Learning lessons of German success: John Eisenhammer finds long-term bank lending a vital ingredient in the Mittelstand, driving force behind Europe's leading economy

FOR those casting around for ways of improving the competitiveness of Britain's medium-sized businesses the German Mittelstand, with its reputation for being the driving force behind Europe's most successful economy, exerts a powerful fascination.

Senior Treasury officials and representatives from the commercial banks have made several visits to Germany as part of the Industrial Finance Initiative to see what lessons may be learnt.

The Germans take a broad view of what constitutes the Mittelstand. Covering firms with annual sales from DM30m (pounds 12.5m) to nearly DM1bn, it accounts for half the wealth created in the private sector, two-thirds of employment and four-fifths of training.

But, as much as size, its defining characteristic is the management style imparted by the owner-entrepreneur - flexible, dynamic, thrifty and committed.

The other ingredient nurturing its development is long-term bank lending. The situation is very different from Britain's, with overdraft financing at one end and stock market equity at the other.

'With a 10-year credit it is pretty close to having your own money because it gives the businessman the ability to calculate, to plan over the long term,' says Alexander Hofkens, managing director of Spectro, a firm with DM100m world sales of spectral analysis instruments.

Spectro may go to the stock exchange later, but at present is aiming to grow to DM300m sales on the back of bank loans.

'The German system is founded on the golden rule of business - that the financing must match the investment,' Mr Hofkens says. 'Any attempt to finance structural investments with hot, overdraft money is fatal. No business can plan while riding the roller-coaster of the money markets.'

One reason British observers are perplexed by the reluctance of Mittelstand firms to seek quotations is the assumption that equity finance must be cheaper than bank loans.

This is certainly the case in a system dominated by costly overdraft facilities. 'But you have to compare like with like,' says Rudolf von Bunau, head of marketing at IKB Deutsche Industriebank, which specialises in long-term corporate financing.

'The Mittelstand experience in Germany is that long-term credits are always cheaper than the stock exchange.'

This highly developed system for long-term bank lending has sustained the traditional unwillingness of many small businesses growing into medium-sized ones to cede control by going to the stock market.

As a result the Mittelstand entrepreneur who is determined to stay boss of his own business can usually do so, and grow to quite a size, by working closely with the banks.

Operating in highly competitive capital markets, the German banks' long-term lending operations have margins of just 1 per cent. In Britain the margins tend to be much higher, but so are the lending risks.

This gap pinpoints the key to Germany's Mittlestand financing. Long-term lending is the product of a stable macro-economic environment, of a culture nurtured - as Germany's has been - on the motto that inflation is poison.

'Unless you have the right economic pre-conditions you can forget the whole idea of long-term financing,' says Gerd Schmidt, senior IKB economist.

The Government now argues that a generation of British business borrowers and bankers, reared on inflation, must adapt to the changed, virtuous, world in which it is now living.

The Industrial Finance Initiative wants to encourage ways of filling that gap between short-term bank finance and equity. A look at British and German long bond yields and inflation rates over the past 20 years does indeed suggest increasing stability on the British side, and therefore improved chances of breaking the banking system's addiction to overdrafts.

But such a shift will in turn require other changes. David Gill, assistant director of Midland Bank's corporate finance and one of those looking at the German system, points to the high level of training for those dealing with business lending.

'We have been very impressed by the sophistication of the German credit assessment and the generally low level of failures,' he says. 'Business managers also benefit from strong back-up from local chambers of commerce and trade associations, giving a better general financial understanding than one sees in Britain.'

Long-term financing implies a closer link between lenders and borrowers, part of what the Germans call relationship banking. 'You cannot just walk away from a 10-year loan,' says Werner Steingrover, head of IKB customer relations in North Rhine-Westphalia.

'Banking is about strategic advice, consulting, working with the client over a whole range of interests. And the more a firm gets into difficulty the more the bank's know-how is needed.'

To make such a system of long-term commitment work, Mittelstand financing is highly selective. The main source of public support, the state-owned Kreditanstalt fur Wiederaufbau, which provides long-term loans at cost, operates through commercial banks.

Because they carry the risk, the banks have every incentive to decline marginal proposals. The entrepreneur gains access to funds only with active support of the commercial bank, reinforcing an interdependent relationship.

This contrasts with the British experience of government funding, which adopts a more scatter-gun approach in the early stages and then lets natural selection determine the long-term survivors.

(Photograph and graph omitted)