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January 26, 2005


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January 26, 2005

  1. 1. Economics Digital Economy January 26, 2005 e-conomics No. 49 Digital economy and structural change Private equity in Europe: buy-outs driving growth; start-up financing drying up • Europe's private equity (PE) market is showing solid growth. The segment has digested the ups and downs of the “new economy” bubble and is returning to its long-term growth path. We expect a volume of EUR 32 bn in 2005. • The uptrend in the European PE market is being driven primarily by major takeovers. At EUR 18 ½ bn, European PE firms’ buy-out investments were up nearly 9% in 2003 on the year-earlier reading. They represent the lion’s share (nearly 65%) of all investment in the segment. Their share should continue rising towards 70% in 2005 to a volume of EUR 22 bn. • The risk of overshooting in the buy-out market can no longer be disregarded. Prices are shooting up owing to the stiff competition between bidders. The debt portion of deals has also risen considerably. One argument against the claim of overheating, though, is that the financing needs in European buy-out business are high because of the strong consolidation pressures especially in mature industries. • The flipside of the buy-out dominance is that financing for early-stage investments is increasingly drying up. Practically no money is going into seed financing any more. From a growth standpoint, it is worrying that many innovative projects are lacking funds in the crucial phase before a company is set up. • The German private equity market as a whole is also growing solidly, with buy-outs essentially determining the rate of growth. The venture capital segment is making a tentative recovery. In the start-up financing segment, conversely, the lustre of the new economy proved to be shortlived. • Germany attracts a relatively large number of foreign PE firms that finance big takeovers, but has virtually no domestic players involved in the Editor Antje Stobbe major transactions. In 2004 Germany witnessed buy-outs worth EUR 22.5 bn. +49 69 910-31847 We expect a volume of EUR 30 bn in 2005. The high share of debt financing in particular explains the size of these figures. Technical Assistant • Generally, investments in private equity promise sizeable returns over Sabine Kaiser the long term. As a result of the equity market crash, though, the five-year +49 69 910-31831 rolling returns for PE collapsed from 25% in Europe in 2000 to about 7% in 2003. While they are likely to remain stuck at this low level in 2005, they Deutsche Bank Research should slowly start to recover in subsequent years. However, it is doubtful Frankfurt am Main whether returns will regain their past highs, as overheating in the buy-out Germany Internet: business could slow the cyclical upturn. Performance of the entire PE E-mail: segment will not improve substantially until the European stock exchanges Fax: +49 69 910-31877 create growth segments that are liquid enough to make greater numbers of Managing Director initial public offerings attractive. Norbert Walter Author: Jürgen Schaaf, +49 69 910-46830 (
  2. 2. January 26, 2005 2 Economics
  3. 3. January 26, 2005 Private equity in Europe: buy-outs driving Private Equity in Europe growth; start-up financing drying up Investment by European PE houses 40 Europe's private equity (PE) market is showing solid growth. The EUR bn 35 segment has digested the ups and downs of the “new economy” 30 bubble. The volume of inflows and capital invested are settling back 25 into their long-term growth path. However, the pace of growth is 20 slowing. A total of EUR 29 bn was invested in private equity in 2003, 15 a good 5% more than in 2002. We estimate that investment topped 10 5 EUR 30 bn in 2004 and that it will rise to EUR 32 bn in 2005. 0 Buy-outs dominating the PE market 96 97 98 99 00 01 02 03 04e 05f Sources: DB Research, 2005, EVCA, 2004 In the buy-out market there is a major difference between the volume of equity investments by PE firms and the number of transactions executed. The number and volumes of these deals have risen considerably in Europe. While the value of announced Buy-out transactions in Europe buy-outs in Europe was just EUR 64 bn in 2001, the figure rose to 160 EUR bn 140 EUR 107 bn in 2004. We expect a further increase to EUR 135 bn in 2005. The value of buy-out transactions is so much higher than the 120 volume of European PE investments because American PE firms 100 are also dominant in Europe without necessarily being organised in 80 the European Private Equity & Venture Capital Association (EVCA). 60 Moreover, the very high debt portion of the buy-out deals is not 40 logged in the EVCA statistics, only the capital invested by the PE 20 0 fund is recorded. 2001 2002 2003 2004e 2005f At EUR 18 ½ bn, European PE firms’ buy-out investments were up Sources: DB Research, Merger Market, 2005 nearly 9% in 2003 on the year-earlier reading (see chart). They represent the lion’s share (nearly 65%) of all investment in the segment. We estimate that this share continued rising towards 70% PE-Investment in Europe in 2004 and will continue to do so in 2005. One major factor Investment by European PE houses supporting this view is that over three-quarters of the funds raised in 40 2004 were earmarked for buy-outs. Buy-outs EUR bn 35 The importance of management buy-outs has thus grown 30 considerably. Over the past four years there has been an impressive Replacement rally. Back in 2000 only 40% or so of total European PE investment Capital 25 flowed into buy-outs. This percentage has since risen by over half 20 and is now a good 10 percentage points higher than the average of 15 the past four years (see chart). 10 Start-up Risk of speculative overshooting in the buy-out Seed Expansion 5 segment 0 Critics have started to point to the risk of speculative overshooting. 1999 2000 2001 2002 2003 Source: EVCA, 2004 Prices are skyrocketing owing to the stiff competition between bidders. In leveraged buy-outs, the PE houses sometimes have to borrow heavily to refinance their stakes. Banks can earn Stage distribution of PE considerably higher margins on loans to private equity firms than investment with traditional corporate lending. In addition to the upfront fee of 100 around 2% of the loan amount a risk premium (risk margin) of some % 90 Buy-outs 200 to 300 basis points is charged. 80 From the investor’s point of view, a large proportion of debt capital Replacement 70 jacks up profit – to the degree that the increase in the value of the Capital 60 stake outstrips the rate of debt interest. During low-interest-rate 50 periods leveraged buy-outs thus become more appealing. But this is 40 only true as long as a high price can be achieved when the stake is 30 Expansion sold. The relatively new phenomenon of secondary buy-outs, that is 20 the selling-on of a stake to another financial investor, shows that 10 selling stakes to strategic investors has in some cases become Start-up/Seed difficult. The exceptionally high degree of leverage in the buy-outs 0 suggests that caution is called for. Since 2002 the average equity 1999 2000 2001 2002 2003 Source: EVCA, 2004 Economics 3
  4. 4. January 26, 2005 share of buy-outs has fallen steadily from nearly 39% to almost Share of equity capital in buy- 36%. There have even been equity ratios of under 20%. Similar figures have been recorded in the past, however. outs 45 % One argument against the theory of speculative overheating, 40 though, is that financing needs are indeed high in the European buy- 35 out business. The competition in the global markets raises the 30 consolidation pressures especially in the mature sectors of the 25 industrial economies. Large companies that are not listed on the 20 stock market will be compelled to raise large sums of venture capital to shoulder the restructuring process. Accordingly, the big buy-outs 15 in the UK, Germany and France dominate the segment in value 10 terms. The old economy sectors such as chemicals, real estate, 5 automobiles and consumer-related areas rule the roost. The prices 0 currently being paid for stakes are high, at 6-7 times earnings before 97 98 99 00 01 02 03 04e 05f interest, taxes, depreciation and amortisation“ (Ebitda). In the late Sources: Standard & Poor's, DB Research, 2005 1990s, however, Ebitda multiples were even higher at more than 8. Strong decline in early-stage financing continues The flipside of the buy-out dominance is a venture capital market that, in relative terms, is increasingly drying up. The financing particularly of early-stage activity (product development, start-up and product launch) has declined drastically since the speculative bubble in the high-growth markets burst. Practically no money is going into seed financing any more. But from an economic point of view, the start-up and seed phases are the most important. In the high-tech field, especially, it is new companies that launch the latest products and processes in the market. They are the conveyors of structural change. It is in the early stage, in particular, that company founders need venture capital from an external source. The reasons are that they normally have little equity at their disposal and are often denied sufficient bank credit to tide them over because they lack collateral, are at high risk of default and could abuse pronounced information asymmetries. Financing difficulties in the start-up phase thus represent a serious obstacle. PE earns higher returns than traditional types of investment From the investor’s point of view private equity partly serves a portfolio diversification function. If PE is added to a balanced Private Equity improves Risk- portfolio of stocks and fixed income securities, a higher return can Return Trade-off be obtained for the same level of risk. Alternatively, the risk can be reduced while the desired rate of return remains constant. Optimal Mix of 3 Assets 100% Equity Another function of PE for investors is to secure sizeable returns Return (%) over the long term. Their returns have to be higher than those of traditional types of investment in order to compensate the investor 100% Equity for the higher risk, the lower market transparency and the lower liquidity. Empirical analyses tend to confirm the expected yield 100% Bonds premium. For example, a series of international studies determined that, over the long term, private equity generates higher returns than Risk (%) ordinary shares. To illustrate: publicly quoted PE companies Source: EVCA (2004) included in the Listed Private Equity Index (LPX) achieved a return of close to 10 ½% p.a. worldwide between the end of 1993 and the 4 Economics
  5. 5. January 26, 2005 1 start of 2004. They have also outperformed the DAX and Dow LPX 50 outperforms DAX and Jones since 1998 in a direct comparison (see chart). Dow Jones The size of the rate of return hinges strongly, however, on the 350 Index definitions of region and segment, and the expertise and experience LPX 50 1998 = 100 300 of the private equity companies. Generally, the overall PE sector 250 achieves poorer returns on aggregate after a boom. This is largely due to the relatively large number of newcomers in the market, 200 whose performance lags well behind that of the established PE 2 150 companies. The latter are also less susceptible to cyclical factors. The earnings of those in the top quartiles are traditionally much 100 Dow Jones higher than the average for the sector as a whole. That is why fund DAX 50 raising is also easier for the established PE firms with a track record. 0 The worst is over: European returns set to take off … 98 99 00 01 02 03 04 Sources: LPX, DB Research, 2004 In Europe, five-year rolling returns on PE stakes have been declining for over three years. They are measured using the internal rate of return (IRR). The IRR indicates the annualised return on Rolling 5-year returns in Europe capital invested and factors in any pay-outs to investors. The five- 35 3 % year IRR slumped from 25% in 2000 to about 7% in 2003. Returns Buy-outs 30 in the venture capital segment, at just over 2%, are much poorer 25 than in the buy-out segment at nearly 10%. The difficult 20 macroeconomic environment and the lack of exit options have Total private weighed on performance. While the 5-year returns are likely to 15 equity persist at this low level in 2005, they should slowly start to recover in 10 subsequent years (see chart). 5 Venture Capital 0 … historic highs will not be attained, however -5 A repeat of the high returns of the past is doubtful despite the 85 90 95 00 imminent recovery. Structural factors in the buy-out segment Sources: EVCA, Thompson Financial, 2004 suggest that returns will not so rapidly regain their historic highs. The expertise of the PE firms, which makes a major contribution to the increase in value of their portfolio companies, has now become a standard business resource. Moreover, the number of players has increased, with the big US firms in particular forcing their way into the European market. As competition becomes fiercer the price of equity stakes is rising and squeezing returns. No pan-European market despite EU initiatives Our analysis so far has been based on the European private equity market as a whole. At present, though, a homogeneous pan- European market is not in sight. The PE markets are still highly fragmented, even though a risk capital market for all of Europe has been a strategic objective of the European Union. The EU’s Risk Capital Action Plan is meant to eliminate the differences between the member states as well as the barriers to domestic and cross- border stakeholdings. The member states have partly harmonised their legislation, but there are still major differences between their tax systems and legal arrangements, such as in insolvency law. The frictions that remain reduce liquidity and market capitalisation. This weighs on the efficiency of European private equity financing. This is 1 Deibert, Volker (2004): Erste Untersuchung einer kaum bekannten Anlageklasse – Börsengehandelte Private Equity-Gesellschaften, in: VentureCapital Magazin 10/2004, pp. 24 ff. 2 Kaplan, Steve and Antoinette Schoar (2003): Private Equity Performance: Returns, Persistence and Capial Flows, in: MIT Sloan School of Management Working Paper 4446-03; November. 3 EVCA Research Department (2004): Pan-European Survey of Performance – from Inception to 31 December 2003, Research Note, October, pp. 7 f. Economics 5
  6. 6. January 26, 2005 one of the most significant structural disadvantages compared with the US. Private equity investment as % of GDP in 2003 UK has biggest and most dynamic market by far GB 0.85 The standing of the private equity market differs considerably from SE 0.38 country to country in Europe. This holds for both structural and cyclical aspects. Claiming nearly half of the funds invested and FI 0.31 much more than half of funds raised, the United Kingdom is by far EU average 0.29 the biggest and most dynamic PE market in Europe. Britain’s market FR 0.27 share of European private equity investment increased by nearly 9 percentage points in 2003, to 46 ½%. This growth was driven by a NL 0.24 more than 30% rise in PE investment to EUR 13 ½ bn. IT 0.23 Traditionally, equity financing has always been of greater DK 0.22 significance in the Anglo-American environment than in continental IE 0.19 Europe. This applies to both listed and unlisted stakes. PE investment in the UK amounts to almost 0.9% of GDP. None of the ES 0.18 other European states posts a reading of even 0.4% – in other NO 0.14 words, less than half this amount (see chart). DE 0.12 Trailing far behind the UK come the booming Scandinavian BE 0.11 countries Sweden and Finland with the next largest national PE markets relative to GDP. Germany ranks eleventh with a market of a PT 0.09 mere 0.1% of GDP, making it the poorest performer in the group of CH 0.08 big European nations. In the small countries of southern Europe, PL 0.07 such as Portugal and Greece, PE activity is still negligible. AT 0.05 IPO as exit channel fosters PE market HU 0.05 Structural reasons that underpin the UK’s leadership are a more CZ 0.02 established capital market than in continental Europe, a functioning GR 0.02 market segment for initial public offerings (IPOs), and strong economic growth. SK 0.01 % The UK leads in the number of IPOs by a wide margin. A total of 192 0 0.2 0.4 0.6 0.8 1 British firms had gone public by Q3 of 2004, or nearly twice as many Source: EVCA, 2004 as in all of 2003. Surging with strong momentum, the number of IPOs on the London Stock Exchange has risen by a geometric mean of over 40% versus the respective previous quarter in the past two IPOs on European stock years. exchanges A long way behind the LSE comes Euronext, which unites the 100 90 financial centres of France, Benelux and Portugal. In 2003, 29 IPOs 80 companies went public there, and by Q3 2004 the figure was 70 already 32. In Germany there were a mere five IPOs in 2004 and in 60 2003 just a single one (see chart). 50 The reason that functioning stock exchange access is so important 40 for the PE market is that the IPO is the most lucrative form of exit 30 channel. Without a few extremely profitable holdings it is impossible 20 to achieve the average returns investors demand. Investors expect 10 a premium for the higher risk of this asset class. Write-off rates of 0 40% or more are not uncommon in the portfolios of the PE Q1 Q2 Q3 Q4 Q1 Q2 Q3 companies (see box p. 7). 2003 2004 London Stock Exchange What is more important than the technical possibility of going public, Euronext though, is a salubrious climate for the PE market. Only a critical Deutsche Börse mass of successful IPOs will create the right stimuli. In institutional Stockholm Stock Exchange terms this means that countries without a functioning market Source: DB Research, 2004 segment for IPOs will not be able to raise the significance of their PE markets substantially in the long run. 6 Economics
  7. 7. January 26, 2005 GDP growth and PE market go hand in hand But not only the stock market environment has an impact on the climate in the PE market. A strong private equity market goes hand PE investors favour IPO as exit in hand with robust GDP growth. However, the direction of cause channel and effect is not clear. • PE companies can build up their reputation if the IPOs they stage are repeatedly On the one hand, studies confirm that the accumulation of venture successful. This way, they signal compe- 4 capital makes a direct contribution to productivity growth. Moreover, tence to uninformed investors and can use companies funded by venture capital post higher earnings and their reputation to negotiate better 5 obtain higher stock market valuations. A stable private equity conditions when seeking to raise further market thus contributes to macroeconomic growth. capital. • The cost of capital for acquisitions falls It is also the case, though, that entrepreneurial activity is more likely when the companies are listed. They can to be successful, and investors are more inclined to back alternative then use their shares as acquisition investment forms, if the overall economic environment is flourishing. currency. In Europe, the countries with a relatively high level of PE activity – • For a company's valuation, the book- except for Ireland and Greece as outliers and the UK as building procedure before an IPO and the outperformer – were the ones that posted more robust growth on market price of already listed companies average between 1997 and 2003 (see chart). may function as benchmark. This is helpful not only for company flotations, but also for However, the outliers in particular give indications that the trade sales and buybacks of passive institutional framework and the structure of the private equity market holdings. This transparency generally play a key role. In the UK, IPOs boost the volume of PE investments raises pricing efficiency in the PE market. sharply. By comparison, Ireland’s private equity market is still • Employees can only exercise stock options relatively small. However, it is catching up fast: Irish PE investment if companies are listed on the stock jumped 143% yoy in 2003, to EUR 255 m. 96% of investments are market. Options can help motivate channelled into high-tech firms (83% in the IT sector). This also fits employees. in with the high growth scenario. Greece, by contrast, has not seen any IPOs for a long time, and nearly all (90%) of the funds raised there come from the public purse. Law and taxes: strengths in the UK, weaknesses in GDP growth & size of PE market Germany 0.9 The legal framework and the tax systems in the European states GB % 0.8 PE investments as % of GDP influence the national PE markets in two ways: on the supply side, 0.7 the private equity companies are directly affected by taxes and 0.6 regulations, and on the demand side, entrepreneurs and company 0.5 founders are either supported or hampered by the frameworks. SE 0.4 • From the investor’s point of view, the tax systems should be FI 0.3 simple, transparent and non-discriminatory. This means that the ES IR 0.2 tax office should not treat investments in PE funds any differently 0.1 GR than those in direct company stakes and prevent double taxation. 0 Institutional investors with a long-term investment horizon, such 0 2 4 6 8 as pension funds, should be able to choose PE as an asset class GDP growth, real (1997-03) p.a. and decide for themselves how much PE exposure to include in Source: DB Research, 2004 their investment strategy. • Company founders and entrepreneurs attach importance to a low level of regulation and red tape, as this means that they can concentrate on their actual business. Low income tax rates promote performance. Low corporate taxes, especially for companies set up as partnerships, also encourage entre- preneurial activity. The European Private Equity & Venture Capital Association has an indicator that bundles together a plethora of tax and regulatory aspects. This indicator roughly reflects the quality of the tax and 4 Romain, A. and B. van Pottelsberghe (2004): The Economic Impact of Venture Capital, Deutsche Bundesbank, Discussion Papers, Series 1, No. 18/2003. 5 Bottazzio, L. and M. Da Rin (2000), Euro.NM and the Financing of European Innovative Firms, IGIER Working papers 71. Economics 7
  8. 8. January 26, 2005 legal frameworks in the different countries of Europe. It shows that the UK, Luxembourg and Ireland had the most favourable Tax and legal environments for environments for the PE industry in 2004. Finland, Germany, Austria private equity and Denmark were the worst environments according to this 6 ranking. Finland nevertheless has a relatively big PE market, while GB 1.26 1 = very favourable Germany and Denmark occupy mid-table positions in the ranking of 3 = unfavourable LU 1.49 European PE markets according to relative size (see chart). This suggests that the legal and tax systems are very important, but do IE 1.53 not have a dominant influence on the development of the PE GR 1.75 market. NL 1.76 Germany in focus: typically European – with national PT 1.81 characteristics IT 1.86 The German private equity market is in many respects typical of the FR 1.89 continental European market as a whole. However, it does have its own pecularities. A typical feature is that the PE market as a whole CH 1.95 is expanding robustly, with buy-outs essentially determining the rate ES 1.96 of growth. The venture capital segment, by contrast, is recovering NO 2.04 only tentatively. In the start-up financing segment, conversely, the lustre of the new economy proved to be shortlived. EU 2.04 In 2004 German PE companies invested more than EUR 3.1 bn (our SE 2.05 estimate). This is almost 30% more than in 2003 (EUR 2.4 bn). FI 2.3 However, the volume is still well short of the historic highs of 2000 and 2001 (nearly EUR 4 ½ bn in each year). A good EUR 1 bn was DE 2.37 invested in the venture capital segment in 2004. This is over 50% AT 2.42 more than in the preceding year (EUR 666 m). The VC market is thus growing again, after three years of severe contraction (see DK 2.46 chart). However, only a meagre EUR 300 m was invested in early- 0 1 2 3 stage seed and start-up financing. Source: EVCA, 2004 Germany attracts a relatively large number of foreign PE firms that finance major takeovers, but has virtually no domestic players involved in the major transactions. In 2004 Germany witnessed buy- Venture capital and private outs worth EUR 22.5 bn. We expect a volume of EUR 30 bn in 2005. equity in Germany The high share of debt financing in particular explains the size of (annual investment) 5,000 these figures. EUR m 4,500 Germany is attractive for the following reasons: 4,000 Private equity • While the private equity market in the US is mature and 3,500 competitive, there are still some treasures for the US private 3,000 equity firms to unearth in continental Europe. German companies Venture 2,500 with their high-quality products and skilled staff can still generate capital 2,000 considerable improvements thanks to the know-how of PE 1,500 managers. 1,000 • Germany Inc. is being unwound. The big companies are dis- 500 posing of their non-core activities. Until a strategic investor 0 appears or as long as restructuring is needed, PE firms can keep 96 97 98 99 00 01 02 03 04e the relevant businesses running and bring them up to scratch. Sources: BVK, 2004, DB Research estimate • German SMEs appear particularly attractive. Their notorious undercapitalisation can be significantly alleviated by the injection of equity capital. Greater capital resources in turn will enable SMEs to borrow at more favourable terms. The future capital adequacy rules for the banking industry (Basle II) lay down firm provisions for this relationship between capital ratio and credit rating. 6 European Private Equity & Venture Capital Association (2004): Benchmarking Paper – Benchmarking European Tax and Legal Environments, May. 8 Economics
  9. 9. January 26, 2005 • Finally, PE companies can function as buyers of family firms without a successor when the firm is soon to be passed on from one generation to the next. All the same, family firms in particular still hesitate to allow financial investors to look at their books and cede control of their life’s work. Anglo-American PE companies are the main executors of the big transactions. Above all this is because the US private equity firms not only have the financial clout (pension funds, foundations) but also the track record required for both the fundraising and the winning of mandates. Newcomers, by contrast – and not only domestic ones – find it difficult to force their way into the market. The few German institutions whose financial muscle and reputation would give them a real chance of penetrating the market are currently busy getting their own houses in order or do not want to take PE on as another core activity for strategic reasons. Weak stock market, lack of entrepreneurial spirit Germany’s main structural weaknesses as a market for PE are its lack of a functioning IPO segment in the stock market and the poorly developed entrepreneurial nature. The stock market exit channel remains blocked. Retail investors’ scars from their Neuer Markt wounds have still not healed. Institutional investors are not displaying sufficient interest in new IPOs either. Capital market reforms are therefore urgently required – even though they are likely to be inadequate. With the end of the Neuer Markt and SMAX segments as IPO platforms it has become more difficult for high-tech start-ups and traditional SMEs to present themselves to the appropriate investors. Stock market segments for high-growth companies and SMEs are thus needed in Germany to provide hope for the future. New concepts must guarantee sufficient liquidity of stocks and ensure a 7 broad range of independent research about listed companies. This alone is difficult and costly. A less tangible problem, for which there is no miracle cure, is the risk aversion of the typical German. It puts a brake on the dynamic entrepreneurship that brings technical innovations onto the market and determines the demand for venture capital. Other studies see the problem as lying in the lack of high- quality, first-class entrepreneurs and the relatively limited appeal of 8 being self-employed. Apparently being one’s own boss is insufficiently lucrative – given the high risk of failure – for top-notch talent to try it out. The main factors impacting entrepreneurship in Germany that were criticised in the EVCA Ranking for 2003 were the high corporate taxation (28-40%) and personal income tax (top rate 47 ½% including the solidarity surcharge, as of 2003) as well as the time- consuming procedure for setting up a company (30 - 40 working days, compared with the European average of 23 ½). The further stages of the tax reform and the Venture Capital Promotion Act that was passed in 2004 will improve Germany’s position in the 2005 benchmark ranking, though. But as long as the number of IPOs does not rise appreciably, the German PE market will not gain 7 Achleitner, Ann-Kristin and Christian H. Fingerle (2003): Venture Capital und Private Equity als Lösungsansatz für Eigenkapitaldefizite in der Wirtschaft - Einführende Überlegungen, EF Working Paper Series No. 03-03. 8 Becker, Ralf and Thomas Hellmann (2004): The Genesis of Venture Capital: Lessons from the German Experience, for publication in C. Keuschnigg und V. Kanniainen (Edt): Venture Capital, Entrepreneurship, and Public Policy, MIT Press. Economics 9
  10. 10. January 26, 2005 significance in structural terms. As already discussed, this would require a functioning market segment for high-growth start-ups. State subsidies: a lot of old wine in new bottles Germany has a long tradition of providing state funding for people to Realignment of government- start up their own businesses. In 2004 a number of programmes backed PE financing were restructured. The most important change was that the ERP The equity financing programmes previouly run Start-up Fund replaced the Investment Programme for Tech Start- separately in Germany by KfW Mittelstands- ups (BTU). The new fund is very similar in substance to the old BTU bank and tbg were merged in 2004. Now, new Programme. Total funding of EUR 250 m will be available for the business in the market is handled exclusively five-year investment phase. The KfW (Kreditanstalt für by KfW Mittelstandsbank. To this end, parts of tbg were integrated into KfW Mittelstandsbank. Wiederaufbau) manages the fund. A private individual has to make a The ERP start-up fund forms the core of the parallel investment according to the same conditions as the KfW. A programme in the early-stage segment. special “early-stage“ module offers stakes in newly established Together with a private investor, the start-up companies. fund makes equity available to young technology companies. A special early-stage The high volume of the fund underlines the great importance that module offers stakes in newly established the federal government attaches to the venture capital market and in companies, while the later-stage segment of the ERP programme offers equity to traditional particular the early phases. The inclusion of private investors helps SMEs. Via its initiative to provide equity to the to ensure the quality of the investment and keep out speculators. broad SME segment, KfW Mittelstandsbank When the public purse is under pressure it is certainly to be attempts to broaden the existing programme applauded that funds are invested and repaid according to market for stakes between EUR 1 m and EUR 5 m. Furthermore, it offers other refinancing and criteria. guarantee programmes. All the same, miracles cannot be expected. The programmes Source: KfW, 2004 primarily make capital available and reduce the financial risks for private investors in the case of failure. Undoubtedly there are some projects that fail because of a lack of capital. However, this is not where the structural problem of the German early-stage segment lies. In the late 1990s the IPO gates of the Neuer Markt were wide open and promising business ideas were tested. At the time a great deal of money was injected into the market – too much in hindsight. A development concept that grants subsidies parallel to investment by private investors does not take into account that pro-cyclically the market gets inflated during an upturn and then contracts sharply during the downturn. Rent-seeking is likely, as in the second half of the 1990s when a steady 20% or so of early-stage investments were refinanced via state programmes – regardless of the overall 9 demand. The relatively small amount of EUR 36 ½ m of state subsidies was disbursed in 1995, whereas the boom was helped along to the tune of EUR 600 m. Overall, the programme is sensibly structured. Its weakness is its procyclical orientation. However, since it does not address the actual problems of the German VC market (paralysed stock market, German risk aversion), it could have been allocated fewer financial resources. Outlook: division of fragmented markets persists The European private equity market is very heterogeneous. The national differences will not disappear in the near term either, for there are currently no signs that a pan-European private equity market is evolving. The UK's dominance within this fragmented market remains unbroken. The division of the European PE market in takeover and expansion financing versus seed financing will also continue, though. While buy-out activity is set to continue to grow rapidly until it overheats, the early-stage segment is merely marking time. From a growth 9 See Franzke, Stefanie, Stefanie Grohs and Christian Laux (2003): Initial Public Offerings and Venture Capital in Germany, CFS Working Paper No. 2003/26, p. 12. 10 Economics
  11. 11. January 26, 2005 standpoint, it is worrying that innovative projects are lacking funds in the phase before a company is actually set up. From an investor’s standpoint, the worst is over. While returns are likely to persist at this low level in 2005, they should slowly start to recover in subsequent years. They are, however, unlikely to climb to new historic highs. In the buy-out segment in particular the risk of overheating remains, which means the situation must be monitored. Performance will not improve substantially until the other European states besides the UK create high-tech and growth segments that are liquid enough to make greater numbers of IPOs attractive again. Author: Jürgen Schaaf, +49 69 910-46830 ( Economics 11
  12. 12. conomics ISSN 1619-3245 Private equity in Europe: buy-outs driving growth; January 26, 2005 start-up financing drying out Alternative trading systems: a catalyst of change in securities trading January 11, 2005 Rising stars in information and communication technology November 12, 2004 Offshoring: Globalisation wave reaches services sector September 27, 2004 E-payments: modern complement to traditional payment systems May 5, 2004 IT outsourcing: between starvation diet and nouvelle cuisine April 22, 2004 Mobile telephony - cooperation and value-added are key to further success January 15, 2004 Copyright reloaded: The attempt to protect technology from itself November 12, 2003 Asian Tigers after the IT boom September 30, 2003 Dotcom crash: the worst is over in Germany September 4, 2003 B2C e-commerce: internet is no “great equaliser“ July 2, 2003 More than “pretend competition“ in German telecommunications April 25, 2003 The mechanical engineering and automotive industries March 18, 2003 - online marketplaces on the advance? Germany’s broadband networks - innovation on hold February 17, 2003 All our publications can be accessed, free of charge, on our website You can also register there to receive our publications regularly by e-mail. For the print version please get in touch with: Deutsche Bank Research Marketing 60262 Frankfurt am Main Fax: +49 69 910-31877 E-mail: © 2005. Publisher: Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Federal Republic of Germany, editor and publisher, all rights reserved. When quoting please cite “Deutsche Bank Research“. The information contained in this publication is derived from carefully selected public sources we believe are reasonable. We do not guarantee its accuracy or completeness, and nothing in this report shall be construed to be a representation of such a guarantee. Any opinions expressed reflect the current judgement of the author, and do not necessarily reflect the opinion of Deutsche Bank AG or any of its subsidiaries and affiliates. The opinions presented are subject to change without notice. Neither Deutsche Bank AG nor its subsidiaries/affiliates accept any responsibility for liabilities arising from use of this document or its contents. Deutsche Banc Alex Brown Inc. has accepted responsibility for the distribution of this report in the United States under applicable requirements. Deutsche Bank AG London being regulated by the Securities and Futures Authority for the content of its investment banking business in the United Kingdom, and being a member of the London Stock Exchange, has, as designated, accepted responsibility for the distribution of this report in the United Kingdom under applicable requirements. Deutsche Bank AG, Sydney branch, has accepted responsibility for the distribution of this report in Australia under applicable requirements. Printed by: HST Offsetdruck Schadt & Tetzlaff GbR, Dieburg. Print: ISSN 1619-3245 / Internet: ISSN 1619-3253 / E-mail: ISSN 1619-4756