Emerging markets: Playing catch-up

RobertManz 180 

Managing partner
Manz joined Enterprise Investors, one of the largest private equity firms in Central and Eastern Europe, in 1990, and is responsible for investments in the FMCG, retail, pharmaceutical and telecom sectors. He was the founding president of the Polish Private Equity Association, where he served for five years, and is chairman of the Central and Eastern Europe Task Force of Invest Europe.

PawelPadusinski 180
Padusinski is a partner of Mid Europa Partners and the co-head of the Warsaw office. He is responsible for deal sourcing, and executing and monitoring investments. Prior to joining the team, Padusinski worked in the corporate finance department at PwC in the Polish capital.

MarcoNatoli 180
Head of division
Natoli has been at the European Investment Fund since 2009. He leads the lower mid-market team investing in equity, hybrid debt/equity and private debt funds across Europe, with a particular focus on the northern, eastern and southern regions. He represents EIF on the advisory boards of over 20 funds.

MateuszSzczurek 180
Associate director and lead regional economist
Szczurek joined EBRD in October 2016 to lead the bank’s assessment of macroeconomic developments, monitoring of structural reforms and policy dialogue in Central Europe and the Baltics. Prior to these he was Poland’s Minister of Finance in the cabinets of prime ministers Donald Tusk and Ewa Kopacz.

What do you get if you cross emerging markets-style long-term growth with European stability? The answer is Central and Eastern Europe, according to Robert Manz from Enterprise Investors’ Warsaw office.

Manz is one of the four experts assembled by PEI to discuss private equity in the region. Alongside him is another general partner, Pawel Padusinski of Mid Europa Partners, and two limited partners: Marco Natoli of the European Investment Fund and Mateusz Szczurek of the European Bank for Reconstruction and Development.

Private equity investment in Central and Eastern Europe defies easy definition, as does the region itself. Should we characterise it as the EU accession countries, or is everything from the Baltics down to Turkey more accurate?

Our participants offer slight variations in their answers, but all agree: Poland remains the engine room of the region, both in terms of economic output and private equity activity, and the country dominates our discussion.

Manz begins by characterising Central and Eastern Europe’s growth as in “long-term catch-up mode”. He notes that it has delivered gross domestic product growth of approximately 2 percent more than its neighbours in Western Europe in the years before and since the financial crisis.

This thread is picked up by EBRD’s Szczurek: “The high-growth markets among the new EU member states are distinctly different from those in old Europe. Unlike Spain or Portugal, where per capita GDP growth has been driven by intensive investment, in the CEE growth has come from above average productivity growth. Most countries in the region are more balanced in a macroeconomic sense; they are not fuelled by crazy credit growth or investment.”

“And there is still a growth gap for investors in the region to take advantage of,” he adds.

Mid Europa’s Padusinski echoes the point: “We view the region through the same lens; growth here will be better than markets in Western Europe by between 1 to 2 percentage points per year for the next 15 to 20 years. We see the catch-up story – mainly in the consumer-facing industries.”

Padusinski goes on to note the complexity of investing in a region that, for his firm, extends from Estonia down to Turkey. “Yes, it is complex,” he says. “There are 20 countries, some in the EU, some not, some using the euro. But it is this heterogeneity that makes it very attractive.”

The region – driven by that Polish engine room – has indeed performed relatively well from an economic perspective. The IMF estimates Central and South-Eastern European economies to have grown by between 3 and 4 percent during 2016. This compares with the 1.7 percent growth expected for the eurozone countries, as estimated by the European Commission.

But the private equity landscape, despite all these positives, is still dominated by development finance institutions. So what is holding back commercial institutional investors?

It is not a question of returns, according to our four experts. A study produced in 2014 using the EBRD’s fund investment programme as a database, showed that the 10-year IRR at that point across all funds was coming in at more than 15 percent. The numbers are likely to be even better now, says Manz, who also points out that failed funds are included in the data set: it is a full industry index with no “survivor bias”. “If an LP had been investing consistently here, these are the returns they could have expected,” he says.

The issue, says the EIF’s Natoli, is that international commercial LPs are weighing investment in Central and Eastern Europe against a bucket of emerging markets. “For international LPs, it is very important to assess how absolute returns stack up against their benchmarks in a risk adjusted manner,” he says. “We often speak with other LPs for reference calls on the funds we have invested with; they will compare CEE to other emerging markets around the world and want to see a premium for what they might consider to be a greater level of risk. This is the main sticking point when it comes to convincing international investors of the region’s attractiveness.”

The EIF invests with a development mandate, but “we do not compromise on the financial viability of what we do,” says Natoli. “Returns in our CEE portfolio are comparable with those in the rest of Europe.”

This comparison that pits the region against other high-growth markets around the world is not completely relevant, says Manz. “The LPs need to catch up; I would like to challenge any LP today to ask them how they perceive the risks of investing in Poland or any of the other core markets here compared with, say, investing in the UK in a Brexit environment: where is there more uncertainty?”

“Or Southern Europe,” adds Padusinski.

“LPs tend to compare these markets to other emerging markets,” continues Manz. “We are part of Europe; we are a high-growth part of Europe.”


Is the ‘emerging market’ label helpful – or even appropriate?

“This is not a new discussion,” says Szczurek, who draws on his recent experience working at the Polish Ministry of Finance to illustrate that the “emerging market” label should probably be consigned to history. “In 2014-15, by far the highest foreign demand for Polish government bonds comes from central banks and sovereign wealth funds around the world; this essentially proves that in many respects it is no longer really an emerging market.”

Szczurek concedes, however, that his development finance institution still has a role to play. That role is less and less to do with plugging gaps in governance and more to do with encouraging international LPs to take a close look at the region.

The same applies to the EIF, which over the last 15 years has invested close to €1 billion in private equity funds in CEE, outside Turkey. “Many commercial investors rely on the assessment made by DFIs for validation of their assessment,” says Natoli. “We are often seen as a cornerstone investor and have a preference for committing at first closing. Having DFIs there is often crucial to attract other investors, especially for emerging teams.”

If international LPs aren’t swayed by the returns, are they spooked by the risk? In 2014, Russia annexed the Ukrainian territory of Crimea and the ensuing conflict shows no signs of stopping. But this event did not add to the risk premium, Mid Europa’s Padusinski argues. From an investment perspective, the only real outcome from the hostilities was that it removed what was starting to look like a promising market. “We didn’t do anything and it is effectively now a no-go area for us. But hopefully it will return,” he says.

The Ukraine conflict is discussed in the same terms as the other seismic geopolitical events that are shaking Europe and the world: the refugee crisis, instability in Turkey, Brexit and unpredictable election results. “Every year there is something,” continues Padusinski. “At this point in time there is more speculation about what may happen rather than what is actually happening. We live in pretty turbulent times, but not particular to Eastern Europe.”

Brexit is one macro event that hasn’t touched Poland; very few of the country’s businesses deal directly with the UK. “If it were happening in Germany, then we would be more concerned,” says Padusinski.

Szczurek underscores the point: in research recently undertaken by the EBRD, Poland stands out as the one country to be almost totally unaffected by Brexit “either indirectly or directly”, he says.

The struggle to mobilise international LPs needs to be fought on two fronts. First is that the economic fundamentals of the region – sustainable productivity-driven growth and Western Europe-style stability – are worth buying into. The second is that the best way to buy into it is through private equity.

“The beauty of private equity is that it is a long-term asset class,” says Manz. “During the life of one fund, many things can happen; you can adjust to find opportunities and this is borne out by looking at the returns data.”
Natoli agrees: “Value-additive private equity holding helps companies to react to situations that might affect them. We have seen that companies in our portfolio that have been exposed to market events have – after some time – been able to compensate for it by turning to new markets, new business models.”

“We had some strongly export-oriented portfolio companies whose exports declined significantly as a consequence of certain macroeconomic or geopolitical events,” he says. “We have not seen any that have not been able to adapt to the situation.” This is in part down to the EIF’s selection process of capable fund managers, he adds.

Szczurek draws a parallel between the adaptability of a private equity-backed management team and a distinctly Polish management characteristic: “The experience of Polish individuals and firms throughout the last few centuries has been navigating various restrictions, whether it is Communist rules or export restrictions. The SMEs especially are rather adept in doing so, using different partners, finding ways around restrictions that would otherwise hamper the business. Unfortunately, this sometimes includes official regulations, which is not good news for the finance ministry given that it includes tax optimisation.”

Another compelling reason to access the region’s growth through the private equity model is the prevalence of family-owned businesses as a deal source. This represents an attractive cross-section of the economy and the asset class is the best way to access this, comments Manz.

These are all sound reasons why private equity in CEE is an attractive proposition, but LPs remain unconvinced. In terms of fundraising, the region has never got close to the 2007 high-water mark, when managers collected more than €4 billion for the region. In 2015, the total was just €418 million, according to data compiled by InvestEurope. About a third of this is accounted for by government agencies.

But Manz argues this is evidence LPs need to take notice. “LPs not paying attention to the region need to play a bit of catch-up of their own,” he says, before dissecting the data. “If you look at the pre-crisis period: in the five years up to 2008, around €11 billion was raised and €7 billion invested; fundraising outpaced investment,” he says.

“Since 2009 onwards, there has been €5 billion raised and €10 billion invested. In other words, investment has been double fundraising.”

“Exits have been reaching new peaks,” he continues, “totalling around €7 billion at cost in the last five years. If I were an LP today I would be looking at where the market is in terms of demand and supply of capital versus investment opportunities.”

Szczurek is surprised that with so much private equity capital being raised globally, LPs have not cottoned on to the CEE opportunity. “There is enough investor capital looking for a home. It is startling,” he says.

Around the world private equity investors are treading carefully amid what they see as cyclically high asset prices. In the CEE, where the capital overhang – the backlog of capital awaiting investment – seems to have been burnt through, presumably competition is scarcer and prices a little more reasonable? Yes and no, our experts say.

“While we are not intensely competing for assets like in other markets, we do face competition, says Manz, who notes cash-rich strategics are the primary source of competition, as well as “internal competition” from founder-owners, who can choose to withdraw from a process if they don’t see enough value.

Padusinski notes occasional competition from global or Western European players for more sizeable assets but, in a resolutely mid-market private equity landscape, this is a rarity. At the time of meeting, his firm Mid Europa had just signed a club deal with two such firms, Cinven and Permira, to buy Polish online shopping business Allegro Group for $3.3 billion. Don’t expect this to turn into a trend of global buyout firms targeting the region, Padusinski says, but “don’t exclude the possibility of more consortia deals as you are seeing in Western Europe”.

Clearly international private equity firms recognise the favourable fundamentals of the region; the international LP community seems to be lingering behind.