In pursuit of Polish equity

Poland emerged from behind the Iron Curtain with a Byzantine governmental structure, the complexity of which was rivaled perhaps only by the Polish language itself. Now, more than a decade later, European Union accession, coupled with legislative and economic initiatives on the homefront, are changing the way private equity players may operate in the area.

Poland and its fellow EU newbies have been magnates for private equity activity. The European Venture Capital Association estimates that Central and Eastern European private equity funds to date have raised approximately €4.8 billion, with a substantial part of that money flowing towards Polish private equity. But the capital that fuels the Polish private equity market comes largely from abroad.

PENSION CATCH-22
The lack of domestic funding for private equity is obviously an attribute of an emerging market. However, as Polish public equity and debt markets became more sophisticated, outdated regulations have barred domestic institutions from committing to private equity funds. In particular, pension funds are practically excluded from the private equity market, as private equity firms are mostly offshore vehicles not quoted on security exchanges, and therefore inaccessible to pension funds under Polish law.

Further complicating matters, the country has no legal structure for funds to operate as private equity vehicles registered in Poland, which would explain why funds operating heavily or exclusively in Poland are outside the country to begin with. As a result, private equity firms are shut out from a significant source of domestic capital: The Polish Chamber of Pension Funds estimates that the country's pensions currently manage more than €10 billion in assets.

Ewa Kupiecka, an analyst for asset management firm Copernicus Group, says a major change in government rules just recently may alter the private equity landscape in Poland. Under the changes, a closed-end investment fund may now take the form of a domestic fund of funds. Such a fund of funds would be allowed to commit to offshore-based private equity vehicles, thus circumventing the Poland-only restriction placed on pension funds' allocations.

Under the new amendments, the amount Polish pension funds may commit to closed-end investment funds has been increased to 10 percent of pension fund assets. In addition, a single pension fund may now buy up to 35 percent of an issue of a closedend investment fund, an increase from 10 percent.

Seizing on the opportunity, Copernicus Finance, the investment banking arm of Warsaw-based Copernicus Group, last fall announced the launch of the country's first private equity fund of funds, targeted to raise between PLN 300 million and PLN 600 million (€64 million and €128 million).

Additional changes to the Investment Funds Act already have been proposed that would make it possible for single-manager private equity funds to exist within the Polish legal framework. The Polish parliament has not yet passed these amendments. Although the parliament may accept these amendments, Kupiecka notes that many private equity houses may still choose to set up funds outside Poland for tax and administrative reasons.

Khai Tan, the head of global private equity firm Advent International's Polish operations, says the inability of domestic institutional investors to allocate funds to private equity firms, and alternative assets in general, is one of the reasons why the public market in Poland is booming.

Last month, the Warsaw Stock Exchange indices steamed to record highs, with the main index surpassing the 25,000 level, as foreign institutional investors intensified their support of the purchasing efforts of domestic pension and investment funds.

“There is an excess of liquidity and limited possibilities to put that money away, so the market can only go up,” Tan says. “Pension funds generate an incredible amount of excess liquidity. With the premiums they're getting in, they have to get that money out somewhere. And even though they can invest a limited amount outside of Poland, they're not willing, they don't know how to do it yet, and so they play the local markets.”

However, some analysts feel the majority of inflowing capital to be speculative, and that once the benefits of EU entry have been fully reaped, the money may flee the country.

For now, the run-up in the public markets has been directly helping private equity investors, with 32 percent of exits made through flotation in 2002. Initial numbers for 2003 indicate a similarly important role for IPOs, according to Kupiecka.

WILD ON WARSAW
Changes in the legal structures – such as those for pension funds – are slowgoing as Poland continues to incrementally shed the remnants of its Socialist skin. Nonetheless, Polish private equity players since 1990 have taken many steps to accelerate a catchup with their Western counterparts. The Polish Private Equity Association, for example, was established two years ago by more than 20 private equity firms as a means not only to attract funding to the country but also to lobby the government for changes benefiting fund managers, portfolio company managers, and investors.

“These days, there's more discussion and more understanding in the government that new [private equityrelated] regulations should be introduced,” says Piotr Misztal, a partner in the Warsaw office of The Riverside Company, a middle-market private equity firm based in Cleveland, Ohio and New York. “The activities of the PPEA [are] starting to have an effect. More and more government people agree about the importance of private equity money. Now it's time for the country to execute these changes.”

Andrzej Bartos, a partner for Dresdner Kleinwort Capital's private equity office in Warsaw, admits that Polish lawmakers have a tendency to over-regulate the market. But the prominence of the private equity industry is forcing the government to rethink some of the strictures placed on the domestic investment market.

“One of the key areas we look at is easier access to local capital because obviously that's something that has to change for the industry to develop normally in the future,” Bartos says. “The Polish private equity industry is financed almost entirely from abroad, while in other countries, 60 percent to 80 percent of funds are raised with local capital. It's something we're trying to change.”

Most private equity fund managers agree that Poland's accession to the EU means the country will be seen and evaluated in the same way as its Western European counterparts, resulting in greater inflows of capital from foreign markets. In order for that to happen, Poland must consequently submit to EU reforms, including those opening up private equity firms to funding from domestic sources. In the first year of EU membership, current legislation will still prohibit or limit pension funds to invest in vehicles that invest only in Poland.

Jacek Pogonowski, a partner with Baring Private Equity Partner's Baring Central European Fund, says changing such regulations is difficult at such an early stage of change for the economy. He notes many people in Poland are simply skittish about allowing domestic capital to leave the country.

“Politically, it's not yet fully understood by people at large that diversifying abroad may provide a very good return in the long term,” Pogonowski says. “It's been a short time in which Poland has gone from state-owned, closed economy to a very much open economy like the US or UK. Political constituencies don't support that yet because it's too far-reaching a concept at this stage.

“Although gigantic progress has been made to date, Poland and the rest of Central Europe are still transitioning,” adds Pogonowski. “For domestic capital sources, such as pension fund and insurance companies, to immediately make a leap from no private equity commitments to Western-like levels of investment in all alternative asset classes is just too big a step. It is an even bigger step for legislators