Caught in the Mittelstand
Germany’s small to midsize private companies are finding bank loans too pricey and capital markets too daunting. Enter bankers and deal makers with some creative ideas.
Dienes Werke is a cutting-edge company in the most literal sense. A Dienes machine can take a two-meter-wide sheet of photographic paper and slice it to passport-photo-size pieces within a tolerance of 0.15 millimeters. Some of the world’s leading corporations -- like Eastman Kodak Co. -- rely on devices built by Dienes to trim paper, cardboard and even steel.
Bernd Supe-Dienes, 47, and his brother, Rudolf, 44, are the third generation of their family to run Dienes, which their grandfather, Karl Rudolf Dienes, founded in 1913. Headquartered among farm fields in Overath, Germany, 20 kilometers east of Cologne, the company employs nearly 500 people worldwide in five factories and had revenues last year of E40 million ($49 million), up substantially from E22 million in 1995. Profits in 2004, however, were “disappointing,” Bernd Supe-Dienes confides, “yet still in the black.”
What really worries him and his brother -- as it does most of the owners and managers of Germany’s small to midsize companies, the Mittelstand -- is how to finance the growth of the family business now that they can no longer count on cheap and easy loans. The Mittelstand credit crunch has a number of causes, from banks’ desire to bolster their balance sheets in advance of tougher global capital rules to their reluctance to lend to companies battered by Germany’s prolonged economic hard times, especially after already being hard hit with loan defaults.
In the most recent setback for the Mittelstand, on July 18 the European Commission barred German states, or länder, from guaranteeing loans to Landesbanken, thus sharply raising the financing expenses of these 11 state-linked institutions -- and indirectly boosting the borrowing costs of the Mittelstand. Small and midsize German private companies mostly borrow not from Landesbanken but from the 477 Sparkassen, the municipally owned savings banks. But the Sparkassen partly own the Landesbanken and in turn depend on them for financing. Brussels also declared government loan guarantees for the Sparkassen verboten. The consequence, which has been building for a few years, is a tougher borrowing climate all around.
“The atmosphere is changing,” says Bernd Supe-Dienes with almost palpable dismay. Some Mittelstand proprietors glumly liken their lot to being in a formerly happy marriage in which one partner suddenly changes the rules of the relationship. Financing their businesses -- once as straightforward as seeing their neighborhood bank branch manager for a genial chat and a low-priced loan -- can now bring much higher costs, not to mention anxiety. Adding to many Mittelstand owners’ sense of gloom is Germany’s economic stagnation and the vicissitudes of globalization.
Yet the future may not be as dreary as many fear. The EU’s abolition of loan guarantees has unleashed a wave of financial competition. Mittelstand enterprises are being courted by a dizzying array of domestic and foreign institutions eager to cultivate their business by providing everything from old-fashioned loans to structured finance to derivatives.
“Funding of the Mittelstand is going to change dramatically over the next few years,” predicts Dietrich Becker, a partner at Morgan Stanley in London. “Right now there is huge resistance to going into equity markets, but that may be a luxury not all companies can afford. We will see more capital markets, more IPO activity.”
It can all be a bit overwhelming.
The biggest German financial institutions, such as Deutsche Bank, Commerzbank and HVB Group, want to continue making conventional loans to the Mittelstand but are also vying to arrange mezzanine financing for them so that the companies can build up their equity. That side of their balance sheets tends to be stunted, because they were overreliant for so long on cheap bank credit for the bulk of their capital.
“They had no need to build up equity,” points out Dirk Becker, a Frankfurt-based analyst for Kepler Equities. A healthier equity-debt balance, of course, makes Mittelstand enterprises more attractive to lenders and investors alike. Accordingly, the banks are proffering a range of innovative securitized mezzanine financing schemes, bearing names like PREPS and HEAT, that let Mittelstand owners fortify their equity without forfeiting control.
PREPS is the prototype. Preferred pooled shares, as they are formally known, are an asset-backed instrument that provides access to the capital markets for investment-grade but modest-size companies that are too small to tap the markets on their own. PREPS pools the companies’ profit-participation-rights agreements in a special vehicle and securitizes them through notes. The rights agreements entitle investors to share in the companies’ earnings for a set period.
Günther Berger, a member of HVB’s management committee, notes that companies in Anglo-American countries meet 70 percent of their financing needs through the capital markets and 30 percent with loans, whereas in Germany, it’s the reverse. “It will take a while, but we will slowly turn that around,” he vows.
The timing of the capital markets campaign happens to suit the banks as well as the Mittelstand. “German banks have spent a lot of time restructuring: lowering their costs, getting their act together with better risk,” points out one not-disinterested observer, Achim Klüber, a former Deutsche executive spearheading Royal Bank of Scotland’s push into the Mittelstand market and Germany generally. “Now they’re looking ahead and asking, ‘How can I get my revenues up, how can I get more business?’ They have come to the conclusion that banking without customers doesn’t work. What we are seeing now is the rediscovery of customers.”
Many multinational institutions, such as ABN Amro, Citigroup, Credit Suisse First Boston, Lehman Brothers and RBS, view the Mittelstand as both a great untapped market and a wedge into Germany. “The German market is very fragmented -- it is possible that we can find niches that one can very well occupy,” says Klüber. The banks are pursuing opportunities among Mittelstand companies in leasing, factoring and capital markets products.
Martin Kannegiesser, the owner of Herbert Kannegiesser, a manufacturer of industrial laundry machines that is located near Dienes in North RhineWestphalia, gets probably four or five calls each month from bankers. But what surprises him, he says, is that not all the banks are German. He has been contacted by, among others, RBS and ABN Amro, though he says he doesn’t need their wares and prefers to bank with Germans.
Meanwhile, aggressive U.S. private equity and hedge fund firms, sniffing profit in the Mittelstand’s predicament, have swarmed into Germany to scoop up their bad loans, shore up their capital and, in some cases, buy the companies themselves (Institutional Investor, July 2005). Germany happens to offer the largest distressed-debt market in Europe, estimated at E180 billion. A few Mittelstand enterprises have changed hands more than once.
Yet the sort of freebooting, Anglo-American-style capitalism practiced by these deal entrepreneurs grates on many Germans and touched off a fierce national debate in the run-up to last month’s federal election. The head of Chancellor Gerhard Schröder’s Social Democratic Party likened foreign private equity firms to “locusts” preying on German companies.
By contrast, East Germanraised Angela Merkel, the head of the conservative opposition party, the Christian Democratic Union, is a staunch champion of market solutions to Germany’s economic woes. But her plurality in the September 18 vote was so narrow that in the aftermath of the election it looked as if Merkel’s CDU might have to cast its lot with Schröder’s SPD in a so-called grand coalition. An uneasy alliance at best, such a union could stymie real reforms and set the stage for early federal elections.
To Germans, it’s no surprise that the nature of capitalism and the condition of the Mittelstand would both be matters of urgent national concern during an election campaign. If France is a nation of shopkeepers, Germany is a nation of small manufacturers. The 3.4 million Mittelstand accounted for nearly 80 percent of the country’s GDP in 2003. Their 20 million employees make up 70 percent of German workers and 82 percent of apprentices. The Mittelstand’s importance looms all the larger against the backdrop of an economy stuck in the doldrums, with a 12 percent unemployment rate that is close to preWorld War II levels.
Like Supe-Dienes, most Mittelstand proprietors still prefer bank loans to more exotic forms of financing. A recent survey of 10,700 small and midsize companies (maximum revenues: E500 million) by Kredit für Wiederaufbau, the government-sponsored bank for small businesses, confirmed that bank credit was by far their most important financing source in 2004.
Yet bankers insist that alternatives such as mezzanine finance and even private equity are beginning to catch on with the Mittelstand. “Credit is and remains an important product -- but earlier it was the only product,” says Wilhelm Freiherr von Haller, a member of Deutsche Bank’s regional management board.
Düsseldorf-based IKB Deutsche Industriebank, which has assets of E38 billion, leads private sector banks in granting long-term loans to the Mittelstand, claiming a 12 percent share of this E317 billion market. Four fifths of the loans are for E5 million or less. IKB’s volume in long-term corporate lending and leasing is E16 billion, or more than 40 percent of its total assets.
But competition from the formerly state-subsidized banks long held down IKB’s margins on this business. Thus, although lending and leasing to Mittelstand companies generates 51 percent of IKB’s loan volume, it provides only 40 percent of its profits. By contrast, securitization and structured finance, which account for 31 percent of loan volume, deliver 46 percent of the bank’s profits. The remaining 14 percent is from real estate and private equity financing. Naturally, IKB wants to pursue more structured finance, through a stepped-up marketing campaign.
Lending to the Mittelstand “was always defined as low-profit, but it was always stable,” observes Klaus Kubbetat, the Commerzbank regional executive board member responsible for midsize companies. One result is that German banks as a whole have the lowest margins on loans of any banks in Europe. Kepler Equities calculates the average in 2002 at 1.02 percent, compared with 1.11 percent for French banks, 2.40 percent for British banks and 3.07 percent for Greek banks.
Still, German banks’ margins appear to be edging up. IKB, for instance, reports that its average margin on new business in the fiscal year ended March 31 was 1.82 percent; it was 1.73 percent the previous year. Stefan Ortseifen, the bank’s CEO, says heightened competition will damp a further rise this year but that the improved margins should remain intact.
That increased competition largely reflects banks’ jockeying for position in the Mittelstand market. Both Deutsche and Commerz have tapped new managers to go after borrowers like Dienes. Jürgen Fitschen took over as head of Mittelstand business at Deutsche a year ago. And Martin Blessing, seen as a potential successor to Commerz CEO Klaus-Peter Müller, was shifted from retail to corporate banking in November and given a mandate to bolster Commerz’s Mittelstand business.
The bank, Germany’s third biggest, claims 51,000 Mittelstand clients now. In 2003, Commerz set a goal of increasing its Mittelstand customers by 9,000 within three years; to date it has added 7,431. It is going after companies with sales of E2.5 million to E250 million, and the bank devotes half of its capital to Mittelstand businesses.
The Mittelstand strategy, analysts say, is the only option for banks like Commerz and IKB. They are too small to compete in global investment banking against heavyweights like Goldman, Sachs & Co. and too weak to vie in private banking against such dominant players as UBS and J.P. Morgan Chase & Co. “What else can Commerzbank do?” asks Robert Früchtl, an analyst at Hauck & Aufhäuser Privatbankiers, a midcap asset manager in Frankfurt. “They pulled back from investment banking; they can’t be an international bank. They have no other choice.”
Last fall Commerz split its corporate banking division in three and put Blessing, the grandson of former Bundesbank president Karl Blessing and the son of onetime Deutsche Bank executive Werner Blessing, in charge of one of them: the aptly named Mittelstand Bank. The bank’s first-half profits of E77 million were better than its results for all of 2004 (E47 million). The secret, Blessing told investors, is cross-selling.
Commerz’s great rival, Deutsche, may not be in such a favorable position. Five years ago the No. 1 German bank all but abandoned the country’s small corporate market to pursue a grander role on the international stage. “Deutsche will have the toughest time because they were the most visible to have left the market,” says Guido Hoymann, a banking analyst at Bankhaus Metzler in Frankfurt. Now that Deutsche is a prodigal returned, it has a credibility problem with the Mittelstand companies it shunned but would now like to court.
Fitschen, the only member of Deutsche’s executive committee with a specific geographical mandate, has spent most of the past year in the field glad-handing existing and potential clients to induce them to use more of the bank’s products. Yet, as he concedes, “very aggressive competition has been piling in from foreign banks.” Still, Fitschen stands by his goal of adding 700 Mittelstand clients in the next year to the 12,000 he already has.
Deutsche does have a powerful marketing tool in its coveted brand name: A German company is considered to have made it when it can list a Deutsche Bank account at the bottom of its letterhead.
Nonetheless, Deutsche felt it had to recruit IKB as a partner for its EquiNotes mezzanine finance product. “IKB has access to the Mittelstand, and Deutsche Bank is one of our best partners for securitizations,” says IKB CEO Ortseifen.
HVB, with its tight capital ratios, may not have the money to splurge on a big thrust into the Mittelstand, analysts suggest. (The bank’s takeover by Italy’s UniCredit could conceivably change that: see Institutional Investor, July 2005.) In 2004, HVB’s Mittelstand business added up to 23 percent of its E325 billion loan volume. But like most of its competitors, the bank is avidly wooing small and midsize companies, in part because it fancies their owners as private banking clients. And its mezzanine product, PREPS, has been a winner.
Foreign banks see niches as their best entree into the Mittelstand market. Klüger boasts that Royal Bank’s leveraged finance team has led more than 50 German deals totaling more than E6 billion over the past two years, more than half for Mittelstand companies.
ABN Amro, meanwhile, has targeted 200 top Mittelstand companies to which it offers the bank’s panoply of products. “We want to have core bank status,” contends Frank Hoefnagels, who heads the bank’s German commercial banking operation. But in addition to commercial and investment banking capabilities, ABN Amro aims to build on its private banking franchise. Indeed, having purchased three German private banks over the past five years, the Dutch bank now claims to be the fifth-largest wealth manager in Germany, with E11 billion in assets -- most of which derive from the Mittelstand crowd.
CSFB is focusing its German strategy on the Mittelstand -- and poached Dresdner Bank’s leveraged finance team earlier this year to further that effort. “We expect the level of activity on the financing side will increase, given that banks here have pulled back as traditional lenders and most companies have not really accessed the high-yield bond market,” explains David Abrams, head of CSFB’s German initiative. “The inability of midsize companies to access capital has created a tremendous opportunity for CSFB.”
Some Mittelstand companies might prefer that the banks wooing them with fancy financing techniques stick to making simple loans. The Berlin-based Working Group of Independent Companies, a lobbying outfit for the Mittelstand, found that nearly one out of every two Mittelstand companies had more trouble securing credit last year than they did five years ago. Germany in fact has the slowest loan growth of all major economies, according to CSFB; lending volume has fallen every month since the end of 2003. Blame everything from the country’s economic stagnation and the resulting rash of bankruptcies to stricter lending standards under the Basel II banking accords.
But don’t excuse the Mittelstand altogether. Easy money in the form of debt made companies complacent about raising equity. The average equity-to-capital ratio of German companies is among the industrialized world’s lowest: 18 percent, versus 33.9 percent for French companies and 44.9 percent for American. And when the German locomotive began to lose steam at the turn of the millennium, many barely capitalized Mittelstand companies ran off the tracks. According to the Institute for Mittelstand Research, 437,800 companies went belly-up in 2003.
Bulking up their equity is a high priority for many owners of Mittelstand companies. The Working Group’s survey of its 6,000 members revealed that one third intend to raise equity this year. Now all investment bankers have to do is coax more Mittelstand companies away from their loan dependency and into the capital markets for a corrective dose of mezzanine financing. The bankers’ pitch is as much an educational exercise as a sales effort.
“It helps companies with equity problems to immediately improve their ratings,” explains Commerz’s Kubbetat of the virtues of mezzanine finance. “Once they are stabilized, companies can make way for other financing plans. We see it as a long-term growth plan.”
Nonetheless, selling mezzanine options can be a challenge for bankers. Alexander Küpper, head of cost control for the Verlbert-based Küpper Group, which supplies exhaust manifolds and clutch housings to automakers, says that the company has wanted to pump up its equity, currently 25 percent of its total capital, but balked at the conditions. Banks demanded 12 percent in interest and fees for mezzanine financing.
“It’s too high,” the 37-year-old says flatly. So he and his father, Hans-Joachim, who heads the company, decided to raise the E1 million to put up a new factory in Hungary by taking out a conventional loan from the Budapest branch of Kubbetat’s Commerz, the company’s house bank. (Hans-Joachim Küpper sits on the bank’s regional advisory committee, and the head of Commerz’s Hungarian subsidiary is a member of Küpper Hungaria’s board.)
Yet mezzanine finance can be highly seductive to Mittelstand companies because it allows owners to raise badly needed equity without sacrificing their independence. A bank (typically) takes a silent equity position that the company pays off in seven to ten years through interest installments, effectively converting the loan into stock.
Banks, for their part, find mezzanine financing alluring because it pays generous interest and fees: usually about 12 percent per annum plus one-off costs ranging from 2 to 5 percent. Commerz’s Kubbetat also commends mezzanine financing for providing investors with a well-diagrammed exit strategy.
Commerz’s typical mezzanine financing is for between E5 million and E10 million, he says. The bank’s plan is to package individual deals into E400 million bunches and sell them as asset-backed securities to minimize its risk. Commerz provided nearly E120 million of equity to Mittelstand companies in the first six months of its program, which coincided with the second half of 2004. The bank won’t provide a 2005 tally but says that as of July it had not reached the E400 million threshold for securitization.
The catch to classic mezzanine financing? One sizable hurdle is persuading Mittelstand owners, who tend to be intensely private, to publicly divulge financial details about their companies, as is required for securitization. Automotive suppliers, in particular, are loath to divulge profits because they fear that could hurt them in contract negotiations with car companies.
Innovation may be one answer to Mittelstand owners’ qualms. Capital Efficiency Group, a consulting firm in Zug, Switzerland, invented PREPS. Highly standardized, these asset-backed securities let Mittelstand companies access the market to raise small sums of money (as little as E5 million) on comparatively good terms -- almost 5 percentage points less than for conventional mezzanine financing. What’s more, companies do not have to reveal their innermost secrets to investors, just to the arranging bank and the rating agencies.
HVB, which licensed PREPS, tested the concept early last year by packaging 34 Mittelstand companies’ participation rights in a E249 million offering paying 7.9 percent interest and maturing in 2011. It was so oversubscribed, says the bank’s Berger, that HVB immediately launched another tranche.
That second round drew in Ralf Lauer, finance director of Nici, a maker of stuffed animals, in Altenkunstadt, Bavaria. His company took out a E10 million financing at 7.5 percent to help expand its U.K. toy business. PREPS II collected 67 such financings totaling E616 million at 7.5 percent each. The maturity date is 2012. That issue, too, was oversubscribed. Lauer found the PREPS experience so positive that he put Nici into a third batch in August.
Working in tandem, HVB and Capital Efficiency Group concluded E1.2 billion of PREPS deals in the 18 months through August. CEG now plans to market the concept to midsize Swiss companies in partnership with Credit Suisse Group and, if all goes well, to roll out PREPS in other European countries.
A product this popular was bound to inspire knockoffs. This summer HSBC Trinkaus & Burkhardt came out with HEAT, for hybrid equity access trust. Like PREPS, HEATs target investment-grade small and midsize enterprises that need mezzanine loans of E8 million or less. Depending on their rating, HEAT, carry fixed rates of 6.5 to 8 percent. The maturity: seven years.
Michael Auracher, the Trinkaus manager leading HEAT, reports heavy investor demand for the firm’s initial, E220 million issue in August. Typical investors for the loan portion were insurance companies, asset managers and pension funds. The much riskier but also potentially more lucrative equity portion sold out even before the formal launch, primarily to Trinkaus’s high-net-worth clients. “Investors have not been able to tap into this asset class before,” Auracher notes.
Other banks have also attempted to play copycat -- but not with any conspicuous success: Deutsche Bank and IKB with EquiNotes; Commerzbank with MezzCAP; and Landesbank Baden-Würtemburg and a coalition of banks with SmartMezzanine. Although all these brand-name banks announced their PREPS-like products with suitable fanfare in late spring, none has managed to bring a deal to market.
One competitor contends that the hitch is that the banks want to keep the equity portion on their books and that Mittelstand companies, fearing a conflict of interest with the banks, are reluctant to sign up. None of the bankers would give a reason for the delays.
But there may be another reason that these banks have had trouble completing issues: the difficulty of assembling a galaxy of Mittelstand companies whose ratings will be acceptable to investors. Moody’s Investor Service gives the typical Mittelstand enterprise a RiskCalc expected-default grade of Ba2; investors much prefer at least Baa3 -- two notches higher.
One closely involved banker estimates that the market for PREPS, HEATs and their kindred is more like E5 billion than the E10 billion to E15 billion that some had hoped it would be. How the market evolves, says this financier, will depend on whether or not interest rates remain low. IKB’s Ortseifen agrees. “This phenomenon is purely market-driven,” he says. “It is closely connected to the low-interest-rate environment we have.”
The Mittelstand’s gross undercapitalization makes them tempting targets for more than just purveyors of mezzanine financing. Foreign investment banks and private equity firms are fashioning a German franchise. Last year the country had 1,065 private equity deals worth $75.9 billion, according to research house Dealogic. It’s a safe bet the bulk of those involved Mittelstand companies. And of the top ten deal makers, seven were foreign banks.
German bankers caution, however, that the country’s lack of a functioning IPO market will inevitably stifle the full development of a vibrant private equity market. And as long as Germany’s financial markets remain fragmented, it will be hard for new ideas to take hold. Political uncertainty doesn’t make matters any easier.
IN OVERATH, GERMANY, IT’S LUNCHTIME AT THE Dienes factory. As the men who have been assembling and sharpening blades take their break, Bernd Supe-Dienes walks through the old green warehouse, nodding and wishing his workers mahlzeit, or hearty appetite. They nod back at the familiar figure in the gray suit and white shirt.
He is well aware that the 200 workers at this plant and their families -- who live in his community -- depend on him. Back at his cramped office, with its black metal desk and cabinets, Supe-Dienes says he knows he must continually innovate to stay competitive in the global marketplace and adds that he’s willing to expand.
Yet he is not convinced of the merits of most of the exotic financial instruments that bankers keep thrusting upon him. In any event, although he has diligently beefed up Dienes’s equity over the years, the company is not eligible for the more attractive financing vehicles because its revenues are below E50 million. So when Dienes opened a service center in Malaysia and expanded its factory in Hungary last year, Supe-Dienes passed up the fancy financial tools and borrowed the money to do so from IKB in an old-fashioned loan, at 4.5 percent.