Private equity

Return of the Locusts

  • Why it matters

    Why it matters

    The increasingly high amounts paid by private equity firms for big companies at the moment is reminiscent of the situation before the 2008 financial crisis.

  • Facts

    Facts

    • Investor Bain and Cinven has just paid €5.3 billion ($5.6 billion) for German pharmaceutical firm Stada.
    • Pre-2008 private equity firms embarked on so-called financial engineering, buying debt-laden firms with little equity capital and reselling them at a high price.
    • Restructuring the firms often meant job losses.
  • Audio

    Audio

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Stada Arzneimittel
Bain and Cinven paid top price for pill maker Stada. Source: Frank Rumpenhorst/dpa

By 5 o’clock last Monday morning, all the legal hurdles had been overcome for the second biggest deal ever by financial investors in Germany.

The executive and supervisory boards of the pharmaceutical company Stada recommended shareholders accept the offer of the investment companies Bain and Cinven. The company is worth €5.3 billion ($5.6 billion) to the private equity investors. That corresponds to a good 13 times adjusted operating profits before amortization. This was a high price indeed, reviving memories of times before the financial crisis when prices and debt were going sky high until reality caught up with the private equity market.

This was also the era of mega takeovers. The most daring deal of all time was by a purchasing syndicate, including private equity giants KKR and TPG in February 2007. In the euphoric climate of the time, the bidders spent $45 billion on the utility company TXU from Texas. The takeover ended seven years later in insolvency, leaving a $40 billion mountain of debt and a bitter lesson to stay away from such transactions in future.

Such events triggered the debate about so-called locusts, an expression used by the then chairman of Germany’s center-left Social Democratic Party, Franz Müntefering. He spoke of an irresponsible swarms, which devoured everything in their path, leaving companies to go broke. His colorful words got the attention of everyone in Germany’s federal election campaign of 2005.

We do not need another plague of locusts.

More importantly, the reputation of an industry which was relatively unknown at the time was ruined. Only more transparency and a change of thinking in the industry itself helped to change things. But that took time and a great deal of persuasion.

That’s because back in their heyday prior to the financial crisis, some financial investors really did act like locusts. Money was made from “financial engineering”. Or to put it another way, companies were bought with little equity capital, fully burdened with the debt incurred by the takeover and then resold at a high price. Returns of 25 percent were the norm in those days.

When using the term locusts, Mr. Müntefering had the cautionary example of the fittings manufacturer Grohe in mind. It was passed from one financial investor to the next, and suffered for years under the huge debt burden. Many jobs had to be sacrificed before the company recovered. Today Grohe belongs to the Japanese Lixil Group.

But there are other more recent examples of deals that went wrong. The sporting goods manufacturer Jack Wolfskin, for example, which was bought by the financial investor Blackstone, is struggling with the debts heaped upon it – at a time when business is not as good as it could be.

For a long time the automobile workshop chain ATU, originally bought by the private equity firm KKR, also had more on its mind than just strategy and automotive tools. The company had to be restructured and hundreds of jobs were lost. The chain now belongs to its former French competitor Mobivia.

Nowadays “financial engineering” is no longer a major topic, with a new emphasis being placed on building up and restructuring firms. Taking over mid-sized companies offers opportunities for private equity, but many such German firms refuse to play along, even if the reputation of financial investors has improved. According to a survey conducted by Advaq, a provider of private equity funds, it is clear that in the 11 years after 2000, 142,000 new jobs were created in Europe.

But let’s not kid ourselves: Financial investors today still want to achieve a good 10 percent annual return on their investment. If companies are to be restructured and made profitable, then job losses are difficult to avoid.

It is therefore wise for companies like Stada to negotiate comprehensive job protection agreements for their staff. But the acquisition of Stada is also conspicuous for its high purchase price. There was a hard, competitive fight for the company right to the very end, because another bidding syndicate was also determined to prevail. In situations like that, it’s easier for executive and supervisory boards to squeeze concessions from the investors and drive up the price. Stada also looked at the way employees were dealt with in other portfolio companies of Bain und Cinven.

However, current developments are causing concern throughout the industry and are reminiscent of the bad old days. There is enormous pressure on private equity as there is too much money coming into the industry, which has to be invested. But Germany doesn’t offer enough possibilities.

A consequence of this is that financial investors are bidding against each other and paying too much for companies. It all feels like the excessive behavior of the year 2007, before the world plunged into financial crisis. It must not be allowed to happen again. We do not need another plague of locusts.

 

To contact the author: landgraf@handelsblatt.com

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