PEI: A number of institutions have recently warned of flagging growth in the region. Are changing macroeconomic prospects a cause of concern for local managers?
Rekusz: I don’t think you can analyse the economic context separately from what happened in Western Europe last year. At the beginning of 2012, there was hope that the economy would rebound; since then it has become clear that the current crisis will continue. This has obviously impacted CEE too: in Poland, for example, the GDP growth forecast for 2013 was around 2.5 percent last year, whereas now it is probably closer to 1.5 percent. Having said that, long-term prospects are actually, I believe, quite favourable. At a four or five year time horizon, the GDP growth forecasted for [CEE] is actually much higher than the rest of Europe, which combined with the fairly stable legal framework embedded in EU legislations gives us reasons for optimism.
Seewald: The region as a whole remains poised to continue down the convergence path over the next decade. However, in the short term, it is dependent on Eurozone recovery for growth. Some of the structural advantages that countries like Poland and the Czech Republic have are low current account deficits, high capacity utilisation in export-oriented industries, low yields, and favourable monetary conditions, [all of] which will help position these countries reasonably well going forward.
Siwicki: The dividing line here in CEE goes somewhere south of the Czech Republic or Hungary. The farther south you go – Slovenia being the most recent example – the worse it gets. The north of the region, by and large, is doing better. The small Baltic countries have gone through very heavy restructuring without any major social unrest, and have done very, very well since then. That is the sort of message we keep pointing out to LPs that are concerned about the region.
PEI: Does it make CEE a more risky bet than other emerging markets?
Siwicki: When you look at CEE, there is a big discussion about whether you are talking about Europe or whether you are comparing it to emerging markets. At times we regrettably find ourselves somewhere in between: unfortunately we are not this nice, young child anymore; hopefully we’re not a teenager anymore; but we’re not a 35-year-old Western European either, with an established job and predictable revenues. And being a nice-looking 25-year-old university graduate at the beginning of your professional career is not always the best place to be when talking to investors. There’s a lot of promise in terms of further professional development, but it’s not a very strong CV that you can confidently throw on a desk…
Seewald: Jacek’s analogy of a 25-year-old college graduate and the risk-reward profile that one could ascribe to the region is a good one. Central and Eastern Europe has a unique balance of strengths: elements of emerging markets in terms of potential growth and catch-up phase to Europe, and on the other hand elements of developed markets with a strong legal infrastructure and a 20-year track record in private equity. The report card is impressive and should reflect a reasonably bright future in a maturing environment.
Siwicki: Even though we are reconnecting with Western Europe, we are not starting from scratch, as opposed to emerging markets. We may have mismanaged our economies during 50 years of communism, but now we’re going back to where we used to belong. That process has gone very, very fast, and a lot has been achieved over the last 20 years compared to any other emerging market in the world. The drivers behind that are the region’s entrepreneurial spirit and its relative “greed” in terms of consumer aspirations: CEE is seeking to emulate Western Europe’s consumption patterns, with the added advantage that it uses less financial debt.
PEI: Does it mean the region can avoid the austerity that has impacted Western Europe in recent years?
Rekusz: If you compare indebtedness levels across Europe, the CEE average is probably around 40-45 percent, compared to 80 percent in Northern Europe, or over 100 percent in Southern Europe. Combined with low tax rates, it means that these countries should face less austerity … than other European countries.
Siwicki: [In addition], the net debt of Polish households is more or less zero, because household deposits are almost equal to their indebtedness. This obviously helps smooth out the consumption patterns, and that – to a varying degree – applies to other countries of Central and Eastern Europe as well.
Rekusz: There are some risks, of course, because [the economic situation in] Slovenia for example is on the agenda. However, it’s telling to look at what happened in the Baltics: these countries fell off the cliff in 2008-2009, with GDP dropping by double digits, and yet they got out of trouble very quickly and without the kind of riots we’ve seen in other countries. It shows the resilience of this region: these countries are well equipped to deal with [the downturn] in a fairly easy way and a relatively short time. The slowdown is creating a perception of crisis, of course, but compared to what these countries have gone through the last 50 years, this is really nothing.
PEI: Do you see Russia and Ukraine as being part of the same basket?
Seewald: We look at Russia as an attractive market for private equity. Russia will become the largest consumer market in Europe in many key segments and sub segments over the next 5 to 10 years, ranging from automobiles [and] household goods [to] the services sector. It is already is the largest internet market, overtaking Germany last year. The private equity opportunity in Russia is primarily a growth capital play: companies [there] have the potential to grow larger than counterparts in CEE, given the size of the domestic market, and [have] a sizeable domestic public market [they can potentially] list on.
Siwicki: We see both Russia and Ukraine as very interesting places for the expansion of our portfolio companies, because that’s … the natural growth pattern for Central European businesses. It grows first in its home country, then becomes a regional player in CEE and then starts growing east toward Ukraine and Russia – and then the dream is maybe to conquer ‘the west’. And in terms of exit size, these companies have become quite interesting targets for trade sale to foreign players. We were able to sell a small appliance company to Bosch, for instance, primarily because we managed to establish a very strong presence in Poland and in CEE – but also by building platforms for growth in Russia and Ukraine.
Rekusz: Ukraine is different, however. I remember looking at that market in 2003-2005 and thinking that it was Poland 20 years back. Unfortunately it is probably the same picture right now: nothing we thought would materialise ever happened, and it looks like Ukraine will always remain about the future.
PEI: Do you see any clouds gathering on the political and regulatory front?
Siwicki: There is a general European development – the AIFM Directive – that is going to have an unknown impact on us in CEE, because I don’t believe any of the regulators here are well prepared. They don’t really recognise private equity, let alone the legislation that will flow over from Europe. In order to be able to fundraise post-2015, you either have to be outside Europe and get a passport, or you have to be approved by some sort of regulator somewhere in Europe. So … there’s going to be an additional layer of bureaucracy and oversight we’re not really looking forward to.
Rekusz: There’s been a lot of talk about how private equity should be regulated in Western Europe, which at the end of the day was the reflection of a negative sentiment towards the industry there. We don’t have any of that in CEE. It [is linked] to the history of this industry: private equity entered this market in the early 90s, when the countries were transformed from communist states to free economies, so it’s always been associated with development. Private equity provided growth capital, as opposed to financial engineering. So when you ask politicians here about private equity, they all think of it in positive terms. Therefore it’s not on the radar screen of regulators – with the exception of what is coming from Brussels – and I don’t think that there are going to be any self-driven changes that would reinforce any regulations or restrictions on private equity.
PEI: How has competition evolved since the financial crisis?
Rekusz: I see actually less competition nowadays than in previous years. Five or six years ago, we saw an inflow of Western European houses establishing offices here, taking part in highly visible auctions and usually overpaying for assets. They were quite keen to put their flags in the ground to show a commitment to the region – sometimes driven by fundraising considerations. But since then the economic crisis came, and some of these houses have actually moved out of the region, reshuffled their teams or reduced the headcount.
Siwicki: I don’t think that as an industry we’re concerned about competition. We’re more concerned about our ability to develop deals, because … there are far fewer situations where the guy just walks in unannounced and then we find out [he has] a great opportunity [to offer]. This is increasingly about a systemic effort to analyse sectors, industries, individual players, trying to build relationships. And that is time-consuming.
Rekusz: If I look back, very often we lose not to financial sponsors, but to the trade. They’re powerful competitors. Our exits are predominantly to trade, because we buy companies to execute a strategy and then sell to a strategic. But very often you have to buy the company at the right moment, before the strategic is ready to buy it; and sometimes, when we target a company, we face competition from a trade who’s actually ready to buy it immediately. We can face deep pocket guys who are active and quite interested in the region, and unfortunately when this happens we very often lose.
PEI: What about exits? Are IPOs and secondaries becoming viable alternatives to the classic trade exit route?
Siwicki: I wouldn’t say IPOs are impossible, but exits through the stock market will take time and will happen in stages. Way back, if we sold only a piece of our holding [at the IPO], there were no limitations on further transactions. Now you have to offer six to 12 months in lock-ups, so one has to be more cautious in terms of how quickly you can monetise your holding. But it’s still possible – and the larger the better. I think it’s relatively easier to put together a $100-plus million IPO than a $30-plus million IPO, because there are fewer investors in the stock market who are interested in smaller and less liquid stocks.
Rekusz: In terms of secondaries, it is actually a good source of deals for us because we very often buy companies from other financial sponsors. So [successful] private equity deals, for us, have very often been a good source of deals rather than exits. And one of the reasons for that is strong competition from trade: in a number of exits we were looking at there was interest from Western European PE houses, but there was a trade buyer who wanted to be in the region and [was] willing to pay a premium – which means the Western European guys were not competitive.
Siwicki: The reason why there are substantially fewer secondaries than in Western Europe is that opportunities here are not being perceived as a “must-have” by Western European private equity players. So whenever we’ve discussed potential exits with Western European-based private equity players, they were extremely opportunistic in their pricing, which effectively excluded the possibility of transacting. And then the local private equity houses are probably a bit too small to transact with each other.
PEI: What sectors are currently proving the most attractive?
Rekusz: Five or 10 years ago the majority of our deals were in telecoms. Historically we happened to run the largest funds in the region, and the largest companies happened to be either financial institutions or telecoms. But these prospects fell away several years ago. For the last three or four years we shifted our focus to other sectors … including healthcare, retail, transportation and logistics. These are attractive sectors where we see a potential not only for organic growth, but also for consolidation.
Seewald: The level of innovation and growth in the IT segment in the region has yielded world class companies with global reach. Part of this success is driven by a positive culture for engineers and scientists in most parts of the region, as well as a focus in educational systems … on mathematics and science. This has produced a deep pool of human capital that should yield further success in the future. The IPO of AVG Technologies, a leading security software vendor listed on the New York Stock Exchange, and that of EPAM Systems, a leading IT outsourcing firm listed on NASDAQ, are examples of this.
Siwicki: The first main theme was clearly consumer spending, from retail and financial services to healthcare and maybe education sometime down the road. The second main theme will be business process outsourcing, be it IT services or manufacturing, which is moving here again because of the [strong culture behind] engineers and professors.
PEI: How is that translating on the fundraising front?
Siwicki: In 2006-2008, following EU accession by the main economies of the region, there was clearly an imbalance in favour of [funds raised] versus amounts invested. Now we’re net spenders, not net raisers. The imbalance between amounts invested and amounts fundraised is continuously there, not only relative to the old-time highs of 2006-2008, but also relative to any time [in the past].
Seewald: Given the challenges to raise new private equity funds in the current market, I believe these imbalances will remain in place over the next five years. And a shakeout will occur where managers unable to raise will exit the market. This type of shakeout is a natural evolution of the market, and healthy for private equity investment in general.
Siwicki: Since the region is clearly not a darling for LPs, the process is by nature slow and time-consuming. It’s slow, painful and far more research-intensive than it used to be. People spend much more time talking about details than in the ’90s. Some of this is partly imposed by regulators as well – because everybody got registered with the SECs of the world – and that also means complying with KYC [know-your-customer] requirements, anti-money laundering, anti-corruption etc. Some of these questions were not asked before, because the legislation was simply not yet in place.
PEI: Is this going to induce DFIs to become more involved in the region?
Rekusz: I would say that they are active again. They are much more difficult, much more demanding investors than other LPs; however, given the fundraising environment, they are increasingly important and very often a key to anchor interest and get momentum for fundraising. While some GPs would not have considered them five years ago, right now there is an increasing awareness that they have to be taken into consideration.
Siwicki: I particularly appreciate the wealth of their experience. EBRD, for example, is able to say: look, these are 10-year returns, these are 20-year returns, this is a sample of that many funds and so on, and there is nobody else in the marketplace that [can] provide this sort of data. That’s what they call additionality – because they create this additional value by making a lot of the research they produce in-house available to outsiders not familiar with the region.
PEI: Do you see any other major obstacles to progress?
Rekusz: My main concern is obviously the situation in Europe. Yes, a lot of growth in CEE is driven by internal demand, and there are very positive [developments] within the region. But at the end of the day we are part of Europe, and if there is a prolonged crisis there it will have an impact on CEE. And this will impact the performance of … our portfolio.
Seewald: Aside from Eurozone risk, I am concerned about the level of innovation that is taking place within companies in the region, particularly in the manufacturing segment. The CEE region must accelerate innovation across industry sectors in order to position itself as not only a lower cost region, which for the most part in the core countries it no longer is, but also a high value, productivity driven business environment. Without this, economies will become stagnant over time and the region will lose its edge.
Siwicki: In addition to that I am concerned about the increasing influence of red tape on the way I run my business. We send tons of data … that is not processed by anybody out there but that we’re increasingly required to provide. Ten years ago I rarely consulted the lawyers about my daily operations, and now I have to do it more and more often. I like the old notion of private equity, and I don’t want to become a public company that reports on a weekly, monthly, or quarterly basis – but that’s regrettably what we’re getting dangerously closer and closer to.
PEI: So what’s in store for the rest of the year?
Rekusz: I hope that there will be an improvement [in overall sentiment about the region], and there is this general expectation that at the end of the year [the situation in] Europe will start to improve. This will have an impact here as well: we could see Poland and other CEE countries growing faster next year on the back of improvements [further West].
Seewald: On the fundraising front, we are seeing investors that are encouraged by the opportunity that is present in CEE and Russia particularly via a platform that offers diversified exposure across the spectrum of private equity opportunity … via primary commitments to leading GPs, secondaries and direct co-investments. Private equity fundraising for Europe has been a challenge since the Eurozone crisis – however investors are taking a second look and discovering that the region remains a compelling place to be.
Jacek Siwicki, Enterprise Investors
Jacek Siwicki is president of Warsaw-based mid-market private equity group Enterprise Investors. He manages the firm’s operations and is responsible for implementing its strategy across the whole CEE region.
Zbigniew Rekusz, Mid Europa Partners
Zbigniew Rekusz is a partner at CEE-focused buyout firm Mid Europa Partners, where he heads the Warsaw office. He is responsible for deal sourcing, executing and monitoring of investments.
Richard Seewald, Alpha Associates
Richard Seewald is a partner at Alpha Associates, a Zurich-based global private equity investor with over $2 billion under management. He is responsible for direct investments, secondary transactions and primary fund commitments and is a member of the firm’s Investment Committee.
CEE at a glance
• CEE, as commonly defined, comprises 12 European countries that were under communist rule prior to 1990
• The region today includes 10 members of the EU, as well as two candidate countries for membership
• Among the EU member countries, all but Romania and Bulgaria are members of the Schengen borderless travel zone
• The region counts 113 million inhabitants
• Average GDP is $19,665 per capita (at PPP), 42 percent less than the euro area
• 59 percent of its €1 trillion economy is driven by exports
• The region is projected to grow by 1.2 percent in 2013, better than the 1.0 percent of 2012 but still far off the 3.3 percent of 2011 (World Bank)
• The region returned 15.66 percent (in US dollars) and 9.95 percent (in euros) net in the 10 years to 2011 across all investments (EBRD)
• Gross returns for fully realised investments were at 2.09x (in euros) since inception (EBRD)
• Unrealised portfolio is currently held slightly above cost, while the partially realised portion shows a 2.29x return (EBRD)
• €13 billion has been raised and invested by PE firms between 2003 and 2011
• 65 percent more capital has been invested than raised between 2008 and 2011
• 93 percent of PE deals are primaries; 58 percent are sourced from the founders
Sources: “Time for Another look – Central & Eastern Europe Private Equity” report (unless otherwise stated)