How increased interest rates impact the Private Equity industry?

After an unprecedentedly long period of close-to-zero interest rates, central banks have been aggressively hiking interest rates to control inflation. This has impacted the global markets, and the private equity industry is no exception.

In general, higher interest rates result in lower returns and lower competition, which leads to lower asset prices in Private Equity. In theory therefore, this should be a zero-sum game for the investors over a long period, as increasing interest rates should be balanced off by lower multiples and visa-versa. The market corrections may however take years. In the short run therefore, increasing interest rates may have the following impact on the private equity industry:

Lower returns: Private equity firms often rely on borrowing money to finance their investments, and higher interest rates can increase the cost of borrowing. This can result in lower returns on investment, as more money is required to service the debt.

Reduced deal activity: Higher interest rates can make it more difficult for private equity firms to finance acquisitions, leading to reduced deal activity. This can lead to fewer investment opportunities and slower growth for private equity firms.

Portfolio company performance: Higher interest rates can increase the cost of debt financing for portfolio companies, which can put pressure on cash flow and profitability. This can negatively impact the overall performance of the private equity firm’s portfolio.

Decreased competition: As borrowing becomes more expensive, private equity firms may have fewer competitors, which can lead to lower valuations for assets and decreased returns on investment.

Impact on exit strategies: Higher interest rates can impact exit strategies for private equity firms, as it can be more difficult to sell assets in a high-interest-rate environment. This can result in longer holding periods and reduced returns on investment.

Who is impacted?

Strategic PE players vs. leverage-driven

The devil is in the detail. Some of the traditional Private Equity competitors noticeably struggle in the current environment.  “The key decisive factor is the source of the value-creation. We keep seeing our competitors entering deals with up to 80% leverage with adjustable rates and basically no growth plan. Obviously, they are in trouble now”, says Fabian Kröher, Executive Director at Winterberg Group.

Meanwhile, more hands-on PE players, implementing a wide range of organic and non-organic growth drivers, for instance via a buy-and-build strategy, are not expected to be negatively impacted in any significant way by the current turmoil. Key growth drivers for more hands-on Private Equity funds mostly include strong growth plans, extraction of synergies between multiple entities, access to new markets, value-add expertise in more efficient management, and others. As a result, the return rates are much less sensitive to any changes in interest rates.

Large-cap vs. Small-cap

We at Winterberg Group also see a big disparity in how the changes in interest rates differently impact larger-cap transactions vs. the smaller-sized environment.

Larger acquisition targets with an established track record have a much larger debt-carrying capacity. As a result, we saw ridiculously high multiples in the past, which were purely justified by vast debt amounts at low interest rates. Those funds also face minimum IRR thresholds, which are now becoming more and more difficult to achieve. As a result, we see funds being forced to hold onto assets much longer, due to min. return thresholds, which are not going to be realized in the event of an exit. Strong competition on the buy-side at the same time is not fully compensating for the valuation multiples correction, forcing the buy-side participants to overpay for the assets. As a result, we see less deals getting to the market at acceptable prices.

Smaller-cap Private Equity deals, in contrast, feature lower leverage in the capital stack, limiting the impact of the overall interest rate hikes on the returns. In combination with lower competition, the current market conditions create a much more buyer-friendly environment.

Shifting credit landscape (alternative credit providers vs traditional banks)

The combination of increasing regulatory standards (Basel I – IV) with very low-interest rates made the credit leverage finance business for traditional banks extremely unattractive. Especially in the lower-size segment, the transaction execution expenses on the bank’s side often exceeded the potential interest rates, they would get in return. In addition, increasing KYC requirements and strict risk policies made banks very slowly in their processes, becoming a potential bottleneck of a transaction from the Private Equity’s point of view.

All of the above created an unprecedented growth of private debt providers emerging. Indeed, the global Private Debt market has more than tripled in the last 7 years. The USPs of Private Debt providers are clear: quick execution, less strict credit policies, and high leverage amounts in exchange for a higher interest rates, compared to a traditional bank. Given the overall ultra-low interest rate environment, this seemed like an attractive trade-off for the Private Equity industry.

However, we believe that the competition between traditional banks and Private Debt providers is expected to intensify in the coming years, as Private Debt providers will have to adapt to growing delinquency rates and as a result, adapt their credit policies. At the same time, the spike in interest rates makes traditional credit leverage finance more attractive for the banks, who are expected to ramp up their deal-sourcing efforts soon. “We already see the competition between different lenders intensifying. We’ve never seen that many players proactively reaching out to us with very flexible financing solutions”, says Fabian Kröher, Executive Director at Winterberg Group.

Moreover, with the increasing difficulties to generate attractive returns in a high interest environment, Private Equity funds will need to put a larger emphasis on the overall cost of capital, which shall favour the traditional banks.

When we at Winterberg Group acquire Mittelstand companies in the DACH region, we encourage the selling shareholders to re-participate with a minority stake in the company. Why? The answer is simple – on the one hand, we want to share a portion of our risks. On the other hand, for owners, it’s usually a good way to invest part of the proceeds from a sale and continue to build up their wealth.

From our experience, ways of re-participation may vary on a case-by-case basis, but are generally one or another form of the following three mechanics:

Re-investment: The business owner can re-invest some or all of the proceeds from the sale of the company into the acquiring company (AcquiCo or the Fund). This can be done through investing cash proceeds from a sale in a new fund that will hold the acquiring company.

Equity rollover: In an equity rollover or in-kind contribution to the Fund, the business owner exchanges their ownership in the acquired company for ownership in the acquiring company. This allows the owner to maintain their stake in the business and benefit from future growth.

Earn-out: An earn-out is a contractual arrangement where a portion of the purchase price is contingent on the future performance of the acquired company. One way of looking at this, is that a part of a purchase price is simply deferred, while others may consider it as an investment mechanism. Ultimately, the seller receives less cash at closing with an opportunity to receive more if the business performs well. Technically it is equal to re-investing cash or company shares in the Fund.

In certain cases, we offer a combination of the above options which helps us and the selling shareholders to achieve a mutually beneficial result. Not all deals are created equal, so it’s important for us that the business owners carefully consider the re-participation mechanism that they’ve been offered.

Typical Seller’s perspective on re-participation and earn-outs

Typically, the seller will be open to a reasonable re-participation and/or an earn-out, provided that key aspects are well and transparently documented in the SPA. However, the most frequent questions are the following:

Q: Are the milestone targets reasonably achievable in a reasonable time period?

A: We usually base our KPIs based on the Seller’s business plan and/or historical performance of the business. Therefore, the Sellers are definitely capable of evaluating the possibility of a business plan achievement.

Q: How can the seller make sure the buyer doesn’t operate the business in a way that minimise or eliminates the earnout payments?

A: It has never been and never will be our intent to undermine business performance in any possible way. That’s not wise to shoot your own business in the leg, as the business needs to have a compelling story for the next buyer. If the concern is strong, we usually provide a performance metric range, so that the seller receives a portion of the deferred payment even in cases when the company performs worse than planned. In addition to that, re-participating sellers usually have customary board representation rights and are participating in the operations, so they have enough leverage to see the true performance.

Q: Is the amount of the potential deferred payments significant enough to delay the seller getting all cash up front?

A: All deals are different, and all sellers have different circumstances and plans. In deals we typically do, the earn-out and re-participation components are within a range of 10 to 30% of the purchase price.

Why is it important for us that the selling shareholders re-participate?

Overall, the re-participation of selling shareholders is usually beneficial to both us and the selling shareholders, as it helps to drive growth and profitability for the company.

First off, re-participation aligns interests: When selling shareholders re-participate in the company, they have a stake in the ongoing success of the business. This aligns their interests with those of the financial investor and management team.

Secondly, and this is critical for Mittelstand, expertise and experience: The selling shareholders, who are usually owning the business for generations, often have significant expertise and experience in the industry and with the company. This is valuable to the financial investor and management team as they work to grow the business.

Another reason is confidence in the business: If the selling shareholders are willing to re-participate in the company, it is a positive signal to us that they have confidence in the business and its future prospects.

How does the common market practice look in 2023?

In terms of the DACH market, some agencies regularly solicit feedback from a wide number of M&A advisory firms on their market outlook. One of the recent reports by Firmex, for example, suggests that M&A advisors reported that deal volume remains constant with half of the respondents forecasting deal volume in the coming three months to increase. At the same time, over half of the M&A firms questioned observed a growing gap between prices asked by sellers and prices buyers are willing to pay. The gap in value expectation is being increasingly filled by special mechanisms to narrow the gap in price expectations, like re-investment and earn-out mechanisms. Four out of ten M&A advisors said that earn-outs have become much more common. That certainly resonates with our own experience here and we see this as a necessary instrument in times of uncertainty which we definitely have today.

Water is essential for human survival, and ensuring a secure and reliable water supply is of paramount importance. In Germany, the Water Security Law (Wassersicherstellungsgesetz) aims to provide emergency water supply to cities in times of crisis, ensuring the population’s uninterrupted access to clean drinking water. The law has been designed to provide a framework for local authorities to ensure that water supply can be maintained even in the face of extreme weather events, natural disasters, or other crises.

The Water Security Law stipulates that the Federal Government is responsible for equipping cities with necessary machines, devices or pumps to ensure the uninterrupted supply of water to the population. The law emphasizes the need to provide one pump per approximately 1,500 inhabitants. This guideline is based on the assumption that a single pump can supply water to about 3,000-5,000 people, depending on the pump’s capacity and the distribution network’s design.

The law’s implementation is the responsibility of the local authorities, who must develop and maintain emergency water supply plans to ensure that the population’s water needs are met during a crisis.

The Water Security Law is just one part of the broader framework that ensures water supply security in Germany. The country has a robust water management system, which includes the Water Resources Act (Wasserhaushaltsgesetz), the Drinking Water Ordinance (Trinkwasserverordnung), and the Federal Water Act (Wasserhaushaltsgesetz). These laws regulate water use, protect water resources and ensure drinking water meets the highest standards of quality.

In addition to legal frameworks, Germany also has a well-established water infrastructure that provides reliable access to drinking water to its population. The country’s water supply system is decentralised, with more than 6,000 water supply companies managing the water distribution network. This decentralised system ensures that the water supply is less vulnerable to disruptions than centralised systems.

Despite the robust legal framework and well-established infrastructure, Germany is not immune to water crises. In recent years, the country has faced extreme weather events, such as droughts and floods.

Recent droughts in Germany: when there’s not enough water, it does not necessarily mean there’s not enough drinking water.

The hot and dry years in the 1990s, and particularly the year 2003 have shown that Germany can be hit by low water and drought, despite being in the temperate climate zone. In Germany this exceptionally long dry and hot phase has led amongst other things to increased risk of forest fires, losses in the agricultural sector, restrictions on inland waterway traffic and on the operating times of thermal, hydroelectric and nuclear power plants. The reinsurance company Munich Re estimated the costs of the heat wave of 2003 in Germany at more than 1.2 billion EUR. Others report an agro-economic impact of this drought event for Germany of 1.5 billion EUR, and 15 billion EUR for all of Europe. However, the supply of drinking water was not threatened during 2003.

The period 2014-2018 was a dry period in large parts of Europe, the worst multi-year soil moisture drought during the last 253 years (1766-2018) in especially Central Europe. In Germany, an exceptionally hot summer happened in 2015, when almost 75% of the area of Germany was under at least moderate drought in July. During August 2015, the total area under drought decreased, but the areas of extreme and exceptional drought conditions increased to 22% and 5%, respectively.

The degree to which a region is hit by changes in runoff depends strongly on the size of the change and on the initial situation. Especially regions that presently have an unfavorable water balance and low runoff, such as e.g. the central regions of Eastern Germany, can be strongly impacted by climate change. In these regions, the shift of precipitation from summer to winter leads to further decreases in summer runoff, when the situation has already been difficult in arid years and causes further water shortages. Even if the results vary between climate models, there is considerable evidence that climate change will increase the risk of arid periods and droughts.

Flood and drought conditions in five large river basins in Germany (covering 90% of the German territory) were estimated from a large number of regional climate model projections. The results for 2061-2100 (compared with 1961-2000) show that many German rivers may experience more frequent occurrences of current 50-year droughts. During the summer there will be much less water available than at present. Between 1990 and 2080 the runoff in summer, depending on the climate model used and the emission scenario considered, will show a decrease of up to 43%. Rivers with a markedly Alpine runoff regime will also be affected by other components, such as accelerated melting of glaciers or permafrost soils and changes in the stability and thickness of snow cover.

However, since Germany’s drinking-water supplies are obtained largely from locally available groundwater resources and only partly via bank filtration or from surface waters (for example, reservoirs), no fundamental problems in drinking-water supplies are expected even under changed climatic conditions. On the other hand, regional scarcities might occur in areas that suffer extensive periods of drought.

Floods: when too much water puts availability of drinking water in danger.

On the night of July 14-15, 2021 the floods hit the Ahr Valley in southwestern Germany. Within a day, the floods turned many people’s lives upside down. Heavy rains transformed small rivulets and streams in the states of Rhineland-Palatinate and North Rhine-Westphalia into torrents. More than 180 people lost their lives and around 17,000 people lost all their possessions. At least 60,000 houses and 28,000 companies were destroyed altogether, causing damages of at least 33 billion EUR.

Last year, Germany marked 20 years since Elbe floods. In 2002, dozens were killed, hundreds injured and tens of thousands left homeless when torrential rains caused the Elbe and other rivers in eastern Germany to burst their banks in one of Europe’s worst natural disasters. In August 2002 a heavy rainfall in Central Europe caused record-breaking floods in the Czech Republic, Austria and Germany. One of the first cities affected was Passau, in Bavaria. The Danube reached 10.8 meters, its highest level since 1954. On August 17, the Elbe and Weisseritz rivers flooded parts of Dresden’s historic city center affecting the Zwinger Palace. In 2002, the floods caused major damage across Germany. It left behind destroyed roads, bridges and railroad tracks, as here near Riesa. Houses and dikes were damaged, and harvests were ruined. The Elbe flood of 2002 is still considered the most expensive natural disaster in German history. The total damage amounted to 11.6 billion EUR.

Flooding can lead to contamination of water sources, damage to water infrastructure and disruption of water supply networks. One of the primary ways that floods can impact drinking water availability is through the contamination of water sources. As rivers and lakes overflow, the pollutants and debris enter the water. This includes sewage, chemicals and other hazardous materials, which can contaminate the water and make it unsafe for drinking. Another way that floods can impact drinking water availability is through damage to water infrastructure. Floods can cause significant damage to water treatment plants, water supply networks and water storage facilities. This damage can result in disruptions to the water supply and can take time to repair, leaving people without access to clean drinking water.

The Water Security Law, along with other water management laws and regulations, aims to address these challenges and ensure that the population’s uninterrupted access to clean drinking water is ensured even in times of crisis.

Emergency water supply market: an interesting niche

The emergency water supply market can essentially be split into two large segments: (1) emergency water wells and (2) emergency water equipment.

The market for emergency water wells in Germany is a relatively small but important sector of the water supply industry. Emergency water wells are a critical source of water during times of crisis, when traditional water sources may be unavailable or contaminated. In Germany, emergency water wells are typically drilled into underground aquifers or other water-bearing rock formations. These wells can be equipped with pumps and filters to extract and treat water for drinking and other purposes. Emergency water wells can vary in size, depth and capacity, depending on the specific needs of the community or region they serve. Despite the relatively small size of the market, the demand for emergency water wells in Germany is expected to grow in the coming years. The Water Security Law as well as increasing frequency of extreme weather events and the need to ensure a reliable and safe water supply during emergencies drives the emergency water wells market. The market consists of a limited number of companies specializing in the design, drilling and maintenance of these wells.

As for the equipment part, there are various types of emergency water pumps and filters available, including portable pumps, submersible pumps and large-scale water pumps. These pumps are designed to be used in different situations and can range in capacity from small pumps that can deliver a few hundred liters per hour to large pumps that can deliver thousands of liters per minute. The pump and compressors sector belongs to the most important areas of mechanical engineering in Germany and is estimated at ca. 12 billion EUR in 2022. The market consists of a number of large players, as well as from the long tail of smaller producers of equipment, engineering and value-add distributor companies.

Winterberg Group in the context of emergency water supply market

Following successful execution of the Buy & Build strategy in water and wastewater treatment market in recent years, Winterberg Group aims to create a holding in the emergency water supply market by consolidating niche Mittelstand companies in this sector. We are on the watch for players with EBITDA in the range of 1-5 million EUR with strong product and services portfolio, experienced management and robust market position.

“The German Mittelstands boasts many highly specialised players which in some way contribute to battle the water crisis. We would like to invest into this macro trend to not only make attractive returns, but also to help countering the effects of this crisis on our country and our lives.”

Fabian Kröher, Executive Director at Winterberg Group