Quest for return dulls appetite
Germany’s stature as one of the powerhouse nations of northern Europe is not reflected in the private equity market. In terms of pension fund investment in the sector, the country lags well behind its neighbours.
Private equity investment in 2003 – the last year for which figures are available from the European Venture Capital Association – was 0.116% of German GDP. This ranked the country 11th in Europe, behind the likes of Spain and Ireland.
Within Germany itself, the influence of the pension funds on the sector is tiny. Of the private equity funds raised from German investors in 2003, a mere €5m – only 0.5% – came directly from pension funds, while the insurance companies provided 21.7% and the banks 40.7%.
Furthermore, this represented a huge fall from the previous year, when pension funds had directly contributed €34.5m, or 2.1%, of the total raised.
“Private equity is a minor investment for most German investors, especially since it is not liquid,” says Christian Schlenger, managing director of consultancy Alpha Portfolio Advisors. “We would suggest to clients that they invest in small or mid-cap companies quoted in liquid markets instead.”
Patrik Roeder, head of Germany and Austria for asset manager Henderson Global Investors, says: “German investors who have not dipped their toe in the water until now are hesitating to enter this market because most pension funds, as elsewhere, lost their surpluses due to the market correction in 2000 – 2002. That means there is little appetite to invest in assets which do not deliver a running yield. They are not prepared to wait three or four years for the first payout.”
Even those pension funds which already invest in private equity are wary, he says.
“They generally started in the 1990s and work with up to three equity partners. But they are hesitating to make new commitments at the moment, because they want to see the results first. The trend is towards buyouts and they tend to invest with the small or medium-sized buyout managers, rather than bigger ones, because they give better potential for growth.”
One crucial factor inhibiting the use of private equity is the legal requirement for pension funds to deliver a minimum rate of return each year. Each fund has its own minimum, but for most funds this is around 3% or more.
“With interest rates around 4%, pension funds have no room to invest substantial amounts into other asset classes besides traditional fixed income,” says Roeder. “This is the reason for the lower equity component – averaging 20% of a portfolio – in German pension fund portfolios.”
“The minimum return is one of the biggest restrictions on private equity investments, because for the first few years you get nothing back,” says Patrik Bremerich, managing director, pension consultants RMC Risk Management Consulting.
“Furthermore, yields in Germany have worsened over the past few years. Typically, pension funds must return between 3.5% and 4% a year. The 30-year bund is currently yielding 3.8%, while a 10-year bund is at 3.4%. As long as yields are this depressed on low-risk assets, it will be difficult to get much interest in riskier sectors. However, we think a realistic level for private equity returns is the average public equity return, plus 500 basis points.”
Those RMC clients who do invest in private equity normally use it for up to 5% of their portfolio. They tend to go in via fund of funds, although RMC recommend they still engage a strategic adviser. Most of the investment is outside Germany.
Later-stage companies dominate, with venture being given a fairly limited benchmark weight of up to 20% of the private equity allocation.
Mid-cap companies are a big feature of the German private equity market. Later this year, Norddeutsche Private Equity plans to launch the Crescat Equity II fund to invest in medium-sized German companies with turnovers of €15-100m.
Last August, the EQT IV Fund closed after raising €2.5bn to invest in Nordic and German-speaking countries. It is a buyout fund investing in mature well-managed businesses with organic or add-on growth opportunities.
“Mid-cap is the flavour of the month,”says Andreas Tallberg, senior partner, EQT, the investment adviser to EQT funds. “But equity partners have to work extremely hard to build up trust with what are very often family companies.”
Tallberg says the bulk of his pension fund clients deal direct, rather than using the fund of funds route.
“My perception is that the large pension funds are more likely to remain with relationships they’ve forged with a number of funds, rather than look at new opportunities,” he says. “This is because of the risk control issue. There have been a number of new fund launches in the past 10 years. Some have been successful and some have not. There is a feeling the market might be saturated.”
He also says that venture may be making a comeback: “Professional investors see good money to be made in venture funds, so they are coming back to that asset class. Overall, however, there is a good solid private equity market in Germany, and we feel optimistic.”
There is, however, another legal requirement which might act as a partial brake on expansion – the investment law which came in last year which made it easier for pension funds and insurance funds to invest in hedge funds. Previously, they could only invest in this asset using structured products.
The new law does not directly affect private equity. “But since hedge funds, along with property, also belong to the alternative asset class, the three are in competition,” says Roeder. “And there is more demand for property at present, because it offers a stable running yield. So the demand for private equity and hedge funds is less by comparison.”