Avoiding contagion

If the wretched weather in London as Private Equity International left for Poland in early May (torrential rain, with dark clouds overhead) seemed symptomatic of Western Europe’s economic gloom, the blazing sunshine in Warsaw – where three local industry luminaries gathered for our annual Central and Eastern Europe roundtable – was equally fitting for a region that has generally weathered the storm rather better than some of its peers to the West. We asked three local experts (for biographies, scroll to the end of this article) for their view on the current state of play.

PEI: From a macroeconomic perspective, how has the region fared over the past year, especially in light of what’s going on elsewhere in the Eurozone?

Strassberg: If you read the Western media reports and other publications of that sort, you probably think the world is coming to an end. Frankly it has been coming to an end since 2009 – but it is 2012 and none of the banking failures that were predicted have happened. There has been turbulence, but most of the countries in the region have done pretty well, and actually had reasonably robust domestic consumption. They have very pro-growth tax regimes and they have much lower debt-to-GDP levels. The level of fiscal resilience and flexibility is therefore much greater.

Seewald: In comparison to the Eurozone, the economic environment in the region has been resilient with an average GDP growth rate of 4.4 percent in 2011 and a forecast growth rate of 3 percent in 2012. Poland, Turkey and Russia have performed especially well and this is expected to continue in 2012. In Q1 of this year we have seen softening in some of the export-dependent economies in the region like the Czech Republic, reflecting the challenges of trade partners in Western Europe.

That said, consumer sentiment has remained positive and is an important driver of private equity performance. Looking at some of the fundamentals of the region, almost all the CEE countries fulfill the Maastricht criteria or are closer to fulfilling them than many members of the EMU, and with the exception of Hungary have lower debt as percentages of GDP than the key Western economies of France, Germany and the UK. So, in light of what is going on elsewhere in the Eurozone, on balance, CEE has fared better. I say this with caution, however; the Eurozone crisis clearly presents potential hazards to the region should its contagion effects spill over into greater Europe in a more pronounced way.

Rusiecki: I totally agree with the positive notes, so I’ll add some negative items, just for the full picture! I agree with the consumer resilience, but the crisis has undeniably brought the economic cycle to Central Europe. Before that, with the exception of Russia and the 1997 crisis, the Central European region and new EU members more or less benefited from strong growth irrespective of what was happening elsewhere.  The current crisis has ended that and brought the economic cycle to the region.

You see it most acutely with cyclical businesses exposed to the construction market – there’s been a lot of pain there and it is not going away. So I think if you invest in cyclical businesses, you need to start being much more mindful of the downside. Where we have a consumer-focused business or a business which is not cyclically exposed, it’s done well. Our export-led businesses have done well, obviously helped (especially in Poland) by the weakening of the currency. Generally Poland matters so much to what you see in the overall region.

PEI: Poland may be the standout performer, but this is a diverse region – how does the picture differ across the board?

Seewald: The region’s economies are as diverse as the various opportunities for private equity capital to be deployed in CEE. They are by no means homogenous.

A good starting point is Russia, which will become the largest consumer market in Europe in many key segments and sub-segments over the next five to ten years, ranging from automobiles to household goods and the services sector. It already is the largest internet market, overtaking Germany last year. Private equity investors in Russia, in aggregate, have done very well, outperforming other BRIC markets over the last ten years and with reasonably good prospects going forward.

Rusiecki: I think it is increasingly difficult to justify investments in many of the smaller markets of the region.

Strassberg: There has definitely been a decoupling. In the golden days of 2006/07, you had a lot of investors who became less discriminating, despite obvious signs of differences within the region. Investors went into places like Romania and Bulgaria and showed effectively no price discrimination on assets, relative to what they were prepared to pay for Polish or Czech companies. Now people have learned that there is a difference. There’s the unique case of Hungary, too, which for a long time was among the good countries and then for the last few years has been in the doldrums.  

Rusiecki: Then there’s the former Yugoslavia, which we are much less enthusiastic about – it’s one of those places that remains in a world of its own.

Strassberg: You see, on that we differ, because we actually see the former Yugoslavia as an attractive place to invest – in terms of their pro-business attitude, good growth prospects and where they stand on issues such as the corruption index.

Rusiecki: I think the former Yugoslavia is still a market marked by a long history of debt-fuelled high valuations paid by local investors. The bubble hasn’t completely burst – expectations still remain high. When the debt is worked out, expectations go down and assets can be picked up at reasonable prices, then it will be attractive. There are many strong manufacturing businesses in the former Yugoslavia which would be interesting if the sellers’ price expectations were in line with valuations elsewhere in Europe.

Strassberg: Particularly Slovenia and Croatia have shown good indications in terms of convergence trends. Serbia requires more thoughtful asset selection – but again, we find opportunities in that market. As those countries have traditionally been neglected by investors, there is low-hanging fruit in terms of the availability of transformational transactions, and the ability to add value very quickly by improving processes and corporate governance. In places like Poland, things are at a different level of sophistication and it therefore requires a more considered approach to value creation.

PEI: What is your perception on Russia, which always seems to come in fourth in conversations about the BRIC countries?

Seewald: Our perceptions of Russia are founded on experience gained investing in the country, and on balance this has been good to date. In aggregate, private equity returns in Russia over the last 10 years have outperformed places like China, India, Western Europe and the US. For casual observers of the market, there is often a less flattering perception which is driven in some cases by faulty assumptions and in other cases by actual risks present in all of the BRIC markets. 

If what you say is true – that Russia seems to come in fourth in conversations about BRIC countries –then implicitly the type of inefficiencies that private equity thrives on should remain in place, and position the market well for investors familiar with the opportunity.

PEI: How about your portfolio companies? Have they been affected by the wider malaise in Western Europe?

Strassberg: If I look at our portfolio companies that are exposed to the consumer end of the Central European market, by and large they have done very well. If I look at investments in regulated sectors such as alternative energy or telecoms, the driver for performance has frankly been less about macro statistics and more about regulatory shifts. But ultimately nothing that has happened to the companies in the region seems to be directly correlated with the eurozone crisis. By and large, we think the region has been sheltered to a large extent.

Seewald: Across our portfolio, including underlying fund investments and direct investments, on balance we saw both top line and EBITDA growth come back over the last two years. So it has been resilient. We had two direct portfolio companies go public on the New York Stock Exchange in February 2012, namely EPAM Systems, a Russian IT outsourcing business and AVG Technologies, a security software developer that was founded in the Czech Republic. Both companies are examples of businesses built by scientists and engineers from the region.

PEI: How do LPs perceive the region? Are they still enthusiastic about the opportunities here, or are concerns about Europe clouding the issue?

Rusiecki: Investors recognise that even if you are performing better than many European countries, if the eurozone collapses then obviously there’ll be a knock-on effect. European investors obviously have a slightly different perspective – but encouraging investors from outside of Europe is a challenge.

Strassberg: We have had some investors who for various reasons did not come into our last fund in 2007, but have remained in contact since then and appear to be maintaining their level of interest.

There are some investors who, for their own reasons – either because they don’t have the capital or because of regulatory constraints – will have some hurdles. But I don’t think that LPs have fundamentally walked away from the region. The noise emerging from all the issues around the eurozone has made LPs, particularly those from the US or Asia, more concerned if they are considering Central Europe for the first time.

Seewald: Most investors implicitly understand the opportunity for private equity here – the concept of convergence with core Europe, the consumer driven growth, the growth buyout market in the region and the inefficiencies that usually present investors with good opportunities. The main concern comes from the question of how the eurozone crisis may affect the region and derail some of the opportunities in CEE in the short to mid-term.

PEI: What about local LPs? How has that market developed over the last few years? Is there capital to be found?

Strassberg: We haven’t seen any. One of the attractive features of the region from an investment standpoint is the relative scarcity of domestic capital competing against funds like ourselves. There are very few investors in the region that are willing and able to allocate to alternative asset classes. There is limited understanding of the non-traditional asset classes, and there are some regulatory-driven constraints.

PEI: Across the region, which sectors do you see as most attractive at the moment?

Rusiecki: It’s consumer-driven. I think we generally assume that the underlying level of market growth is going to be much slower than pre-2008, so the real growth has to be market share driven – as with food retail and healthcare.
Renewable energy is interesting, but could be a victim of the crisis. A lot of the activity has been driven by investors from Eurozone countries with perceived zero cost of capital. And that source has dried up, which actually creates opportunities. On the other hand, there is also a regulatory risk, as governments look at the cost of supporting renewable energy. So we’re very careful about how we structure deals in this area.

Strassberg: Our investors want exposure to the GDP growth profile of the region. So we have consistently sought opportunities that give us exposure to anything that’s consumer-driven, plus service sectors like healthcare, telecoms and cable television. We like sectors where the fundamental theme involves benefiting from the growth in disposable income of the local population.

We avoid themes based on labour cost arbitrage, because then you suddenly find yourself rooting for a delay in convergence. We believe convergence is a good thing, and want to benefit from it, rather than hoping it slows.

PEI: Has your approach to investing changed over the last few years in terms of how operationally engaged you are with your assets?

Strassberg: We have ended up spending more time on buy-and-builds – which is more labour intensive because the onus on M&A falls on more on our teams rather than on the management teams.

Also, we’re seeing the creation of regional platforms. Historically, it was less common; it seemed dangerous, given management teams typically didn’t have the requisite expertise and were absorbed by the challenge of managing growth within their domestic confines. Now, we’re seeing situations where there’s an explicit opportunity created, as the business has grown as much as it can in its domestic market and is now looking for expansion. That’s where private equity investors are able to help – but it also means more labour intensity from us, in making introductions, bringing in incremental management teams, financing locally, and so on.

Rusiecki: Management teams are becoming more sophisticated, and the involvement in setting up the basic management systems is getting smaller and smaller. Also, the new generations of entrepreneurs are 35 to 45 years old and they are more sophisticated and understand the need to build teams. So I think that involvement is actually less in basic tasks, which leaves more time for helping companies grow.

PEI: Have debt-to-equity ratios changed at all?

Strassberg: Dramatically. In effect, the equity cushion requirement has marginalised mezzanine, to some extent – because at this point, with valuations that have come down somewhat, you are finding that with the 45 to 50 percent equity cushion requirement, you can fully finance with senior debt only.

PEI: What about competition? Is there too much capital chasing too few deals?

Seewald: I wouldn’t say there is a capital overhang in the region. Quite the opposite. In the mid-market and lower mid-market, where we believe the sweet spot is for private equity in CEE, we are seeing imbalances of supply and demand of capital that favour investors. Given the challenges to raise new private equity funds in the current market, I believe these imbalances will remain in place over the next five years and a shakeout will occur where some managers unable to raise will exit the market.  This type of shakeout is a natural, healthy evolution of the market.

Strassberg: One of the things we’ve seen is that some of the pan-European players who have made forays into the region have had their fingers burnt in some instances.

There are still quirks as to how the region operates, and you really need to have that local know-how – hiring two freshly-minted MBAs from Ivy League schools who speak whatever local language is just not enough. As long as you have the money and the will, you can buy a company. It’s what you do afterwards – your ability to follow up day-to-day, working with the management teams, speaking their language, meeting the regulators, meeting the relevant counterparties – that’s quite operationally hands-on for most of the big pan-European guys to get involved in.

Rusiecki: Quite honestly, the difficult competition has not so much been from private equity players – although there have been auctions where we’ve competed against each other head on. A lot of competition has been from strategic investors, who are willing to pay a very high price for growth. If you look at the food companies sold in Poland in the last few years, there have been exceptionally high valuations placed on them by investors willing to pay for any growth whatsoever.

PEI: Looking forward then, what’s your prognosis for the region?

Seewald: I like the private equity opportunity in CEE and Russia but I am concerned that the Eurozone crisis will cause further disruption in the near to mid-term. Assuming no protracted market disruptions in the mid to long term, the region remains well positioned to benefit from the tail winds driving the convergence with western markets, especially the CEE consumer and the deep pool of human capital in the region.

Strassberg: We are very big believers in the fact that the region still has a lot of intrinsic growth from all these trends in consumer-based convergence – demand for things that they don’t even know they need yet. It’s not just about GDP growth being slightly at a premium; it’s the overall dynamic of being able to roll out a lot of incremental services.

PEI: And what are the biggest clouds on the horizon?

Seewald: Aside from Eurozone concerns, the CEE region must accelerate innovation across industry sectors in order to position itself as not only a lower cost region, which for the most part in the core countries it no longer is, but also a high value, productivity driven business environment. Without this, economies will become stagnant over time and the region will lose its edge. Private equity can play an important role in achieving this and already has accomplished a great deal, but the human resources needed going forward for fund management will be different.

Rusiecki: Will companies move from the model of offering reasonable quality at a lower price to offering some sort of innovation and value-add? Will they move from being just component suppliers to being suppliers of complete systems? If they don’t, I think the threat is that Central Europe will end-up similar to many parts of Southern Europe: no longer fully competitive as just a subcontractor, but lacking enough inherent innovation.

Where I think Central Europe is quite weak – and where the likes of Sweden, Germany and so on excel – is in innovation around manufacturing. There is not very much worthwhile research being done in the technical universities of Central Europe – and if it is done, it’s often very theoretical, with no link to the commercial world.
But I think this is something that will cure itself. There are quite a few serial entrepreneurs that are redeploying their capital from some straightforward consumer business into supporting innovation and breaking down this barrier. So time will deal with that; I think the challenge is: will that happen fast enough to provide an additional boost to productivity? I am positive but I see it as a major challenge.


Michal Rusiecki is managing partner at Warsaw-based mid-market private equity group Enterprise Investors. He is responsible for investments in the food retail, consumer goods, healthcare, renewable energy and cleantech sectors. He also oversees the firm’s activities in Slovenia and Croatia. He has completed 15 transactions, including those in Polish Energy Partners, Harper Hygienics, DGS, Dino, Wento and UOS. Before moving into private equity, he worked at the Polish Ministry of Privatization and at the University of Warsaw.


Matthew Strassberg is a partner at CEE-focused buyout firm Mid Europa Partners. Formerly an investment banker with Merrill Lynch in London and with JP Morgan in London and in New York, and an executive at US buyout firm TLC Capital Partners, he joined Mid Europa in 2002. He was involved in Mid Europa’s investment and recapitalisations of Invitel, and the financing of the Bité buyout. He led the series of four acquisitions which constitute the Lux Med Group, the acquisition of Kent Hospital Group and is responsible for the on-going consolidation of the Diagnostics Platform. Most recently he led the exit from Aster.


Richard Seewald is a Partner at ALPHA Associates, a Zurich based global private equity investor with over $2 billion under management. He is responsible for direct investments, secondary transactions and primary fund
commitments and is a member of the firm’s Investment Committee.