In Central and Eastern Europe, private equity has been welcomed and the opportunities are plentiful — if you know the right people. Ian Fraser reports on whether new entrants have the composure and cultural sensitivity to succeed.
Fifteen years ago Central and Eastern Europe was in a mess. More than four decades of Soviet-style central planning had left the region’s infrastructure clapped out, its buildings shabby, its industry archaic, its institutions dysfunctional, its people traumatised, and its cars a joke. Today, the region has changed beyond recognition and private equity has played a big part in this transformation.
While the transition has clearly not been painless, the return of democracy, individual freedoms and market economies have brought a dramatic rise in prosperity and an immeasurable strengthening of the region’s economies.
This meant 10 of the countries in the region were able to join the EU in 2004 and two more — Romania and Bulgaria — joined last year. Others are queuing up to get in.
Over the last three years Latvia has been the EU’s fastest-growing economy, with GDP growth averaging 11% per year. Slovenia has already leapfrogged Greece and Portugal in terms of GDP per capita and it is predicted that levels of prosperity in the region will match the western European average within a generation.
“The eight central European countries joining the EU was a major step. Once they became EU members, their whole risk-profile changed. Instead of being seen as emerging economies they were suddenly given the same profile as western Europe, particularly by the western banks,” says Rob Irving, a Budapest-based partner with US law firm White & Case, who specialises in deals in the region.
In 2003 conventional private equity deals, using leveraged special purpose vehicles, became possible in the region for the first time. This followed a re-rating of central and east European countries by ratings agencies such as Standard & Poor’s and Moody’s.
The move followed the privatisation of many of the region’s banks, a move that was reluctantly made by national governments in 2002-3. Many have since been swallowed up by western players. Today the biggest banking player in the region is Italy’s Unicredito, followed by the likes of Austria’s Erste and Raffeisen banks and France’s Societe Generale.
Taken together with the region’s spectacular economic growth (there was a lot of catching up to do after the dark days of Communism), these changes have meant the CEE is an unusually attractive stamping ground for western European private equity players at the moment.
Of particular attraction is that region’s ability to generate emerging market growth rates, but with risk-levels more typically seen in developed markets.
“CEE is primed for private equity investing, with enhanced deal flow and consolidation opportunities stemming from EU accession,” says Pierre Mellinger, managing director, AIG Capital Partners.
He draws parallels with the developmental sweet spot seen in Spain, Portugal and Greece after these countries joined the EU. He warns, however, that since the region is going to converge with western Europe economies in about fifteen years, there is a “one-off opportunity” to make a splash in the region.
Funds aplenty
According to figures from the EVCA, fund-raising in the region grew by 74% to reach €2.25bn in 2006, with more than 80% coming from investors based outside central and eastern Europe.
The latest fund raised by Warsaw-based Mid Europa Partners, the region’s largest buy-out house, is illustrative of the trend. The region’s largest buyout fund, this closed at €1.5bn in October 2007. Commitments came in from 60 investors around the world – including Alpinvest, Axa, Caisse des Depots, Citigroup, the Singapore government, Goldman Sachs, HarbourVest, MetLife and Pantheon.
Approximately 28% of commitments came from pension plans, 24% from funds-of-funds, 19% from banks, insurance companies and other institutions, 16% from government-related entities and international financial institutions, and 13% from endowments and foundations. European and North American investors respectively accounted for 50% and 36% of commitments, with the balance of coming from the Asia-Pacific and Middle-Eastern regions.
Thierry Baudon, managing partner of Mid Europa Partners, believes the mere fact the fund-raising was completed in six months —straddling the onset of the credit crunch – speaks volumes investors’ enthusiasm for the region. “We are part of the index, so it’s hard [for investors] to avoid us.”
The EVCA figures show that private equity investment in the region totaled €1.67bn in 2006, a threefold increase on 2005. 90% of that was funnelled into Hungary, the Czech Republic, Poland and Romania. Buyouts represented 91% of the total, with growth capital representing 5.7% in 2006.
According to Mid Europa’s Baudon, two-thirds of the deal-flow in the region originates outside auctions, compared to western Europe’s 5%. This has been major factor in the stellar returns seen from buy-and-build strategies in sectors including telecoms and pharmaceuticals.
Investors in the region also claim that it has remained largely immune from the credit crunch which has impaired deals in the west. One reason for this is that average deal sizes are smaller. Irving says: “It is less common to find a single transaction worth more than €1bn. A lot are in the €50m-€400m range.”
Another factor is the region’s faster growth. The World Bank predicts this will continue to average about 5.5% to 6% over the next three years, nearly three times predictions for western Europe. Strong growth has the advantage of meaning deals are less reliant on financial engineering.
Baudon says: “Unlike in western Europe, leverage is not essential to deals here. We can make them work through top-line margin expansion and value creation, and if necessary by cost-cutting and efficiency gains.” To an extent, that is synonymous with a return to the good old days of venture capitalism.
This could be one reason the industry is seen in a much more positive light than it is in western Europe — where it has in some quarters been caricatured as peopled by heartless and greedy asset-strippers.
“That is a total non-issue here,” says Baudon. “I’m very popular in central and eastern Europe, because I have helped to create thousands of jobs. The industry is seen as an agent of change and a contributor to economic growth.”
Irving agrees: “There are a substantial number of success stories where private equity has saved businesses from going under, or where it has really expanded businesses and made them more competitive.”
Even so, Mid Europa’s Baudon points out the region still remains well behind western economies in a number of important respects — one of the reasons why private equity players that recently arrived in CEE may struggle to generate the sort of returns that have been achieved by the region’s established players. These have been as high as 46% in the past couple of years.
“Despite being part of Europe from a political perspective, the region remains an emerging market from a deal-processing and an origination perspective,” he says. “Due diligence is quite different here. You basically have to do it yourself. There are no intermediaries like bulge bracket investment banks. The market is still very poorly intermediated.”
Chris Mruck, managing partner of Advent International, says that most of the countries in Central and Eastern Europe are relatively small, which in itself impacts on deal sizes – and even through their legal systems are ostensibly on a par with those of western Europe, legal decision-making can take a very long time. He also says that many of the laws remain untested by precedents.
“These are the sort of things that limited partners in western Europe don’t even have to think about.”
New kids on the block
In recent years, private equity players that have established presences in CEE, including Mid Europa, Enterprise Investors, Innova Capital, AIG Capital Partners and Advent International, have been able to mop up the best deals in the region. However the incumbents’ dominance looks set to be eroded.
During 2007 Bridgepoint, Carlyle and 3i all opened offices in Warsaw and others are said to be on the way. Each has established local teams of between three and seven investment professionals. And, without even establishing a presence in the region, Permira plunged into the market with the €1.63bn buyout of Hungarian plastics manufacturer Borsodchem in 2006-07.
The newcomers have hired old hands from the existing players to gain a more immediate understanding of local markets. Carlyle poached Ryszard Wojtowski, managing partner of Enterprise Investors, to run its Warsaw office while Bridgepoint plucked Khai Tan out of Advent International. 3i hired of Zoltan Toth from Advent International and Andrzej Szostak from the local office of investment bank Rothschild.
Baudon believes it is inevitable that newcomers will overpay for deals. “Some will want to plant their flag at almost any cost. This is especially true of those who are investing as part of a broader European fund, where return expectations will be lower.”
“That will artificially inflate valuations which is, by definition, a bad thing. However at the same time we are bound to see some effect of the credit crunch here, which should counterbalance that in that it will help to deflate valuations.”
Even so, some local players are sceptical about whether that the trio of newcomers have what it takes to seek out and nurture proprietary deals in the region. One said: “Whether they’ll have the patience and the cultural sensitivity to identify the opportunities that won’t involve auctions, I don’t know. To do a proprietary deal in this region means spending at least two years nurturing the entrepreneur first.”
However Henry Potter, a senior banker with the EBRD in London, believes that the arrival of Bridgepoint, Carlyle and 3i will be largely positive. “It means that the market will become tougher at the larger end and people will have to work harder to generate returns. But it means the capital markets are getting deeper, which has to be a good thing.”
One mistake commonly made by newcomers to the region is to assume it is a single homogenous region. A legacy of the period from 1945-89, when regional differences were largely ironed out by Soviet influence, was that it did become one. However, Baudon says the region is now reverting to pre-Soviet spheres of influence. “The old fault lines are reappearing,” he says.
This is already effecting the development of private equity in the region. Hungary based White & Case partner Rob Irving says: “There are currently several distinct markets. Poland is out on its own. It’s the most populous country in the region and it’s got a ready-made exit route, given the strength of the Warsaw stock exchange.
“The Baltics are also off on their own. Then there are the Balkans – a lot of private equity investors treat the former Yugoslavia as though it’s one region and are trying to build pan-regional companies there. Greece-based players are particularly active there – it’s only a short hop across the Adriatic for them.”
Baudon believes these sub-regions already have their own investment flows. “You see a lot of Scandinavian investment in the Baltic States and the north of Poland – its the Hanseatic League all over again.
“Then there’s a central group – the Czech Republic, Slovakia, Hungary, Austria, Croatia and Slovenia – which once were economically intertwined under the Austro-Hungarian Empire, and that is again reasserting itself. Then there are eastern Balkans – parts of Turkey, Bulgaria, Romania, Greece, Macedonia and Serbia – which have formed a sub-region with a lot of Greek investment. Then there are massive investment flows between Germany and western Poland.”
Baudon says specialist localised private equity players including Scandinavia’s EQT and Industri Kapital, as well as Greece’s Global Finance have been helping to reinforcing these geographic patterns.
Exit route
Another reason the region remains so buoyant for private equity deals is that the options for exits have increased fourfold in recent years. A few years ago, there was really only one — trade sales. Trade sales accounted for 47% of exits in the region in 2006, according to EVCA figures.
Other options are now becoming more common. In Poland smaller private equity players such as Enterprise Investors have benefited from the buoyant market for IPOs on the Warsaw stock exchange. The exchange’s main index, the WIG, climbed by 41% in 2006 and 33% in 2005. However this growth slowed last year to 10.8%. Secondary buyouts are also becoming more popular across the region. They accounted for 12.7% of exits in 2006, up from 6% in 2005.
The sword of Damocles hanging over the central and east European region is that the explosive economic growth seen in the past few years will slow, which would inevitably mean returns from deals in the region would suffer.
The World Bank in its regular economic report says: “In some countries, an outright credit boom has contributed to large macroeconomic imbalances, potential asset market bubbles, and significant vulnerabilities that call for a more determined policy response.” It said the worst effected areas are the Baltic States, Romania and Bulgaria.
Another danger is that the large number of new funds launched and raised in recent months means the market will becomes over-crowded pushing up asset prices.
“There’s a danger that the scarcity of large deals will cause the larger private equity funds to move down the value chain, making the mid-market more competitive and more auction based,” says Robert Manz, a partner at Enterprise Investors. “There’s a tremendous amount of interest in any sizeable deal and it’s not just from private equity, it’s also from trade buyers.”
Robert Gross, a partner in law firm Berwin Leighton Paisner, who specialises in advising on private equity in the region, says: “Multiples are increasing dramatically: I’ve seen 18 times EBITDA on one deal.” He says telecoms deals were on multiples of just three or four times earnings during the 1990s, but that rose to seven to eight times by 2003. “At these multiples the banks may become reluctant to provide leverage.”
Irving predicts opportunities are going to become less attractive in Central Europe’s most developed markets: Czech Republic and Hungary. “Deals are still being done in those countries but we may see less dynamic growth there.”
However Baudon believes the general outlook remains very good. He believes that certain sectors are going to benefit from the growing middle class in the region – with healthcare, personal services and leisure being among the most promising sectors.
He believes the fact so many of the companies in these sectors “face scale issues” — meaning they remain too small to be of much interest to Western multinationals — means that private equity houses like Mid Europa will be able make money for their investors by growing companies in these sectors into national or even regional players and then handing these on a plate to strategic investors once they’ve been bulked up and operationally improved.
Baudon concludes: “If you continue to pick the right assets and continue to work with the right people (and make sure you don’t work with the wrong ones), the opportunities remain plentiful.”
This article was published in EVCJ, the European Venture Capital & Private Equity Journal, published by Thomson Reuters, in February 2008.