Buyout Mania

Hanns Ostmeier was stunned to pick up a popular German newspaper one recent Sunday and find a photo of himself along with several colleagues in a mock WANTED poster. Ostmeier’s offense: he runs the German operations for the Blackstone Group, the big U.S. buyout firm. Blackstone isn’t exactly a household name in Germany. But this spring, a top German politician named Franz Müntefering likened Blackstone and other private-equity groups to “swarms of locusts” that fall on companies and devour all they can before moving on. “Some financial investors don’t waste any thoughts on the people whose jobs they destroy,” said Müntefering, who is chairman of Chancellor Gerhard Schröder’s Social Democratic Party (SPD) and who promised to fight against what he called this “anonymous, faceless” form of capitalism.

The critique, just before a key state election that the SPD lost badly, sparked a furor and a nationwide debate about capitalism that continues to reverberate. Initially nervous, Ostmeier and managers at other major private-equity groups in Germany were silent. But these days, Ostmeier is speaking out in public, trying to convince his fellow Germans that private-equity investors are not villains but heroes who are good for the nation because they increase business efficiency. “Germany is now part of the global economy. It’s essential to have that debate and come to grips with it,” he says. “The part I don’t like is the personal attacks.”

The backlash against American “locusts” in Germany reflects recent wrenching shifts in the way continental Europe does business. Germans in particular have taken pride in their “humane” form of capitalism, characterized by relatively short working hours and high pay, in contrast to what they see as a more cutthroat, competitive American way. But as global competition grows, European firms are under pressure to trim costs. Private-equity transactions–in which investors buy up a company using substantial amounts of debt, overhaul operations, then sell out after a few years–have been common for years in the U.S. and Britain. They used to be the rare exception in continental Europe, where financial leverage has long been frowned on and relationships with investors were based on tradition. No longer.

Starting in the late 1990s, all the big U.S. players, including Blackstone, Kohlberg Kravis Roberts (KKR), Carlyle Group and Texas Pacific Group, set up small-scale European operations. They’re now bustling, growing rapidly and accounting for ever more of the U.S. groups’ business. In four years, Blackstone’s investments in Europe have jumped from about 10% to 30% to 40% of its total business, and the firm has opened offices in London, Hamburg and Paris. “It has become quite a significant part of our business,” says Stephen Schwarzman, Blackstone’s CEO and one of its co-founders. “It’s a moment of structural change in Europe.” The American moneymen last year were involved in about one-third of all European buyouts, doing deals worth more than $25 billion. That’s triple the amount in 2001 (see chart). And there’s no end in sight: several of the groups, including Blackstone and KKR, are in the process of setting up new investment funds aimed in part or entirely at Europe.

As the American money pours in, the deals are larger, more frequent and more highly leveraged. Five years ago, the largest European buyout transactions had a value of about $1 billion. Today’s biggest deals are three times as large, and several private-equity groups are poring over at least one transaction involving a telecommunications firm in Spain that is worth more than $12 billion. One reason Europe is attractive: such huge firms as electronics giant Siemens, automakers DaimlerChrysler and Fiat and the French media company Vivendi Universal have shed operations they deem no longer core to their fundamental business. Also, investors have been buying medium-size companies whose family owners are looking to sell. Once the Americans take over, they move fast, prodding the firms to make their operations leaner and frequently reshuffling management. The worse off an operation is, the more money the investors stand to make from selling after turning it around. “We like the complexity of Europe,” says Jim Coulter, a San Francisco–based founding partner of Texas Pacific. “It often means there is more inefficiency.”

That’s where the controversy kicks in. In their drive to reduce working capital and improve cash flow to pay off the debts incurred during the buyout, managers can’t afford to be sentimental about businesses that don’t do well. They spin off, reorganize or shut down poorly performing subsidiaries. Thousands of workers can lose their jobs in the process. But what’s bad for the workers is good for the company’s financials.

MTU Aero Engines is a recent example. The Munich-based company, which builds and services civil and military aircraft engines, used to be a part of Daimler. But after that company merged most of its aircraft operations with a French rival in 2000, MTU was left behind, an orphan inside the huge automaker. To make matters worse, the market for air engines nose-dived after the terrorist attacks of Sept. 11, 2001. Daimler soon looked for a buyer. KKR stepped in and took MTU private in November 2003. Since then it has replaced several top managers, including the chief executive; put the screws to the new bosses to improve operating performance; and, more quickly than initially anticipated, cashed out.

MTU’s June public offering on the Frankfurt stock exchange set off a stampede by investors. The shares were more than seven times oversubscribed, not least because MTU’s sales are rising briskly and its cash flow more than doubled in the first quarter as the aircraft industry picked up again. KKR’s total equity investment in MTU was $326 million. Following the IPO, KKR has returned $590 million to its investors, and it continues to hold a 29% stake, valued at $390 million. KKR tripled its money in 19 months.

German critics are crying foul. As part of its restructuring, MTU, which employs 7,400 people worldwide, has cut about 1,000 jobs. Germany’s metalworkers’ union, the nation’s biggest and most influential, holds up MTU as an example of several firms that it views as victims of unscrupulous American financiers. THE PLUNDERERS ARE HERE, ran the headline on a cover story in the union’s monthly magazine in May. The article was accompanied by a crude caricature of insects in Stars and Stripes top hats circling over a German factory; they had cigars in their mouths and dollar bills falling out of their briefcases. “Financial investors from America are cannibalizing German companies,” read the story, likening them to bloodthirsty mosquitoes that suck the cash out of firms to enrich themselves.

MTU executives and private-equity investors argue that without the investor-backed restructuring, the firms would be worse off. Udo Stark, MTU’s chief executive since the beginning of this year, points out that the restructuring plans, including layoffs, were put in place even before KKR bought the company. Moreover, while the firm trimmed its working-capital needs, spending on research, critical to MTU’s future, wasn’t affected. Stark calls the locust debate his firm is caught up in “irksome and damaging,” and he is worried that private-equity investors are being built up as “the straw men for all of Germany’s problems, from high unemployment to the financial problems of the national pension system. It’s the easy way out.”

Locusts haven’t been sighted elsewhere in Europe so far, although there are concerns beyond Germany. In France, President Jacques Chirac and his new Prime Minister, Dominique de Villepin, have fiercely criticized the “Anglo-Saxon model” of deregulated free-market economics, of which private equity is a bedrock, saying it is inappropriate as a remedy for the nation’s economic woes. “I am profoundly attached to the French social model,” Villepin said after taking office last month.

And even in Britain, there are some lingering qualms. At least two big buyout deals, involving retailer W.H. Smith and food producer Uniq, have fallen apart in the past few months because of objections raised by the trustees of the firms’ pension funds, who were worried that former employees could suffer.

In fairness, the caricature of cigar-chomping Americans trampling over Europe seems misplaced. While some of the major U.S. investors have Americans on staff in Europe, their public face is usually local. “We are not showing up with a cowboy hat,” says the principal of one U.S. fund. Ostmeier, for example, who is based in Hamburg, is German, a former management consultant with Boston Consulting Group in Düsseldorf. He spent seven years working for a London-based European private-equity group before he joined Blackstone in 2003. Jean-Pierre Millet, who runs Carlyle’s European operations out of Paris, is the first non-American to work for the company, which is based in Washington. He spent a decade running a Paris-based food group he founded before setting up Carlyle’s European operations and says using national staff was an important part of the strategy. “I didn’t want Americans or English people coming to do the deals in France, Germany and Spain. I wanted French, German and Spaniards.” One of Carlyle’s first European transactions involved a major French national daily newspaper, Le Figaro–a deal that could have been a political minefield, given the importance of the press. But, says Millet, “they did the deal with us because they had the impression they were dealing with French people.”

Foreign investment firms have incentives to improve, not destroy, the businesses they buy. Wincor Nixdorf is a case in point. The German firm, which makes ATMs for banks, was singled out by the SPD’s Müntefering in his “locust” critique because of the profits that its investors, KKR and Goldman Sachs, made when they sold out. The two firms acquired Wincor Nixdorf from Siemens in 1999 for $709 million and by the beginning of the year had sold their entire stake, starting with a public offering in 2004. KKR and Goldman haven’t disclosed details, but people familiar with the finances say the investors at least tripled their initial investment. Over the five years of ownership, the firm has expanded in Asia and Europe, strengthened its U.S. business via a joint venture with IBM and doubled its operating profits. Karl-Heinz Stiller, Wincor Nixdorf’s CEO, points out that the firm created 3,200 jobs, including more than 1,000 in Germany. “I would go the same way again anytime because I was and still am convinced about our business model,” he says.

A study by consultants Ernst & Young published in France last month estimates that the 3,700 French firms with private-equity backing collectively created 39,000 new jobs last year, bringing the total number they employ to more than 1 million. At a time when unemployment in France is close to 10% and the government is introducing one program after another in an effort to deal with it, private-equity firms provide a rare glimmer of hope.

In the town of Limoges, a famed center for French porcelain, Gilles Schnepp has a perspective different from the government’s anti–Anglo-Saxon mind-set. He is chief executive of Legrand, a $3 billion electrical equipment company that was acquired late in 2002 by KKR and French group Wendel in France’s biggest buyout. Legrand had been in the process of merging with a French competitor, Schneider Electric, and suddenly found itself in limbo after the European Union vetoed the deal on antitrust grounds.

Schnepp says Legrand quickly put in place a reorganization program, even before the private investors bought into the company. Still, once the new owners arrived, “they stimulated our performance,” Schnepp says. Overall, “the Legrand model is turning more quickly and more efficiently.” KKR and Wendel helped the firm bring in consultants, who recommended sweeping changes to more than 3,000 processes. Result: Legrand has reduced its purchasing costs by about $95 million. “They helped us formulate our needs,” Schnepp says. “They gave us confidence to go further” than the firm might otherwise have done. KKR has also encouraged Legrand to acquire three firms in the past six months alone.

Yet as the American moneymen continue their advance through Europe, the grumbling seems sure to continue. Jürgen Peters, head of Germany’s metalworkers’ union, for one, says his union, with its criticism of the big U.S. groups, simply “brought to light what others obviously wanted to leave in the dark”–and has every intention of shining more lights on the phenomenon. It’s not just labor that is complaining. Blackstone made such a big return–more than $3 billion–from its investment in German chemical fiber company Celanese, which it acquired and quickly took public again in the U.S., that it has drawn the ire of a New York City–based hedge fund, Paulson & Co., which alleges that the initial deal wasn’t fairly valued. And some private-equity firms are starting to fret that the European buyout scene has grown so fast that it’s in danger of overheating. “It’s like a perfect storm,” says Carlyle’s Millet, who is worried about the increased amounts of debt and dwindling returns. “All the ingredients are there for a big blowup.”

Millet is well aware that many Europeans still view U.S. private-equity groups as unscrupulous financiers “who will debone a company and chop it up into slices like a sausage.” But with time, as more and more companies on the Continent get bought and resold, he believes people will understand that private equity is a positive force. “We are important actors, and we are creating value, we are creating jobs, and we are developing firms. Little by little, that message is getting through,” he says. Perhaps, but the Europeans are still on the lookout for locusts. –Reported by Daren Fonda and Barbara Kiviat/New York