A model to aspire to

Michel Perraudin, who was an executive director of Adidas, is now chairman of Maerklin, a company based in Göppingen that makes model railways. It is one of the best-known brand names in the German-speaking world, beating even Coca-Cola for recognition. German men over the age of 30 get misty-eyed remembering Christmases playing with their new Maerklin train set. In the late 1990s Maerklin passed into the joint ownership of 25 family members. They were divided into three warring camps, each with an executive director, which meant there was no effective leadership and the company lost sight of its changing market. It suffered from underinvestment and its remaining 1,350 employees feared for their jobs after successive rounds of cutbacks. Revenues fell, losses rose and debts piled up.

In May last year Maerklin's banks lost patience and sold the company to a private-equity firm, Kingsbridge Capital, part of the Austrian Hardt Group but based in London's West End, the European capital of private equity. The new owners called in Mr Perraudin and Jan Kantowsky of Alix Partners, a restructuring firm, who quickly drew up plans to widen the product range and to start selling online. As Mr Kantowsky says, “We are now opening the brand to a younger customer base to kickstart growth again.” The challenge will be to keep the brand exclusive at the top end while coming up with toy trains that will appeal to today's children who are used to the speed and excitement of online computer games. Some components and simpler products will be made offshore, but many jobs will stay in Germany.

In 2005, when Franz Müntefering, then the party leader of the Social Democrats, described private-equity firms as “locusts”, Maerklin employees staged a demonstration to support the boss of Kingsbridge, Mathias Hink. A German tabloid newspaper put his picture on the front page and called him “the friendly locust”.

Agony in Italy

On the other side of the Alps decline is evident in industries such as textiles and machine tools. Italy's main tool for controlling costs, devaluation, was removed by the introduction of the euro in 1999. For the Italian textile and clothing industry things have been going from bad to worse since China joined the World Trade Organisation in 2001. Foreign direct investment poured into China to build up production capacity for both fabrics and clothes once the country was free to export at will. Italy, which had been Europe's leading textile and clothing producer for about 25 years, felt the effect almost immediately. EU imports from China increased by nearly half in 2004 alone. In some products imports have grown sixfold and prices have fallen by a third. An emergency deal in 2005 on trade restraint between the EU and China will offer only temporary relief.

Places such as Busto Arsizio and Gallarate, north of Milan, are turning into ghost towns as firm after firm goes under, leaving empty factories boarded up. Some 30 miles to the west, in the foothills of the Alps, the same thing is happening to the cluster of woollen mills around Biella. Window grilles are rusting on the Manifattura di Valduggia, where woollen undergarments were made until the early 1990s. The Grignasco group is still turning out knitting wools, but its output halved to 2,500 tonnes in the decade to 2004 and its workforce has fallen steeply.

“We are suffering, that's for sure,” says Michele Tronconi, a mill owner who is deputy chairman of a local trade association and of Euratex, the industry's lobbying body in Brussels. “But we are still struggling, still fighting.” He has studied what has happened to the textile industry across Europe and vows not to let the Italian industry go the same way as Britain's, which more or less imploded in the 1980s and 1990s. As he sees it, the British firms grew too complacent, producing middle-of-the-road garments at middling prices for Marks & Spencer, a giant retailer. When their customer went farther afield for better quality at lower cost, much of the industry fell apart, with a few upmarket exceptions such as Pringle, a Scottish maker of woollen goods.

Mr Tronconi thinks private equity will play a role in rescuing the industry, but he is not content to leave it to outsiders. He is trying to put together a private-equity fund from among the surviving firms so that they can help each other consolidate at the top end of the market. But most mid-market clothing brands in Italy have already shifted their production to lower-cost countries such as Romania, Bulgaria and Turkey. Romania is a favourite outsourcing destination for Italians because it is relatively close and wages are around one-tenth those at home. Italians own some 1,500 textile and clothing firms there. Italy's trade minister called it “an Italian industrial province”.

The next destination is China. In the 1970s Benetton, based in Treviso in the hinterland of Venice, used to outsource garment-making to home workers near its base. In 1990 about 90% of its clothes were still produced in Italy. Now the proportion is 30%, and set to drop to 10% in a few years. The company has opened an office in Hong Kong to supervise its growing supply chain in mainland China.

Another part of Italy's survival strategy is to seek out niches in which to sell fashion items. One example is Ermenegildo Zegna, near Biella, whose brand stands for classy men's suiting. Zegna has taken to selling rather than producing in China, opening its own shops in 24 cities. It now sells 7% of its output there, about the same as in Germany. Zegna considered taking its production to China a decade ago, but decided that the advantages of Italian skills and its closely integrated production system outweighed savings in wages.

Luigi Galdabini has also considered and rejected outsourcing. He is managing director of an old-established Italian machine-tool company, Cesar Galdabini, in Varese, on the outskirts of Milan. Galdabini is famous for making small specialised metal presses. It is the world leader in the highly specialised market for pressing tools to straighten shafts used, for instance, in car transmissions. China is a new market for these specialist tools, which cannot be bought anywhere else. But at the more humdrum end of the business, smaller presses for simple metal shapes, Chinese competition is hurting Galdabini. The firm has a sales office in China and is opening a service organisation. But Mr Galdabini is reluctant to manufacture in China because he fears the Chinese will copy or steal his designs. He fumes about the CE stamp many Chinese exporters put on products to give the impression they are made to approved European standards. All it stands for, he says, is Chinese export.

He recalls that five years ago he did not see the Chinese as a threat at all. Now he worries that in another five years they will be challenging him even in the more sophisticated versions of his complex machines. The only hope, he says, is for the Italian machine-tool industry to consolidate, invest and move steadily upmarket. Like his colleagues in textiles and clothing, he and other machine-tool manufacturers are looking at setting up their own private-equity firm to help them restructure.

Germany and Italy both have strongly export-oriented manufacturing sectors with many small and medium-sized companies, often family-owned. Both are turning to private equity to help their firms deal with Chinese competition. France's exports, by contrast, are either highly specialised—eg, wine, where the competition comes from the New World rather than from China—or they are in the hands of large companies. The country's small and medium-sized companies export almost nothing. That brings its own problems.

Howard Read

Feb 8th 2007 From The Economist print edition

Read again to do the assignments that follow.