On the face of it, the moons appear to be well aligned for private equity in Central and Eastern Europe.
Political and economic convergence with Western Europe continues, thanks partly to European Union enlargement. With most countries in the region enjoying stable government and growth rates that far outstrip the West, a burgeoning consumer class is being created with more and more money to spend. It's an ideal market for goods and services companies, and the private equity firms that back them.
Meanwhile, the industry has been steadily mustering its forces. Fundraising for the region has reached unprecedented heights; new entrants are coming into the market to challenge established players; and banks are suddenly keen to make more leverage available, allowing firms to do bigger deals than ever before.
It all adds up to an attractive environment, at least for as long as this economic growth story continues. The only question is: can the infrastructure for private equity in the region – which up to now has always been a cottage industry – grow fast enough to keep pace with demand?
Speaking to general partners operating in the region, it becomes clear that the overall mood is bullish. This is largely due to the economic situation – while Western European economies are struggling to muster growth rates of more than two or three per cent, this region is growing at twice that. And that's just the average – among the urban middle class, growth is more like 20 percent, according to some estimates.
Political attitudes to private equity have also softened. When Advent International won the auction for Bulgarian telecoms firm BTC in 2002, it took the firm two years and fifteen court cases to make the deal happen. This year it completed a successful exit, following the €1 billion sale of the business to AIG – and the proceedings went largely unnoticed.
“This is an environment with very high growth but little macroeconomic risk,” says Thierry Baudon, managing partner of CEE-focused private equity firm Mid Europa Partners. “The criteria for economic convergence and entry into the eurozone create a very disciplined environment, where the local currency is bound to appreciate prior to entry. So you see emerging market growth, with developing market risk.”
As a result, companies are expanding their horizons all the time. “Regional businesses have been growing in size, and their management getting stronger, so they're becoming more outwardfocused,” says Zoltan Toth, a director at 3i in Budapest. “Take Poland, for instance – everyone there wants to expand internationally”.
This creates opportunities for private equity to consolidate industries. “Businesses typically grew along national lines, and are now too small to compete,” says Baudon. “This is especially true of industries that are particularly capital-intensive and require economies of scale, like chemicals or downstream oil and gas.” Michal Rusiecki, managing partner of Poland's Enterprise Investors, says this consideration is key to his firm's sourcing process: “We look for businesses with the capacity to become market leaders,” he says.
Other obvious candidates for private equity treatment include companies facing succession issues, and also corporate orphans – particularly those sold off as a result of competition issues arising from cross-border mergers and acquisitions. So it's not surprising that deal flow is strong across the board.
ON THE GROUND
Another reason for confidence is that there are established players – like Mid Europa and Enterprise – which have been operating in the region for a very long time and know it intimately; they have built their local teams and can now point to some impressive returns, particularly in recent years.
Baudon believes a big first-mover advantage exists: “It takes many years to build contacts with government, local business, and other people who can help make deals happen. We have a London base for originating with large corporates and dealing with financing institutions, but we also originate a sizeable part of our deal flow in our regional hubs.” Pierre Mellinger of AIG Capital Partners agrees. “You need local networks, and we've been in Central Europe for ten years.”
Until about 2003, it was next to impossible to get acquisition finance in the region. Now the ratings are up, the banks are coming in and pretty much every layer of debt is accessible for the right deals. This gives us access to targets we couldn't previously touch
Certainly, investors are embracing fundraisings by firms focused on the region. They raised a record €2.3 billion in 2006, according to Private Equity Intelligence – more than doubling the previous year's total for the second year in a row. These funds represent “a good choice of dedicated teams and differentiated strategies,” according to one funds of funds manager – from growth and expansion capital all the way through to buyouts.
But as the fund sizes get bigger, deals usually will too. After all, if a firm has twice as much money to invest, it won't necessarily want to do twice as many deals.
The increasing use of leverage is another big driver of this trend. “Leverage has changed everything,” admits Baudon. “Until about 2003, it was next to impossible to get acquisition finance in the region. Now the ratings are up, the banks are coming in and pretty much every layer of debt is accessible for the right deals. This gives us access to targets we couldn't previously touch.”
Joanna James, managing director of Advent International's Eastern European operations, agrees. “We're seeing a continuing increase in the availability of leverage, and also an improvement in the terms – now we can finance deals on pretty much the same basis as in Western Europe. Covenants are becoming more favourable – for instance, loans are being made on a nonamortising basis, which gives you much more flexibility.” Debt multiples tend to be a little more conservative, but then these tend to be high-growth companies, which need the cash to grow.
Mezzanine and other types of junior debt are becoming more common. “In terms of sophistication, layering and optimising structures, we find ourselves in a position pretty similar to Western Europe,” says Baudon. “Most banks in the region are Westernowned,” Toth points out. “So they have knowledge and experience of putting these structures in place.”
This is good news for specialist debt providers like Mezzanine Management. Executive director Franz Hörhager believes higher prices are forcing firms to use more leverage to maintain returns – and as a result returns have actually gone up, despite the higher prices. “That makes an excellent opportunity for us – it's why we did a record number of deals last year.”
The market has increased in breadth, as well as depth. “We're seeing a big increase in the number of banks that are keen to lend,” says James. “For the first time, we're seeing really keen German banks, particularly for deals in Poland.”
With debt so freely and widely available, firms can target bigger businesses without putting in any more equity than before – leverage is facilitating deals “that couldn't have been contemplated previously,” says James.
Most experienced practitioners are proceeding with caution, however. “We are increasing leverage, but we're still very conservative. We invest in growth businesses, which need cash to keep growing,” says Rusiecki. Mellinger concurs. “We don't want to overstretch ourselves – we want to keep enough margin for error. And besides – if you're only getting returns by maximising leverage, there's something wrong.”
But the steady increase in deal size and the easy availability of sophisticated debt finance isn't necessarily all good news for established players. The bigger the deals become, the more likely they are to attract the attention of the West's bulkier funds – as Permira demonstrated last year when it bought Hungarian chemical company Borsodchem, for €815 million. It won the deal – one of the biggest ever in the region – despite having no local presence other than a tie-up with local Austrian group Vienna Capital Partners.
Investment banks and other intermediaries are much more likely to be involved in big deals now. Even banks that have largely ignored the region are likely to get interested when €1 billion assets hit the market. As James says: “The larger deals – i.e. €250 million plus – will be run by London-based investment banks and will go to the highest bidder, whereas smaller deals tend to be sourced through family owners.” Crucially, the presence of intermediaries neutralises some of the advantage that players typically gain from a local presence.
But that's not the only competitive threat they face. As well as the “fly in, fly out” phenomenon (which only applies at the top end of the market), this year has also seen some prominent Western European firms looking to try and copy the local network model. And since there are relatively few investment professionals with experience in the region, they have little choice but to do so by poaching dealmakers from incumbent firms. Pan-European GP Bridgepoint lured Khai Tan from Advent to open its Polish office, while 3i hired Zoltan Toth, another Advent alumnus, for its Hungary operation.
Some rivals have suggested that Advent is paying for the fact that it is a small part of a large organisation – whereas other firms in the region have more independence. Not surprisingly, James offers a different view. “It's flattering,” she smiles. “People must think we have trained them well. And it's not easy to hire – there are not many firms in the region, and we're all competing for the same people.” Advent's preferred approach has always been to bring in people from a banking or consulting background and train them up. But this takes time – and new entrants don't have the luxury.
The market is more competitive, but it's still a fraction of the competition in Western Europe. The reality is that there's a lot of competition for the deals where you can fly in and out, but not for deals where you have to know your partner and he has to know you
Indeed, the prospect of replicating a model that established players have built up over a decade seems a daunting prospect. Can the likes of 3i really take on Advent at its own game? “We respect the competition,” says Toth. “Some of the larger funds have a very good track record. So it's a question of what we can bring that's new. Money's not enough; it's about sector experience, a larger portfolio of investee companies, a wider network of possible advisers; financing expertise… There's a proposition here that's very competitive with other players in the region. It's pan-European, not just regionspecific, with the global resource of 3i behind it. But it will need patience.”
Some managers are worried about the effect of competition on prices. “The problem with new entrants can be that it drives prices up, because new funds are desperate to plant a flag by doing a deal,” says one. James is sanguine, however: “Bridgepoint and 3i are both well-respected firms with good investment discipline. If we were talking about completely new entrants, I might be more worried.”
Others like to think in terms of liquidity benefits. Rusiecki says: “It's actually a positive thing in terms of exits, because it provides opportunities for secondary sales. It will obviously increase competition for larger deals – but it hasn't really made its presence felt there yet. It's certainly not affecting our franchise, which is working with local entrepreneurs and company owners.”
Scarcity of quality management is another possible threat to the regional industry's growth – just as it is in any emerging market. As the bigger companies largely didn't exist five years ago, experienced local managers tend to be in relatively short supply – and it's not always easy to attract managers from more mature markets.
However, increasing scale can be an advantage here too. The larger the company, the easier it becomes to attract good people. Baudon says: “Our management teams are typically part expat, part local. If you're buying large companies, good Western managers will come for that kind of challenge. But there is an increasing pool of very good young local managers, who are gradually taking over.”
Most agree that although this issue can never be resolved totally satisfactorily, it isn't currently a major constraint. “Good management is always in short supply, but not desperately short supply,” says Rusiecki.
The difficulty of finding good managers is likely to be even more pronounced in regions less familiar with the private equity model – and with so much financial firepower, regional players are constantly pushing back the boundaries. “There's been a gentle but visible move further East,” says Hörhager – not just to Bulgaria and Romania, which joined the European Union in January, but also further afield. “Take Ukraine for example – there's little increased risk but firms have the opportunity to tap new markets.”
Indeed, Ukraine is likely to be one of the major areas of activity in the next couple of years [see “The next frontier”, p. 78]. Lying on the border of the European Union, and with a relatively homogenous population of some 47 million people, it is an attractive market for private equity, despite ongoing political difficulties. That's why many regional players are looking to step up their activity in the country – Advent is planning to open an office there in September.
PLENTY TO GO ROUND
Generally speaking, although threats do exist to the continued development of private equity in the region, participants seem confident that as long as economic growth continues, there will be plenty of opportunities to go round – even taking into account the increased competition. “The market will grow at least as fast as new entrants join it,” Hörhager believes. “Though if you're there already you have a first-mover advantage from your local network.”
The level of competition is, in any case, relative says Mellinger. “The market is more competitive, but it's still a fraction of the competition in Western Europe. The reality is that there's a lot of competition for the deals where you can fly in and out, but not for deals where you have to know your partner and he has to know you – and that's what we've been doing for ten years.”
Competition for deals and talent will almost certainly intensify over the coming year – but don't expect to see private equity's rapid development in Central and Eastern Europe start decelerating any time soon.