Financing German’s Mittelstand: a balancing act between fueling growth and preserving ownership.
Investing in digitalization, venturing into capital markets, low interests: The capital structure of German’s SME has undergone a massive transformation.
According to Sven Foos, Head of SME Banking at ING Germany, german SMEs are forced to set up a sound financing strategy due to changing market conditions: investments in R&D, digitizing products and processes, international value chains, CAPEX to stay ahead of the competition.¹ Especially, firms with <50 FTEs experience a substantial investment need. Small service and manufacturing firms need to decide whether their retained earnings cover for investments or money must be raised through outside capital (debt/equity). Rating agency Moody’s concludes, European SMEs collectively are lacking 400bn € for investments, innovation and expansion.²
Basel III: Capital Requirements hit German Mittelstand
Since 2013, SME are required to have a Capital Ratio (CR) of 10,5% (up from 8%). Kai Gerdes, Direktor Analysis at Euler Hermes Rating, stresses that this leads to an increase in financing costs of +1% as 70% of SMEs are heavily reliant on bank financing.²
Over the past 20 years, the Capital Ratio of SMEs has increased signficantly. From 1997–2016, German SMEs have quadrupled its Capital Ratio to 28%, just 3% shy of of big corporates (31%). The biggest improvement happened among sole traders (‘Ein-Person Unternehmen’): from -.7% to +18%.
The Capital Ratios of the German Mittelstand, vary a lot per industry. R&D driven manufacturing and manufacturing industries lead the pack with 32.3% , 41.1% respectively. Constructions firms possess the lowest industry-average of 25%, overall the median CR surpassed 31% in 2019.³
While companies increase their Capital Ratio to get access to cheaper credits (Basel III), SMEs also do so to secure independence. In a survey by KfW in 2017, 80% of SMEs state they don’t want banks to meddle with their daily business decisions. 70% of SME also improve their CR to gain more attractive conditions in further outside capital financing.⁴
A solid CR is also paramount for future acquisitions and business succession planning. The later is one of the key challenges of the German Mittelstand (see previous article) as 150,000 business owners will hand over the reigns. 1/3 of owners pursue to sell to external buyers (outside family circle). The better the financial position, i.e CR, the more likely a suitable buyer can be found.
How the German Mittelstand finances its operations
German SMEs are hesitant to use outside capital for operating supplies, raw materials and goods. 7% do no consider loans at all and dip into their savings, only 3% of firms would finance between 75–100% of daily operations through loans. If they take on loans, firms prefer short-term horizons, 60% of firms borrow money for less than 9 months whereas only 12% have loans running for more than a year. 72% of SMEs only have one or two bank accounts, according to financing platform Compeon.⁵ Hans-Jürgen Völz, Chief Economist at BVMV-German Association for Small and Medium-sized Businesses, highlights the need: “500,000 SMEs in Germany take loans at their local, trusted house bank. About 50% of those require a loan of ca, 60,000€”.
The dependancy on banks is also depicted in the following graph. In 2018, the share of grants (grey) was at 15%, loans (navy blue) at 34%, while the majority of investments, 45%, were funded through retained earnings (light blue).⁶
What are alternative way of financing for SMEs?
I) Another Bank Account
To reduce dependancy and improve loan conditions, SMEs could open up a second bank account at another branch.
II) Factoring
Factoring allows for financing of accounty payable; i.e payments to suppliers. The biggist advantage of factoring: accounts payable in the financial statement are reduced, hence increasing the CR and state of liquidity. The creditworthiness of the firm as a whole is strenghtened. Since the 2000s, this form of financing has gained popularity. About 44,000 German SMEs handle their claims through factoring.
III) Employee Lending
SMEs could also look inwards to avoid taking a loan with banks by asking employees to lend them money. One sucess story is window manufacturer Sorpetaler Fensterbau, where more than 50% are owned by its 60 employees. The owners explained the rationale: “Over the 10 years, we didn’t need any bank loan. In 2008 the company needed >2,4m€ to purchase new machinery, resorting to the help of employees put them in a good bargaining position. Several FTEs invested more than 100,000€, receiving back >5,000€ p.a next to an attractive profit sharing scheme. Similarly, printing firm Drucker Kolbe-Coloco, wood machinery manufacturer Homag and tractor manufacturer Claas work with their employee’s money.
IV) Grants
In Germany alone, SMEs can tap into over 1,700 grant programs. Advantage: Low interest rates and up to 25m€ in grant volume for firms with less than 500m€ revenue. Disadvantage: Does not increase ratings/creditworthiness, just loan conditions as local banks are responsible for handling applications.
V) Venture Capital / Private Equity
BrauKon, Bavarian beer bottling plant manufacturer was neglected by its local bank due to a low CR, when it wanted to raise money in order to fulfill the 1,3m€ orders it collected in 2010. To enable the growth, BrauKon turned to Bayerische Beteiligungsgesellschaft (BayBG), a PE with over 40 years of experience in the SME sector. Its portfolio comprises 500 firms with over 320m€ invested, ranging from acting as silent partners to majority stakeholder. BayBG prides itself in providing capital AND knowledge through an in-house research department for market and competitor analyses.
The throughout screening process typical for PE firms also served as a positive signalling of creditworthiness towards banks as BrauKon’s ratings improved.
However, only in 1 out of 6 transactions, SMEs turn to investors like BayBG.
KPMG’s SME expert, Michael Königer states prejudices on PE fonds based on previous negative stories: Formerly healthy firms were taken over, leveraged and put in the red like HVAC manufacturer Grohe. PE firms have understood the concern over the transfer of ownership and now offer deals where PE only get a minority stake. SMEs must consider, though, PE demand higher interest rates, between 6–9% p.a., than banks, ca. 2–3%.
Smart capital vs Stupid capital
CEOs will have to ask themselves whether they just want to have a capital injection, where bank loans suffice. Or do they want to tap into VC’/PE’s pool of contacts and expertise, too.
BrauKon leverages the expertise of BayBG, but interventions in daily businesses do not occur. BrauKon profited a lot from the know-how; since 2010, revenues quintupled.⁷
The VC Market in Germany’s SME Sector
The major player in this submarket of Private Equity are depicted below. Together, those firms account for 51 takeovers in 2019. Since two years, PE deals climbed to record-highs, which is due to an increasing need of buyers (Business Succesion Planning — see previous article) as owners retire.⁸
VI) Online Platforms/ Crowdlending
Online financing platforms have gained traction, also among German SMEs. Since SMEs are required to show hardly any collateral for loans below 100,000€, this option is very popular for hassle-free investments. On a plus, conditions are transparent and can be compared easily between competitors e.g. Fintura, Compeon, Funding Circle, Kapilendo.⁵
Consultanty Deloitte has revealed that among German SMEs, 82% know the concept of crowlending, up from 48% in 2015. However, it remains a niche topic, as only 1% of the financing volume in the SME sector was done through crowdlending. The reason for the slow adoption is due to the aforementioned strong bond between house bank and borrower. 95% of respondents value the personal contact, transparency, speed and flexibility by banks.⁹ Crowdlending is particularly interesting for firms with a low CR and startups as regular banks view those borrowing deals as too risky or tiny. In most cases, crowdinvesting is undertaken by a broad base of fans of the product offering, providing a key way to retain customers. 5% ROI are common on these deals, according to Berlin-based credit market place Smava.⁵
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