The Warsaw pack

Investors have – over the course of the last 18 months – been given cause to rethink their definition of an “emerging market”. With developed markets shaken to the core first by the credit crunch, then the financial crisis and now in Europe by what is looking increasingly like a contagious sovereign debt crisis, emerging markets have started to look like a relatively reliable place to find growth.

This may be true for the BRIC economies (or should that be BIC?), but can the same be said for the disparate set of nations that constitutes Central and Eastern Europe?

Those with an intricate knowledge of the region question whether the “emerging market” moniker is even suitable for it. Emerging markets are often characterised by a shortage of long-standing private equity managers, difficult or unpredictable political and legislative environments and – crucially – faster than average GDP growth.

Central and Eastern Europe is home to 10 European Union member nations – with all the regulatory and legislative controls membership provides – with seven more countries in line for accession. The region also plays host to some genuinely experienced private equity management teams, some of whom have been investing there for two decades.

For LPs and GPs who approached the region as one homogenous bloc, the crisis has been an education. In 2009, according to data from the European Bank for Reconstruction and Development, GDP growth figures across the region varied from modest expansion in Poland of 1.4 percent to cataclysmic contractions of as much as -18 percent in Latvia. The EBRD now expects most countries in the region to return to at least modest growth for 2010, but the recovery period will be protracted and overall growth will be patchy and below pre-crisis levels for the foreseeable future.

In early May, three of the region’s most experienced private equity professionals gathered in Warsaw to have an open and frank discussion about how the crisis has affected their businesses and where the industry is heading. Around the table were private equity GPs Craig Butcher of Mid Europa Partners and Robert Manz of Enterprise Investors and fund investor Petr Rojicek of Alpha Associates.
PEI: Is CEE subject to the same capital overhang of private equity capital waiting to be deployed as elsewhere in the world?

Robert Manz

BUTCHER: I think we do feel it, but it is around very selective assets. I feel more sheltered than I would if we were a UK mid-market buyout fund. There are still opportunities in Central Europe that are not professionally intermediated.

MANZ: One upshot of the financial crisis is that pre-Lehman, there was a lot more interest from non-local private equity firms looking into the region. Central Europe was very much the flavour of the day; it was getting as popular in Europe as the BRICs. One of the results of the crisis is that any firm that has not set up some kind of serious local presence, has pretty much disappeared.

BUTCHER: I don’t really agree. I still think there are a large number of credible buyout guys monitoring the region. They may not be making a lot of noise, but they are still there.
MANZ: The fact is, transactions getting done here are really only getting done by those who have local people full-time on the ground. In the current situation, even more than in the recent past, where you have true differentiation between the countries, you really require a local insider’s view to distinguish between the Polish, the Romanian and the Czech investment landscapes.

PEI: If there are fewer pan European firms active in the region – and clearly that itself is a matter for debate – how does that affect your exit possibilities?
BUTCHER: That’s my point. I think they are still there, but they are there for the big, well-scrubbed, well-presented assets which are professionally intermediated and where someone else has done the hard work. I don’t think Central Europe is off-limits for any of them right now, but their ability to process and appetite for some of the things we do is just different.

PEI: In geographic terms, which countries have been the winners and losers of the crisis, and where will you be concentrating your efforts?

Craig Butcher

BUTCHER:  There is no doubt in my mind that there are only two winners: Poland and Czech Republic, and everyone else is a loser to a greater or lesser extent. With the exception that Slovenia and Slovakia – being in the Euro zone – have taken away currency volatility, albeit with the loss of the ability to promote competitiveness through devaluation as elsewhere.

Ukraine is in a world of its own in terms of political volatility and the Baltics have been massively impacted. Who has ever seen a drop of GDP of 25 percent outside of wartime?

Romania, Bulgaria and Hungary are all seen as risky. But we are not off-limits anywhere and are much more micro-driven. We think that you can still selectively find good opportunities in the regulated industries of healthcare and telecoms. And the Baltics might be the most compelling place to invest right now because absolutely no one is trying to do any business there.
MANZ: Nothing is off-limits for us, although we certainly have preferences at any given time. Our core basket is Poland, Romania, Slovakia and the Czech Republic. We have offices in all of those countries. However, we are looking for deals throughout the whole region, with active projects in Poland, Croatia, Hungary and some of the other ex-Yugo countries. Where we are currently more cautious would be Baltics and certainly Ukraine as well.
ROJICEK: Even though macro conditions were obviously difficult, activity in our portfolio suggests that there are good opportunities across the entire region. We saw deals completed pretty much everywhere last year except the Baltics, which have been most seriously affected by the crisis; we haven’t seen a single deal there. The most active markets by a margin last year were Poland and the Czech Republic.

Petr Rojicek

BUTCHER: Many of the countries have taken their medicine and are now more competitive than they were a few years ago. Looking at the Baltics now, it’s incredible. Some portfolio company salaries have dropped 30 percent but the companies have increased competitiveness, so when there is a recovery in exports, they will recover very quickly.

Hungary has had to cut government spending throughout the recession and now has one of the lowest government deficits in Europe. It can afford to be expansionary when the recovery comes and should therefore grow very quickly.

PEI: What sort of questions have your LPs been asking throughout the crisis?
ROJICEK: Reading the international press you would have thought that everything across the region was a disaster. Some of the articles – focused in particular on the Baltics – implied that the whole region faces the same difficulties and that everything was going down the drain. However, Central and Eastern Europe is not a homogeneous block but made up of many countries with different macroeconomic dynamics and prospects.

BUTCHER: Make no mistake, Q4 ’08 and Q1 ‘09 were very, very dark days for all of us. You saw currency volatility, declining sales. You had to be very introspective and portfolio focused. Having said that, for all the leading players we consider to be our peers in the region, I don’t think anyone has lost a position in a portfolio company. I doubt there are many Western European buyout firms who can say they haven’t lost at least one company.
MANZ: I would disagree with Craig in terms of the words “dark days”. There were obviously a lot of unknowns and questions, but we were focused heavily on the portfolio companies and the resilience and competiveness of the companies in the region has been proven.
ROJICEK: From our perspective as an LP, having invested in the region for more than a decade, our long-term view has not really changed. The convergence story is still intact and we expect the economies to return to growth at a higher level than Western Europe. There is still cheaper labour. The banking sector is in relatively good health. Only one of the top seven banking groups in the region did not post a profit in 2009.
MANZ: People stopped using the word “convergence” during the last year and a half, but it is very much still in our vocabulary. OK, we are in the middle of a cycle; we have lived through four of them now in Central Europe. We can still expect long-term GDP growth across the region some 2 or 3 percentage points ahead of Western Europe.

The Greeces and Spains of this world have some bigger structural problems than the economies we are looking at here in the region. Whatever way you look at it, private equity investing as a percentage of GDP is still half of what it is in the rest of Europe. 
BUTCHER: What does hold true though, is that – with the exception of Poland – these are very much export driven economies, so I don’t think you will see significant recovery until Germany, France and others also recover.

ROJICEK: This market is unique in a sense globally. It does not really belong in the “emerging markets” category any more. These are functioning economies with EU legislative and regulatory frameworks. And moving down from the macro set-up, what is certainly different to other emerging markets is the maturity of the private equity market. Some of the groups investing in the region started 20 years ago.

According to the performance statistics, available now up to 2008 from the European Bank for Reconstruction and Development and Cambridge Associates over a 3-, 5- and 10-year horizon, Eastern Europe has been the best performing private equity market globally. You have an experienced universe of fund managers, combined with what we discussed before –a low supply of private equity capital and economic growth and convergence. It is a unique situation.
PEI: So why is there this incredibly low supply of private equity capital, if the performance data is so compelling?
MANZ: Because Enterprise Investors and Mid Europa only fundraise once in a while!

ROJICEK: Some investors still view Eastern Europe as an emerging market, so it falls outside their allocations to “Europe”. Also, they are faced with a collection of countries which they find hard to place on a map. If you look at the China or India story, they are both large, single markets and here it is much more complex. The other problem is the lack of data. It has been improving thanks to the work done by EVCA, but still – compared to the developed markets – it is difficult to find. Pretty much the only data that exists that goes 10 years back comes from the EBRD and us.

PEI: What about local LPs? Are there any untapped pools of capital within the region?
MANZ: Yes. The obvious target would be the Polish pension funds, who are basically not investing in private equity for regulatory reasons. They are interested and would like to do it, but it has been difficult so far. We’re working on it with the Polish Private Equity Association, but it is still quite a long road.

To some extent there is a whole segment of this market that is not developing because there is no local capital.
ROJICEK: In some [Central European] countries there are a few pension funds making small commitments to funds, including ours. But if you look at the total amount of capital committed, it is just a small fraction and barely visible.
BUTCHER: The real story is why the big Polish pension funds aren’t allowed to invest.
PEI: Talking of fundraising, how much does the pending European Directive on Alternative Investment Fund Managers play on your mind?
MANZ: This is something we get asked a lot. My response is that it impacts Central Europe as much – if not more – than anybody else in Europe. There is unfortunately little awareness – even within the industry – of the problems that could arise as a result of this legislation as it was originally drafted. Particularly on the fundraising side, because all the capital for private equity is basically imported to the region, so the “third country” issue can cause significant problems for funds operating in this market.

The disproportionality of what is being proposed also impacts Central Europe in terms of the capital requirements and information requirements. If this is adopted in anything like the current form it will be harmful to the development of this industry and may concentrate capital even further among the very few funds that can meet these requirements.
BUTCHER: The question is: Where is the problem with private equity in Central Europe? There has been no fuss or backlash about it. The only obsession – and we have talked about it today – is that we really want more of it: more funding coming in to fund development of economies. Anything that puts a brake on that is not a good thing.
MANZ: This is key: private equity’s reputation among the public, even among trade unions and policymakers, is very positive. In Central Europe, private equity has been doing all the things that private equity says it does, and not doing the things that are seen as abuses of the system in other parts of the world.
ROJICEK: The private equity industry pretty much started right when these economies opened in the early 90s. It became an integral part of the change and the new economic environment and has been accepted by the market and the regulators. It would be unfortunate to reduce sources of capital, when the crisis has already caused many sources to disappear.

PEI: Is there any room for optimism in the short- and near-term future?
BUTCHER: I think economically we are going to see a slow recovery, but it will overtake Western Europe and we are going to see more deal flow from the second half of the year. We are already starting to see some forced transactions, albeit not a wave.

MANZ: I would echo many of the same things. I think this year will be a year of stabilisation with some more deals happening – particularly on the exit side … unless we go into a global double dip recession.
ROJICEK: One thing to remember is that this is not the first crisis that all three of us have seen. We launched our first fund in October ‘98 in the middle of the Russian Crisis. The investments made in ‘99 – and subsequently 2002/03 – produced excellent returns, and I think some of our optimism comes from this. The crises are all different, but there are common elements, so we are certainly optimistic.