German Market Outlook 2014 Mid Cap Financial Markets in Times of Macro Uncertainty and Tightening Bank Regulations

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1 Mid Cap Financial Markets in Times of Macro Uncertainty and Tightening Bank Regulations 213 A Good Year for Germany s Financial Markets For contact details please see contact list at the end of this report The following highlighted snapshots of the financial markets in 213 reflected the healthy state of Germany's economy: A 21% DAX outperformance over its European peers surpassed only by the 33% and 22% performances of the MDAX for mid-caps and SDAX for small caps, respectively A 33% growth in buyout transaction volumes with DACH involvement driven by the return of larger transactions Over 8bn raised in the Schuldschein market with a record number of foreign issuers entering the market Ca. 3bn capital raised in mid-cap bond markets despite concerns about defaults and weak creditor protection. However, the strong loan market performance needs to be benchmarked against a lackluster credit demand given the slow capital expenditure. 214 Where did all the Risks go? Will the memory of a doom s day sovereign debt crisis in mid-212 fade away? Contents Global Economic Outlook and Prospects for the German Economy 2 Corporate Germany: at Crossroads to Financial Markets? 1 German Private Equity Market 13 Corporate Market 17 Corporate Schuldscheindarlehen: Tongue Twister Goes Abroad 19 Leveraged Market: Borrower Friendly is back 21 European High-Yield Market: Coming in Strongly 22 Mid Cap Bond Market 26 Credentials 29 Contact Details 3 Visit us and Meet us 31 Disclaimer 32 No noticeable headwinds and continued liquidity provision through central banks result in optimistic outlook: German GDP growth expected at 2% in 214 Pick-up in capital expenditure and investment to bolster growth, in particular overseas Likewise, increased M&A and buyout activities given improved outlook, still attractive valuations and ample "dry powder" Further deleveraging in the banking sector driven by Basel III and ECB stress tests. Consequently, we expect a steady increase in issuance activities by mid-cap companies across Europe including the German Mittelstand. We would like to take this opportunity to thank our clients for engaging in numerous interesting discussions, exploring ample business opportunities and offering constructive feedback regarding how to further shape our business, and better address our clients needs. We look forward to working with you in 214!

2 Global Economic Outlook and Prospects for the German Economy Industrialized economies still struggling with possible stagnation concerns Credit growth poses concerns for Eurozone growth prospects, but the 214 outlook has improved Global growth is set to recover in 214 on the back of strong industrial output growth of emerging markets, a stabilizing Eurozone as well as robust growth in the US. Germany, by virtue of being an exceptionally open economy with a strong industrial base, should benefit from this development. As a result, the growth in the German economy should accelerate from.6% in 213 to around 2.% in 214. In 213, the industrialized world and its policy makers have struggled to shake off the remaining concerns over possible balance sheet recessions and their deflationary impact. The consequences of ambitious fiscal consolidation measures in the Eurozone have further magnified such concerns and have delayed any significant recovery in business and consumer confidence. As a result, key central banks have continued to initiate extraordinary monetary policy measures in an effort to support their respective economies. This has led to a significant increase in central bank balance sheets and real money balances especially in the US, Japan and Great Britain. Credit allocation to the private sector is still shrinking in many Eurozone countries, thereby enforcing balance sheet adjustments for households and corporations. However, the pace of economic decline has moderated and the Eurozone s GDP appears to have turned the tide, showing positive growth in the second and third quarter of 213. Given the reduced need for further fiscal tightening in 214 and signs of a revival in confidence, we expect a moderate recovery in the Eurozone economy, suggesting a sizeable turnaround in the Eurozone s contribution to the global growth in 214. In addition, the US economy is expected to grow around one percentage point higher next year, while the Chinese growth continues to surprise on the upside despite concerns over a possible property bubble and an inefficient allocation of savings. Not surprisingly, global growth is expected to be at least one percentage point higher in 214 than what it was in 213. Fig. 1: Industrial Production Index (25=1) World Advanced Economies Emerging Economies Global growth continues to be driven by industrialization of emerging markets Source: CPB; IKB Since the beginning of the new millennium, the industrial output of emerging markets has emerged as the major global growth driver. In the 199s, the growth was primarily driven by industrialized economies mainly due to their service industry s growth and to a smaller extent by their industrial output. Since then, around 75% of global growth dynamics can be attributed to the industrial output growth of emerging markets. As a result, the current global growth dynamics strongly favor open economies with a high industry/gdp ratio, that is, economies that can participate particularly well in the global production of primary and secondary industrial goods. December 12th, 213 2

3 Fig. 2: Average GDP Growth and Industry Share of GDP Average GDP growth in % 1) Latvia France Greece Poland Estonia Lithuania Romania Bulgaria Sw itzerland Sw eden Belgium Austria Slovenia UK Netherlands Germany Finland Spain Croatia Denmark Hungary Italy Portugal Slovakia Czech Rep Average share of industry as % of GDP 2) 1) Average 25 to 212 2) Average 25 to 21 Source: Eurostat German economy has globalized on a broad scale and should benefit from the expected global recovery in 214 The German economy is one of the most open economies in the world. The country also has a stable industrial base, with output in excess of 2% of GDP. Both of these features suggest that Germany has not only focused on export markets to ensure adequate demand for its products. The economy has also adjusted its supply side to be in tune with a changing global environment and increased competition. This is evident from the high percentage of foreign production found not only among DAX companies, but in particular among mid-sized German companies. Companies supply and demand profiles bear evidence of an economy that has globalized on a broad scale. Not surprisingly, the German economy is in a particularly favorable position to benefit from the reviving global growth dynamics in 214. Fig. 3: Exports and Imports as % of GDP (212) Germany UK Italy France China Japan USA Exports Imports Source: E.I.U.; IKB Confidence revival induces recovery in investment spending across the Eurozone, favoring German exports Over the last two years, the growth in the German economy was driven by foreign as well as domestic demand, with net exports to GDP falling marginally to around 7%, just short of the pre-crisis peak of 8% in 28. The reasons for the relatively reserved export growth include a general reluctance among many European economies to raise their investment spending, which is a major demand component for Germany s industrial exports. Given the increasing revival in confidence across Europe, we expect investment spending to recover in 214, albeit from fairly low levels, given the ample spare capacity. The decline in real investment spending appears to have turned around in the second quarter of 213, as is evident across all major Eurozone economies. December 12th, 213 3

4 Fig. 4: Real Investment in Equipment 14 Index (2=1) Germany Eurozone Source: Eurostat; Federal Statistical Office; IKB German GDP growth expected to reach around 2% in 214 Falling inflation, solid wage rate growth and a robust labor market have ensured healthy real income growth for German households. Not surprisingly, domestic demand, especially private consumption has become a stable growth driver in the last two years. This trend is likely to continue, as accelerated GDP growth will create enough room for productivity gains to unfold without exerting excessive pressure on the labor market. Therefore, 214 will be a year in which domestic demand and strong exports support Germany s growth prospects. The German economy grew at.7% in the second quarter of 213, followed by.3% in the third. Leading indicators confirm a renewed revival of growth in the final quarter as well. Given the expected global growth dynamics as well as the pent-up demand for investment spending in Germany and the Eurozone, we believe a growth of around 2.% in 214/15 is fairly plausible. Fig. 5: Outlook: GDP Growth F 214F 215F Germany 3.4%.9%.6% 2.% 2.% Eurozone 1.6% -.6% -.4% 1.1% 1.7% UK 1.1%.1% 1.4% 2.3% 2.3% USA 1.8% 2.8% 1.7% 2.7% 3.2% Japan -.6% 2.% 1.9% 1.6% 1.4% China 9.3% 7.8% 7.7% 7.8% 7.6% Source: IKB Manufacturing sector s output growth set to accelerate in 214 Many sectors of the German economy experienced negative output growth in the first half of 213. However, a general revival has been witnessed in many sectors in the second half. Given the improving global prospects, we expect the output growth to further recover in 214. This is especially the case for sectors such as automotive and machinery the two primary export sectors of the German economy both are rather sensitive to the local and global business cycles. December 12th, 213 4

5 Fig. 6: Outlook: Sector Output Growth F 214F 215F Food 1.% -.2%.%.7% 1.%.7% Textiles and clothing 7.5% -.4% -7.7% -.2%.7% -.3% Wood and forestry 6.% 12.4% -.1% 1.8% 2.3% 2.% Paper 7.7% -1.7% -1.6%.5% 1.7% 1.6% Chemicals and pharmaceuticals 11.% 1.% -1.9% 1.8% 3.% 2.7% Rubber and plastics 12.8% 4.4% -1.5% 2.9% 3.1% 2.7% Building material (non-metallic mineral products) 6.6% 9.6% -4.% -1.6% 1.9% 1.6% Metal production 2.4% 2.2% -3.4% 1.6% 4.% 3.3% Metal products 14.1% 11.1% -.9% 1.6% 4.3% 3.8% Electrical engineering 16.3% 11.9% -2.% -2.4% 4.5% 3.9% Machinery and equipment 9.7% 13.8% 1.9% -.6% 3.6% 3.% Automotive 24.9% 13.1%.2% 1.3% 5.6% 4.9% Furniture, other manufacturing 5.% 3.9% -1.2% -3.8% 1.%.8% Source: Federal Statistical Office; IKB SWOT-Analysis Strong Industrial Base Globalisation Competitiveness Strengths High level of globalization among German Mittelstand Specialization has led to high level of global competitiveness Globalized market penetration allows participation in all growing markets Fiscal consolidation largely completed Opportunity Global recovery should favour an open economy Increased recovery of investment spending supports German exports Mittelstand increasingly globalized and less dependent on German labour market Weaknesses High personal saving rate hampers accelerated growth of private consumption expenditure Demographics limit potential output growth Threats Renewed breakdown of investor confidence and continued deleveraging could hamper demand for investment goods EU concerns over Germany s current account surplus could lead to domestic policies that erode competitiveness A minimum wage rate could affect labour market and consumer confidence negatively Ageing Population Legislation Global Recovery December 12th, 213 5

6 Inflation, Interest Rates and Monetary Policy Inflationary pressures in the Eurozone are well contained Inflation in the Eurozone continues to surprise on the downside. Starting the year with an inflation rate of around 2% in January 213, the annual change in headline CPI fell to.7% in October, largely due to energy prices. Credit allocation to the private sector has continued to put deflationary pressures, although this process should gradually reverse in 214. As a result, inflation is expected to increase moderately over the next 18 to 24 months, but should remain well contained due to the rather moderate medium-term growth prospects for the Eurozone. Fig. 7: CPI-Inflation in the Eurozone YoY % Change Possibility of negative ECB rates cannot be discarded Money market rates to remain at current levels at least until the middle of 215 Source: Eurostat; IKB The ECB expects the headline inflation to remain well below 2% for 214, possibly warranting further monetary policy easing to speed up the turnaround in the credit cycle. In this regard, the option of a negative deposit rate on banks excess liquidity held with the ECB continues to be debated. Whether such a move will trigger increased credit allocation is questionable, since interest rates are already at record low levels and the impediment to an increased credit demand is rather based on the lack of business and consumer confidence. Nevertheless, such a policy appears to be a possible option for the ECB. Another option the bank can exercise is to follow in the footsteps of the Bank of England regarding its Funding for Lending Scheme (FLS). In this case, the central bank provides relatively attractive funding to banks under the provision that such funds are used for lending to the real economy. The ECB has clearly stated in its forward guidance that rates will remain at the current or lower levels for an extended period of time. As the key ECB lending rate has been cut to.25%, concerns over the impact of a continued reduction in excess liquidity have been abated. Money market rates are essentially capped at around their current levels, a situation that should prevail at least until early to mid-215. From then onward and on the assumption that the Eurozone economy and credit supply recover on expected lines, a forward-looking central bank might see a growing need for normalization in its policy stance meaning a reversal to real positive interest rates starting 216. Fig. 8: ECB and Money Market Rates in % Source: Bloomberg; ECB; IKB ECB Main Refinancing Rate 3M-Euribor Deposit Rate US labor market to improve slowly The monetary policy in the US continues to be dictated by labor market developments. However, even with an economy growing in excess of 2.5% in 214, it is unlikely that the unemployment rate will fall much below the Federal Reserve s target of 6.5% before early December 12th, 213 6

7 No quick termination of Fed s QE program 215. This, however, would be consistent with the Fed s forward guidance, which points toward a reversal in the interest rate policy of the US Central Bank in 215. The tapering of the Fed s quantitative easing program (QE) should commence over the next couple of months. However, the Fed appears to be in no hurry for an early and complete termination, given the prospects for the US labor market. Further, the Fed s next chief Janet Yellen follows closely in the footsteps of Ben Bernanke and considers an active policy of supporting the economic recovery as the Fed s primary responsibility. According to Yellen, the surest way to an ultimately normal monetary policy is decisive policy action over the short-term. Fig. 9: Long-term Interest Rates (1-Year) 4 3 in % Germany USA Source: Bloomberg, IKB Long-term bond yields should drift higher on both sides of the Atlantic Besides the labor market prospects, the reaction of financial markets will be another important determinant for the pace of the Fed s exit strategy. Long-term bond yields have reacted quite sharply to the initial announcement of a possible tapering, increasing by over 1bps in the US and inducing a global repricing of financial assets. Since then, and despite the Fed s postponement, yields have not receded to their previous low levels. A forthcoming reduction of the QE program by the Fed is expected, reducing the risk of major surprises. Nevertheless, with an improving economic outlook, long-term bond yields in the US should drift higher in 214, causing German bond yields to follow. Fig. 1: Outlook: CPI Inflation, YoY % Change F 214F 215F Germany 2.1% 2.% 1.5% 1.7% 2.% Eurozone 2.7% 2.5% 1.4% 1.4% 2.2% UK 4.5% 2.8% 2.6% 2.4% 2.1% USA 3.1% 2.1% 1.4% 1.9% 2.4% Japan -.3%.%.3% 2.2% 1.5% China 5.4% 2.7% 2.7% 3.1% 3.% Source: Bloomberg; IKB Fig. 11: Outlook: Short and Long-term Interest Rates 25 Nov. in 3M in 6M in 9M End 214 3M-Euribor.23%.22%.22%.22%.24% 3M-$-Libor.24%.26%.28%.28%.28% 1-Year Bund 1.72% 1.9% 2.% 2.3% 2.5% 1-Year U.S. Treasury 2.73% 2.8% 2.9% 3.% 3.2% EUR Swap 1-Year 1.98% 2.2% 2.4% 2.7% 2.9% US-$ Swap 1-Year 2.81% 2.9% 3.% 3.2% 3.4% Source: Bloomberg; IKB December 12th, 213 7

8 Outlook for the /US$ and other Exchange Rates Fed s policy has triggered significant financial market volatility The Fed s monetary policy continues to have a significant influence on global financial markets, as an increasing flood of US dollars chases financial returns around the globe. Unintended consequences of this policy have become evident in May 213, when the Fed for the first time contemplated a reduction in its monthly asset purchases. Markets reacted quite sharply, especially in emerging economies, as a significant amount of US dollars found their way back into the US, causing a general depreciation of emerging market currencies. Fig. 12: Federal Reserve Bank: Total Assets 4, in US$bn 3, 2, 1, Source: Fed; IKB Fed s policy to favor dollar s strength in 214 Financial markets in general, and foreign exchange markets in particular, will be shaped by expectations surrounding the Fed s policy change in 214/15. However, given current bond yield levels and the Fed s forward guidance, the impact of tapering and eventual termination of the Fed s QE program on asset prices should be contained. Nevertheless, US long-term bond yields are expected to drift higher, widening the interest rate differential between the US and other major economies. This, in turn, supports the possibility of a dollar appreciation in the first half of 214. Fig. 13: Long-term Interest Rate Differential USA vs. Germany bps Source: Bloomberg; IKB Euro to strengthen over the medium term The Eurozone s economic stabilization should fundamentally improve the sovereign risk profile of many of its member states in 214 and beyond. This together with prospects of a sustained economic recovery, supports the notion that German bunds will continue to lose their attractiveness as a safe haven. This should prevent an excessive widening of the interest rate differential between the US and Germany, and support the /US$ exchange rate over the medium-term. December 12th, 213 8

9 Short-term Euro weakness is likely and possibly wanted by the ECB The forthcoming changes in the US monetary policy as well as favorable US growth prospects for 214 increase the probability of a short-term dollar appreciation against the Euro. This should be a welcoming development for the ECB, as it eases deflationary pressures within the Eurozone. Over a period of time, the Euro should be supported by the recovering Eurozone economy, declining sovereign risk premiums and a gradual reduction of the US-Eurozone growth differential. Fig. 14: Outlook: Selected Spot Exchange Rates 25 Nov. in 3M in 6M in 9M End 214 /US$ / / /CHF Source: Bloomberg; IKB December 12th, 213 9

10 Corporate Germany: at Crossroads to Financial Markets? In Southern European countries, a credit crunch can be seen Despite a revival in bank lending, falling margins and low default rates, German corporations will be increasingly looking to tap the capital markets. The reasons include long-term bank funding costs, regulatory aspects and a higher acceptance of marketbased financing solutions. These range from increased usage of Schuldscheindarlehen over direct lending vehicles to bond issuance. Large German corporations are currently enjoying a comfortable financing environment as rosy as it was in 27 on the back of buoyant bank lending and capital markets. This is in stark contrast to their Southern European peers where a situation similar to a credit crunch could be observed in the past 15 months; the loan supply to companies has been constantly declining in absolute figures. This credit cutback has been driven by the local banks limited lending ability given their liquidity/refinancing constraints and the volume of non-performing loans and weak borrowers. In this macroeconomic environment, even better-rated companies are facing limited finance supply. % YoY Source: Bloomberg; IKB Fig. 15: Loans to the Non-Financial Sector Germany Italy France Spain Source: Bloomberg Fig. 16: CDS: 5-Years Senior Spreads UniCredit Commerzbank Santander In Germany, corporations have changed their balance sheet structure from an equity ratio of 2% to 3% As the ECB through its choice of policy instruments attempts to stimulate bank lending and credit provision in Southern Europe, German companies continue to enjoy the luxury of relaxed financing and lending conditions. However, they do not seem to derive full advantage of the financing environment. German corporations, especially manufacturers, have improved their balance sheet structure over the last decade from an equity ratio of less than 2% to approximately 3% (fig. 17). This was mainly achieved by increased retained earnings and also by mezzanine instruments accounted for as equity, thereby restraining themselves on both investment activities and credit growth. Fig. 17: Equity Ratios of German Firms Fig. 18: Share of Corporate Investments of GDP in % in % Total Companies Manufacturing Source: Federal Statistical Office Source: Federal Statistical Office December 12th, 213 1

11 The share of bank loans in total liabilities was reduced from more than 2% to around 13% In light of the ongoing uncertainty in financial markets and discussions about the Eurozone s future, corporations have remained rather cautious in their investment decisions. Similar to 212, investments in long-term assets such as machinery and equipment are expected to decline again in 213. Muted investment activity was to a large extent funded out of operating cash flows, bringing down the share of bank liabilities as a percentage of total liabilities from more than 2% to 13% over the last 1 years. Further, with concerns about the impact of Basel III regulations and possibly negative experiences among banks during the 28/9 financial crisis, many mid-cap companies have started to look at capital markets as a way to diversify their funding sources (fig. 19). Fig. 19: External Funding Structure of Companies in 212 in bn Trade credits, prepayments 19. Bonds etc Pension provisions Shares etc. -5. Loans Corporate finance is in the midst of a structural transformation process: New financing solutions beyond the traditional bank loan are evolving Regulatory framework supports the trend towards market-based financing solutions Financing solutions for the German Mittelstand Source: Bloomberg; IKB Consequently, in 213, the German mid-cap financing market has been marked on the one hand by improved credit quality and muted demand for financing, and by an improved credit supply through a slowly recovering banking sector on the other. With further economic recovery likely to occur in 214, investments in new machinery and equipment are expected to rise steadily in 214. In addition, export companies in many sectors are expected to focus on expanding their production and development capacities in growth markets such as Asia and North America for strengthening their market position. With the ongoing changes to the regulatory banking frameworks (Basel III) as well as the insurance industry (Solvency II), it will be interesting to see how long-term financing demand will be covered, and which instruments will provide long-term funding. The regulatory objective to create stronger banks requires higher core capital ratios, which can only be met through a further deleveraging of bank balance sheets. This will clearly affect the ability of the banking sector to meet the growing credit demand in 214. The introduction of a net stable funding ratio will limit, especially long-term bank lending, which in Europe has been traditionally the dominant pillar of investment financing. With an increased link between ratings and risk-weightings, we believe this development will be most pronounced for corporations at the lower end of or below the investment grade space. We, therefore, expect the trend toward market-based financing solutions and to some extent disintermediation of the banking sector, to gather pace in the coming years. There is a need for adequate financing solutions for the German Mittelstand. Such financing solutions have been pioneered by us and other institutions over the last couple of years: Expansion of the Schuldschein market: Historically, the Schuldscheindarlehen market (see the specific section for more details) has been an investment gradefocused market with a minimum issue size of c. 5m. Investors appetite to put money at work opened up this market for both crossover credits as well as smaller issue sizes (e.g. IKB s 3m issue for Analytik Jena AG in 212). Insurance-based solutions: With the long-term investment needs of the insurance companies and the Mittelstand s long-term investment focus, numerous initiatives December 12th,

12 have been focused on matching insurance money with long-term mid-cap lending. IKB s Senior Secured Debt Fund Hidden Champions is a credit vehicle that combines the investment funding for mid-cap companies with the investment requirements of insurance companies. Development of a mid-cap bond market: Mid-cap companies have in the past shied away from the disclosure requirements of public bond markets, while at the same time, the minimum issue sizes of 2m+ often exceeded the financing needs of the Mittelstand. With the introduction of dedicated mid-cap bond market segments, German SMEs can now cover funding needs through these channels and over 5bn worth of capital has been raised thus far. While these new market segments still face numerous issues in terms of documentation, underlying credit quality and overall liquidity, the emergence of dedicated institutional fund managers, various initiatives covering issuer quality and the ongoing need for yield will ensure the further development of this market into the little brother of the high-yield market for established German corporations. The recent successful and oversubscribed issues such as Alfmeier ( 3m) or Hörmann ( 5m) underpin the fact that investor appetite for such issues is still high. Mid-cap mezzanine: With expansion and investment programs predicted for the German industry for 214 and beyond often requiring additional risk capital, we also forecast an increased demand for dedicated mezzanine capital. The Valin Mezzanine Fund of IKB/Seer Capital is one of these dedicated funds, providing mezzanine capital to companies having up to 5m turnover and holding further growth potential. Outlook 214: Further diversification of funding sources In summary, we expect a further diversification of funding sources in 214, utilized by German corporations away from traditional bank lending given the increased funding needs and the desire to reduce dependency on banks and against the backdrop of continuing regulatory scrutiny for the financial industry. December 12th,

13 German Private Equity Market 213: overall M&A volume continues to rise After a slow start into the year with the total German M&A volume of 5.8bn in Q1 (down -57% from 13.6bn in Q4 212 and -52% from 12.bn in Q1 212), the pace picked up with 29.4bn and 23.4bn in Q2 and Q3 respectively. The aggregate YTD volume as of Q3 is up 32% as compared to Q3 212 and already slightly above the entire year of 212 ( 58.6bn vs. 58.1bn). The number of deals over that period amounts to 482 vs. 692 for the entire year of 212, implying an increase of 45% in average deal value during YTD 213 as compared to last year. The increase is, among others, driven by three large sponsor-backed transactions in Q2. Fig. 2: M&A Activity in Germany (Value bn) Fig. 21: M&A Activity in Germany per Quarter (Value bn) YTD Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q Value in bn No. of deals Value in bn No. of deals Source: Merger Market, Q3 213 Source: Merger Market, Q3 213 Buy-out activity increased 33% YTD compared with 212 driven by three large deals in Q2 This year s total buy-out volume reached 1.1bn until Q3, representing an increase of 33% over the same period last year. On a quarterly basis, the buy-out activity has followed a similar pattern, although more pronounced, with a total deal volume of.4bn as compared to 3.9bn in Q Later, a significant rise of 8.9bn was witnessed in Q2 213, accounting for 88% volume in YTD on the back of 26 transactions. Of this amount, nearly 7.9bn was contributed by only three transactions: CVC/ ista (Apr-13), Cinven/ CeramTec (Jun-13) and BC Partners/ Springer Science (Jun-13). On that basis, the buy-out activity as percentage of the total value has slightly decreased to 17.2%. Fig. 22: Buy-outs in Germany (Value bn) Fig. 23: Buy-outs in Germany per Quarter (Value bn) % % % 1.6% 8.% % 17.2% YTD 3% 25% 2% 15% 1% 5% % % 8.9 4% 27.% 28.6% 3.3% 3% 23.1% % 11.5% 9.5% 4.5% 7.6% 7.4% % 1% % Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q Value in bn % of total M&A value Value in bn % of total M&A value Source: Merger Market, Q3 213 Source: Merger Market, Q3 213 Most buy-outs in industrials/chemicals, while highest value in TMT driven by a few large transactions In terms of industry sectors, Industrials/Chemicals continue to represent the majority of buy-outs in Germany with 42.% of all transactions, but with only 35.% in terms of value. TMT was the most sought after sector in terms of value with 3.7%, which was also driven by the large transactions mentioned above. December 12th,

14 Fig. 24: Buy-outs in Germany by Industry (Value, YTD 213) Fig. 25: Buy-outs in Germany by Industry (# of Transactions, YTD 213).3% 1.8%.9%.2% 3.6% 27.6% 35.% 2.9% 2.9% 1.4% 2.9% 5.8% 7.2% 42.% 7.2% 3.7% 1.1% Source: Merger Market, Q3 213 Source: Merger Market, Q % TMT Business Services Industrials & Chemicals Financial Services Pharma, Medical & Biotech Consumer Energy, Mining & Utilities Construction Leisure Agriculture More buy-outs than exits sponsors increase German exposure The primary buy-out activity in YTD 213 has declined by around 45% as compared to the same period last year, while the secondary volume has more than doubled. Exits to strategics remained flat, resulting in an increase in sponsors net exposure to Germany. Fig. 26: Average Mid-Cap: Senior Debt/EBITDA 1) 6.x 5.x 4.x 3.x 2.x 1.x.x 4.9x 4.4x 3.9x 3.8x 3.4x 3.5x 3.3x Europe 1) European buy-outs of companies with 5m EBITDA or less Source: Bloomberg Growing willingness to invest in leveraged paper Key trend I: reduced funding costs Willingness of both banks and investors to invest in leveraged paper has continued to grow. For European issuers with EBITDA of 5m or less, the average senior leverage has increased by 1.1x to 4.4x senior debt/ebitda this year as compared to 212. While 212 represented a break from the post-crisis trend resulting in increased risk awareness driven by the European sovereign crisis, leverage in 213 has resumed the upward trend towards the 27 high of 4.9x. The continued decline in funding costs has added to these increased leverage levels and has also led to a significant increase in refinancings. In 213 YTD, almost 5% of all leveraged loans were issued to recapitalize existing portfolio assets. December 12th,

15 Fig. 27: Weighted Average New Issue Spreads in Germany Fig. 28: Sponsored New-Issue Leveraged Loan Volume E+ 55 E+ 5 E+ 45 E+ 4 E+ 35 E+ 3 E+ 25 E+ 2 E % % 18.3% % % %.9% 37.% 31.7% 48.8% % 5% 4% 3% 2% 1% % RC/TLA TLB/TLC Leveraged loan volume ( bn) Recap/Refi as % of total loans Key trend II: continued availability of funds Source: S&P, Q3 213 Source: S&P, Q3 213 Private equity investors continue to raise significant amounts of funds, driven by investors search for return. According to Preqin, assets under management as a sum of the unrealized value of existing portfolios and dry powder, continued to increase by 5% in 212. This reflects a slight decline of -1% in funds available for investment, which was overcompensated by the 8% increase in assets (unrealized value). Fig. 29: Private Equity Assets under Management ,5 3, 2,5 2, 1,5 1, 5 1,265 1,24 1,413 1,783 2,28 2, ,11 1,75 1, , Dry powder US$bn Unrealized value US$bn Source: Preqin, 213 Key trend III: reduced uncertainty The funding costs of Europe s weaker economies are used as an estimate of the current market assessment of the Euro sovereign crisis. The figure below illustrates that one significant contributor to overall market uncertainty has been reduced (or is being ignored for now). Spain s spread for 1-year government bonds has reduced by over 4bps from the peak of the crisis in summer 212 to around 2bps currently. This reduced uncertainty could increase buyers as well as sellers willingness to reach a deal. Fig. 3: CDS for Spain/Italy 1Y Government Bonds (bps) Jan 7 19 May 8 5 Oct 9 22 Feb 11 1 Jul Nov 13 Italy CDS USD SR 1 Y Spain CDS USD SR 1 Y Source: Bloomberg, November 213 December 12th,

16 Key trend IV: attractive valuations Reduced uncertainty has not only facilitates M&A transactions, but has also led to a significant appreciation among equity capital markets around the globe. Since the beginning of this year, DAX and MDAX have gained 21% and 33% respectively after rising 25% and 31% in 212. On this basis, valuation levels have increased further. On an average, EV/EBITDA (1-year forward looking) increased by.8x, increasing sellers willingness to exit non-core assets (strategics) or to consider early exits (sponsors). 14.x 12.x 1.x 8.x 6.x 4.x 2.x.x Fig. 31: DAX EV/EBITDA 12.6x 8.1x 6.8x 7.x 7.8x 6.x 6.x EV/EBITDA 1 Year Forward Fig. 32: Performance of DAX and MDAX % 16% 14% 12% 1% 8% 6% Jan-211 Dec-211 Dec-212 Nov-213 DAX MDAX Source: Bloomberg, November 213 Source: Bloomberg, November 213 Outlook 214: more of the same It appears as if all the ingredients are available for maintaining the positive M&A momentum into the next year, releasing some of the pent-up demand for the post-crisis M&A activity. Reduced uncertainty from the abatement of the economic crisis provides a more stable environment for both buyers and sellers. In combination with a favorable funding environment, financial sponsors should continue to take their share in the rising M&A activity, potentially even increasing their contribution. Rising asset valuations combined with cheaper funding and higher leverage should increase the likelihood of corporate sellers and financial buyers coming to terms. However, a reemergence of the sovereign debt crisis or an economic slowdown would negatively impact the overall trend. December 12th,

17 Corporate Market Fig. 33: Corporate Loans Volume (Western Europe) Fig. 34: Pricing (Western Europe) Volume ( bn) Q9 1Q1 3Q1 1Q11 3Q11 1Q12 3Q12 1Q13 3Q Count Spread E+3 E+25 E+2 E+15 E+1 E+5 213bps 186bps E (-131bps) 82bps (-143bps) 44bps DACH Other Deal Count A Pricing BBB Pricing Sources: LPC Sources: LPC Key Trends 213 The Western European loan market managed to arrange a loan volume of 268bn as of September 213 YTD, which is 18% below the previous year. The loan market was quite dynamic, reflecting the competition among European banks to maintain their important role. The major trends in YTD 213 were: Refinancing transactions drove the loan market (82%), while use of proceeds for M&A activity remained at a low level (5%). Pricing tightened for A and BBB range corporations from 115bps to 44bps and from 185bps to 82bps between January and September 213 respectively. Within an 18- month period, margins have been squeezed even more with -143bps and -131bps for same rating spectrum. Maturities for large Blue Chips extended from 3 to 5 years toward 5 years with two 1-year extension options. The Investment Grade volume in Western Europe amounted to more than US$7bn and was almost equally divided between loans and bonds. Historically, the average split was at around 8:2 in favor of loans. In the German small and mid-sized corporate market, we have observed an increasing number of non-ig corporations were able to convert bilateral baw commitments in up to 3-year credit lines. Outlook 214 The competitive environment among banks will remain intense for large and midsized Investment Grade companies. Particularly on the back of Basel III implementation, more banks will be active in the German mid-cap market segment, which would substantially improve funding costs for IG corporations. With respect to the overall loan vs. bond volume for corporate financing, we expect the split to shift in favor for loans given the strong loan market dynamics. However, corporations have learned their lessons to quickly adjust to market changes and switch horses. Institutional investors are positioning themselves to play a more important role through their direct lending activities. However, competitive pricings and longer maturities offered to IG corporations will slow down the rollout of direct lending activities. This competition among lenders has led to tightening margins during 213 YTD for larger IG corporations. We would expect this margin pressure to remain in place until an exogenous factor affects the risk/return profiles of banks. In addition, we would expect this trend to roll down the rating scale toward crossovers. However, the refinancing volume will decline since many Blue Chip corporations have already taken advantage of the favorable market environment in 213. Subsequently, we would expect an increasing number of refinancing transactions December 12th,

18 with a lower average deal size as larger mid-cap companies would try to benefit from the increasing bank appetite and aggressive terms. In 214, the trend for longer maturities will intensify and slowly move down the scale into the mid-cap space. On the back of these developments, refinancings will continue to play a dominant role in corporate land. We would expect more IG mid-cap companies to focus on early refinancings in order to take advantage of the current favorable market conditions. Thus, an increasing number of early refinancings should be observable. Furthermore, we expect the volume of M&A-driven deals to increase, though from a rather low starting level. Corporations have improved their operational performance and are now exploring strategic opportunities. KfW financing programs for capital expenditures will play a more important role for prosperous small and mid-sized companies. Depending on the economic climate, volumes are expected to cross the 23bn threshold in 214 vs. around 2bn in 213. For small and mid-sized companies, we see a continuing trend for borrowers to push for 3 5 year credit lines based on a standardized documentation, while trying to avoid the syndicated loan product as financing instrument of choice. December 12th,

19 Corporate Schuldscheindarlehen: Tongue Twister Goes Abroad Current developments and outlook Over the last 1 years, the Corporate Schuldschein market in Germany has attracted strong demand from investors. With a total issuance volume of approximately 8.3bn in 213, the positive long-term trend remains intact. Around 65 transactions were completed on best efforts basis in the current year which is similar to 211. Especially in the last two years, Corporate Schuldschein transactions with a minimum volume of 5 75m were executed with more than one arranger in order to increase transaction certainty. A considerable number of private placements below 3.m (also bilateral transactions) were not included in the market volume. While a public rating can be utilized for marketing a Corporate Schuldscheindarlehen, the majority of issues were marketed on an unrated basis. It will be interesting to see whether this changes in 214, on the back of an increasing footprint of continental European agencies such as Euler Hermes and higher awareness of the Schuldschein product by insurance companies that often require ratings. Many corporations have taken advantage of the Corporate Schuldschein market as first time issuers sometimes using Schuldschein as a first step toward capital markets, and thus showing capital market readiness. We estimate the total volume of outstanding Corporate Schuldschein volume to be in the range of 6 7bn currently, and the corporate Schuldschein market redemptions to be approximately 5. 6.bn in 213. A large number of these redemptions have been replaced by new issues. Approximately 25% of the Corporate Schuldschein issuers were foreign companies. Foreign issuers from European countries have frequently tapped the Corporate Schuldschein market and have successfully executed transactions. Additionally, besides Euro tranches, the market also saw a couple of transactions that include US dollar tranches (e.g. Software AG, Biotest AG). Transaction maturities extended from around 3 to 5 years in 212 toward 5 to 1 years in 213, depending on the industry a trend that we expect to continue in 214. The investor universe remains broadly unchanged and dominated by banks in the shorter maturities. However, as an implication of Basel III, we expect institutional investors such as insurance companies and pension funds to assume increasing importance. Consequently, issuers will have to continue to broaden and diversify their investor base. In 214, we expect no change regarding investors interest and liquidity, and estimate the issued volume to be in the range of bn. Fig. 35: Total Corporate Schuldschein volume 24 YTD 213 2, 18,9 in m 16, 12, 8, 4, 3, 4,5 5, 5,5 7,2 3,725 7,59 11,985 8, Total SSD volume Source: IKB; Bloomberg December 12th,

20 Fig. 36: Average Schuldschein Volume per Transaction 29 YTD 213 in m Source: IKB, Bloomberg Fig. 37: Issuance Volume by Rating 29 YTD 213 in m 3,5 3, 2,5 2, 1,5 1, N.R. BBB A AAA/AA itraxx Main Source: IKB, Bloomberg December 12th, 213 2

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