Picking a DACH mid-cap master

Oscar Geen
20 October 2017

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The Mittelstand in Germany remains the driving force behind private equity dealflow in the region, but with so many proponents of the mid-cap space, Oscar Geen finds out how LPs decide on their allocations

The DACH buyout market is driven by Germany's Mittelstand, generating most of its transactions in the < €500m range, and, in the first half of 2017, the majority of its value as well.

The region, and Germany specifically, has a strong reputation for research and development, and high productivity companies. According to unquote" data, more than half of buyout transactions in H1 2017 were in the industrials or technology sectors. The target companies are supported by strong infrastructure and a favourable regulatory environment. Market participants often refer to good German companies as "hidden champions" and this term highlights the main problem investors in the region encounter, good opportunities are hard to source and even harder to win.

Pan-European has always been a key word for marketing but I would emphasise the need for a strong local presence to do deals in [the DACH] region, especially in the lower-mid-cap space" – Dirk Schekerka, Equistone

For this reason LPs need to allocate to managers that can find opportunities in this notoriously competitive space. Torsten Krumm of HQ Equita explains that LPs are attracted to the region because of its SMEs but these companies are historically family-owned and can be difficult to get access to. "LPs want to allocate to DACH-based GPs because we are native German speakers with local knowledge and we know how to win the hearts and minds of German entrepreneurs," says Krumm.

Mounir Guen of MVision Private Equity Advisors tells unquote" he expects the regional idiosyncrasies of private equity to decline. This is because there are many opportunities in the DACH region, and especially Germany, but the PE groups are small in size and therefore larger pan-European or international funds take the majority of the larger deals. "Regional definitions were arbitrarily created by private equity and they are becoming increasingly less relevant," he says.

Equistone's Dirk Schekerka agrees with this to an extent. He explains that within Equistone there is a strong trend towards consolidating the marketing and fundraising activities of the firm but less so on the deal side. "We manage our regions from our regional offices. Pan-European has always been a key word for marketing but I would emphasise the need for a strong local presence to do deals in this region, especially in the lower-mid-cap space," he says, adding that he has never encountered any issues regarding the firm's German credentials when dealing with business owners.

Family affair
There is a certain distrust of PE among some business owners in the region, especially proprietors of long-established family businesses. Flexibility of financing arrangements can be key to winning this trust. Christian Böhler, head of DACH fund investments for Akina Partners says flexibility is a key differentiator when choosing managers "We like funds that can also take minority positions because some of the best entrepreneurs prefer to retain some control."

Many of the businesses that attract interest from private equity are family-owned. Having access to networks of German business families is therefore very important and is part of the reason for the increasing importance of family offices. "Family offices are very much a part of the European fabric." says Guen, and specifically in Germany where "they are sophisticated institutional investors and have a lot of breadth", referring to the increasing trend of family offices investing in businesses directly.

However, Schekerka is not convinced that family offices are in PE as deal-doers for the long haul, "In the early 2000s we saw a lot of family offices getting into venture but many ended up closing down," he says. Although he does acknowledge that they have become part of the competition. Equistone no longer takes investments from LPs that have their own direct investment arm. An industry insider tells unquote" that Bregal, the family office of the Dutch-German Brenninkmeijer family, has lost access to some funds since the launch of its direct investment teams, Bregal Unternehmerkapital in Germany and Bregal Freshstream in the UK.

Käpplinger thinks that because of issues of this kind, many family offices are turning to funds-of-funds. "Family offices will try to invest in the big funds but if they can't they'd rather take funds-of-funds than a second tier buyout fund," he says. Finding the right fund manager can be a headache for an LP, so from a technical point of view it is much easier to use a fund-of-funds manager that can choose the top tier PE funds.

Big hitters
Large-cap deals remain elusive in the region and this is partly due to the legal framework. Schekerka highlights a lack of listed companies as one key reason: "There are only around 300 listed companies in Germany, compared to several thousand in the UK, and there are strong limitations on squeeze out." This refers to the process by which a private equity firm takes publicly listed companies private in Germany, first acquiring an agreed majority of shares in an initial acceptance period, before entering into further negotiations until it owns 95% of shares, at which point it can "squeeze out" remaining shareholders.

International PE firms Bain Capital and Cinven Partners have experienced first-hand the difficulties involved in this process in the first eight months of 2017 as they initially had a management-approved €5.3bn bid for German pharmaceutical company Stada rejected by shareholders in June. The consortium then finally gained the required number of shares on the final day of the acceptance period with an improved offer taking the enterprise value to €5.4bn in mid-August. In the case of Stada it was likely opportunistic financial investors that caused the delays, but another common problem is that the larger family offices build up positions in public companies, and act as blocks on a successful take-private.

Because of this lack of larger deals, Schekerka believes there is a natural limit to the size of purely DACH-focused funds: "I think the maximum size is around €600-800m. There are not many funds above €800m-1bn because of the structure of the market." Krumm agrees on this point and thinks the optimum size is perhaps a bit lower: "The ideal size for this market is up to €500m fund size with around 10-12 portfolio companies. Some DACH-based GPs are pricing themselves out of the market by raising larger funds and then they have to compete with pan-Europeans."

Deutsche Beteiligungs AG has found what it considers a novel solution to this problem. Its latest buyout fund, a €1bn vehicle that closed in September 2016, is structured as an €800m main fund with a €200m top-up fund for larger equity tickets. Management fees are only charged on deployed capital for the top-up vehicle, which takes away some of the pressure to deploy. Krumm acknowledges this but believes it reasserts his point: "The existence of a top-up fund proves that investors would rather stick to smaller tickets."