Pressure to converge

 Post-communism, Central and Eastern Europe became an emerging market. That label has stuck for two decades – but today, CEE is harder to classify. 
The massive 20-year shift from centrally-planned economies to free market systems has been surprisingly effective: much of the region now has more in common with Europe to the west than anywhere to the east. As a result, people aren’t sure which allocation bucket CEE managers belong in.  
“It’s a tough call,” says Brian Wardrop, co-managing partner of CEE-focused Arx Equity Partners. “The risk profile of investing in CEE is getting lower all the time, and the countries are somewhere in between east and west. Generally speaking, we increasingly tend to be perceived as being in the European market.” 
Abris Capital Partners, which closed its CEE Mid-Market Fund II on the €450 million hard-cap earlier this year, faced a similar issue, says managing partner Neil Milne. 
Current industry health indicators look good. Fundraising for the region in 2013 already exceeds last year’s level (even excluding the $6 billion Georgian co-investment fund that aims to invest in CEE).  
Returns have also been eye-catching. Among emerging market sub-regions, CEE ranks highest except for the five-year horizon, according to data from Cambridge Associates (see chart, below).  
“[CEE] GDP growth may not be not as strong as in Latin America or Asia,” says Brian Lim, partner at Pantheon Ventures. “But company growth is very good, so a number of levers are available for private equity to enhance the bottom line.” 
However, the region’s convergence with a Europe beset by a sovereign debt crisis has had an impact on perception, sources say. 
Enterprise Investors, the CEE-focused private equity firm founded 23 years ago, closed Fund VII earlier this year on €314 million, well down on its initial €600 million target. The reason? Sentiment. 
Managing partner Dariusz Pronczuk explains that even investors who have known the firm for many years nonetheless linked CEE with the eurozone crisis. That’s a misperception, he says, since Poland, the largest CEE economy, doesn’t even use the euro.  
“Some investors believe that in view of Europe’s troubles, capital is better off invested in China and Brazil,” he says. 
Europe’s woes have also stymied CEE’s exit environment, sources agreed. Abris had no exits this year. Arx Equity’s last exit was the sale of Czech eye clinic chain Lexum in December 2012 to a strategic buyer. 
Most CEE deals are exited through trade sales. But strategic acquirers, often from Western Europe, remain cautious. “Corporate Europe is short of cash and M&A in CEE has been low,” says Abris’ Milne. “We had exit discussions with quite a few parties, but unless we can see fair value for our business we’ll probably keep holding it a bit longer, as long as that business is growing.” 
A complicating factor is that CEE GDP growth has slowed and consumer markets are muted. “In the medium term, growth should outpace Western Europe,” says Arx’s Wardrop (whose firm may look to raise a new fund next year).  “But today, to convince strategics of a good solid growth forecast is harder. Only assets of obvious strategic importance get acquired.”