Distressed Debt

Germany: Day of the Locusts?

Markus Lahrkamp, President North America, Droege & Company
Originally published in the March 2007 issue

When a German politician referred to hedge funds as “swarms of locusts raiding our German companies,” he was playing to the political landscape and widespread fear in Germany of foreign owners and layoffs, which often result after a buyout as a way to reduce bloated cost structures. Although, not his intent, there is an interesting thought to consider here. In a distressed situation, hedge funds will buy debt of a struggling company and swap debt-for-equity to gain control of the company. Hedge funds then might call for management to make difficult (read: apolitical) ‘cuts’ in order to rebuild an inefficient organisation upon a stronger foundation.

Admittedly, nothing good ever came from locusts, so perhaps a better analogy would be that of a fire, which can destroy a decayed forest while simultaneously planting the seeds for future healthy growth. Of course, we know that equity and debt investors do far more than ‘clear-cut’ in terms of capital raising, strategy and developing new business relationships. With new political leadership in Berlin ready to embrace outside investors in ways not before seen, the opportunity has never been greater for foreign investment. In particular, the passage of the German Investment Act and the Investment Tax Act in 2004 – making it easier for institutional investors to invest in hedge funds and retail investors to put money in funds of funds – has loosened the rules governing hedge funds.

The bare facts

So, how easy is it for hedge funds to invest indistressed German companies? And what do Germans think of foreign investment? According to Professor Edward Altman of New York University’s Stern School of Business, “Germany may be the single largest market opportunity for distressed investors today.”

To understand why there is a huge potential for investment, here are some statistics on Germany. Germany is Europe’s largest economy with a total GDP of $2.48 trillion (the US has a GDP of $12.31 trillion), a per capita GDP of $30,100 (compared with the US with a per capita GDP of $41,600), and a trade surplus of +$215 billion (the US has a trade deficit of -$800 billion). Germany operates as a social market economy with elaborate social welfare and health programs – 98% of the German populace has health insurance. The growth in Germany’s DAX has consistently outpaced the US’s DJIA. Yet, Germany ranks only fourth in European hedge fund and private equity investments, despite being Europe’s largest economy. [Source: CIA World Factbook, Paderborn University Germany-map.org, WTO, Droege & Comp].

There are some good reasons for this ranking. First, while the German hedge fund and private equity market is relatively unsaturated and untapped, there is a cultural mindset that makes owners resistant to sell to private equity and hedge funds. Second, the stagnant growth in manufacturing because of the emergence of China and India has created an increased distressed pool, in need of research and development funding, that has not yet been understood. Third, heavy bureaucratic regulations burden many businesses (beginning 2008, recent laws will treat private equity and hedge funds as limited partnerships, which offer significant tax breaks). And, finally, there have been some jingoistic rumblings in the ruling party.

It should be noted that not all Germans are as resistant to foreign investment as the German politician who considers hedge funds ‘locusts.’ His comment should be considered in the context that investors in Deutsche Börse, which operates the Frankfurt Stock Exchange, impeded efforts by the exchange to acquire the London Stock Exchange and then ousted both its chief executive and chairman. Although, the media daily skewers ‘locusts,’ politicians are more and more often staying silent, so as not to slur firms when it comes to finding investors. Many politicians recognise that the key to growth in the German economy is by freeing up opportunities for investment, whether by domestic or foreign players.

Therefore, this begs the question, how would a hedge fund begin to understand this complex climate of doing business in Germany? And, more to the point, how would a hedge fund actively begin investing in distressed German companies? The answer is simple. Foreign companies need to recognise German cultural differences, the intense public pressure for German entrepreneurs to live up to their social responsibilities, and the German regulatory climate for hedge funds.

As an example, the CEO of a well-respected and very successful US private equity firm was picketed at a speech in Germany as the ‘head locust.’ He had said, “We are bringing the concept of shareholder value to Europe’s inefficient social state policies,” thus implying that foreign investment will make European countries more efficient. While this CEO’s audience was a public policy forum in the US, his statements reached the burning ears of Germany, and was not very well-received by the populace. The debate about ‘locusts’ remains as intense as ever in Germany, and foreign investors must remember that many German CEOs have strong cultural ties through their companies to their communities. This complex emotional relationship of many German entrepreneurs to their companies and communities further complicates the already ingrained trepidation at relinquishing ownership to an outsider, like a hedge fund or private equity fund.

Similarly, thinking about domestic investment in Germany, a foreign investor may have an upper hand because German investorshave different appetites for risk and return. An appetite, which may prevent a domestic player from investing in a distressed German company, whilst an American or English hedge fund might not have the same aversion to risk. A foreign investor may be more likely to recognise the value in adding a distressed debt investment to a diversified portfolio.

Understanding the marketplace

While foreign investors may want to add German distressed companies to their portfolios, there are a few important facts about Germany that an investor must remember. First, German owners are still confused as to what hedge funds are, and how they can help during difficult times. Hedge funds must educate German CEOs and other managers about how hedge funds can preserve the value of a business during a time of need.

Second, local advisors are absolutely critical to the success of foreign hedge funds entering the German market. The most successful hedge funds have employed armies of local advisors and market experts, like accountants, lawyers, industry veterans, ex-politicians, etc. These local advisors have guided foreign hedge funds through the nuances of doing business in Germany, while appeasing politicians along the way. The US hedge fund DB Zwirn has, quite presciently, acquired a banking license and branded itself as Bankhaus Zwirn in Germany, thus neutralising any potential stigma as a foreign fund invading German companies.

Finally, foreign investors should stay mindful that Mittelstand, or small to mid-market companies, are the backbone of the German market. Mittelstand in Germany represents 99.7% of all companies, 70.2% of all employees, and 40.8% of all total revenues [Source: IMF Bonn]. Mega-deals (over €300 million) are rare in the German market and are fiercely competitive. This fierce competition among hedge funds surfaces in the current oversupply of capital, which decreases the internal rate of return achievable on potential investments. Therefore, the most lucrative and potentially sweet deals are in the €50 million to €150 million range.

An outsider looking in should also note that Germany has virtually no domestic hedge fund players due to strict laws enacted in 2004 to subject hedge funds to transparency in the market. Many hedge funds were afraid their trading strategies would be revealed, although in time this has proven not to be the case. This current dearth of domestic players and the structural deficits of the German market – the lack of a liquid secondary market – create an opportunity for knowledgeable firms.

Many German Mittelstand are world leaders in their respective technical fields (machinery, automotive), but Europe lags behind the US in distressed debt opportunities. In a distressed situation, many investors focus on a firm’s likelihood of defaulting on its bond interest payments, or on companies that have already defaulted. Debt-for-equity swaps are more difficult under German law, yet new insolvency laws have widened the scope for bankrupt companies.

Planting the seeds of change

Insolvency holds tremendous potential for foreign investment. There is a preponderance of out-of-court restructurings because insolvency is not understood to be a restructuring option in Germany. German restructurings are expected to increase in 2007, especially in the paper and packaging, chemicals, automotive, boat, bedding, and retail sectors. For instance, in late 2006, the German auto parts maker Kiekert Group completed a restructuring with a debt-for-equity swap. Understanding and accepting local conditions is a key factor for success.

Succession issues are also widely believed to be a source for potential investment by hedge funds. Mittelstand companies are understood to be either entirely family run, owned by a family and run by outside management, or partially owned by a family and shareholders. There are 2,122,000 companies in Germany, two million of which are family owned and 8% of allcompanies have been shuttered because of a lack of a successor. From 1997 to 2002, 51% of announced handovers were family transfers of ownership. There are 283,000 company transfers to a direct successor expected from 2006 to 2009. Many opportunities exist for investors through complexities in corporate change at the CEO level. [Source: IMF Bonn]

There is an enormous potential upside in the German market. With the change in regulations and laws, there will be more and more opportunities for hedge funds to help distressed companies through succession issues, restructurings, IPOs, fundraising, and other corporate complications. Hedge funds looking to invest in distressed German companies have huge prospects ahead of them in the next two to five years, particularly in mid-market, or Mittelstand, companies. And it will be a heady success if hedge funds remain mindful and respectful of German cultural nuances in doing business. Germany is a land rife with opportunity, and hedge funds must encourage German companies and regulators to view them not as devouring insects, but as gardeners planting the seeds for growth.