busy 2012, given that a number of transactions had been pulled or deferred in 2011 due to the Greek crisis, and in fact the first half of 2012 was rather good, with a number of transactions taking place, even in the billion euro range. However, the deal flow significantly slowed down in the second half of the year due to uncertainties caused by the eurocrisis, so that on average one can only speak of mediocre year.
Roberts: The PE deals market has shown a relatively stable number of transactions since 2009 highlighting that the post-crisis level has been established. The key drivers have been the accessibility of financing, a pressure on certain funds to demonstrate successful exits ahead of upcoming fundraising, and the general availability of deals in the market. In contrast to 2009-2011, the last 12-18 months have seen several larger transactions in the private equity space, which have driven the average deal size higher. However, the level of deal activity has been broadly consistent.
FW: Which sectors and industries seem to be attracting the interest of buyout houses, and why?
Memminger: It is hard to name certain sectors or industries as the most active in the last 12 to 18 months, as transactions occurred across a wide spectrum. Rather, it appears there was not a particular industry responsible for increased deal flow in comparison to 2011, but that investors took advantage of the fact that businesses with a decent track record and cash-flow were up for sale in 2012, and transactions were more easily financed than in 2011. It was the quality and availability of certain targets which led to successful transactions, rather than a specific industry trend.
Roberts: Unsurprisingly, the landscape did not change in 2012, with funds continuing to see the main potential being in the traditional German middle-market heartland of engineering and industrial innovation. Healthcare and related services continue to be supported by the shifting demographics in Western Europe and the relative protection offered from the economic environment, however, the political and reputational dynamics that need to be assessed in this sector remain a key consideration.
Kirchner: Due to the current unstable market and economic environment, there is a strong preference for investments in industries that promise a stable cash flow and are not too cyclical. Therefore, industries such as healthcare and life sciences, as well as the traditional manufacturing and industrials sectors are preferred areas of investment. The cleantech sector has been very attractive in recent years. However, due to the existing grid connection issues that affect investments in offshore wind power projects and solar overcapacities in the German market, investors tend to be more hesitant. It needs to be seen if this trend will keep up its pace in the future. The current market conditions not only limit investment opportunities, but also foster some others. Historically low interest rates and the pressure of the public sector to save costs have lead to an increased deal flow for infrastructure investments, and we expect to see more of them in the next year.
FW: What impact, if any, has the persistent eurocrisis had on private equity activity in Germany?
Roberts: The eurocrisis continues to affect all sectors, and private equity is no exception. The industry has demonstrated itself to be relatively resilient and the stability in transaction activity is proof of that, albeit at a much reduced level compared to pre-crisis times. The impact of the ongoing economic situation is that it is limiting the growth in activity levels, resulting in flexibility and creativity remaining the key factors to deal-making in 2013, potentially including a greater willingness by many funds to non-control positions. Primary situations will continue to be less abundant than secondary and tertiary opportunities, meaning that creating a new equity story will be crucial to driving investment decisions and consequently deal activity levels within the private equity space.
Kirchner: The German private equity market clearly reflects the turmoil and fluctuations in the wider financial market. Fundraising, deal sizes and deal flows have all dropped significantly since 2008. Investors remain careful about Europe. In particular, US buyout funds seem to be more reluctant to invest in Germany, with some notable exceptions such as the recent investments by Advent in Douglas or Onex in the Munich-based KraussMaffei group. But although investment times have been better, private equity as an asset class is still seen as a favourable investment opportunity rather than a risk. However, when it comes to the actual negotiation of the deal, the current market uncertainty and the eurocrisis make the price-finding process extremely difficult these days. As a result, more auctions are aborted and highly competitive auctions have become rare.
Memminger: The eurocrisis certainly had an impact in 2012 and it is not a coincidence that a number of transactions were signed in early summer 2012, in anticipation that the eurocrisis might defer transactions for at least a few months. In fact, deal activity then slowed down significantly, as the ghosts of the past years – uncertainty about the future economic development and the availability of financing for deals – came back, as had been the case in 2011 and 2009. It is, however, interesting to note that concerns in relation to the eurocrisis have weakened in the last two months and it is no longer such a popular topic for discussion as it had been before.
FW: How would you describe the availability of financing for leveraged private equity deals, and the appetite of banks to lend in the current market
Kirchner: Raising debt for acquisitions in the German market is currently difficult. Not only have private equity firms learned their lessons during the crisis, banks have as well. There seems to be only small to medium hunger in banks these days. Although the financing is available, it is difficult to arrange. The European leveraged finance market is much more complicated than the market in the US where banks compete for investments. This has led investors to use US-style bond financings for European transactions. Banks in Europe scrutinise their investments more carefully nowadays which also leads to a longer pre-negotiation phase. Another result of the current uncertainty is that even small debt tickets often require large consortiums of banks. As a consequence, high-yield bonds will play an important role for the financing of medium and large buy-outs in the future.
Memminger: The answer to that question to some extent correlates with fears about the further development of the eurocrisis. So while the eurocrisis lead to a reduced availability of debt, particularly in the second half of 2012, one also has to mention that the LBO market never dried out completely as we had seen it in connection with other crises in the last five years. Rather, good businesses were financeable throughout most of the last 12 to 18 months. What the eurocrisis did, however, was to alert debt – and equity – providers that we are still in a time of uncertain markets and hence the trend to more aggressive financing terms, which one could see in late Spring 2012, stopped before it ever really got on its way. As a general notion, debt is available at reasonable terms for good targets, even for a leverage recapitalisation. One has to be aware of the fact, however, that banks are rather selective and may apply an enhanced level of scrutiny on not so well-regarded targets or business models.
Roberts: Although financing remains challenging, it continues to remain available albeit at considerably more conservative levels than before the crisis. As with deal activity levels, the new norm for debt-to-equity ratios appears to have established itself at between 40 to 50 percent. As elsewhere in Europe, financing markets in Germany appear to be divided: for small-to-medium-sized deals, credit was provided by club-style financing solutions from local banks, to a certain extent supported by free CLO liquidity. Larger transactions more heavily rely on either big investment banks with global distribution networks or on capital markets using the high-yield bond route.
FW: In your experience, are private equity firms showing particular caution when it comes to carrying out due diligence and valuing a potential target
Memminger: I would not say that private equity firms are showing more caution as they have done in the last few years, rather that, as a general notion, they have maintained the high-level of caution and scrutiny which they have applied ever since 2007 – and in a large part even before. Doing deals in our times necessarily requires due diligence, and a careful evaluation of the target and its business plan, in particular if third party financing – be it from banks or investors – is required or involved.
Roberts: All aspects of due diligence continue to have a high priority amongst the private equity firms. However, with a smaller deal pipeline in the market, quality assets attract significant attention and our experience is that firms are more reluctant in the early stages to commit to spend money on advisors until their position in the auction is clearer. This is only to be expected in the current environment and is a feature that we do not expect to reverse until the deal flow increases. Valuations are becoming more conservative, impacted to an extent by the level of debt financing available. This has inevitably led to a ‘price gap’ between the expectations of the sellers and what the buyers are willing or able to pay, and has resulted in certain processes lasting much longer than usual. We see this trend continuing into 2013.
Kirchner: Private equity firms have always shown caution when carrying out due diligence. But clearly the times of fast decisions, with aggressive pricing to beat competitors in an auction, are the exception. Funds are reluctant to engage in and spend money on processes in light of the difficult price finding process.
FW: Have secondary buyouts been a prominent feature of deal activity in Germany?
Roberts: Secondary and tertiary buyouts continue to be a feature of deal activity as primary transactions are less abundant. As noted earlier, the equity story is becoming more challenging, and, as the valuations are more conservative, we have seen a trend towards corporate acquirers accounting for the majority of buyers of private equity assets in 2012. This does not exclude the secondary market for private equity and there were certain landmark deals done in 2012 to support this. However, these were at the upper end of the deal space with the more mid-market sized transactions proving to be more difficult.
Kirchner: Secondary and tertiary buyouts have definitely been one of the major driving forces of deal activity.
Memminger: Yes, secondary buyouts played an important role in the private equity market in Germany 2012. This can be explained in part by the fact that private equity firms had, and still have, a number of German portfolio companies with a holding period of well beyond five years. A second reason is the relative weakness of primary deals in Germany in 2012, which has resulted in the increasing relative importance of the secondary market.
FW: What strategies are private equity firms utilising to maximise the value of their portfolio companies and prepare them for sale?
Kirchner: Add-on acquisitions are still one of the preferred ways to maximise company value. The traditional goal of expanding market coverage is now focused in particular on gaining access to the emerging markets. Cost-cutting strategies are still seen as a necessary measure, but there is also an increased willingness towards spending more time on the management of portfolio companies and leveraging their potential. In the light of the difficult M&A and capital market environment, PEs make use of recapitalisations to receive funds proceeds from investments.
Memminger: One can see that the process for exits is increasingly well-thought through, prepared and planned, with steps taken in that direction already years ahead of the exit, such as with the implementation of an appropriate management team for the next phase of a company’s business cycle or a public float of the company. A further example is that almost no company today is put up for sale by a private equity firm before it has been reviewed beforehand for weaknesses by external advisors, as the value of such vendor due diligence review has proven to be rather high. Given the importance of sufficient debt financing, smart private equity investors now try to create a competitive, auction-like environment not only for the bidders, but rather towards for debt financing environment as well, and do not leave that to bidders or to the later stage of the transaction, but get banks on board rather early. Finally, one sees that private equity sellers are less and less hesitant to pull out of the sale process if the pricing is not adequate.
Roberts: The focus on portfolio companies has been firmly entrenched since the financial crisis broke. Value creation is the main strategy being adopted, which covers a wide spectrum of initiatives from expansion and growth to operational improvement.
FW: What trends do you expect to unfold in Germany’s private equity market during 2013 and beyond?
Memminger: We will see that the relative importance of secondary buy-outs will continue in 2013, for pretty much the same reasons as in 2012 – this translates into the expectation of a market that will not be strong, but rather similar to 2012. There is simply a lack of the huge number of attractive primary targets – in particular in the medium to large size segment – required for a significant uplift in the number of private equity deals. Together with this, we will see that the emphasis on very well planned exits will continue. When it comes to certain sectors, the energy and renewables industry might have surprises for us in the future.
Roberts: Our Private Equity Trend report will be published in February, and the consensus from the feedback was that the PE community is expecting a continuation of the stable trend of recent years, albeit with a level of optimism that the situation will slightly improve. This optimism has been a feature of all our reports in recent years, and may well represent more hope than cold reality. The pressure faced by many funds to put money to work before investment periods expire – ‘use it or lose it – as well as to demonstrate successful exits ahead of upcoming, often more challenging fund raising also play into these results. There is a known pipeline of deals coming to market in the first half of 2013, though the question remains as to whether the buy-side market will continue to be dominated by corporate acquirers and to what extent PE funds can agree upon price expectations for secondary and tertiary buyouts. It should be noted in this context that corporate balance sheets have large cash balances enabling them to continue to play a major role in the M&A market in 2013.
Kirchner: There are no signs yet as to a substantial change in the German private equity market over the next two years. We expect to see consolidation of the private equity market by 2013/2014, resulting in fewer PE houses that will have to face stronger competition – in particular when it comes to fundraising. The days of the megadeals are not necessarily over, but they will definitely be limited in number. Our European PE practice was lucky enough to have a good year in 2012 and we are cautiously optimistic about the deal flow this year.
Dr Jörg Kirchner is a vice chair of Latham & Watkins’ global Corporate Department. He advises clients on private equity and M&A matters, handling both cross-border and national transactions, including LBOs, minority investments, joint ventures and carve-outs. JUVE continuously names Jörg Kirchner as one of the best known private equity lawyers in Germany. In Chambers Europe 2012, he is ranked in tier 1, and he has also been named among the ‘Lawyers of the Year 2012‘ for Private Equity in Germany by Best Lawyers. Mr Kirchner can be contacted on +49 89 2080 3 8000 or by email: firstname.lastname@example.org.
Dr Peter Memminger is a partner in the Frankfurt office of Milbank, Tweed, Hadley and McCloy LLP. He specialises in mergers & acquisitions (including distressed situations) and public takeovers, with a particular focus on private equity transactions. He is also involved in outsourcing transactions. His recent transactions include the public takeover of Germany-based W.E.T. Automotive Systems AG by US-based Amerigon Inc. Mr Memminger is a regular lecturer and commentator on M&A related topics. He can be contacted on +49 69 719 143 453 or by email: email@example.com.
Steve Roberts is a partner at PwC and leads the firms Private Equity practice in Germany. Mr Roberts joined PwC in the UK in 1993 and joined the Transaction Services team in January 1998. He has worked exclusively within the M&A field since that date. Having primarily worked on cross border transactions during his time in the UK, he transferred to the Frankfurt office in July 2001 where he has focused upon serving the private equity market and was promoted to partner in July 2005. He can be contacted on +49 (0)69 9585 1950 or by email: firstname.lastname@example.org.
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