Central Europe not yet centre stage

The process of EU convergence is considered by many market observers to be the linchpin of harmonising the markets of Central Europe with their counterparts in the West. Theoretically, this convergence will open the economies of the former Soviet bloc to the broad markets of Western Europe, thus affording tremendous investment opportunities.

Private equity investors who have been operating in the Central Europe since the fall of the Berlin Wall see great potential in the region, but they take a more prosaic view.

The stock markets have gone backwards, if anything

Ali Artunkal, a marketing director at ARGUS Capital Group, points out that the EU convergence process will not be quick or simple. Consider, he says, the markets that emerged in Greece, Portugal, and Spain after their emergence as democracies: these economies are continuing to evolve. Likewise, investors in Central Europe are buying into a ten- to fifteen-year horizon.

Many of the difficulties facing investors today relate to legal issues. Nick Fletcher, a partner at Clifford Chance's Warsaw office, says: “Fundamentally, it is quite hard to do deals, primarily because of the legal infrastructure. The law is being churned out left, right and centre, but it is just not good enough in most cases. There is a really bureaucratic, “ribbon and stamp” culture, that has not moved on.”

What the region needs, according to Fletcher, is less legislation. “I would change tax culture, not tax legislation. [Law makers] need to understand that it is not about screwing every last Groszy out of people and take a more balanced approach.”

To overcome the legal hazards, practitioners have to dig deep to do transactions. As Jaroslav Horák, managing director of DBG Eastern Europe, says: “Everything is doable at the end of the day.” His firm's strike-rate of five investments in five years from its €46m first-time fund tells its own story: doing deals is indeed possible, but it is also hard work and needs persistent ingenuity.

However, as the economies evolve in the region, so do the private equity opportunities. The cumulative advances the region's investor community has made in little over a decade are impressive. Figures from the European Bank of Research and Development (EBRD), due to be published later this year, provide an interesting snapshot of the progress private equity has made in CEE so far. The EBRD's first effort to produce some concrete performance data for the region revealed that up until the end of 2001 private equity funds backed by the bank had made 643 investments in companies which had resulted in 175 exits or write-offs returning a 26 per cent aggregate gross IRR.

Buyouts to the fore
Reflecting a natural progression in the Central European market, the region is increasingly providing buyouts as opposed to expansion capital investments. “I think the most interesting thing that's happening is the emergence of middle-market transactions in the $15m to $30m range,” says Gyuri Karady, managing partner at Baring Private Equity Partners.

According to Janusz Heath, managing director of Central and Eastern European private equity for Dresdner Kleinwort Capital, “transaction sizes are gradually getting bigger. They're a long way from being in the line of sight of the Western LBO funds, but they've moved away from a $5m investment being considered a larger deal. Investments in the $10m to $40m range are becoming standard.”

The statistics, to the extent that they exist, reflect these statements. In 1994, says the EBRD, the average deal size in Poland ran to $5m; by 2002 it had more than doubled to average $11m. Warsaw's funds had shifted from a country-specific approach to encompass a multicountry focus. Deal structures had become increasingly sophisticated, with senior debt, mezzanine and acquisition finance all available.

Leverage has arrived
A number of large LBOs have also been achieved. Among the biggest recent transactions was Vivendi Telecom Hungary, bought out in January by a financial consortium comprising American International Group's AIG Global Investment (Hungary), which manages private equity fund AIG Emerging Europe Infrastructure Fund, and GMT Communications Partners. The €325m transaction settled in May. The two partners had previously teamed up with JP Morgan Partners, the buyout arm of JP Morgan Chase, to acquire KPN NV's Czech cable television business Intercable CZ.

In November 2002, a consortium of private equity firms, including US-based Hicks, Muse, Tate & Furst, ARGUS Capital Partners, and the Emerging Markets Partnership Europe Infrastructure Fund, acquired Polish cable company Aster City Cable and the cable operating activities of Elektrim Telekomunikacja, a 51 per cent subsidiary of Vivendi Telecom and a 49 per cent subsidiary of Elektrim S.A., in a €110m buyout.

While transactions get bigger, observers note a growing potential for returns to improve as well. Much of what the region's equity investors have achieved so far, particularly in smaller transactions, was done without leverage, partly because businesses were not stable and cash-generative enough to take on debt, partly because banks were unfamiliar with the concept of leverage.

Jaroslav Horák says: “We see opportunities in companies that are being sold by strategic owners that are being forced to sell non-core businesses that are cash generating.” Such assets are prime targets for leveraged transactions, allowing regional investors to pursue a different investment approach after years of concentrating on expansion capital deals.

Robert Manz, chairman of the Polish Private Equity Association and a partner at Warsaw-based Enterprise Investors, which has invested over $700m in Poland, Romania and Slovakia, agrees: “I think we are seeing more deals in the guise of traditional buyouts from corporate sellers, both domestic and international. Here we can either invest alongside management or recruit new managment.” The firm has recently completed three such transactions, all of which were full or partial buyouts. Manz is close to completing a transaction funded with 50 per cent equity and fifty per cent debt. He says: “There are a few banks now in Poland that will give it a shot. It will help our returns and it is good business for them.”

Woes of privatisation
In the early days, after the fall of the Iron Curtain in 1989, buyers originally targeted state-owned assets. According to Artunkal, the privatisation wave largely happened during the 1990s. Today only the big monopoly assets – telecom and power – remain to be stripped.

It is this corner of the market where would-be investors are still encountering the cultural and political difficulties that in the early days characterised the market as a whole. A number of recent high-profile failures have highlighted the difficulties involved in doing private equity deals in Central Europe.

We are seeing more deals in the guise of traditional buyouts from corporate sellers, both domestic and international

The Bulgarian government has already killed two deals this year: at the eleventh hour last month it pulled the rug out from under a €210m buyout of state telecom monopoly BTC by Advent International (see Hollow ring: Bulgaria hangs up on Advent on page 50), and in March, it scuttered the €110m sale of tobacco monopoly Bulgartabak to a Deutsche Bank-led consortium.

“It's very unfortunate, in my opinion, that in 2003 Bulgaria should be making the same mistakes as were made in Russia and Poland ten years ago,” says Joanna James, managing director Central and Eastern Europe, Advent International.

In February, the government of the Czech Republic voted to postpone until 2005 the privatisation of its Cesky Telecom asset. The decision followed the collapse late last year of a planned €1.8bn sale of the government's stake to Deutsche Bank.

The reason why these deals have come unstuck is not that local vendors don't respond well to the private equity process. “It's not aversion to private equity; it's purely aversion to price,” Heath says. “The experienced Central European investor knows that if you engage in privatisations in the region they are time-consuming, they are complicated, and there are very high political risks involved.”

Another lingering problem for private equity investors operating in Central Europe is that exit opportunities via the public markets remain unviable. This makes a trade sale the only option. “The stock markets have gone backwards, if anything,” James says.

The one bright note for investors looking to employ the IPO route in order to realise assets is Poland, Central Europe's largest market, where Karady says a key development is the accumulation of savings and capital in private pension funds and insurance companies. Starting from a zero-base three years ago these institutions now control the equivalent of several billion dollars in assets. The three to four private equity exits on the Warsaw stock exchange last year were all acquired by domestic pension funds. “The exciting news is that, in Poland at least, it looks like there is beginning to be enough domestic capital accumulated in insurance companies and private pension funds that public offerings on the domestic stock exchange are beginning to be a credible exit route,” Karady says.

Talking to Brussels
Meanwhile practitioners keep their gaze fixed on the prospect of EU accession. The private equity industry is determined to make the most of the potential this historic event is expected to unlock. Brussels policy-makers say now is the time to intensify the dialogue to ensure the right measures are taken to foster future expansion. At a recent Central and Eastern European policy meeting held by the European Venture Capital Association (EVCA) in Brussels, David Wright, Director General Internal Market at the European Commission, said: “Nothing is finished; nothing is final. We need to take stock in 2003. What are the priorities? What should we drive forward up until 2010? My plea to you is to help us to define a new way forward.”

Wright's comments underline that the region's ultimate position in a newly expanded European Union is yet to be negotiated. In late 2002, the European Commission launched an open consultation to finalise the implementation of the EU's Financial Services Action Plan (FSAP). The plan aims to improve the way the EU institutions draw up, adopt and put into effect legislation on financial services, including an IPO prospectus directive. Robert Manz at Enterprise Investors, says: “A third of the FSAP measures are not yet completed. CEE policy makers can have some influence on FSAP processes to maximise domestic economic benefits. The private equity industry is ready to work with them.”

Perhaps one of the most significant benefits to come with EU membership will be the pensions directive, which will encourage further pension fund investment into the asset class. A strong domestic source of funding will help ensure the industry's long-term viability. Foreign capital comes and goes too easily, following cycles of its own.

That said, international investors follow the cash and as long as the returns are there, they will be in the region. Over the past ten years, central European private equity has progressed despite the odds being stacked against it. Now that several of its key market are moving closer to the rest of Europe, its rise is only going to continue.