A mini revolution took place in Germany this summer. Private equity firm JC Flowers and four other investors bought a large stake in public sector bank HSH Nordbank. Christopher Flowers and his consortium spent €1.25bn on the holding, which gave them 24.1% of the bank’s share capital and 26.6% of the voting rights. The sale would barely have raised an eyebrow in many parts of the world, but in Germany it was momentous.
“This was the first real private equity deal in the German public sector banking market,” says Wolfgang Richter, partner at law firm DLA Piper.
To appreciate the significance of the transaction, the tremendous self-protection that has traditionally characterised much of the market must be understood.
Public sector dominance
In Germany’s three-pillar banking system, divided between commercial banks, co-operative banks and regional public sector banks, the public sector pillar dominates the market, with a share of about 60%. It consists of Landesbanken and Sparkassen, all of which operate on a highly regional basis. These banks benefit from a strong brand value in Germany and virtual domination of some regions.
“They have quite an incestuous relationship in many instances. Often Sparkassen are owned by Landesbanken or have strong associations with them so they cross-sell products and share customers,” says one German banking analyst.
Historically, too, they were massively advantaged because their borrowings were state-guaranteed, allowing them a significantly lower cost of capital than rival operators. In July 2005, however, the EU said the situation was anti-competitive and could no longer be allowed to continue. Henceforth, public sector banks must borrow capital on terms relating to their own creditworthiness, without the state standing behind them.
“Many banks tried to get in as much cheap funding as possible ahead of the ruling but that capital will not last forever,” says Britta Schmidt, a strategist at financial institution-focused investment bank Fox-Pitt Kelton.
In the meantime, neither the Landesbanken nor the Sparkassen are noted for their efficiency. “They have been able to lend aggressively but they tend to have a high cost base and low profits,” says Ms Schmidt.
Mr Richter agrees. “[Their] average return on equity is between 4% and 8%. That compares with UK banks, where returns tend to hover between 15% and 20%,” he says.
The loss of the guarantee has therefore prompted a belief that change is in the air. “The system is creaking,” says Hermann Prelle, co-head of investment banking at UBS Germany.
Ready for sale
This view has been given greater impetus by the forthcoming sale of one of Germany’s largest Landesbanken, Landesbank Berlin, which also owns the Berliner Sparkasse. Landesbank Berlin was on the verge of collapse four years ago, after some disastrous real estate investments in east Germany. The bank had to be rescued by the state but the EU only allowed the rescue operation to take place on condition that the group was sold within five years – that is, by next year.
Early negotiations have already begun but these are focusing not just on potential buyers but also on the ramifications of the deal. “It is extremely sensitive and has provoked a lot of comment from politicians and members of the Landesbank and Sparkasse communities,” says one banking source.
The concern relates not just to Landesbank Berlin but also to the wider public sector market because many in the industry believe that once Landesbank Berlin is sold, other deals will follow. “This is the first real step in the break-up of the three-pillar system. It will trigger off lots of other situations. The whole sector has been opened up,” says Mr Prelle.
System break-up
Employees, senior directors and others do not regard this as a particularly pleasant prospect. Their sensitivities are financial, political and personal. On the personal front, many of Germany’s great and good sit on the supervisory boards of Landesbanken and are keen to protect their positions.
On the political front, the public sector banks pay taxes to their local regions and there is a concern that this may end if they were taken over by non-regional players.
And on the financial front, the Sparkassen have written into their articles of association that they are not-for-profit organisations. Some of them do make money but it is channelled into areas such as local infrastructure. If they were taken over by outsiders, this arrangement may cease. Also, a number of people in the public sector community have a nostalgic fondness for the status quo and a belief that it serves customers’ interests.
“Advocates of the Sparkassen system say customers will be confused if the not-for-profit position changes. But I think customers just want to know that their deposits are safe and the products produce a good return,” says one investment banker.
The debate is likely to continue and intensify as the date for the sale of Landesbank Berlin draws closer. And private equity firms are expected to be watching developments closely.
Private equity medicine
Traditionally, private equity is not associated with banking deals: banks require a lot of capital and there are numerous regulatory issues, which may make it difficult to buy them effectively and to sell them cleanly. Against this, however, is the recognition that many German banks, particularly in the public sector, are woefully inefficient.
Also, some believe that foreign private equity firms may be able to achieve what German financial firms have so far seemed incapable of: overcoming the financial and political sensitivities that have been a barrier to necessary consolidation.
“Private equity players do not turn their backs on any opportunity if they can see a way of creating value. Banks are simply another type of business and if they can find good targets, they will,” says Christian Cascante, partner at law firm Gleiss Lutz.
There is a belief, too, that private equity’s approach to governance, process and remuneration could provide a massive boost to banks’ performance.
“Private equity can offer enhanced governance and performance/reward systems. Private equity’s discipline and management incentivisation methods could have significant consequences on capital allocation and German financial services overall. Our experience base as owners and investors across many companies from the financial services sector and beyond provides some unique organisational skills and the ability to act with speed,” says Patrick Healy, a managing director at private equity firm Hellman and Friedman.
Advisers concur with this view. “Private equity firms are skilled at attracting and retaining talent and they could make banks operate a lot more competitively. They would be clever in their sourcing of finance and in product creation and distribution,” says Mr Richter.
A tough job
Those who believe that private equity can and will contribute to the greater efficiency of the German banking sector point to the Flowers’ acquisition of the HSH Nordbank stake. “That was a ‘strategic’ investment. Flowers is using that stake to try to influence decisions. He will then either sell it or make his money when the whole bank is sold or floated,” says one investment banker.
For strategic, read less than optimal; and that is the key issue for private equity. Not only are many German banks rigid, bureaucratic and old-fashioned: they are also relatively unprofitable. And such are the strictures of the system that the returns available are almost certainly lower than in other areas of the market.
“Other sectors in Germany can provide much higher returns than the financial sector,” says Mr Prelle.
In addition, banking requires specialist knowledge and only a handful of private equity firms, such as JC Flowers and Hellmann & Friedman, have that knowledge. Even the larger players in private equity, such as Blackstone and Texas Pacific, tend not to have large investments in banking.
“There are opportunities to make returns but you have to know what you are doing and not many firms have sufficient expertise even to dip their toe in this water,” says one private equity player.
Private equity firms are, nonetheless, expected to be among the bidders for Landesbank Berlin, simply because it is such a large organisation and the sale is so rare. However, ultimately the bank is expected to go to one of its peers that can slash costs by leveraging sector synergies.
The private equity industry may prefer to play in this market either by taking stakes, in the manner of JC Flowers, or by taking advantage of particular opportunities as the industry gradually restructures. One such opportunity is Austria’s troubled Bawag. The country’s fourth largest bank is currently being circled by a host of buyout firms and German banks BayernLB and Dresdner following its involvement in last year’s Refco scandal. But no-one knows how long the restructuring will take. Some industry experts, such as Mr Prelle, believe that the sale of Landesbank Berlin is already forcing the other Landesbanken to assess their positions and contemplate similar moves. Others, such as Ms Schmidt from Fox-Pitt Kelton, believe that the public sector is so internally facing and so keen to protect its own that an unravelling of the system is several years away.
Vociferous disapproval
The disapproval that greeted the sale of the HSH Nordbank stake was vociferous. The holding was sold by WestLB, a Landesbank itself but run by the forward-looking Thomas Fischer, formerly at Deutsche Bank. Mr Fischer took the commercial view that the capital tied up in HSH could more sensibly be used elsewhere but other Landesbanken were not best pleased.
Similarly, the sale of Landesbank Berlin has been greeted with controversy and there are hopes in the sector that the Landesbanken can somehow mount a bid for the bank themselves (though success is considered unrealistic). Such controversy does not tend to attract private equity: indeed it is considered hugely unwelcome.
But Sparkassen and Landesbanken are expected, at the very least, to try to merge with one another in the future, which could create opportunities for private equity players. “Speciality banks may be created, as banks merge or find themselves under pressure to become more competitive. These could be of interest to the private equity industry,” says Mr Richter.
One point on which the entire industry is agreed is that the status quo cannot continue indefinitely. The EU has already dealt a huge blow to the public sector market by deeming its practices anti-competitive and, as the banks try to compete on a level playing field, they will be forced to look at becoming more efficient and more cost-effective.
Mergers will clearly be considered – and already are being – but for some, selling to the highest bidder might prove more palatable. Private equity firms may not always be there with a knock-out price, but they may be keen to pick up some of the pieces and turn them to their advantage.
