Who Will Finance the Mittelstand?

Holding a special place in the German lexicon to denote family-owned and often family-operated companies, the Mittelstand represents the engine of industrial productivity and manufacturing export growth that epitomised the economic miracle of post-war Germany. The lasting success and stability of the Mittelstand through successive generations of family-owners centres on longstanding regulatory frameworks and cooperative market arrangements that developed to foster superior technical product quality and an opaque “stakeholder” approach to corporate governance.

The most critical element of Mittelstand sustainability and success, however, relates to the support of the German banking system with its three tiers of private, public and cooperative banks. In particular, the close relationships between Mittelstand borrowers and their community Hausbanken (“House Banks”) from these competing banking sectors distinguish the German “middle market” from much of the rest of corporate Europe.

This report focuses on the largest of Mittelstand companies, many of which have developed leading market positions and international reach in niche manufacturing and capital-intensive industries. It examines the pillars of Mittelstand corporate governance, accounting and financing practices in the context of broader international economic and political developments. In particular, an overriding question and concern among observers in Germany’s financial markets centres on how this important corporate sector may be impacted by the prevailing forces of European integration, international market liberalisation and corresponding regulatory developments in accounting and banking supervision.

The House Bank relationship, so central to providing the Mittelstand with long-term, patient financing appears to be eroding under such forces. Indeed, longstanding features of Germany’s bank-based financing model appear to be giving way to Anglo-Saxon style capital market pressures, leading many advocates to ask: who will finance the Mittelstand?

• In addition to quantitative factors such as annual revenues and numbers of employees, Fitch expands the Mittelstand definition by emphasising common qualitative characteristics, such as: family ownership, exclusive economic and voting control, and the desire for confidentiality and tax efficiency.
• Mittelstand owners typically choose the legal form of ‘limited liability company’ or ‘limited liability partnership’, allowing greater control over corporate decisions while minimising disclosure and tax burdens compared to equity issuing ‘stock corporations’.
• Unlike laws governing stock corporations, which mandate influential universal banks and employee representatives to participate in corporate decisions along with shareholders, limited liability Mittelstand companies embrace German “stakeholder” values via close consultation with workers’ councils and community oriented House Banks.
• House Banks in the private, public and ooperative sectors traditionally provide longer- term, less intrusive and less restrictive credit to Mittelstand companies compared to “arm’s length” terms and conditions in international credit markets.
• The respective accounting systems in Germany and the US illustrate the differences between the patient and opaque “insider” oriented German bank-based system focused on long-term product quality, and the short-term and transparent “outsider” capital market system focused on financial performance.
• German accounting principles emphasise “prudent” concepts such as understating assets and performance indicators while overstating liabilities, whereas US accounting principles emphasise performance indicators.
• The desire for economic and voting control as well as corporate and personal tax considerations lead family owned Mittelstand to favour privately arranged debt financing for incremental capital, resulting in a much- discussed Equity Gap on Mittelstand balance sheets.
• Many of the economic and market arrangements designed to foster the long-term patient character of German corporate management have come under increasing pressure as political commitments to the European Union (“EU”) have led to economic integration and market liberalisation.
• Large, internationally active German stock corporations and leading universal banks took the first steps away from traditional bank-based financing practices in the 1980s and 1990s by applying for public credit ratings and adopting performance-oriented International Accounting Standards (“IAS”) in an effort to attract equity and debt capital from international institutional investors.
• EU integration compelled the German financial system to compete on an equal basis with other European financial markets, leading to the adoption of capital market-friendly policies and reforms, which some observers have argued will continue to erode the influence of universal banks in corporate governance.
• Mittelstand observers suggest that such political developments and related market pressures may have more impact on large listed stock corporations dependent on international institutional investors than private companies reliant on regional and community House Banks.
• The dominant role of banks in the German economy reflects saving practices more inclined to conservatism and bank deposits, given the narrow income distribution through social strata, compared to wider income and wealth gaps in Anglo-Saxon countries where wealthier savers seek riskier assets in equity and bond markets.
• German banks in all three principal tiers of the banking system face considerable pressure to reform and consolidate due to multiple economic and regulatory pressures, including: the loss of public support mechanisms in the public bank sectors, the implementation of Basel II risk measurement and capital adequacy requirements in 2007, and the adoption of performance-based IFRS (formerly IAS) accounting standards for all EU entities with quoted equity (2005) and bond issues (2007).
• The combination of profitability pressures on private banks, new commercial realities for public sector banks, and greater supervision and transparency of all German banks from the implementation of Basel II and forthcoming EU capital adequacy regimes threaten to fundamentally alter the pricing and monitoring demands House Banks make on Mittelstand borrowers going forward.

Corporate Capital Charges Under Basel II

Source: Fitch Ratings

House Banks Respond

The German banking system remains highly fragmented and competitive. Given the slow pace of consolidation, House Banks have learned that to survive in a new era of intense domestic and international competitiveness they must tailor products that meet not only their own economic and regulatory requirements but also the principal concerns of family-owned corporate borrowers. Specifically, Mittelstand borrowers continue to demand cost-effective and flexible credit products that address their principal concerns: maintaining economic and voting control, confidentiality of information and tax efficiency.

In 2004, Mittelstand companies and their financial advisors responded to these tensions by embracing domestic and international products that allow banks to manage their risk exposure while satisfying Mittelstand demands for flexible and patient debt capital. Among these are: certificates of bi-lateral loans, or Schuldscheine, which allow risk to be syndicated among multiple purchasers; long-term, fixed-rate bonds available in the US Private Placement market (“USPP”); and “hybrid” or “mezzanine” capital products such as Silent Participations (Stille Beteiligungen) and German Participation Rights (Genusscheindarlehen or “GPRs”), designed to address the Equity Gap on Mittelstand balance sheets – at least in terms of appearance if not substance.

Germany has an “Equity Gap”

Source: Siemens Financial Services

Mittelstand borrowers clearly avoid the straight equity alternatives presented to them by House Banks intent on addressing the Equity Gap. Public equity alternatives suffer from weak demand among domestic savers following the collapse of the Neuer Markt in 2002, and listings on the Deutsche Boerse must increasingly satisfy the portfolio allocation and volume demands of international institutional investors.

Corporate Germany’s Dependence on Bank Financing

Source: Siemens Financial Services

Mittelstand Avoid Straight Equity and International Credit Products

Public and private equity markets typically demand too much transparency or dilution of control for family owners, intent on independence. Nor have Mittelstand companies embraced the European syndicated loan, European mezzanine loan or the European high yield bond markets with much enthusiasm – given these markets’ demands for restrictive covenants, interim performance-based reporting and market-based returns.

Mittelstand borrowers have instead relied on less restrictive domestic products that are either distributed through the domestic banking system or among German insurance companies. Many of these products reflect distinct German accounting treatment that allow domestic hybrid debt instruments to be classified as equity even though recently EU-adopted IFRS accounting standards would likely treat them as debt. Moreover, new products, such as a Collateralised Debt Obligation issued by offshore vehicle ‘European Private Funding Limited Partnership’, pool credit exposure in the form of PREPS (an acronym for “preferred equity participations”) to Mittelstand companies in a securitized portfolio, which is in turn sold to institutional investors on the basis that the underlying borrowers are “investment-grade.”

Seeking “Investment-Grade” Status

However, many of the ratings assigned to borrowers utilizing domestic products rely on arranging banks’ internal assessments or third-party quantitative models. These may not reflect international rating agency methodologies and, therefore, may not gain acceptance in international markets or among banking regulators determined to make capital adequacy frameworks a more transparent reflection of market risk. The danger for many Mittelstand borrowers remains that equity levels continue to remain low on the basis of IFRS and rating agency treatment. Attempts to avoid unattractive straight equity options by embracing domestic hybrid equity products dependent on distinct German GAAP equity treatment could result in diverging domestic and international market standards.

In light of these developments, one question facing the Mittelstand remains the integrity of close relationships with their community House Banks. While community based banks in each of the private, public and cooperative sectors of the German banking system remain keen to provide competitive solutions to Mittelstand clients, they may not remain as committed creditors when business conditions deteriorate.

Who Owns my Loan? Private Equity and Hedge Funds!

The evidence from 2004 and so far in 2005 suggests the House Bank relationship may indeed break down when business conditions or credit quality deteriorate substantially. Since early 2004, German banks have been selling non-performing loan (“NPL”) portfolios to international private equity investors and investment banks, notwithstanding concerns over the impact such sales may have on their reputations among corporate borrowers. As profitability concerns, consolidation pressures and the costly treatment of risky credit exposures under the forthcoming Basel II and EU capital adequacy regimes compel banks to reduce their exposure to deteriorating credit quality, private equity investors spurned by Mittelstand companies in their offers for external equity financing may access the sector and pursue their relatively high target returns by buying Mittelstand debt.

More troubling, however, may be the development of an active secondary market in German corporate debt. Notwithstanding considerable restrictions to selling corporate credit exposure to a third party in Germany, active selling of individual NPLs (as opposed to portfolios), as in the recent case of construction group Walter Bau AG, could result in more aggressive hedge funds and distressed debt funds ending up as creditors to Mittelstand companies. Recently arranged yet performing loans of troubled retailer KarstadtQuelle AG and auto supplier Schefenacker AG also sold quickly in the rapidly developing secondary loan market such that international hedge funds and distressed debt funds have taken large positions.

Mounting evidence of “capital market” style developments suggest Mittelstand borrowers once accustomed to patient and flexible House Bank lenders can quickly find themselves facing a new breed of creditor. Hedge funds, in particular, frequently seek near term realisation of investment returns by charging substantial fees for covenant waivers, forcing asset sales or wholesale refinancings to improve the price of a loan position in secondary markets. They may even threaten insolvency to gain control.

Look at the Recent Experience in Italy

The implications of international private equity and hedge fund investors actively participating in the German corporate debt markets only underscore the risks Mittelstand borrowers assume when they fail to materially improve their credit profiles. In addition, Fitch notes important lessons for the German corporate sector from recent events in Italy. Specifically, the potential consequences Mittelstand borrowers may face if the less-costly, less-intrusive solutions from domestic debt markets fail to support them over time.

Italy is similar to Germany insofar as its economy is dominated by medium-sized, family-controlled companies, many of which are also international market leaders in niche industries. Italian companies seeking financing for acquisitions and international expansions following EU monetary union in 1999 were frequently refused additional credit by their domestic relationship banks. Rather, several relationship banks offered to raise medium-term debt financing for these companies in the domestic retail bond market.

Italian corporate borrowers were able to access large amounts (up to EUR300m) of unsecured, uncovenanted, and unrated fixed rate notes with modest disclosure and at attractive rates. Following a series of defaults including Cirio SpA, Giacomelli Sport SpA and, most famously, Parmalat SpA, the domestic retail bond market effectively closed in 2004, leaving as many as 20 issuers facing maturing bond obligations without the internal resources or capital market access to refinance them.

Many of these have been forced into costly and disruptive corporate actions or have had to belatedly adopt practices which allow them to access international credit markets:

• Default and insolvency (Fin.Part, Finmatica, Finmek)
• Mergers resulting in loss of control (Aprilia, Impregilo, Lucchini)
• Emergency asset sales (Tiscali, Gruppo Frati)
• Debt exchanges and restructurings with international hedge funds (Italtractor, Fantuzzi, La Veggia)
• Refinancing in the USPP market (Merloni)
• Refinancing in the European high yield market (IT Holdings, Piaggio/Aprilia)
• Refinancing by relationship banks (bridge) in preparation for equity sale (Versace)

In a report titled “Parmalat’s Restructuring: Implications for the Italian Corporate Bond Market” , Fitch highlighted the underlying phenomenon of concentrated (insider) shareholders in Italy avoiding the traditional discipline of concentrated creditors and accessing incremental debt financing from diffuse (outsider) creditors in the domestic retail bond market. The lessons from Italy may not translate directly to Germany and the Mittelstand for numerous reasons, not the least of which is that Mittelstand financing has, to date, primarily remained within a more accommodating German banking system and much of the financing activity remains focused on refinancing House Bank loans and credit lines rather than funding risky expansions or acquisitions. Nonetheless, parallels between the two markets are evident:

• family-owned and operated companies seeking external capital;
• relationship banks hesitant to take direct risk exposure while seeking alternative solutions for valuable clients;
• concentrated-owner demands for inexpensive, un-intrusive, flexible debt capital; and
• unattractive straight equity and international market alternatives.

Is it Just a Matter of Time for the Mittelstand Then?

The real world consequences of NPL portfolio sales to private equity funds, distressed loan sales to aggressive hedge funds and the lessons from the Italian experience highlight the potential risks Mittelstand companies take if they ignore advice for true equity or to adopt international credit market standards while House Bank relationships clearly become more distant. Many German corporate bankers note the difficulty in persuading Mittelstand owners to accept straight equity or international capital market solutions, which may be in the companies’ long-term interests, yet pale compared to more accommodating solutions in domestic markets.

The solution for these bankers lies in the eventual consolidation of the German banking sector, much like that which has taken place in the UK, The Netherlands, France and Spain. In each of these countries, consolidation produced a concentrated group of large commercial banks that dominate lending to large companies. These banks have greater ability to discipline corporate borrowers in their respective markets than do most German banks. However, consolidation among German banks has largely remained focused within each tier of the system. The broader need for consolidation among private, public and cooperative banks will likely face resistance from regional governments determined to maintain their authority and control over constituent banking systems.

Nonetheless, many capital market advocates note that it may only be a matter of time before constraints in the domestic banking market and international trends force Mittelstand companies to embrace equity solutions and more transparent international standards. They note that many Mittelstand companies are preparing for new realities as new generations of Mittelstand staff are increasingly conversant in IFRS accounting and international corporate governance practices. In addition, many Mittelstand borrowers have developed sophisticated treasury management capabilities, and, in turn, more actively allocate banking business among multiple relationship banks. Many of these bankers further argue that products such as Schuldscheine are merely an interim step, together with educating customers on IRB rating systems, in a longer process to prepare the Mittelstand for the broader capital markets.

Furthermore, academic and policy analysts have noted a tendency among third and fourth generation family owners to avoid succession issues and sell their companies outright rather than accept dilution piecemeal via listings on equity exchanges.¹ Finally, some domestic observers also wryly note that family owners themselves would be prepared to utilize their own substantial net worth to improve equity balances and finance expansions if only they had more confidence in structural reforms and the outlook for the domestic economy.

Germany has a Tradition of Managed Transitions

In any event, Germany has a tradition of adapting to modernising influences while compensating impacted constituencies to maintain commitments to consensus and stability. For example, during the process of liberalisation in product markets that had a far-reaching impact on Deutschland AG, advocates of Germany’s system have noted how the dual board structure has allowed management and employee stakeholders to arrive at consensus agreements on wages, working hours, early retirement and benefits. These are frequently characterised as measured solutions as opposed to short-term responses to volatile market conditions.

As noted earlier, many analysts note the difference between the effects that liberalised markets may have on large stock corporations in competitive global industries compared to Mittelstand companies active in specialised high barrier-to-entry niche industries. Moreover, even though the German economy has yet to demonstrate a sustained recovery in 2005, much of the Mittelstand are thriving as part of Germany’s robust export sector. Consequently, the pressures these companies face to change business and financing practices contrast sharply with those struggling to adjust in industries such as retail or construction, which are subject to weak domestic demand conditions.

Not Who, How?

Notwithstanding a menu of mitigating circumstances, it is unlikely the Mittelstand sector can avoid the long-term pressures of market liberalisation and cost pressures their industries face in light of EU membership and a global trade system that includes competition from rapidly developing and industrializing economies such as China and India. Moreover, even for the most insulated Mittelstand, access to long-term, patient capital remains essential to their ability to manage potential risks and sustain advantages in their industries. The House Bank model, which served them for decades, may no longer offer the reliable, committed partnership to which Mittelstand have become accustomed.

As alternatives, Fitch has noted ample sources of unsecured and subordinated corporate credit in the USPP market as well as the European syndicated loan, mezzanine and high yield markets. Each has developed in part to provide long-term debt solutions to privately owned companies in niche industries. While some Mittelstand have embraced these international solutions, and the substantial changes in accounting and disclosure practices that accompany them, others continue to seek the less-costly and less-intrusive options in domestic market products. The question, then, should not be: Who will finance the Mittelstand? Rather: How will the Mittelstand be financed? On terms specific to family owners determined to maintain control, confidentiality, below market cost of funds and flexibility of terms developed in the domestic market? Or, according to “arm’s length” terms and conditions, which emphasise monitoring and transparency based on common international standards? For Mittelstand owners and their constituent stakeholders in communities throughout Germany, both options carry considerable risks. The House Banks are increasingly compelled to prepare for these risks. Are the Mittelstand?

¹ See “Running in the Family: The Evolution of Ownership, Control, and Performance in German Family-owned Firms 1903-2003” by Olaf Ehrhardt (Humboldt University), Eric Nowak (University of Lugano) and Felix-Michael Weber (University of Witten/Herdecke) preliminary paper published by the Center for Economic Policy Research (www.cepr.net) September 2004.