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Cracks in the equity revolution

30 Sep 1999

The swift emergence of an equity culture in Germany has been one of the most remarkable phenomena in international capital markets in recent years. From being a backwater in terms of new equity issuance, Germany has quickly become Europe's busiest primary market - fuelled by the extraordinary growth of interest in the Neuer Markt for growth companies, and by the high level of restructuring activity among major corporations.
But, in recent weeks, cracks have started to appear. Several Neuer Markt issues, especially from foreign companies, have plummeted in the aftermarket. Issuers and investors are getting concerned. And some of the larger corporate spin-offs on the main market have proved difficult to get away.

Last year it was a baby. Next year, hopefully, it will be an adult. But for the time being it is displaying some of the characteristics of a difficult teenager. This is how Grahame Cook, global head of equity capital markets at WestLB Panmure in London, describes the recent evolution of the Neuer Markt.

More like a juvenile delinquent, some believe. Take Ofer Tziperman, who is mystified and not a little peeved. As vice president of marketing at the Israeli developer of contactless smart card technology and product solutions, On Track Innovations (OTI), he had been convinced that a listing on the Neuer Markt would be the way ahead for a fast-growing company looking to raise equity capital in Europe.

"Although there are over 100 Israeli companies listed on Nasdaq we believed that the Neuer Markt would be preferable for us because it has developed recently into an attractive alternative to Nasdaq in Europe," he explains, adding that there were two more important reasons why a German listing looked more attractive.

"In the specific field in which we operate, which is smart card technology, the world leader in terms of market share is surprisingly not the US but Europe," he says. "In the US market investors prefer to see a product achieving local success before they will support an IPO."

Second, there was the issue of management time. "The process of listing on Nasdaq takes significantly longer than on the Neuer Markt," adds Tziperman, saying that a Nasdaq listing can take six months or more, whereas the timeframe for an IPO on the German market is typically between three or four months.

Underwritten by six banks and sponsored by MM Warburg, Baden-Württembergische Bank and Schmidt Bank, the OTI IPO was bookbuilt in August at a pricing range of Eu8 to Eu9.50, with the 4.267m shares eventually priced at Eu8.50. The shares closed after the first day of trading at Eu7.50 and over the next three weeks continued to head south, reaching Eu6.5 by mid-September.

"Maybe there are just too many flotations on the Neuer Markt at the moment," says Tziperman, "but we are definitely not happy with the performance of our share price, especially given that the only news we have to give investors is good news." Specifically, Tziperman says that OTI, which has diversified worldwide operations in the US, China, Europe and South Africa, had net sales of almost $3m in 1998. "This year we expect sales to double and next year we will see $15m," he says, "and we are talking here about orders in hand."

The performance of the OTI share price is disturbing not just because the company's prospects appear to be sound enough. Tziperman says that as far as he is aware, about 60% of the shares were placed with institutional accounts with the balance distributed among retail investors, which suggests that the weakness in the price cannot be attributed solely to flip-sales by retail investors.

Nor is the OTI experience an isolated one. A number of other overseas entrants to the Neuer Markt over the last year or so have good reason to be thoroughly disenchanted with the way their shares have performed.

A much larger Israeli company, Wizcom, which is involved in the "development, manufacturing and marketing of intelligent, portable technology products for the linguistic and educational markets", and which had sales in 1998 of $15.8m, floated on the Neuer Markt at the end of March.

Priced at the top of their Eu10 to Eu12 range, the shares were first quoted at a compelling Eu17, but have since dropped back to a shade over Eu8.

Even for overseas companies closer to Germany, geographically, linguistically and culturally, than the Israeli entrants to the Neuer Markt, the recent experience of listing on Germany's market has scarcely been a spectacular success.

The Austrian company, ATS, which floated in July via a highly cosmopolitan trio of Deutsche Bank, Salomon Smith Barney and BancBoston Robertson Stephens, has struggled to keep above its issue price. Bookbuilt at Eu21 to Eu25, it opened at Eu36, but by the middle of September had retreated to Eu25.9.

Non-German companies do not appear to have been unduly disconcerted by these relative disappointments. Trintech, for instance, which was one of the first companies to do a dual Nasdaq-Neuer Markt listing on the same day, became the first Irish company to list on the German market in September, when it was priced at the middle of its Eu10 to Eu12 range.

Barry Nolan, head of marketing at the Dublin-based company which makes state-of the-art internet security systems, again says that there were very clear reasons for selecting the Neuer Markt ahead of other European bourses.

One of the most important of these was that in excess of 50% of the company's sales are in the German market and that, with 40 people based in Frankfurt, Trintech is virtually a hybrid Irish-German company in any event.

"We looked at Dublin and London as well as the European exchanges and settled on the Neuer Markt because we see it as the Nasdaq of Europe, because it is liquid and because it is now established and mature," says Nolan.

Perhaps. But it is also one which is clearly facing a problem of acute indigestion, and the number of casualties in terms of pulled listings, both before and after bookbuilding, is already starting to proliferate alarmingly.

According to Ulrich Barnickel, a director in the corporate finance department at BHF-Bank in Frankfurt, this development has arisen partly because of concerns over Y2K, as companies seek urgently to ensure that their listing comes in well in advance of year end.

"The Deutsche Börse was expecting some 60 IPOs on the Neuer Markt in September and October alone," he says. "That is an enormous number, and probably too much for the market to absorb."

Cook at WestLB confirms this. "A danger signal is that in our discussions with institutional clients some have been telling us that there are already too many companies in their portfolios," he says.

But bankers add that foreign companies listing on the Neuer Markt face an added difficulty. This may not quite amount to xenophobia on the part of local investors, but bankers say that domestic retail investors are especially suspicious of overseas entrants to the market which appear to be arriving in Frankfurt purely to exploit high multiples.

"If you can choose from 40 or 50 issues you're most likely to pick the ones which look and sound familiar," says one banker. "That means that foreign companies coming to the market need to be able to tell a much, much better story than local ones."

It is not just IPOs and not just foreign companies which have run into trouble in the highly congested Neuer Markt. A capital increase by Kinowelt in September, for example, had aimed to place 4.1m shares, but some 1.7m were left on the books of Deutsche Bank by the end of the subscription period at a nominal value of Eu1 apiece compared to a subscription rights value of Eu59.

In the secondary market, meanwhile, there have also been a succession of spectacular retrenchments, with companies opening at a stratospheric premium to their issue price and subsequently plunging in the aftermarket.

A recent example was, which floated in July via WestLB and Commerzbank, and which is Germany's equivalent of This flew to a first day price of Eu55 after being priced at the top of its Eu16 to Eu19 price range, but has since slid back to a little over Eu20.

Performances such as these ought to be deeply alarming to the Deutsche Börse authorities, which at one stage looked as though they had created an infant phenomenon in the Neuer Markt.

If new issues continue to trade in this way they could rapidly find that they have given birth to a deformed monster which leaves investors who miss out on initial allocations embittered and out of pocket. It could also leave them deeply mistrustful of equity investment and of the so-called 'new economy' which is generating several IPOs per week.

Weakness in the secondary market also kicks off a vicious circle. "Obviously poor secondary market performance has an impact on the IPO market," says Jorg Illhardt, a director in the investment banking division at Deutsche Bank in Frankfurt. "Investors have little incentive to buy IPOs when they can buy into the secondary market at much cheaper levels."

Bankers argue that aside from massive congestion in the new issue pipeline, there are a number of other reasons for the skewed aftermarket performance of IPOs on the Neuer Markt.

One points the finger of suspicion directly at the grey market in general and at smaller stockbroking companies which act as Germany's equivalent of the London's betting business City Index in particular.

He argues that brokers such as the Düsseldorf-based Schnigge are setting entirely arbitrary grey market prices which have a disproportionate influence on investor sentiment.

"If they think software is out of favour they mark the prices of software IPOs down," he says, "and vice versa for media companies, which explains why today software is 'out' and media is 'in'. It becomes a self-fulfilling prophecy which is indiscriminate and faddish, when what this market desperately needs is more fundamental analysis between the good, the bad and the ugly."

Schnigge has reportedly established something of a monopoly for itself in the grey market. "They're setting prices based on ridiculously low turnover of Eu40,000 or so," says one Frankfurt-based banker. "I don't blame Schnigge for this. The problem is that institutional investors who ought to know better are taking the grey market prices as firm indicators."

Some bankers detect that this faddishness is now waning. "We're getting back to normal," says Stephan Albrecht, chief executive of the innovative Frankfurt-based bank net.IPO, which acts as a sort of internet club for retail investors in the market.

"There was a period in 1999 when you could sell virtually any company via the Neuer Markt. Today, retail interest is still there and liquidity is still there. But we're not seeing investors buying into every new issue simply for the sake of it."

Others are not so sure, and say that retail demand, paradoxically, is now one of the main weaknesses of the market. "Retail demand is inherently poor demand," says one banker. "Retail comes in when the newspapers or the grey market tell them a story is hot, but is very seldom there when you need it. I am convinced that retail investors are the biggest staggers in the market."

Neither is the same banker sure that an institution such as net.IPO, which requires would-be investors to fill out questionnaires before being allocated stock, is necessarily a positive development.

"At first glance it looks as though net.IPO is an indication of increased sophistication in the market," he says. "I don't know if that's true. You could argue that investors sophisticated enough to be members of an internet investment club are probably more likely to stag an issue than others."

At WestLB Panmure in London, Cook sees stagging as a major hindrance to the development of the market. "One of the things which makes it difficult to ensure quality allocations is the system of bearer shares," he says. "It means that it is difficult to know who is selling. If you knew who the sellers were, it would be possible to prioritise institutions which hold the shares next time."

The main staggers in the market, Cook adds, are savvy enough to make sure they don't sell their allocations back to the lead managers for fear of being blacklisted in subsequent IPOs.

The pity of it all, say frustrated bankers, is that while there are inevitably rotten apples in the Neuer Markt's basket, many very compelling investment stories are falling victim to a combination of faddishness and volatility.

"The problem is that deals tend to get pitched three or four months in advance of an IPO," says one Frankfurt-based banker, "and pricing discussions take no account of market volatility.

"So back in March or April investment bankers were giving out ridiculously high valuations for companies which were hoping to launch IPOs in August or September, and those companies are now understandably reluctant to list at 20% or 30% below the price they were promised a few months ago. That's a perfectly normal process but companies have to get used to adjusting for different market conditions."

Albrecht at Net.IPO agrees. "I would say that in 95% of cases whether or not a deal is a success is determined not by the investment case but by the pricing. Many issues are today trading below their issue price not because they are a bad investment case but because they were incorrectly priced in the first place."

For all this, bankers remain optimistic about the outlook for the Neuer Markt. In the very short term, Barnickel at BHF-Bank hopes that after a difficult fourth quarter things should stabilise in the early part of next year.

Looking even further forward, a recent DG Bank survey of some 2,400 Mittelstand companies in Germany found that more than 1,500 were contemplating an IPO some time in the future.

If at first glance that figure sounds like a crazy exaggeration, it seems to be supported by the furious pace with which the venture capital or private equity industry is now expanding in Germany.

Few private equity investors have been more enthusiastic about the potential for Germany than the UK's 3i, which has had a physical presence in Germany since the middle of the 1980s, and which recently opened its fifth German office in Munich.

The experience has clearly been a happy one, as 3i was among the investors which provided the initial capital for Mobilcom, the first company to list its shares on the Neuer Markt and one of its most spectacular success stories to date.

"I can't think of a single reason why there shouldn't be 1,000 new listings on the Neuer Markt," says Sebastian Kern, local director of 3i's Munich office.

"The question is the time period of those listings. The low interest rate environment we have seen in the last two years has meant that it has been relatively easy to list companies on the Neuer Markt since it was launched, but I think it would be unrealistic to assume that this rate can be

"So yes, I can imagine 1,000 new listings, but I would not like to say if this will be in the next five, eight or 10 years."

What the Neuer Markt has given to venture capitalist investors, which a decade or so ago would typically have given Germany a wide berth, is an outstanding exit opportunity.

Today, private equity firms are flocking to Germany and rapidly increasing their investments in the country. For its part, according to Kern, 3i invested some DM250m in 64 companies in the year ending March 1999, which is an increase of more than 85% compared to the previous year.

The figures now bandied about for the entire volume of private equity available and ready to be invested in Germany vary enormously, and are put at anywhere between DM6bn and DM50bn.

"You read different figures and they change every day," says Kern. "This is partly because you have venture capitalist firms opening new offices in Germany almost every day and partly because you have companies announcing that they plan to target the German market out of London."

Examples of UK private equity firms which have recently set up shop in Germany include Cinven and Mercury Private Equity, which opened offices in Frankfurt in March and May respectively.

With figures about the precise size of the sector unreliable, Kern says that the most reliable barometer of increased involvement of private equity firms in Germany is the rise in membership which has been seen at the German Venture Capital Association (BVK) over recent years. Three years ago, he says, this association boasted no more than about 35 or 40 members; today, it has more than 125.

For the most part Germany's new and growing breed of venture capitalists are no longer viewed by industry with intense mistrust. Nor is selling some or all of a business to a venture capitalist interpreted as a sign of failure.

Nor are most private equity firms in Germany motivated by a smash-and-grab desire to cash in on spiralling multiples on the Neuer Markt. "I'm not saying 3i would never sell its investments," says Kern at 3i in Munich.

"But in all the IPOs we have done so far we have remained invested much longer than the six month lock-up period demanded by the Neuer Markt. I would say that in six of the eight IPOs which 3i has done so far, it is still invested in them."

Away from the hullabaloo of the Neuer Markt, in terms of new equity issue activity in Germany, this year's track record has been decidedly patchy. Deutsche Telekom's jumbo Eu10bn capital increase in June owed its success predominantly to massive retail demand both locally and internationally, while bankers report that the new market segment for mid-sized companies, SMAX, has also been well received by investors.

"We really needed one or two success stories to get SMAX going," says Barnickel at BHF-Bank, "and we have had a number which have outperformed very well, such as Beate Uhse and the media company, VCL, which is trading very significantly above its IPO price."

Elsewhere in the primary market, however, several issuers unable to offer mega-liquidity or sexy growth potential (very literally, in the case of Beate Uhse) have struggled to achieve the volumes or the pricing they had originally hoped for.

The clearest example of this was the sale in June of fewer than 23m shares in Stinnes by Veba, compared to the 32m which the vendor had earmarked. The Stinnes offering via Dresdner Kleinwort Benson and Warburg Dillon Read was ultimately priced at a modest Eu14.5, compared with a preliminary price range of between Eu15.5 and Eu18.5.

Although some bankers fear that experiences such as these scarcely bode well for future IPOs on the main market - such as the forthcoming sale by Siemens of Epcos via Merrill Lynch, Warburg Dillon Read and Commerzbank - there are three factors which bankers and analysts say ought to support German equity valuations over the coming year or so. In a nutshell, these are the economy, demand and restructuring.

Much of the economic backdrop to the outlook for German equities, of course, is contingent not on what Germany itself does but on developments outside the country, with investors inevitably focusing firmly on Wall Street on the one hand and the European Central Bank on the other.

Nevertheless, there are elements of the macroeconomic framework which are peculiar to Germany. "Germany is a market where we have a greater degree of optimism in terms of relative weighting than in many other European markets," says Richard Kersley, equity strategist at Credit Suisse First Boston in London.

"The world economy is recovering and Germany has been a laggard in the process. The latest IFO survey does suggest that the recovery will feed through to corporate earnings. The economic cycle is tending in Germany's favour, perhaps making it the best of a bad bunch in Europe."

As of the end of July 1999, CSFB had a recommended weighting in Germany of 15.8% of a pan-European portfolio, compared with an index weighting of 14.4%.

Other analysts support the view that in terms of growth, Germany is now poised to turn the corner. According to Salomon Smith Barney, GDP is likely to grow by about 1.1% this year and by 2.2% in 2000, with inflation coming in at an 11 year low in 1999 of 0.5%, rising to 1.1% in 2000.

Also specific to Germany is the prospect of the long awaited tax reform, which is scheduled for approval by parliament in the summer of 2000, and which would see Germany swinging virtually at one fell swoop from the top to the bottom of the European taxation league.

The proposals would lower the total tax on corporate profits from 56% in 1999 to 41% in 2000 and 35% in 2002. That would equate to a net tax relief for the corporate sector as a whole of some DM6bn, although Morgan Stanley Dean Witter reckons that only about DM1.1bn of this would apply to quoted companies which are more capital intensive than their unquoted counterparts.

All the same, the tax reform proposal was enough to encourage Morgan Stanley to increase its expected EPS growth rate for 2001 from 7% to 9%, but not enough to encourage the investment bank to revise its underweight recommendation for German equities.

The jury appears to be out on the impact which the miserable showing by the Schröder government in recent regional elections may have on the fiscal reform in Germany, although analysts appear to remain optimistic.

"It's certainly bad news but it's not something we're very worried about," says Kersley at CSFB. "We don't think that Schröder's losses in the upper house will derail tax reform."

Another positive factor for the equity market which is specific to Germany is that the equity culture still seems to be alive and well, and demand for equities remains robust.

According to the latest survey on share ownership in Germany published by the German Share Institute (DAI), at the end of 1998 more than 10% of total household financial assets were invested in equities for the first time in Germany's history.

Of total assets of DM5,683bn, 8.7% or DM491.7bn was accounted for by direct ownership of equities, with a further 2.32% held indirectly through equity investment funds.

Sales of equity mutual funds in Germany rocketed ahead in the first quarter of 1999, to Eu4.2bn, which compared with sales in the whole of 1998 of Eu2.8bn. Sales of equity mutual funds in Germany also dwarfed those of bond mutual funds, which amounted to Eu1.9bn in the first quarter, and also outweighed the combined sales of mutual funds in France and Spain in the same period which amounted to Eu4.1bn.

Although equity fund sales slowed in the second quarter of 1999 to Eu2.7bn, that was still almost double what France managed, where sales in the second quarter of the year totalled Eu1.4bn.

A third reason for longer term investor confidence in the outlook for German equities is less specific to Germany and is relevant to Europe as a whole. This is that the restructuring of industry continues to gather momentum as companies recognise that, to compete for capital in an era of scarcer bank credit, those which fail to pay attention to shareholder value will soon find themselves trading at sharp discounts to their peers.

"Today shareholder value is a genuine management tool," says Marija Korsch, a partner in the corporate finance department at the Frankfurt-based investment bank Metzler Seel Sohn & Co. "It's no longer a cliché but possibly the most important issue facing German CEOs today."

It can also have a staggering impact on share prices. An update on Preussag published in September by Credit Suisse First Boston remarks: "Over the last 12 months, Preussag has been the best-performing stock in the German DAX30 blue chip index.

"The driver for such an outstanding performance has been the dramatic restructuring of the group (mid-1990s) from a diversified industrial to an organisation where we expect tourism to account for over 55% of group revenues in 2000 and 75% in the medium term."

30 Sep 1999