Mittelstand evolution

THERE ARE FEW countries in Europe that hold as much potential for private equity investors as Germany. It has the largest economy in Europe, powered by a quarter of a million privately owned Mittelstand companies – a population of mid-market businesses that enjoy an international reputation as cash-generative, export-orientated and capable of occupying global market-leading positions in high-margin industry niches.

Despite this, it has proven a tough market to crack for many ‘outside investors’, those not embedded in the local markets. Elsewhere, they say ‘money talks’, but in the German industrial heartlands, unless you can demonstrate a cultural affinity and a similar set of values with business owners and the communities they support, that conversation will be short.

As a result, while Germany has a well-established private equity market, its activity level is lower than might be expected, given the size of its productive output. Over the ten years to the end of 2021, there were 1,008 private equity deals in Germany worth €164bn, compared to the UK’s 2,159 deals with a value of €270bn, according to the Centre for Private Equity and MBO Research.

Equistone Senior Partner Marc Arens, recently appointed as the firm’s Country Head for DACH/NL, says building a successful private equity franchise in the German market has always required a combination of patience, local presence, cultural insight, and an investment in origination.

“Mittelstand companies are family run and have been passed down through the generations. Owners feel a deep sense of family and community obligation,” says Marc. “When they are thinking about doing a deal, extracting maximum profit is not the overriding priority. They want the company to go to a good home,” Marc says.

Succession continues to be a strong catalyst for deal opportunities. The average age of owner-managers of privately owned businesses in Germany increased from 45 in 2002 to 52 in 2019, according to a study by KfW. The report also showed that the traditional preference for a family succession was “fading into the background” with only 44% of owners considering handing over to a family member. Interest in alternative succession options, including private equity, are increasing.

On top of the traditional deal drivers, Mittelstand owners are turning to private equity solutions to help them with very new challenges…

In a world being transformed by software and digitalisation, the high margins enjoyed by niche businesses are under threat across all industries. This is a global phenomenon and having access to an investor with a broad and international perspective of the challenge, is increasingly seen as a big advantage.

“Digitalisation is impacting companies across multiple sectors and the pace of digital transformation can be challenging for leadership teams to manage without support. There is a clear role for private equity to play here,” Marc says.

Historically, Equistone’s European team has not been structured along rigid sector lines, which has the advantage that it now has a broad experience of guiding companies through digitalisation in a wide variety of industries. Take prefabricated house builder Oikos, which the firm sold to a fund managed by Goldman Sachs earlier this year. During its partnership with Oikos, the company’s customer acquisition model moved from a reliance on showroom and catalogue channels and onto a powerful online platform. The company developed digital tools to allow customers to choose designs, materials and finishes remotely – a capability that proved crucial through lockdowns, with the business continuing to engage with customers even when its showrooms had to close.

This model has worked well for Equistone, but Marc believes digitalisation has created an opportunity for significant increases in investment in the German technology sector per se, with firms like Equistone well-placed to fund their consolidation and international expansion. As a result, earlier this year the DACH/NL team decided to formalise and enhance its digitalisation support capabilities. As part of this, the firm made the unusual move of making a senior lateral hire of Sebastian Wintgens, who was formerly a Managing Director in the Technology & Services team at Raymond James (see Our People article).

While there are a number of tech-focused investors in the market (typically investing out of London), there is a consensus that there is an ample demand for home-grown investors to enter this landscape. There is a palpable sense of a ‘coming of age’ of Germany’s technology sector itself, which has kept a surprisingly low international profile to date, particularly given the country’s reputation for excellence in engineering, automotive, industrials and chemicals. 

Although German software engineers are held in the same regard as their industrial counterparts, German technology companies haven’t established the same international reach as tech businesses in other regions.

“Germany has a well-established B2B software sector and there is significant scope for private equity, for example, to augment sales & marketing and support migration to the cloud,” Sebastian says. “The potential to support technology entrepreneurs and build market leaders is vast. Private equity can help German technology businesses to consolidate their markets and expand management team capacity.”

“We are in a frothy market and many company valuations are not driven by fundamentals but by the scarcity of opportunities and the availability of capital. Capital has become a commodity, so the question is what do you offer on top. Equistone has the heritage and expertise to help build, professionalise, and scale highly successful companies.”

This does not mean Equistone intends to overpay. “We must identify and classify the opportunities we really want to go for as soon as possible and not when investment bank memorandum lands on our desks.”

Sebastian says the firm will retain a focus on valuation discipline when assessing technology opportunities, but these will be intelligently informed by proprietary theses that are likely to include buy-and-build strategies – and companies with strong management that need a supportive partner in order to reach their potential.

In other words, while there is specific work and outreach that must be undertaken around technology business models, it is those fundamental strategic levers that have served Equistone so well in the German market for a generation that should allow it to grasp this fast-growing technology opportunity.

Proactive origination has always been a part of the Equistone DNA and the next iteration in the DACH/NL team’s evolution is to develop this capability even further.

“Equistone has a long track record and strong reputation in the German market, and Equistone has always seen almost all relevant deals in the region,” says Partner Alexis Milkovic. “But as more capital has come into German private equity, the market processes become much more competitive. We are really focused on ensuring that, in addition to the continuing high volume of incoming transaction opportunities, we are also actively getting out to meet entrepreneurs and generating proprietary deal flow.”

Overlaying the strategic emphasis on origination and technology is a deal triage structure that the team has put in place to filter transaction flow. 

Before any deal is taken to European investment committee, it has to clear the triage process, which is structured to encourage input from all team members irrespective of seniority.

Every deal in triage is reviewed by a five-member quorum, who scrutinise big picture questions on issues like scalability, management capability and recurring revenues. At this stage, all diligence is done from the outside in, encouraging dealmakers to bring forward opportunities and consult formally with colleagues, but without the pressure that comes with incurring pre-deal costs.

At the end of the triage process, a 10-page report is produced and the quorum votes on whether or not to take the transaction forward to investment committee or approve budget for additional diligence.

For Marc, the process doesn’t only facilitate a rigorous review of deal opportunities, but crucially creates a team culture where everyone contributes and is invested in a deal, rather than a scenario where individuals guard their turf and contacts, and industry knowledge is tightly held.

“Every single discussion at the triage stage is open to everyone. This accelerates the education of junior team members and allows institutional knowledge to flow through the firm at all levels in a way that wouldn’t be possible if dealmakers were narrowly focused exclusively on their own deals,” Marc says. “The German market is evolving and growing rapidly. We are developing our team and skillset to position Equistone at the forefront of the opportunities this will bring.” ☐

A full version of this article appeared in PLATFORM 06, Winter 2021/22