Private equity

Hunting the Mittelstand

  • Why it matters

    Why it matters

    The private equity industry has ballooned as investors seek out returns in an environment of low interest rates. But buying at too high prices risks creating a new financial bubble.

  • Facts

    Facts

    • Germany’s troubled automotive sector could provide buying opportunities for private equity firms that are desperately seeking bargains.
    • The global private equity fund industry has available assets of $613 billion,  according to industry research firm Preqin. In Germany, private equity firms hold stakes in more than 5,000 companies with almost one million employees and revenues totaling €179 billion.
    • The average purchase price financial investors paid for sought-after target companies rose by almost a fifth in Europe and nearly 30 percent in the US between 2012 and 2016, according to investment management and research firm Feri.
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    Audio

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Mittelstand (3) now woth orange
Source: Handelsblatt Global

Delivered with an ironic smile, the time-honored curse “may you live in interesting times” easily applies to Germany’s beleaguered automakers. But for the burgeoning private-equity industry, the diesel scandal and the turbulent switchover from the combustion engine to electric power could be a blessing.

That’s because upheaval always offers opportunities, and private investors are flush with cash and on the lookout for bargains. “For private equity companies that have experience in the automotive sector, there are chances right now to buy at favorable prices,” said Christian Kames, JP Morgan’s boss of investment banking in Germany. Around five to 10 auto component suppliers may come on the market soon, he ventured. Targets might include Schaeffler, a German ball-bearings specialist that issued a surprise profits warnings in June.

Talk of buying opportunities is music to the ears of financial investors such as EQT, KKR, Cinven, BC Partners und CVC, all of whom are seeking bargains in a market where prices have surged in recent years. While private equity firms are little known outside the business world, they control a surprisingly large part of the German economy: stakes in more than 5,000 companies with almost 1 million employees and revenues totalling €179 billion, or $210 billion, according to the German Private Equity and Venture Capital Association (BVK).

Many of these private-equity firms have been scoping out opportunities in Germany’s vaunted Mittelstand, the collection of family-owned firms that have risen to become global players by developing niches within specific industrial segments. More traditional foreign investors like Warren Buffett and Singapore’s Temasek have also been scouring this market for buying opportunities.

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And they are becoming more powerful by the day. Private equity managers are being inundated with cash from pension funds, insurers and government funds scouring the horizon for returns – a growing challenge in the current low-interest environment. The global firepower of the private-equity fund industry now stands at $613 billion, according to industry research firm Preqin.

It’s a dangerous boom because this gigantic arsenal of available capital is tempting companies, most of which are US or British, to attempt ever bigger, ever riskier transactions. According to Feri, an independent investment firm, the overall number of corporate acquisitions has declined, but the volume of deals is growing.

The business model is as simple as it is lucrative: A private-equity firm buys a company, holds it for five to seven years, and then sells it at a profit. But the cash-fueled dash for ever-bigger deals has driven company valuations to record levels, warned Feri. “The average purchase price financial investors have to pay for sought-after target companies rose by almost a fifth in Europe and by almost 30 percent in the US between 2012 and 2016,” said Feri in a report on the sector.

“For interesting companies that have development potential into new technologies, the asking price can be tenfold or more.”

Christian Kames, head of JP Morgan's investment banking in Germany

A prime example of the trend to bigger, more expensive deals: German pharmaceutical company Stada. Two heavyweight financial investors, Bain and Cinven, have been negotiating to buy the company since April and, so far, are bidding €5.3 billion including debt. (Stada’s board has recommended its shareholders accept the deal.) Other firms being chased by private equity funds, such as Ceramtec, a technical ceramics maker, and Techem, an energy services company, are also likely to fetch billions of euros, said bankers.

But there are growing indications the boom won’t last forever. The German Private Equity Barometer, an index compiled by BVK and the state-owned development bank KfW, reveals investor satisfaction with purchase prices is at a record low. And yet, for the time being, overall sentiment in the private equity sector remains buoyant. The overall barometer reached an all-time high of 65.2 points in the second quarter, despite the dissatisfaction with high prices.

“The dissatisfaction of equity capital providers with high entry prices is understandable,” said Jörg Zeuner, chief economist at KfW. But he said that was explained by the “great potential” of many new business models.

Hernan Cristerna, co-head of Global M&A at JP Morgan, said the $2.5 trillion financial investment industry needs to scale back its expectation. In some cases investors are still targeting returns of 20 percent and higher, he said. “It’s becoming increasingly difficult to hold one’s own against strategic industrial bidders,” Mr. Cristerna noted. Sovereign funds, pension funds and family offices are increasingly acting on their own to buy companies, and have lower profit expectations, he added.

Some investment bankers are reminded of the market bubbles that preceded the 2008 financial crisis, especially as some funds have ballooned to rival their bloated, pre-meltdown selves. US investment fund Apollo Global Management has amassed the biggest fund of all time: just under $25 billion.

This year, the industry’s success will hinge on whether investors find enough attractive firms to buy. That’s why issues like the diesel car scandal might be seen as opportunities. The market price for firms with a strong dependence on the combustion engine is around six times their operating profit before write-downs, he said. “With very interesting companies that have development potential into new technologies, the asking price can be tenfold or more,” he added.

The market for combustion engines (including hybrid technology) is likely to keep growing for the next 5 to 7 years before sales start falling, said Mr. Kames. With aging industries that are past their prime, financial investors often push for consolidation to maximize value, or they provide manufacturers with the capital they need to develop new technologies.

Examples like these are where bargains can still be had. Feri is more worried about private equity firms going for large-scale takeovers, where prices risk overheating the most. Its advice is to focus on investments in small and medium-sized companies. “We expect positive returns in this segment of 10 to 15 percent,” said Marcel Renné, chief operating officer at Feri.

It’s also worth noting that central banks could bring the private equity boom to an abrupt end. If they increase interest rates, some debt-financed takeovers could run into trouble, ruining the investors’ returns.

Peter Köhler and Robert Landgraf cover private equity for Handelsblatt. To contact the authors: koehler@handelsblatt.com, landgraf@handelsblatt.com

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