Deutsche Beteiligungs AG

XETRA:DBAN

Earnings Call Transcript 2018-Q3

[Thomas Franke]

Good morning. This is Deutsche Beteiligungs AG in Frankfurt, Germany. I'm Thomas Franke, Head of Investor Relations, and hello to everybody who is in the line this morning. I'll now hand over to Susanne Zeidler, CFO of Deutsche Beteiligungs AG.

[Susanne Zeidler, CFO & Member of the Management Board]

Good morning, ladies and gentlemen also from my side. It's my pleasure to welcome you to our Q3 conference call. We published the figures early this morning. This is going to be an extraordinary conference call because we have a special topic on the agenda. As you might know, we received on 26 July a letter from the German Federal Financial Supervisory Authority, short, BaFin. This put an end to uncertainties surrounding a key accounting issue in our financial statements. As this is of great importance for the understanding of our financial statements, I would like to start today with some extra slides on this topic, and I go to Slide #3 directly.I would like to start with a short overview on the enforcement procedure. It started in January 2016 with a letter from the German Financial Reporting Enforcement Panel, short FREP. With this letter FREP opened a random sample examination of the consolidated financial statements at 30 September 2015. There were 6 areas of examination, which are marked on the slide. And it ended in November 2016 with the identification of an error in the area of carried interest. As we considered our accounting methods to be appropriate, the enforcement procedure entered into the second stage at the level of the BaFin in January 2017. This second stage ended now with the identification of an error. In order to avoid further costs and management attention, we decided now to accept. Our decision was made based on a hearing letter from June 2018. We decided then to accept the result rather than to fight any longer. We decided to change our accounting method immediately in the preparation of the quarterly statement on 30 June, on which we report today. As the change in methodology influences net income and the forecast negatively, we have made an ad hoc disclosure by the end of June.On Slide #4, I would like to give a brief background on what carried interest is and which different models exist worldwide because it is important for the understanding of the accountant -- accounting methodology. The definition is marked on the slide. Carried interest is a share of the profits of a private equity fund paid to the investment manager in excess of the amount that the investment manager contribute to the fund after certain agreed-upon hurdles are cleared. It provides an incentive to investment managers and creates an alignment of interest between them and the fund investor.There are numerous carried interest models worldwide. And there's a large bandwidth between them, and there are 2 models which mark the end of the bandwidth. On the left-hand side, there are deal-by-deal carry models, which were -- used to be very common in the U.S. in the past, which are very aggressive from the point of view of investors because carried interest is paid out once a deal has been successful or reached a certain hurdle. On the other hand side, there are whole-of-fund carried interest models, which seem to be more conservative, used only in -- to be common in Europe, are approved by the ILPA and are now widespread standard worldwide. And in between those models, there are numerous different models, each of them different from another one.On the right-hand side, we summarize the key important framework of our carried interest model in the DBAG funds. In our case, any carried interest paid out to managers is combined with a private coinvestment by the investment managers of roughly 1% of the entire fund volume. We only have carried interest according to the whole-of-fund concept and the distribution of profits follow the European waterfall. To summarize, carried interest models, as they are so different, are the most complex process in PE accounting, usually made such by the convoluted legal language employed in the ILPA. And the challenge for the accounting staff is to translate this into clear calculational terms. And how do the different calculational terms look like? This is -- we tried to show it on Slide #5. And again, following the different models, there's a large bandwidth you can observe in the accounting practice. On the left-hand side, there are those models which are based on a so-called theoretical hurdle. In this case, carried interest is accounted for the first time on the basis once the unrealized fair values of the assets are higher than the deposits that are still outstanding and exceed the hurdle. On the other hand side, there are models who only account for carried interest once it is paid out to the investment manager, which is here called the actual hurdle. And in between is our model, Deutsche Beteiligungs forecast, which we call forecast model. In the past, we accounted for carried interest for the first time when the forecasted distributions exceeded the hurdle probability of a disposal. And how does this look like? I try to show you on the basis of a schematic presentation of cash flows and fair values of a typical fund on Slide #6. In this case, the 3 lines show the paid-in capital plus preferred return, the distribution to limited partners and the sum of fair value and distributions. And you see that in this case, BaFin method will start accounting for carried interest in 2011 in this example, which is schematic. Whereas, DBAG method would start accounting for it in 2015. In other cases, the difference between the 2 starting points could be shorter or longer, depending on the underlying cash flow and fair value development of the assets in the fund.From 2015 on, both methods have accumulated the same amount of carried interest, and the further carry accounting in future years is the same under both method. This shows that there is only a timing difference in accrual of carried interest in a certain period of time. And I come now to Slide #7, which summarizes the commonalities and differences between the DBAG method and the BaFin method. To start with our method, our basic assumption is that a fund, in this case, DBAG Fund V, continues as planned, including the exit maturity of portfolio companies. This means that according to our accounting methodology, we do not assume that every asset is exited at every reporting date, but that it is only exited once we find it appropriate to be exited, because the investment case has been fulfilled and the development potential has been levered over the holding period of, let's say, 4, 5 or 6 years. The BaFin method has a completely different assumption. In this method, the assumption is that the portfolio, the entire portfolio, is liquidated or exited at each -- on each reporting date, regardless of whether or not the portfolio companies are mature to be exited or not. And these different assumptions lead to a different point of time for the first time of accounting of carried interest. In our method [Audio Gap]will be exceeded when the next exit occurs. And according to the BaFin method, the first time inclusion is when the sum of the repayments and fair value of portfolio is more than 8% higher than the acquisition cost. As already shown on the slide before, in January, our method leads to a later inclusion of carried interest. Under BaFin method, how many years up between both methods depends on the special -- on the KPIs of the underlying fund performance. And in the case of the BaFin method, it may be the case that a fund never reaches the hurdle because we have a whole-of-fund concept. And in this case, at the end of a fund lifetime, there might potentially be a reversal of the accrued carried interest if the fund never reaches the hurdle. The commonalities between both methodologies, I have already tried to pointed out in the -- on the slide before. The fair value of the coinvestment vehicle is identical on -- from a certain point of time on. In this case, it was from 30 September onwards. And the difference, and there are only differences in accumulation, but both methods result in the same total carried interest amount if the fund reaches the hurdle at all. If not, there is a significant difference in accounting between both methods.Now I come back to the -- to our enforcement procedure. As already mentioned, the random sample examination date was the consolidated financial statements at 30 September 2015. And the accounting error stated by BaFin leads to the fact that net result of investment activity and net income in 2014, 2015 were too low by EUR 14.6 million, and that in previous years, it was accordingly too high. In September 2015, DBAG Fund V was the only fund for which carry had to be accounted for. However, adopting the BaFin method has an impact on current financial statements, because we would have to take into account carried interest for Fund VI too now. Based on the hearing letter, we assumed that the account would have to be adopted prospectively. On this basis, we made the ad hoc release in June because this impacted our forecast.In the meantime, BaFin clarified that they would expect a retrospective correction of the error. This means that the effect on net income 2017, 2018 is lower and that previous year has to be adjusted. However, the impact on the forecast is the same. We then decided to apply the BaFin method from Q3 2018 onwards. The financial statements on 30 June 2018 contained, for the first time, carried interest of Fund VI. And as mentioned, we adjusted the comparative figures. And the figures of the reporting period and the comparative figures of the previous year are shown, are summarized on Slide #9. And then you'll see that, for example, net result of investment activity, that the first 9 months of this financial year are influenced by EUR 2.1 million negatively by the accounting of carried interest Fund VI, and that the previous year has been adjusted by EUR 7.2 million accordingly. The influence on financial assets is at 30 June 2018. The cumulative effect of EUR 10.5 million and the -- according -- the respective effect on financial assets on 30 September 2017 is EUR 8.5 million.Just to make it sure, the adjustments exclusively refer to DBAG Fund VI. And the retrospective adjustment lead to a first time earnings effect in the third quarter of 2016-'17, which means due to this change in accounting methodology, we only have adjustments in the current financial statements and in the previous year. There's no longer look back -- or no longer correction period in the past.With this, I come to an end with my statement, remarks on carried interest. And I would like to ask, before I enter into the ordinary presentation, whether you have any questions on this issue. Or if this is not the case, I would continue. If this is not the case, I enter into the ordinary presentation on Slide #10. And I usually start with an overview, but I can skip the brown box, which is the box for -- standing for the carried interest topping (sic) [ topic ]. I'm pleased to report now on how successfully we performed in the first 3 quarters of the current financial year. The key messages are, in my -- our point of view, we entered into 5 new management buyouts, 4 alongside DBAG ECF, 1 alongside DBAG Fund VII and invested in total EUR 50 million. We got further commitments from investors of about EUR 56 million, following a successful fund raising of DBAG ECF SECOND NEW VINTAGE. Net income reached EUR 28.9 million, and with this, we can confirm the guidance we recently published by the end of June. I turn to Slide #11. In the first 9 months of 2017-'18, DBAG's net income came to EUR 28.9 million, which translates into a return on equity per share of 6.8% after 9 months. And in the past, the Private Equity Investment business line contributed most to the net income. However, Fund Investment Services performed properly and met our expectation. Net asset value of the Private Equity Investment is slightly below the adjusted figure on 30 September 2017, which was EUR 451 million. I will come back to the most important KPIs later, and turn directly to Slide #12. As already mentioned, further capital commitments from investors. DBAG ECF FIRST NEW VINTAGE was faster invested than planned. Its investment period ended early after only 12 months. The ordinary ending date would have been December 2018. So far, 80% of the committed capital has been called. The remaining 20% are available now to support the enhancement of the existing portfolio company. Accordingly, DBAG ECF SECOND NEW VINTAGE has been recently raised. For the total volume of EUR 97 million, there are EUR 57 million from LP. We broadened the investor base by 2 new investors. More than 90% of the funds coming -- are coming from existing investors.Renumeration for the SECOND NEW VINTAGE is comparable to the FIRST NEW VINTAGE, both our BaFin and the management fees for the original vintage. And in addition, we get 2% of the capital invested in each case as a transaction fee when the capital is called. And you will see that we made -- that we realized a significant amount of transaction fee income in the first 9 months. We were quite happy with the expansion of the investment range of DBAG ECF, which for nearly more than 1 year now, is able to invest in smaller buyouts. We saw, since then, significantly more transactions and did only small management buyouts with this fund since we adopted the investment range. I come now to the investments summarized on Slide #13. And we summarize here only those investments which were agreed and/or completed in the third quarter of the current financial year, because we have already reported on the other transactions in the previous conference call. Now last call, we informed you about the merger of duagon and MEN. This has been meanwhile completed. In the third quarter, DBAG Fund VII acquired a majority stake in Karl Eugen Fischer, or shortly, KEF, as part of a management buyout. KEF is the world's leading manufacturer and developer of cutting systems for the tire industry. DBAG's coinvestment amounts to nearly EUR 23 million. And following this transaction, which is of course executed by DBAG Fund VII, around 1/3 of the fund's investment commitments have now been called, only 1.5 years after the start of the investment period of this fund, which is a really great success. DBAG ECF agreed on 2 management buyouts, both of which were completed after the reporting date. The first one is von Poll, one of the leading broker platforms in the premium segment in the GAS region. In this case, DBAG will spend up to EUR 11.8 million of proprietary capital. Von Poll is the last investment in ECF FIRST NEW VINTAGE. And the first investment in ECF SECOND NEW VINTAGE is BTV, a group of retail and service companies that develop, produce and sell components for the construction of cable and fiber optic networks. This is the fifth broadband communication company that DBAG has invested in since 2013. DBAG's coinvestment will amount up to EUR 4.8 million. The total amount of these 3 new investments agreed in Q3 is EUR 39.3 million. And together with the MBOs in Sjølund and Netzkontor, which were agreed in the first 2 quarters, the total amount of new investments agreed in 2017-2018 is, as already mentioned, EUR 50 million.I come now to the Private Equity Investments business segment. Net result in this business segment is not comparable with the previous year because, as you might remember, in the previous year, it had including the earnings contribution resulting from the disproportionately successful disposals. In total, we had 6 exits in our financial year, most of them taking place in the first 3 quarters and this leads to the fact that the figures are not comparable at all. Nevertheless, we have to report on them. And we try to do so. And to give you more insight on Page #15, this shows the net result of valuation for the first 3 quarters of this financial year compared with the previous year. And this slide does not include the net result from disposals. Therefore, it is more or less comparable. But nonetheless, we have 2 special effects that have a significant influence on the amount of earnings improvement and change in debt resulting from a debt-financed acquisition, a large debt-financed acquisition at portfolio level and a refinancing of a portfolio company. And this leads to the fact that earnings improvement and change in debt are, in absolute terms, significantly higher than the year before.Net of these 2 effects, operating performance of -- and I would like to mention that you'll find the special effects on the right-hand slide (sic) [ side ] on the slide. And these figures are not included in the quarterly statement, I would like to mention. Net of these 2 effects, operating performance of the portfolio companies made a significantly higher value contribution of EUR 10.4 million, after EUR 6.3 million in the previous year.Change in multiple contributed EUR 6.3 million to the net result of valuation last -- in our last call, we talked a lot about the turndown in the multiples of most of the peer groups, which influenced our half year figures significantly negative by EUR 50 million. And this has been offset largely in the third quarter. So in total over the 3 first quarters, we see a positive effect of change in multiples of, in total, EUR 6.3 million.And some additional information on this. As in the previous year, we considered expressions of interest from potential buyers in the valuation of individual portfolio companies while, at the same time, taking into account the unforeseeable outcome of such talks. This resulted in an effect of EUR 7 million, as against EUR 0.6 million in the same period of the previous year. And this EUR 7 million forms part of the EUR 6.3 million change in multiples. The changes in valuation ratios on the capital markets had an effect of negative, in total, EUR 0.7 million, which in the previous year had been positive EUR 11.2 million. And you'll see that the negative effects from the first -- from the second quarter has been offset. But in total, it's more or less 0. And the positive EUR 6.3 million comes mainly from negotiations about the exit of one portfolio company -- 2 portfolio companies, sorry.The -- I would like to say a sentence about the EUR 7.2 million other. In other, we include those companies, those portfolio companies who are valued by the DCF methodology. In this case, we had a positive value contribution because the one -- one of these companies shows a really good performance and we had to adopt the planning assumptions for this company.The overall picture on the portfolio value, which is shown on Page #16, and there, you'll see that portfolio value increased not only by net result of valuation, but also significantly by investments. And I would like to mention that investments on this slide comprise the amount invested after closing of the transactions. And this differs significantly, as it is always the case, from the amount agreed in the accounting period, which was EUR 50 million. There's always a timing difference between agreement and closing of an investment, and this leads to these differences.On the next 3 slides, they are included for reason of completeness, as always. There is only one change compared with previous reporting date, and this is mainly due to the closing of KEF in Fund VII. Therefore, on each of the next 3 slides, 17, 18 and 19, this includes now KEF. And I think I can skip these slides and go directly to Slide #20 and talk about net asset value, which is nearly unchanged. And the most important message on this slide is if you look at the 3 colors on the -- in the bottom line, net asset value is more or less unchanged. And those figures are influenced by the change in methodology. But the main reason why it is unchanged, even though we invested a lot, is that this has been offset through the dividend payment by the end of February, which influenced financial resources, obviously, negatively.I come to Slide #21, and we have nothing new to announce. Fund Investment Services segment is still developing according to plan. Fee income increased due to the fact that Fund VII is included for 9 months compared with only 6 months in the previous year. And additionally, we received in the meantime EUR 1.2 million transaction fee for the new investments of DBAG ECF, which are Netzkontor, Sjølund and von Poll. And this is the transaction fee I mentioned in the very beginning.With this, I come to my last slide, which is always a slide on the forecast. As already mentioned, we had adjusted our forecast in June after having received the hearing letter from BaFin. Today we confirm this guidance. This includes our expectation of a positive net income for the current fourth quarter supported by contributions from both segments. And as always, I would like to draw your attention to the fact that our forecast is subject to the proviso that there won't be a significant influence from capital markets on the valuation [indiscernible]. With this, I would like to thank you for your attention.

[Thomas Franke]

Okay. So if there are no further questions, I suggest that we say thank you and goodbye to everybody.

[Susanne Zeidler, CFO & Member of the Management Board]

Thank you very much.