Private equity firms eye undervalued German small cap stocks
By Alexander Dominicus, Portfolio Manager in Mainfirst’s team Blend / European Equities
The low valuation of German small caps has not gone unnoticed by private equity firms. The sector has increasingly turned its attention to stock market-listed companies. The reason is obvious: after many years of underperformance, small caps are valued historically cheap and can therefore be an attractive target for private equity investors despite the takeover premium.
In August last year, a piece of news at OHB caused quite a stir. The private equity giant KKR was planning a takeover and wanted to delist the company from the stock exchange. OHB is a classic hidden champion and, as a family-owned company, a niche provider in the attractive and growing space sector. However, its potential has long been overlooked by the stock market. The company did not receive the necessary attention in the sidelined small cap segment and was finally discovered as a takeover candidate by private equity.
OHB is not a unique case, as private equity firms are increasingly targeting listed hidden champions in the German SME sector. Other prominent examples are the software company Suse and the medium-sized company Va-Q-tec, both were acquired by EQT.
But why is the market for private equity so interesting as the hurdles involved in taking over listed companies cannot be ignored. Firstly, high acquisition premiums are usually paid to incentivize existing shareholders to tender their shares. These rewards can easily exceed 30 % and reduce the potential return. On the other hand, the regulatory hurdles are high and ultimately there is no transaction security. It is difficult to predict how many shares will end up in the hands of the bidders.
More than rewarding in some cases
And yet such takeovers seem to be more than rewarding in some cases. There is still plenty of private equity capital available and the number of good privately owned companies available at attractive prices is more than limited. The major difficulty: sellers in the private market are often not willing to accept the low multiples on the stock exchange. After all, the stock market is volatile, and the world looked very different a few years ago. Every owner has an approximate price in mind for their company and will often not deviate from this if the multiples on the stock market are turning lower. It can therefore be a better alternative to take over a listed company and still achieve an attractive multiple despite the takeover premium.
This was also the case recently with Encavis. The stock had been an outperformer for many years, but the wind has changed. Encavis shares were also unable to escape the rising interest rates and the sell-off in small and midcaps, despite its good operating performance. The stock price has more than halved in value since its high in 2022 and became therefore probably valued too cheap, ultimately attracting the attention of KKR, which is looking to acquire Encavis at a premium of around 30 %.
We assume that this will not be the end. After several years of underperformance by small and mid-caps, the segment has been completely left behind. But despite great companies and many good business models, the investors are barely interested in these shares anymore. This now doubles the return potential for small caps, as investors can not only hope for a recovery of the segment but also collect attractive takeover premiums if private equity puts out the feelers. We therefore assume that a number of SMEs are still on private equity firms' watch lists and that we will see further takeovers over the course of the year.
