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Institutional investor profile, Marc Brugger, Senior Project Manager, Venture Capital and Private Equity, KfW Group

Brugger on the German market, on tough financing decisions, on the promise of later stage deals and on whether it is possible for the private equity industry to regain investors' confidence.

Based in Frankfurt, KfW (Kreditanstalt fuer Wiederaufbau) is a bank owned partly by the federal government and partly by the Laender. It was originally set up in 1948 with capital from the Marshall Plan to help reconstruct the German economy after the second world war. Its remit is to encourage entrepreneurialism, invest in real estate and environmental programmes to provide loans to developing countries and to provide export and project finance for German companies. It started investing in private equity via refinancing two decades ago and co-investment vehicles in 1997 with a focus on German venture capital. It has continuously expanded its focus to include investments in Europe while continuing its focus on the German market. Brugger joined KfW in 1999.

Why do you invest in private equity?
‘Our rationale for investing in private equity is both promotional and financial. Our role is to support the market, explore new asset classes, such as smaller buy-out scenarios, extend the capital resources of funds and improve small and medium-sized enterprises' access to equity. But by doing all that, we are also returns-focused.'

What type of investments do you look for?
‘We are slightly different from most other private equity fund investors in that we invest in co-investment vehicles rather than in the limited partnership of a fund. KfW has the right to veto within the investment process. In the best case scenario, however, we would have investments in exactly the same portfolio companies as the limited partners in the fund we are co-investing with.

‘We do refinancings as well - that has always been our core business. Our remit is to help encourage innovation in European companies. As such, we are able to refinance companies with an innovative background and share risks, enabling the equity backers - such as venture capitalists and business angels - to enter into their investments. This has helped provide support for the German economy. We have recently broadened our scope to include selected deals outside Germany. In these cases, KfW can take over part of the equity portion, take over the risk and refinance the equity sponsor - the private equity firm. We are only able to do this for professional firms with a base in Europe.

‘Our main focus is on Germany, but we do invest across Europe selectively, too. We know the German market in depth. We work with more than 250 firms in Germany alone. But beyond that, we take the view that we have to cover the market. We do not have specific allocations to particular parts of the market. As such, our portfolio is a mirror of the market itself. As a result, our current deal flow in venture capital-backed businesses has slowed down, but we are still quite active in buy-out deals because there is considerable activity in this area. Our most important aim is to have a well balanced portfolio, but we don't make specific targets. Primarily, we look at the market and support the needs and opportunities we identify there.'

How do you conduct your due diligence?
‘In a regular co-operation, we do not start with a fund financing. KfW starts its relationship with funds through its refinancing programmes on a deal-by-deal basis. That is how we get to know venture capitalists and buy-out fund managers. We build a relationship with a fund through a couple of investments. That means that we know our potential partners and the way they operate very well.

‘We look at the usual areas of expertise, what they have done in the past, their track record, etc. That is not so different from the usual type of due diligence that a limited partner would do. But we do have the advantage of knowing the GPs well before we start due diligence and of having seen them in action - in negotiations, etc.'

What makes a good fund manager?
‘One of the most important things we look for is a deep knowledge of the area in which the manager is looking to invest. We differentiate between the funds that invest from their office without a local presence in the market or a local network to source deals and those who operate very much on a local basis. We believe that managers really have to be on the ground and they need to be getting involved with their portfolio companies to be successful. We look for teams that take a professional attitude to everything that they do - whether they are dealing with us, their investors or with portfolio companies. We also like to know who the other investors in the fund are. The management company obviously has to be solid financially if we are to work with the team. We have to be sure they have adequate capital resources.'

How important is local knowledge in Germany compared to other markets?
‘There is a real difference in attitude between the target companies in, say, the UK and in Germany. Take the Mittelstand, for example. These companies are not often well versed in financial engineering or the way in which financial investors (such as PE-Funds) think. They are not geared up for dealing with the financial markets. But things are changing. We are in the middle of a structural change as the Mittelstand companies are becoming more aware of the financing possibilities available to them. That education process is one of our aims. We are here to help ease the transition and encourage the changes to come about.

‘As a result of these differences between more mature private equity markets and that in Germany, some of the attempts by overseas firms have so far failed. Often they were not set up to deal with the issues particular to Germany.'

How would you characterise the German market now?
‘Germany is an attractive but sometimes complicated market. But things are changing - in some ways that will be positive for private equity. The financial institutions are changing. The banking industry is having to tighten its credit portfolios. German companies, especially the Mittelstand, are having to go elsewhere for their finance. That will be a very important area for the future for private equity. Whereas deal flow has historically been a problem, companies that would previously have received debt financing may well have to look to equity providers instead. The problem is that many business owners in Germany will only want minority investors on board; the private equity houses will want to take majority positions. That gap will have to be bridged.

‘So the market is progressing, but not as quickly as has been hoped. The barriers raised by the Mittelstand owners are diminishing slowly.'

What level of involvement do you have in your investee companies?
‘Our decision-making process - whether in refinancing or fund financing - relies heavily on the decisions of the partners in the deal. We act very much on the basis of what the private equity firm decides.

‘Before we co-operate in any way with a fund, we look very carefully at the equity partner, we do thorough due diligence and checks to ensure that our criteria are fulfilled. This is because we have to rely on a fund's decisions. We are much more hands-off than the equity partner would be. We see them more as a filter for us. We don't want to be and don't have the capacity to be a competitor in any way. We are acting more as a co-investor alongside funds. As a result, we are neutral. That is not to say that we don't have opinions - and sometimes they are different from those of the equity partner.'

How do the LPs in your co-investment partner funds view you?
‘Limited partners know us and they trust us. I think they feel reassured by our involvement because we provide an additional level of due diligence. On the whole, they tend to see us as an extra pair of eyes.'

Which areas do you think are promising at the moment?
‘Our fund financing activities have slowed down because the market has slowed down. But in terms of where to invest, the early-stage sector is going through a structural change. You are seeing better quality businesses in this area than previously, but you are also seeing a focus on later stage investments. The prices for mature and established later stage deals are often not much higher than for early-stage businesses, but with lower risk - that is presenting many firms with good opportunities.'

What is the biggest mistake that you have ever made?
‘I think our biggest mistake was to underestimate the number of financing rounds that early-stage companies were going to need. We are at the same stage as many other investors at the moment in that we have to decide whether to continue to fund these companies. We have to analyse each financial round in detail. Many companies have not fulfilled their original business plans and many are taking far longer than anticipated to reach profitability or even some of their targets. Like many others, we are having to make some tough choices. Secondly, one could add, that we sometimes overestimated the quality of certain management teams.'

What irritates you about private equity?
‘There are a number of funds that originally presented a set of criteria and an investment focus that they were going to follow, but when you look at what they have done - as opposed to what they originally said - there is a wide gap.

‘I also get frustrated by some firms' lack of communication with their limited partners and with KfW.'

What is the biggest issue in the market?
‘I think that one of the biggest issues is that some LPs made the wrong investment decisions in the past and they are now suffering for that. Private equity partnerships are like ten-year marriages. It is very hard to divorce and if you do manage to get out, then it costs. The industry will need to work hard to regain the confidence of these investors if, indeed, that is possible.'

How do you think that the market will change in the future?
‘The understanding and knowledge of limited partners have improved. They are much more disciplined about where they invest in terms of types of fund and area of private equity. Fundraising is harder now than it was in the late 1990s and 2000, but GPs who are professional and who have the right experience are still able to raise money. That is a good thing. This environment is helping to sort out the good GPs from the bad ones.'

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