CEE gets a taste for LBOs

Chris Mruck, director of Avent International's CEE fund, says buyouts financed with pure equity have hampered returns.

Rob Conn, managing director at Innova Capital, which manages about $300 million in three CEE funds, says: "Since 1994, in Poland, Hungary and the Czech Republic, probably 65 funds were established. As of this April, only 20 have available capital. Most fund managers raised one fund, and are no longer in business."

He adds: "Emerging-market private equity in general has been a disappointment. The primary reason is FX losses. During the life of our first fund, the Polish zloty halved in value, so we had to double our money just to get our cash back."

In CEE, another key problem was lack of access to leveraged finance. The CEE banking market was privatized late, towards the end of the 1990s, and the countries' state-owned banks were not interested in providing leveraged finance to private-equity funds.

The banks were, however, prepared to provide extremely cheap financing to local management for management buyouts, because they had personal connections to the management. This made it more economical for managers to buy their own companies rather than sell them to private-equity funds. Some local managers, without experience of private equity, in any case viewed the funds as little better than asset strippers.

Gyuri Karady, managing partner of Baring Private Equity Partners' $86 million CEE fund, remembers: "It was impossible to do a deal in the Czech Republic up to 2000. The Czech banks would lend at very cheap rates without any of the requirements I would have, such as a seat on the board. Banks were taking equity risks and getting debt returns. Of the three or four deals we bid for, we were always outbid by local banks."

As late as 2001, it was next to impossible for funds to get leverage for buy-outs. Michal Rusiecki, partner at Polish private-equity firm Enterprise Investors, which has about $1.1 billion under management, says: "We tried to do a leveraged MBO in 2001, but there was no willingness to think about it on the bank side."

He continues: "The main reason funds couldn't get leverage, at least in Poland, was the high interest rates during a lot of the 1990s, because of the high inflation. Banks were only prepared to lend for working capital purposes. The ministry of privatization, meanwhile, wouldn't even entertain the idea of an LBO strategy."

The honourable exception among banks was Erste Bank, which set up a specialist acquisition finance unit as early as 1997 to provide leveraged finance for buy-outs. Chris Buckle, one of the heads of the unit, says: "We were clearly blazing a trail. There was very little activity the first couple of years. It was quite difficult because we were operating in an uncertain legal environment. You tended to see small transactions, of around €20 million, with lower leverage and higher prices."

When buy-outs occurred, the lack of leverage meant they were usually financed with pure equity, which "obviously hampered returns", says Chris Mruck [pictured], director of Advent International's CEE fund, which has been investing in the region since 1994.

Benjamin Edwards, manager of Mezzanine Management's €150 million Accession Mezzanine Capital fund, ponders: "Why hasn't the region historically returned what the western European private equity industry has returned? Perhaps because there was generally not a lot of leverage available."

In many cases, LBOs were also unsuitable because the companies were high-growth operations, and therefore needed their debt capabilities for reinvestment.

The lack of leverage meant private-equity firms concentrated on start-ups. Buckle says: "PE companies were going for high-growth companies, particularly in the tech sector, as they were in western Europe. The strategy didn't prove very successful."

Innova's Conn says: "Ten years ago, two-thirds of deals were start-ups. In a start-up portfolio, some of your investments will fail. So you need your home runs to generate a lot more than five times your investment. You couldn't rely on that here." Instead, the average successful start-up was returning only around five times money, says Conn.

There were some notable exceptions. For example, Innova and Advent invested in Euronet, a Polish and Hungarian cash machine operator, on which they made 14 times money when they floated the company on Nasdaq in 1997 for $71 million. The company is now the leading global provider of ATM mobile top-up services. DBG Eastern Europe, which manages around €100 million in funds, made famously high returns on Czech Online, the Czech Republic's leading internet services provider, which it sold to Telekom Austria for somewhere between $80 million and $130 million, reportedly for around 40 times money.

However, there were also some high-profile failures. Dresdner Kleinwort Benson set up a CEE fund that specialized in tech start-ups. The fund attracted €150 million from US pension fund Calpers in 2001, but industry insiders say the fund has run into problems with Calpers over lack of returns. The fund did not return calls.

Banks' search for earnings marks a sudden change

Conn: "You need your home runs to generate a lot more than five times your investment"

One of the first LBOs in Poland was Enterprise's €9.6 million acquisition of DIY company Nomi in September 2003. Enterprise managed to secure €4.8 million in leveraged finance from Bank Zachodni WBK, AIB's Polish subsidiary.

Rusiecki says: "WBK understood what an LBO was about. They were willing to negotiate a reasonable package. We didn't need to educate them."