The low-rise glass and steel building in Frankfurt where Lone Star Germany has its offices is partly empty, which is appropriate enough. Germany's troubled real estate market, with high office vacancy rates and stagnant housing prices, has been a disaster for banks such as Munich-based HVB Group or Bankgesellschaft Berlin. But it has been a bonanza for private equity firm Lone Star.
German banks offloaded bad loans with a face value estimated at $13 billion to $16 billion last year, and Lone Star was by far the biggest buyer, accounting for as much as two-thirds of the market. In one eye-popping deal last September, Lone Star acquired troubled loans with a face value of $4.8 billion from Hypo Real Estate Group, a spin-off of HVB Group. While Lone Star does not release financial information, it's obvious that with 200 employees, including sister company Hudson Advisors LLC, it has made Germany a major focus of operations. And Karsten von Köller, 65, a veteran German banker who postponed retirement to become chairman of Lone Star Germany last year, says the firm is hungry for more deals. "Our appetite is not yet sated," he says.
It was Lone Star Funds, based in Dallas, that launched Germany's distressed real estate business. That makes sense. Funds founder John Grayken, protégé of Texas billionaire Robert Bass, cut his teeth on deals for bad loans stemming from the U.S. savings and loan crisis before setting up Lone Star in the mid-1990s. The Harvard MBA, considered one of the savviest dons of the private equity business, has expanded Lone Star's range rapidly in the past few years, and it now has offices buying up distressed assets of all kinds, but especially real estate, from Dublin to Tokyo. "They're very good at what they do," says David Abrams, a New York-based managing director at Credit Suisse First Boston (CSR ) who has worked with Lone Star in Germany.
But can Lone Star continue to dominate in Germany? That may not be easy as competition intensifies. Returns estimated at up to 22% have drawn in other players such as Credit Suisse, Goldman Sachs (GS ), and German institutions such as Deutsche Bank (DB ) and Commerzbank (CRZB ).
And there are fewer multibillion-dollar debt portfolios to bid on. Instead, smaller German banks -- with smaller portfolios -- are making their way to market. What's more, much of the new debt being sold is commercial, which is more complicated to value and restructure than real estate. That will make it harder to maintain the returns investors have come to expect, which range from 10% a year for lower-risk portfolios to well above 20% for riskier deals. "Prices right now are good for [the German] banks," says Wolf Waschkuhn, head of the German desk at New York-based risk consultant Kroll Inc. (MMC ).
Even so, Lone Star is in a better position to profit than most of its rivals because of the depth of its experience and because of Köller's wide range of contacts in Germany Inc. Under Köller's predecessor, Roger Orf, who is now at Citibank (C ), Lone Star effectively invented the German market for distressed debt, with deals such as the 2003 acquisition of the loan portfolio of bankrupt Gontard & Metall Bank. Since then, Lone Star and smaller players such as Los Angeles-based Oaktree Capital Management LLC have helped German banks chip away at a mountain of some $200 billion in bad debt, much of it stemming from ill-advised property investments in Eastern Germany.
While the German banking establishment was hesitant to open the door to foreign funds, few doubt that Lone Star has done German banks a favor. The influx of capital has made the country's banks healthy enough to begin lending again. HVB Group, for example, averted a debt downgrade after reporting on Feb. 24 better profits and a plan to dispose of its billions in remaining problem loans. "German banks are not exactly the most prosperous in Europe," says Finja Carolin Kütz, a director in the Munich office of New York-based strategy consultant Mercer Oliver Wyman. "It's helpful when the energy and time of management is not taken up with old problems."
Lone Star, for its part, says it's ready to bid on whatever the market offers. One of its biggest deals in Germany was completed in two separate tranches in 2000 and 2002, when it bought whole blocks of half-finished communist-era apartments from the city of Berlin for $330 million. Lone Star completed and renovated the 5,000 flats, then raised rents. Indeed, the firm seems willing to take on any challenge as long as the price is right. "Banks sometimes ask us what we want to buy," Köller says. "It doesn't matter. We buy anything."
One person who has worked with Lone Star and declines to be named praises the extremely methodical way the firm analyzes the assets underlying the debt it is considering, then works out a business plan. The workouts are handled by Hudson Advisors, a Lone Star sister company that has developed its own analytical software based on its experience with troubled debt in the U.S., Japan, and other markets.
Keeping Köller from retiring also seems to have been a smart move. Köller had previously been CEO of Eurohypo, a joint venture of Deutsche Bank, Allianz Group, and Commerzbank that is Germany's biggest mortgage bank. Köller is also a former president of the Association of German Mortgage Banks. His contacts and reputation helped German banks warm up to the idea of selling their bad loans, rather than trying to do the workouts themselves. The country's dozens of public Landesbanks and savings institutions have become easier to persuade as they face the loss of their state guarantees in July. That creates pressure to reduce financial risk.
By Köller's reckoning, it will take several more years for German banks to bring their troubled loans down to normal levels. Meanwhile new markets for bad debt are developing in Eastern Europe and Russia as those banking systems mature. Other European Union countries such as Italy also have big stores of bad loans, distressed debt specialists say. Somewhere there will always be somebody who can't pay -- a fact of life that should keep Lone Star Funds busy in Europe for years to come.
By Jack Ewing in Frankfurt