Germany’s record of forming a competitive transaction pipeline among its mid cap family-owned businesses could be under threat if investment at levels seen today does not increase, dealmakers at Mergermarket Germany Forum 2019 in Duesseldorf said last week.

A lack of structural reform is partly responsible for a rare period in German industry where competitiveness has dipped. Unlike most neighbouring western European countries, advanced internet infrastructure is widely lacking in rural Germany. Many of the country’s voluminous Mittelstand (mid-sized companies) are remotely based family-owned business, where keeping pace with digitalisation can be challenging. When broadband access is sparse, companies struggle even more to compete globally, dealmakers said.

Germany is not speeding towards a recession and demand for its targets remains strong; instead, the challenge lies in supplying enough quality targets. The need for Germany to invest in its mid cap backbone has been recognised, and dealmakers recognize a collective responsibility and pressure to invest in the event of looming economic downturn.

Additionally, there are no signs that interest rates in Europe will rise any time soon, and so investment has the opportunity to pick up without the threat of higher interest rates choking growth in Germany, dealmakers said.

Convincing the cautious

German M&A has stepped up a gear following an inauspicious end to 2018 and in recent years, the government-backed Industrie 4.0 initiative has prompted increasing efficiency through investing in automation and robotics. Now there is a need to invest and digitalise the output side, especially in the services segment of Germany’s economy, dealmakers said.

Habitually cautious and risk-averse, German business owners can be sceptical taking on new ideas, particularly regarding technology. Unless there is a shift in attitude, dealmakers say there is a danger of once acclaimed family-businesses heading down a path to mediocrity. Whether via acquisitions, research and development or technology, these mid cap firms rely on investment waves as a way to realise growth, if they are to retain excellence and attract suitors.

Companies are gradually becoming more convinced about the necessity of making their businesses more digital, dealmakers in Duesseldorf said. Advisers have been introducing ideas, for instance, by running pilot projects, demonstrating what can be achieved through innovative technology and bringing management on board to expand these initiatives to other areas of the company.

Furthermore, directly after a deal is signed, a suggested strategy can be sent to the target’s management to expand the digital capabilities of the company.

Tech to ensure stability

Germany may be closer towards correction than recession, dealmakers said when accounting for its stable outlook. Moody's AAA credit profile of Germany, is supported by the country's "very high" economic strength.

Technology and IT service software are areas that promise stability, demand high valuations, and need investment. An increased number of carve out and spin-off situations could signal that Germany is falling behind in core platform technology, one dealmaker suggested.

Germany has numerous start-ups in innovative sectors such as e-mobility and sharing services, but these lag behind Asia in quantity and quality, dealmakers said. More early stage accelerator funds like Bonn-based High-Tech Gruenderfonds (HTGF) are required, they said. After all, it was as recent as 2016 that China's Midea Group [SHE: 000333] turned to Germany for tech innovation by entering into an investor agreement with German robotics firm KUKA [ETR:KU2]. But stricter foreign direct investment regulation combined with a certain complacency has since forced the tide to turn.

Strategic buyers and long-term funds are driving up valuations, as they look to develop their own business models and invest in areas including connectivity, autonomous driving, shared economy and vehicle electrification. Indeed, in the automotive industry, suppliers are using partnerships and minority investments in order to add new technologies and adapt to transformations in the industry.

Drawn abroad

Despite its central position in the global automotive industry, Germany’s offering of start-ups developing new car technologies is not as strong as in other regions, they said.

Among other factors is that Germany does not have competitive early-stage funding conditions. As such, many buyers are turning abroad in search of targets in Silicon Valley and in Israel for example, dealmakers said.

In terms of digitalisation, investors are looking to other European cities with better offerings like London and Paris. While Berlin has a healthy start-up scene, it is not as focussed on the advanced technology needed to transform into software- and services-based businesses, dealmakers said.

Additionally, German family-owned businesses can struggle to establish themselves abroad as they may not fit culturally, or entrepreneurs are reluctant to give up stakes in their businesses due to the amount of personal wealth tied up in an asset, they said.

Yet, a generational shift may be on the horizon as older business owners – often considered more averse to selling a family business - make way to a younger generation of entrepreneurs more open to sharing ideas, and to new markets and challenges, dealmakers said.

It is not only broadband internet holding these remotely located mid-caps back; there is also a talent war to bring jobs to rural areas, and for traditional Mittelstand that is a challenge, dealmakers said. One alternative is to build a digital hub in a nearby city, because by becoming digital companies automatically become more global, they said.

Emma-Victoria Farr Financial Journalist Mergermarket

Emma-Victoria reports on M&A activity in the DACH region for Mergermarket. Previously she has worked for Bloomberg in Frankfurt, The Daily Telegraph in London, Deutsche Presse Agentur (dpa) in Berlin, and Falter Verlag in Vienna. She has a Masters in German Literature from Oxford University.