Centred on growth

Perception and reality can be very different. The media has helped to cultivate the view that Central and Eastern Europe is teetering on the brink of economic collapse, and rife with corruption, yet those on the ground see another story.

The CEE economies have characteristics which make them a unique hybrid of developed market levels of risk and developing market growth, locals argue. From a private equity perspective, it also boasts a pool of experienced managers with proven track records over more than two decades.

Three of the private equity industry’s local heavyweights gathered in Warsaw last month to speak to Private Equity International about the region’s prospects, and to explain how the industry is helping to drive the local economy out of the downturn.

PEI: How is Central and Eastern Europe faring in the wake of the global financial crisis?

Knaflewski: The impact of the crisis varied amongst the different countries. The size of the domestic market was the main differentiating factor between countries which were relatively unaffected by the crisis, like Poland, those that were in-sync with Western Europe, like the Czech Republic, and those which were very badly affected, like the Baltic states.
 
The consumer in Poland was pretty slow to wake up to the crisis in Western Europe, so people kept spending throughout 2009, and it was only really in 2010 that we saw a bit of a dip in spending. By then, Western Europe’s economy had started to pick up and Poland piggy-backed onto that.

Rekusz: To add to that, I think the crisis has shown CEE is actually a very diversified region. It’s not a homogenous group where you can put all the countries together in one basket – I have the impression a lot of investors seem to see the region that way. CEE is very diverse geographically, culturally, economically. There are different entrepreneurial spirits in different countries, different macro situations, different corruption levels, all these factors mean these countries represent very different risk-return profiles.

At one end of the spectrum you find countries like Poland with strong regulatory policies, well-developed debt markets, generally very safe investment areas, but at the other extreme, you find countries like Ukraine, Bulgaria, or Romania, which lack transparency and suffer from corruption. The crisis has actually emphasised the differences between these countries.

Rojicek: There are differences of course, but most countries in the region returned to growth in 2010. Each of them is encountering somewhat different issues at the macro level but the overall trend is positive. But one of the risks to that growth, and this isn’t limited to just the CEE, is commodity prices.

Knaflewski: It’s a particularly bad time for manufacturing processes industries, because we have the situation of a massive uptick in commodity prices but we don’t see this reflected in the final products. This cannot last though. The global commodity markets are seeing signs of pricing coming down.

PEI: How about deal activity – has that picked up?

Rekusz: There’s no question that deal activity in 2009 slowed down, with much of the effort focused on portfolio companies rather than new deals. There weren’t many new deals around. Nor were there many distressed situations, which was quite disappointing. We thought the banks would actively try to restructure their debt portfolios. In fact, banks have solved most of the problems with the borrowers through private deals to reset covenants without going to the market. They haven’t been willing to put companies up for sale. But there are questions about whether the banks are just delaying the issue, hoping that the recovery will help the problems solve themselves.

Knaflewski: My take on that is that the bankers were so shell-shocked by what they were seeing inside their organisations that they were not in the position to take the moral high ground and tell their clients they should have been more prudent putting together their projections or managing their balance sheets. There was so much turmoil.

Rojicek: If you look at developed markets, the distressed opportunity was much smaller than expected, because the debt markets recovered so quickly. Distressed funds were returning capital to their investors unused. There were a number of companies in distress, and some still are. But the total amount of debt in businesses in this region versus the developed market, it’s just a fraction. If you look at the private equity market, the amount of leverage is very modest.

PEI: So you don’t see there being more distressed situations in CEE, perhaps as companies overstretch themselves coming out of recession?

Rekusz: If we haven’t seen many so far, I don’t see there being more. I think the economic outlook is positive. GDP growth has resumed in most countries. You can’t exclude one-offs, but I don’t think anyone in this region would base their investment thesis on distressed situations.

Knaflewski:
I like to equate the situation to the residential property market. In our part of the mid-market, dealflow is driven by company founders looking to address succession issues by putting their businesses up for sale. You do not sell the house you’ve built and owned for 10, 20 years just because bad times have come. But now, sellers are thinking, the company has survived the crisis but it’s not necessarily going to be calm seas ahead – there might be another bump. Maybe on the back of the recovery, with everything going ok, perhaps now is the time to sell?

Rekusz: I remember a couple of situations back in ‘09 where good opportunities came to us, but at extremely high prices. At that time, the justification was, “This company is doing so well in such hard times, I deserve this price!”
Back then, there was so much uncertainty in the marketplace, no-one knew what the future would hold. In such an environment, if there’s a business for sale, how are you going to put together a credible business plan for the next three to five years? It’s extremely difficult if you don’t know what’s going to happen in six to 12 months’ time. This was a significant factor in our case in reducing our deal activity.

Rojicek: Clearly there was slowdown in ‘09. There were few distressed situations. What we saw more was that the deals that were done, compared to the previous years, there were more expansion capital deals rather than buyouts – founders wanted to retain a large portion of their business. They accepted lower valuations and it was easier to negotiate because they needed capital but couldn’t get it from other sources.

In 2010, investment activity picked up. There was still a lot of expansion capital activity, but buyouts came back. We started to see some pick-up in entry valuations, particularly at the high end of the spectrum. More importantly, we started to see some exit activity.

PEI: Globally, it’s been widely reported that private equity is grappling with a significant capital overhang. Is that an issue in the CEE region – are there enough deals on offer to satisfy the need of firms here to put capital to work?

Rekusz: I don’t think CEE is an isolated island, it’s part of Europe – you have all major pan-European players active in the region, so obviously with their funds raised recently, they do need to participate in deals here. In terms of funds raised recently for this region, the most recent was I think Advent’s in 2008.

Knaflewski:
2009 was a bit of a slow year but 2010 was pretty much an average year in terms of investment pace. So we have capital that’s been put to use, but no meaningful fundraising.
Rekusz: That raises interesting questions about the future though and LP appetite. The test is yet to come, maybe in the next 12-18 months.

Rojicek: For funds which are focused on the region, overhang has never been a problem. You see competition for deals from the pan-European players only at the high end of the market – some have a small presence here. But if you go below the size of deals they typically do, the supply of capital is really very low given the size of the opportunity.

Knaflewski:
Looking at the equation of supply and demand, one thing that sets us apart from Western Europe or the US is the practical absence of the mega deal market.  In this region, so far we’ve only had one deal which was above €2 billion – the StarBev deal by CVC. There’s very little happening above €1 billion EV.

In the upper mid-market, from €100 million to €1 billion, there is more activity. Pan-European players are active, as are local players. In our space, €30 million to €100 million it’s only locals, as the pan-Europeans don’t really go below €100 million. We see quite a lot of interesting opportunities with reasonable pricing and decent transaction parameters, with the characteristics of capital expansion, investing alongside the founder and so on.

Rojicek: There are good ingredients here – capital supply is low and the market opportunity is sizeable; and the fact the market has developed over the last few years, so most of the GPs have been here for a long while, decades in some cases. There is a decent universe of experienced GPs with proven track records. There haven’t been many new entrants to this market, so the market is dominated by the experienced local players.

PEI: How does LP appetite for CEE compare to that for emerging markets like Brazil or China?

Rojicek:
It’s difficult to gauge because there hasn’t been much fundraising in this region over the last few years. It’s going to be tested though in the next 12 to 18 months. We are about to start fundraising for our third fund for the region later this year. If the surveys are any guidance, it probably won’t be easy. Fund managers will have to do a lot of hard work to sell themselves to LPs.

Knaflewski: To me the main argument is not “Let’s try to convince people not to invest in China”, but it’s more a case of convincing people to have an allocation to emerging Europe in addition to the allocations they have to China, Latin America and so on. There’s really a specific emerging Europe-related argument which is the story of convergence with emerged Europe.

I strongly believe in the catch-up effect we have in countries like Poland or the Czech Republic, because these countries border Germany. The Oder River is like the Rio Grande economically of Europe. You have the wealthiest large European economy on one side, then you have the largest emerging European economy on the other.

Rekusz: There will be changes to the LP base though. There will be new types of investors coming in, like sovereign wealth funds. They will be more aggressive and they will probably want to concentrate on the larger end of the spectrum. Some LPs may want to limit their relationships with GPs to just one or two GPs in the region.

PEI: What about the exit market here?

Knaflewski: The Warsaw Stock Exchange provides a very strong alternative to trade sales. Here we have the luxury of just investing in a good company with strong growth prospects [without worrying about exit options]. For good companies there will be buyers, be they other private equity firms or trade players, and then we have the stock market in the background. About one third of our exits have been IPOs – we have floated 27 companies on the Warsaw exchange.

Rojicek: Looking at the central European market, it’s a very unique mix of developed market features and emerging market ones, which makes it attractive. Some countries have now been part of the European Union for seven years, so in terms of the legal and regulatory risk compared to typical emerging markets, in CEE they are much lower and more like those typical of the original EU countries. The private equity market started 20 years ago now, you have a functioning exit market. On the other side, the economies are coming back to growth. That growth may not be as high as in China and India but it is significantly above what we can expect from the developed markets. The combination of these factors creates a unique opportunity.

PEI: Is the relatively small size of funds in the region a barrier to larger institutional LPs investing in the region?

Rekusz: Certainly it may be an issue for some larger LPs, but not for all of them. We see quite substantial appetite from LPs based in emerging markets to invest in our region. Such LPs are likely to be huge investors in Asia and elsewhere, but they want to be present in Europe too, they want to diversify their investments. So I wouldn’t say China excludes CEE, I’d say it’s just another story.

In terms of the size, I’d say that again in terms of the larger LPs, if we’re talking about fund size at or around €1 billion, these guys will start to be interested. You have to balance the composition of your LP base so they don’t take too much of the fund.

PEI: What of the locally-based LPs?

Rekusz: None present!

Rojicek:
There have been some investments from LPs in the region, but it’s been a very small amount. None of the large institutional investors in the region have been active in private equity. It will happen one day.

Knaflewski: It takes time to educate potential local LPs about the need and the attractiveness of investing in this asset class. It took time in Germany, it took time in France, and it’s taking time in Poland. We as GPs have not been consistent in pushing the education of local LPs because we had the luxury of an abundance of capital from international LPs. We realise there is a need now to add that new group of LPs.

Rekusz: I sat for a number of years on the Polish private equity association and it was always on the top of our agenda to educate people about and to push them into private equity, but it is a huge task. Yes, on one hand, there’s not a coordinated effort by the GPs but there is a lot of work done by the Association.

PEI: At a wider political level, how will political or regulatory developments like the AIFMD affect your industry?


Rekusz:
AIFMD looks like it won’t be as bad as people originally thought it would be. Obviously there will be some impact, notably in increased costs, but I wouldn’t say it will have a major detrimental impact on our activities.

Rojicek: The private equity industry has never had an issue politically in the region – it’s been well-received.

Rekusz: Private equity has good connotations in central and eastern Europe, as opposed to in western Europe. There’s been no highly-publicised controversial deal. Private equity has always been associated with growth capital, supporting entrepreneurs and it was part of the success of central and eastern Europe for the last 20 years. That’s why, if you ask people, they will usually have a very good image of private equity.

Knaflewski: What we were doing was very similar to what venture capital firms were doing in western Europe, supporting growth in small to mid-sized companies. In the EU, there’s pretty much a dichotomy of buyouts bad, venture capital good.  Here it’s part of the same bag. What we were doing was investments supporting growth, there was no financial engineering.

Rekusz: There’s not been a deal which was a pure financial engineering case.

Rojicek: The investment stories have always been about supporting growth. If you look at the developed market, unfortunately the image has been created by certain highly-publicised large deals where something has gone wrong. Private equity is positive for the economy.

PEI: Do you expect the level of competition from pan-European players to increase as they go looking further afield for deals?

Rekusz: They showed up a couple of years ago. Some opened offices here, and some have shut down their offices since then. We see a trend now of covering CEE or Poland out of foreign offices in Germany for example. Some firms have made a commitment to the region and done deals here, and they’re part of the fabric now. Then you have some who fly in for a specific type of deal like Polkomtel. Whether they’ll come again for a different deal, who knows? You have different guys looking at deals all the time.

Rojicek: It’s usually at the larger end of the spectrum though. The majority of funds in the region are smaller than €500 million, so they’re not really affected by the presence of larger pan-European or international players.

PEI: What’s your view on co-investing alongside a large GP that perhaps doesn’t have a presence in the region – can that type of deal work?

Rekusz:
There were selected cases in the past where we teamed up with big firms to bid for large assets – but if you think about the advantages and disadvantages, I can’t think of many benefits to teaming up with other large GPs. I mentioned earlier co-investments with our LPs, and this for us is much easier – it’s easier to manage the process and the investment.

Knaflewski:
There’s also the possibility of club deals between locally based GPs, which hasn’t happened much recently but was more common a few years ago.

PEI: How would you sum up the prospects for private equity in the CEE region over the next 12 months?

Knaflewski: Overall, the environment is clearly positive, but not with mind-boggling growth rates. So you need to invest in growth areas by taking a clever approach, detecting trends in sub-segments of markets where companies are growing at rates in the high teens at least. We are clearly seeing an improvement in the number of companies whose owners are prepared to talk to private equity companies about a sale.

Rekusz: 
I also continue to be positive on the region’s prospects. Clear differentiation is a must for those firms which want to succeed though. The way forward is to target specific sectors where growth is delivered by growing disposable income – the catching up process we mentioned earlier – growth will also come from buy-and-build and expansion capital. We’ll continue to focus on market-leaders, financing their growth both organically and via M&A.

Rojicek: The important thing for all investors is returns. Funds in the region have delivered good returns, and we believe there is a good opportunity to continue to do that in the future.