Eastern ascent

The European Union has invited some new guests to the party, and like all good company, they're turning up on time and bearing gifts. Not least of which is a surprisingly well developed private equity industry and unbridled optimism among private equity firms about the possibilities within the region.

The accession countries – Poland, Hungary, Czech Republic, Slovakia, Slovenia, Lithuania, Latvia and Estonia – will formally join the EU on 1 May 2004. The date, without question a significant one in the history of the Union, is also a milestone for each of these countries and evidence of a successful transition since the fall of communism to full re-integration with the rest of Europe.

In private equity terms, the Central and Eastern European region (CEE) has also made significant strides since the early 1990s. The framework for development provided by the required harmonisation with EU rules and regulations, coupled with an ability to learn from private equity in neighbouring Western Europe, has accelerated the growth and development of the industry in CEE. The return to market of several repeat fundraisers, as well as the appearance of mezzanine and fund of funds vehicles in the marketplace, confirm this.

So what have been the most telling changes in private equity in CEE over the past decade? Bill Watson, London-based partner at Baring Private Equity Partners, draws on personal memories to graphically illustrate the mutual education process that has taken place since the early 1990s.

In 1992, Watson was involved in negotiating a loan agreement for the European Bank for Reconstruction and Development (EBRD) with what he describes as an aggressive, commercial Hungarian company. Following negotiations “down to the last eighth of a percent,” the deal was finally concluded at one o'clock in the morning. Watson recounts with a smile how “we shook hands on the deal and as we were walking out, the CFO came up to me and said, ‘when you've got five minutes, can you explain the difference between debt and equity to me?'”

The story may be reflective of an early naïveté in relation to corporate finance structures, but contrasts sharply with what private equity firms are seeing in the region today, with a robust legal and regulatory infrastructure, improved professional services, an increasing number of viable exit routes and sophisticated mezzanine and senior debt structures having become commonplace.

Joanna James, managing director of Central and Eastern Europe at Advent International illustrates the point about the recent arrival of leverage. “Until about two years ago, every deal was an equity-only deal. Leverage just wasn't available and you couldn't get structured finance at all.” Today she says the story is different, with structured finance being available in significant quantities and from a variety of sources.

Austrian, German, Dutch and Italian banks, among others, having reorganised and integrated the local houses they acquired, are now in business development mode in the region. As a result, debt to equity ratios are going up, offering enhanced options and the prospect of higher returns for equity investors.

That said, senior debt portions are still relatively modest, and so advances in the availability of mezzanine funding continue as well. In July 2003, London-headquartered Mezzanine Management Central Europe closed the first mezzanine fund dedicated to CEE, Accession Mezzanine Capital (AMC), on €115 million ($137 million). Christiian Marriott, investor relations director at Mezzanine Management, says: “Constrained banking markets, where local banks offer limited leveraged lending means that there is an extra strong case for mezzanine funding to support private equity deals. ” The AMC fund has completed two investments to date, providing debt capital alongside Advent International's equity injection into Danubius Radio, a Hungarian commercial radio station, and backing Lux-Med, a Polish private healthcare clinic operator in February 2004.

Having prepared for accession to the EU and the political and commercial opportunities that come with it, the region is now gravitating towards types of private equity deals that are different from the first wave of transactions that took place postcommunism.

The initial phase of private equity investment, largely funded by public sector institutions including the EBRD, development agencies such as the Washington-based International Finance Corporation (IFC) and USbacked funds like the Polish-American Enterprise Fund, which raised $240 million (€200 million) for investment in the region as early as 1990, was dominated by privatisations, expansion capital transactions and early stage investments. The move towards a private sector economy triggered not only the widescale privatisations of smaller stateowned enterprises, but also the divestments of large entities such as BTC, the Bulgarian state telecommunications carrier, which earlier this year was acquired by Advent International. Today, the privatisation process has largely been completed in most markets within the region.

At the same time, private equity firms were also instrumental in backing the rise of small-scale private enterprises and local businesses. A highly entrepreneurial culture has emerged, which observers such as Watson say isn't surprising: “There has always been a capitalist/moneyoriented way of thinking. Even under communist regimes, there were elements of small-scale capitalism – the so-called ‘goulash communism’ in Hungary for example – which has flourished into a vibrant entrepreneurial economy.”

As a result, after the rush towards privatisation in the 1990s and the initial focus on start-up companies, the region is now starting to see the emergence of a buyout sector targeting mature, post-privatisation industries. Watson believes that buyouts will be increasingly available where owners who grew businesses from nothing have less appetite for managing sizeable operations and will be looking to sell out to private equity investors. And Robert Manz, partner at Poland-based Enterprise Investors and chairman of the EVCA CEE taskforce that was set up in June 2003, points out that the size of deals has grown significantly since the early 1990s and that expansion financing of maturing and welldeveloped companies is becoming more prevalent and will continue post accession: “The expansion and buyout areas will be the natural extension of the continuing economic development in these countries.”

London-based Thierry Baudon, chief executive officer of Emerging Markets Partnership Europe, agrees that the evolution of a more entrepreneurial culture, the coming into play of spin-offs from western corporates that established operations in the early 1990s and the consolidation of start-up businesses that have matured have opened up opportunities for new types of investment.

Baudon, who manages the largest institutional private equity fund in the region, AIG Emerging Europe Infrastructure Fund I (EEIF) with a capitalisation of $550 million (€460 million), is upbeat about the prospects for CEE countries following accession, reinforcing the view that 1 May 2004 is “part of a decade-long process and is a symbol of a successful transition.” He describes the progress of the accession countries as being comparable to that of a funicular railway – an inexorable “clack clack clack” towards clearly defined goals within the confines of the EU.

Baudon believes that the next investment cycle will be predominantly M&A-driven as more Western corporations move into the region post-accession and central European companies also emerge as influential participants in industry consolidation. As a result, a “mainstreaming” of the deal flow will occur, to the point where it will eventually resemble the more traditional structures employed in mature private equity markets such as Western Europe.

Another significant attraction to private equity firms seeking investment opportunities in CEE is in the area of family ownership of businesses. The region does not have a tradition of family-owned firms passing from generation to generation as is common in Western Europe. Watson suggests that instead, first generation owners are more interested in securing wealth for their relatives rather than the prestige of keeping a company in the family: “These guys have an appreciation of how transitory businesses can be. They work hard and want to secure a certain bank balance for their families, rather than passing on some nice share certificates in a business.”

Watson describes the accession countries' main attraction today as being rooted in the offering of “a unique combination of emerging market returns with emerged market risk” to investors.

Figures from the European Venture Capital Association (EVCA) support the view that in some respects the region should no longer be viewed as a truly “emerging” market. For example, private equity investment in Poland, the region's largest economy, in 2002 was 0.061 percent of overall GDP, compared with 0.053 percent in Portugal. Similarly the Czech Republic's private equity investment was onethird bigger than Greece's at 0.048 percent in 2002.

Given such progress, the IFC, which promotes sustainable private sector investment in developing countries and which has invested approximately $119 million (€100 million) in various funds in the region since 1993, accepts that its role is changing, staff say, at least in relation to the more advanced accession countries in the West of the region, and will concentrate in future on funds aimed at Eastern and South-Eastern Europe.

One example of the emerged market status of the CEE region, alongside the creation of an EUcompliant legal and regulatory infrastructure, is in relation to currency. Adoption of the common currency is a non-optional requirement of joining the EU, and most of the accession countries are scheduled for entry to the euro in 2007/8.

Challenges undoubtedly lie ahead, particularly for the smaller accession countries with less well developed market infrastructures such as Latvia, Lithuania and Estonia, but the fact that their monetary future is now firmly hitched to the EU wagon will make it more likely that investors are going to view the region as a whole no longer as “emerging”, but as EU-converging markets. Says Baudon: “The roller coaster effect [of currency-related risk] will cease to exist for accession countries. Investors can focus on the rationality of their investment without having to worry too much about inflation or devaluation of currency as each country comes within the legal, financial and regulatory frameworks of the EU.”

Given the perceived investment opportunities in the market today, it doesn't surprise that general partners are eager to make sure their coffers are filled. And on the evidence of the current fundraising activity in the region, there is a significant level of interest from institutions.

With EEIF 85 percent invested at this point, Baudon says his firm is gearing up for a return to the market place to raise a second fund “within the next few months.”

Watson's team at Barings is also getting ready to go back into the marketplace to raise a second fund. Investors in Baring's first €86 million ($103 million) CEE fund included ING and the European Investment Fund. Now that the first fund is nearing full investment, Watson says the group is hoping to double in size for the new vehicle. “LPs always face a smorgasbord of opportunities that compete in terms of risk and return. With EU accession, there is now the perception that the central Europe risk premium has declined dramatically and LPs are making a real effort to understand these markets.”

Other houses currently in fundraising mode include Advent International, which is marketing its third private equity fund dedicated to the region with a €300 million target; Alpha Associates, the recent spin-out from Swiss Life which is preparing to raise a second regional fund of funds (see also On the Record on p. 72) and Poland's Enterprise Investors. Having already raised four funds for the region to date, the firm recently held a first close of their fifth fund on €200 million and is expected to soon reach a final closing near its €300 million target.

Enterprise Investors' previous funds have grown in size each time. The other consistent factor has been the make up of its limited partners, which have all come from abroad, principally North America and Western Europe. The firm's Manz cites a lack of domestic capital pools that can be tapped into as a reason for the need to attract non-domestic investment in private equity in the region to date. However, as Art Janik explains on p. 64 of this issue, Poland is currently at an early stage of growing domestic pools of capital such as pension funds, of which the country's private equity houses will be certain to try and take advantage.

Without doubt, these and other fundraisers stand to benefit significantly from the symbolic significance of the 1 May accession date and the seal of approval that it will be bestow on the new EU members. International interest in local investment opportunities is bound to increase. The preparations for participating in Europe's political enlargement, coupled with the key structural and economic changes achieved in the CEE to date, have slowly but surely created a future for private equity investment that practically every participant active in these local markets describes as bright. Now is the time for the region to deliver on this promise.