Monday, May 29, 2006

Lessons from Germany’s Mittlestrad

Last weeks Economist contained an interesting piece on German exports (subscription required.) One of the things that caught my eye was some of the discussion about the problems in the Mittelstand sector. Not that long ago the Mittelstand was seen as a role-model for how British industry could do better, for example Will Hutton’s The State We're in based a lot of its economic argument on the comparison between British and German on regional industry.

Now things aren’t looking so rosy for the Mittelstand or for other parts of German industry. In fact, sometimes Germany seems to be having a hard time coming to grips with the modern world economy - not so long ago one German minister described private equity investors as “locust.”

There is still much to be admired in German industry and I’m not really looking to bash German industry - or cheerlead for British industry. I’m just interested in understanding and finding some lessons from the predicament of the Mittelstand.

One of the problems highlighted by the Economist last week was that of innovation. True, German companies can be very innovative but much of their innovation centres around incremental improvements to existing products - and in particular quality improvements. This is an engineers dream, reaching for the highest quality product possible but it also means there is less radical innovation and fewer completely new products.

Companies, and individuals, are not producing completely new products, instead they are stretching the existing products. Problem is, when the existing product more than satisfies 90% of consumers requirements does it make sense to continue improving it? There isn’t much more market to take but quality improvements may increase price.

Sometimes pushing on in one direction is the right thing to do. Other times its better to try a different direction.

Part of this problem is success. These companies have had great success with these products so not only do they expect continued success but they see little reason to change their ways.

One of our images of private business people is as risk takers, people who say “Heck, I’m fed up 9-5, I’m going my own way” and accept the risk of starting something from nothing. Its worth remembering for a moment that many of these firms were started in the decade after 1945, at that time there wasn’t much else. The risk for these German entrepreneurs was low, safe jobs in big corporations didn’t, on the whole, exists. Starting a new business was the low risk option.

And there in lies a lesson for many privately held businesses. Once the initial risk has been taken, once cash flow appears and the product has a modicum of success the appetite for risk can disappear. Boot-strapped businesses may come to value predictability, low investment, low risk developments because they place a high premium on being around tomorrow. Since there are none (or few) outside shareholders nobody is going to complain about the lack of growth.

Conversely a business that takes cash from outside investors early on has to meet their expectations, and these expectations are for growth. Since the business founders aren’t playing with their own money they have less to loose by taking a risk on a big new product development, somebody else is paying and they are taking the risk.

In effect there is a specialisation here. The entrepreneur specialises in founding the business, building the company and creating new products and the investor, be they Angle or Venture Capitalist, takes on the risk in return for the reward of profit.

Now, move forward 50 years, those who founded in their business in 1950’s are looking to retire. If they are lucky they have the management talent within their family and they can simply hand it over.

Unfortunately it doesn’t always work like that. Perhaps nobody in the family wants to be in the business, perhaps they aren’t particularly talented or maybe the most talented person is a manger in the business and not a family member. What happens next? How does the founder cash-out?

Again external investors come into play. They buy the business, giving the founder an exit, and they seek out the best person to run the business. And this is what is happening, this is why so many private equity houses are so active in Germany just now.

Unfortunately, this kind of changes the German way of doing things. Suddenly businesses aren’t owned and run by the family. Ownership and management are separated. The new owners have more appetite for risk and want to see some more growth, more innovation and reduced costs. Then, on top of this the investors probably plan to sell the business in 4-5 years.

There is nothing fundamentally wrong with this model, its been operating in the US, UK and elsewhere for a good while but it does come as a surprise to many in Germany, hence the recent debate about the role of shareholders in Germany and the social model over. (A debate I’m not going to comment on, I don’t know enough and it is German’s debate not mine.)

On the bright side, more external investors in German business may encourage more innovation in different directions. With a little luck everyone will end up better off.