KfW Research. No. 3, April 2003. Economic Observer. Page 2: KfW s Management Succession Finance for Small and Medium-sized Enterprises. Page 7: Business Finance in Rough Waters.
KFW S MANAGEMENT SUCCESSION FINANCE FOR SMALL AND MEDIUM-SIZED ENTERPRISES Management successions will become an increasingly important issue in Germany. The financing of takeover transactions will prove to be a particular obstacle that may be overcome with the aid of promotional instruments. FACTS AND TRENDS As the first generation of post-war company founders is set to retire for age reasons an increasing number of family business owners will likely decide to sell their enterprises, since the bond between the enterprise and its owner is not as firm as it used to be because of the need for professionalizing the management or the desire for an alternative form of living. But there are other reasons why more and more enterprises or parts of enterprises will be acquired or sold. As the division of labour progresses and the competition as well as other conditions continue to change dynamically, enterprises must react faster and more flexibly than before. This can be done more easily and quickly through acquisition or sales transactions than by organic growth or shrinking within existing companies. The problem of succession becomes evident from the fact that, according to the Institute for SME Research in Bonn, approximately 71,000 family-owned enterprises with around 907,000 jobs were poised to replace their management in the year 2002. Around 5000 enterprises had to be shut down for lack of a successor, which affected around 32,000 employees. 2
The most frequent arrangement continues to be the handing down or sale of the enterprise within the family. What is becoming increasingly important too, however, is the sale to another enterprise, the sale to company employees management buy-out (MBO) and the sale to external managers management buy-in (MBI). MANAGEMENT SUCCESSION PROBLEMS To be successful, a management succession must be planned carefully in advance. Apart from deciding to whom the enterprise is to be transferred, tax issues need to be settled, the enterprise has to be appraised not always an easy task and contractual problems and liability issues have to be settled. Preparations often take several years. In a company takeover the obvious problem is the unusually high volume of the transaction, which typically exceeds the transferee's funding capacity. In the financing of takeovers it is particularly problematic that the purchase price sometimes also covers immaterial assets that cannot be secured, such as a trademark, the image or an established clientele. For this reason it is usually impossible to collateralize the financing in full. Because the transferees typically must perform the repayment of capital from the cash flow of the transferred enterprise the risk for potential lenders is quite high. Obviously credit institutions want to avoid such cluster risks in their books and therefore hesitate to finance business takeovers. 3
DISCRIMINATION OF SMALL AND MEDIUM-SIZED ENTERPRISES IN THE FINANCING OF TAKEOVER TRANSACTIONS Unlike large enterprises, which are able to raise the purchase price by issuing shares or borrowing from the capital market at favourable conditions, small and medium-sized enterprises depend on financing from their house bank. The object of the transfer can only partly be used as collateral for financing for the above reasons, and the small and medium-sized transferee often cannot provide additional security - in contrast with larger enterprises. This puts small and medium-sized enterprises at a disadvantage. Besides, for most SMEs a takeover transaction constitutes a very considerable effort (a so-called expansion investment) which, if it fails, can threaten the survival of the entire enterprise. For banks and savings banks the risk is therefore disproportionately higher than in financing a takeover by a large enterprise, so that either small enterprises have to accept worse conditions or the bank even denies the loan application. What also needs to be taken into account is that the credit institutions incur relatively high appraisal costs. The reason is that the financing of a takeover requires a much more in-depth analysis of the entire undertaking and of the market development and risks than would a "normal" business expenditure financing. Its character is rather that of a project financing. Given the complexity of the funding task and the risks involved, standard solutions can hardly be applied in such cases. The bank will take the increased 4
appraisal costs into account when determining the financing terms, and this will have a stronger impact on the interest rate for small takeover transactions than for larger volumes as is the case with large company takeovers. An alternative or complement to financing from banks may consist in attracting external capital (private equity) or mezzanine capital (subordinate loans, participation certificates, etc). But here too, similar restrictions apply as to loan financing. These typical difficulties in the financing of takeover transactions are surely an important reason why small and medium-sized enterprises only very rarely act as "transferees". From a regulatory perspective this is deplorable, because if small firms tend to be swallowed by large ones this consolidates the trend towards concentration and market power. THE ROLE OF KFW IN FINANCING MANAGEMENT SUCCESSION In the past years KfW has systematically expanded financing offers for small and medium-sized takeover transactions. Smaller takeovers carried out within the framework of management succession can be financed primarily under the KfW SME Programme and the KfW Venture Capital Programme. In order to finance more complex takeover transactions of SMEs KfW is currently testing the Programme for Acquisition Finance (borrowed capital with project finance character) and the Private Equity Programme 5
(complementing loan finance by an equity component). This provides an attractive and consistent offer of financing programmes that can be tailored to individual needs. The offer can tangibly reduce the financing disadvantage of smaller enterprises. CONCLUSION In the future there will be a rising number of management successions in small and medium-sized enterprises. The arrangements for the succession represent a very complex economic, legal and organizational process that may fail unless properly and diligently handled. Many old company owners are not paying enough attention to these problems, a neglect that may lead to failure. The consequence may be loss of employment and growth. Smaller and medium-sized enterprises in particular often fail to obtain financing for takeover transactions. This is where KfW has developed its market-conforming, efficient and targeted instruments. They provide financing offers for different needs (low-interest loans, exemption from liability, guarantees, equity financing) that can be combined in a useful way, thus permitting a financing solution to solve almost every problem. Author: Dirk Plankensteiner 6
BUSINESS FINANCE IN ROUGH WATERS The far-reaching changes in the financial system in Germany will make it more difficult for small and medium-sized firms to maintain their market position in the future. However, the situation also offers a chance to develop constructive solutions for the financing needs of SMEs, provided that the necessary analysis is based on the relevant data. In 2002 KfW, together with 16 professional and regional associations of industry, has conducted an extensive survey of enterprises of all size categories, branches of industry, legal forms and regions as to their bank connection, the borrowing conditions they obtain and their preferred financing practice. As in the previous year, the objective was to find out more about these problem complexes and current trends, and more specifically to find out to what extent the structural changes in the financial markets have transformed business finance. The 10 most important results of the survey are as follows: 1. For many enterprises financing conditions have once again clearly deteriorated against the previous year: Borrowing has become more difficult for 45% of the enterprises surveyed (32% in the previous year). Around one-third of them had problems in obtaining a loan at all. As much as one eighth of the enterprises have had their bank account terminated or have been threatened with termination in the past three years. 2. Banks are more risk-aware than before. They are urging for more 7
transparency, both in regard to the enterprise in general and to the specific project for which funds are to be borrowed, and they are demanding more security - especially from smaller enterprises. 3. With respect to short-term financing of working capital (collateral), tension appears to be easing: the share of enterprises that have been granted an extension of their credit line is bigger than the share of those that have had to accept a reduction, and it is growing. 4. In investment finance as well, the transformation taking place in the financial markets and the banks' increased risk awareness is becoming apparent: nearly one-fifth of the enterprises were denied the investment loan they applied for. For the first time a low equity ratio headed the list of reasons for such a denial (see graph p.11). 5. Around one fourth of the enterprises surveyed applied for promotional funds last year. The main sources were KfW/DtA promotional loans, as well as guarantees and subsidies. 6. The credit institutions usually provide comprehensive information on promotional schemes they are the main source of information for many enterprises. Smaller and eastern German enterprises, in turn, prefer to seek informationon promotional schemes from financial consultants and promotional banks. 7. Today the enterprises are much better informed by their bank about the criteria for their credit worthiness rating than just one year ago. Nearly three fifths of all enterprises are familiar with the criteria (51% in the pre- 8
vious year). The majority of enterprises are satisfied with their credit worthiness rating (60%). 8. Internal financing continues to be by far the most important source of finance. Short and long-term bank loans also continue to be particularly important. In addition, leasing and equity finance will also gain in importance, however. Thus far only few enterprises are considering a direct public listing as an option. 9. More than half the enterprises are seeking to raise their equity ratio. The main means of achieving this is by increased retention of earnings; quite a considerable number of enterprises also intend to absorb equity capital, provided they can avoid external influence on their management of the firm and provided that the investors will not sell their shares to third parties. 10. In 20% of the enterprises surveyed there has already been a management succession in the five years before the survey. However, the wave of successions has not reached its climax yet: in the next five years 30% of the enterprises will need to find a solution for their management succession. Taking over the management of an enterprise is primarily associated with tax, liquidity, financing and legal problems. In the coming years bigger problems than in the past are being expected. This year's survey clearly shows that the transformation in the financial markets is in full swing and more and more enterprises are having problems in obtaining necessary finance. This calls for adjustments on all sides, and 9
they too are in full swing. The enterprises must examine alternatives to the bank loan (such as leasing, factoring, bonds) without prejudice and, above all, strengthen their equity capital. Many must professionalize the management of their business and show more openness towards the banks. Above all, they must regard their rating as an opportunity to identify and eliminate weaknesses. This also poses new challenges for credit institutions: they must acquire rating competence and place it at the disposal of the enterprises in the sense of a management consultant. It is precisely when the financing conditions become more difficult that the promotional institutions are more strongly called upon. The classical promotional instruments need to be adapted to the changing framework conditions and further developed in order to make them fit for the challenges of the future. What also needs to be done is to improve the overall conditions for SME finance by applying innovative financing instruments and offering new financing alternatives to small and medium-sized enterprises. KfW has responded early to these challenges. Global loans and loan securitisations for example increase banks' willingness to extend loans, and the range of promotional schemes is being consistently adapted to the changing financing needs of the enterprises within the framework of the newly formed SME Bank, which resulted from the merger of KfW and DtA. Author: Dr. Dankwart Plattner 10
Refusal of loans - reasons given by banks (Company size in annual turnover, shares in percent) Bank s changed business policy Profitability too low Equity ratio too low Inadequate security Investment project not convincing Other reasons EUR under 1 m 1-2.5 m 2.5-10 m 10-50 m more than 50 m all companies 1.4 5.7 3.8 3.8 7.9 7.9 12.5 17.1 15.4 15.4 20.8 27.0 33.3 41.3 26.9 31.4 26.9 40.0 45.8 38.5 42.3 25.1 51.9 5.9 10.9 44.8 46.2 46.2 45.8 56.9 55.6 53.8 48.1 62.9 65.7 61.5 0 20 40 60 80 100 11
KFW AT A GLANCE The KfW Group gives impetus to economic, social and ecological development on a global scale. With a balance sheet total of 246.2 billion euros (2001) it is Europe s largest national development bank. KfW operates in the business areas investment finance in Germany and Europe, export and project finance, and investment finance in developing countries on behalf of the German government. Important promotional concerns are the support of SME s, housing finance, communal infrastructure and environmental protection. KfW has been proving its competence for more than 50 years as a strategic partner for the economy and government. It is a member of the Network of European Financial Institutions (NEFI) and is working closely with EIB, EIF, CEB, and the European Commission. KfW Economic Department Palmengartenstrasse 5-9, 60325 Frankfurt am Main Press Office Phone +49 (0) 69 7431 4400, Fax +49 (0) 69 7431 3266 Information Centre Phone +49 (0) 18 01 33 55 77, Fax +49 (0) 69 7431 6 43 55 e-mail: info@kfw.de, www.kfw.de 187252