Private equity: CEE private equity on the fast track

MUCH HAS BEEN made of the fantastic growth opportunities for private equity in central and eastern Europe but there might be more obstacles than many in the market have expected. Depending on who you talk to, the CEE private equity market is a stable source of great opportunity with relatively high returns and no sub-prime exposure or a risky market that requires overly heavy investment of capital and time and that may be more exposed to the credit crunch than many investors realize.

For now, the numbers support the optimistic case. According to ISI Emerging Markets, which gathers financials and company data for more than 70 countries, there were almost 170 private equity deals in CEE in 2007, with an overall deal value of some $10.1 billion. (This figure does not include numbers for Russia and other CIS countries, such as Ukraine, Belarus and Moldova.) That amounts to an increase in deal volume of one-third over the 2006 figure, and a rise in deal value of almost 50%. And there is still much room to grow. Private equity as a percentage of GDP in CEE is about 0.22%, just two-fifths of the European average, according to the European Venture Capital Association.

Given that GDP growth in the region is running at an annual average of about 6%, with maybe twice that in large urban areas, this is a high-growth environment. "There are still not many general partners," says Henry Potter, a senior banker at the European Bank for Reconstruction and Development. "The amount raised each year is in the single-digit billions [of euros], whereas it’s hundreds of billions globally. There is still a lot of legs in it."

"The amount raised each year is in the single-digit billions [of euros], whereas it’s hundreds of billions globally. There is still a lot of legs in it" Henry Potter, EBRD

Sub-prime shadow

But not everyone is convinced. Many of the world’s most active limited partners are not invested in the region, and feel that it is still exposed to greater macroeconomic and political risk than investors might assume. In terms of exposure to the sub-prime-induced turmoil and reduced access to funding, that pessimism might have some resonance.

"I am sitting on a number of investor advisory boards of CEE private equity funds and the sub-prime question is almost always raised," says Klaus Aichorn, director of CEE private equity funds at UniCredit. "And almost always the answer is, we are not affected: most local banks in CEE have no exposure to the asset class and the appetite to provide financing for LBOs is still good."

But local banks cannot finance the bigger deals. To do that, CEE private equity players have been turning to western European houses and relying more heavily on debt. "We are at the high end of the market in terms of size and complexity, where large deals need sophisticated financial engineering," says Thierry Baudon, managing partner at Mid-Europa, one of the three big funds, along with Advent and Enterprise, that have about 50% of the market. "We need constant access to financial institutions in London," he says.

Fortunately for the region, though, the move towards western standards in terms of debt multiples was nipped in the bud by the credit crunch. "The debt crisis came just in time," says Potter. "Leverage multiples were creeping up in CEE, and I was worried about them getting unsustainably high."

Despite the credit crunch and with restricted access to debt financing, investors are still raising funds and have capital to deploy. However, greater competition among funds, especially at the top end of the market, is driving up valuations. Moreover, as these economies continue to grow, albeit at lower rates than in the past few years, that will also push up valuations. Companies in such sectors as media and telecoms, financial services and consumer industries are growing at a much faster rate than in western Europe, and valuations reflect this. "Ten years ago, the question was ‘What is the appropriate discount over western European values?’," says Potter. "Now there is quite often a premium to pay, which makes sense considering the growth potential."

Still, as with any emerging region, there might be more risks than many people realize. Take the recent problems in Turkey. The ruling AKP party has been given much of the credit for the growth of the country’s private equity market, which came about largely because of efforts to prepare for EU accession. But recent events, such as the lawsuit to shut down the AKP and ban the prime minister from politics, underscore the opinion that the CEE region, or parts of it at least, are not immune from significant risk, political or otherwise.

Driving force

It is among smaller companies that the engine room for private equity development in CEE operates. At the mid-market level, with deal valuations of up to about €25 million, there is less competition and practically no exposure to the sub-prime crisis, as deals can be financed by local banks.

The reason that there is less competition at this level, despite its vast growth potential and attractive returns, is that funds must be very hands-on. The mid-market is full of family-owned businesses and entrepreneurs, and historically there has been a sense that many are reluctant to grow their business beyond the level of their own control. That is less of an issue now, as most deals are buyouts. There were 123 acquisitions in CEE in 2007 compared with only 36 minority stake purchases. The question is now whether or not investors want to sell, and more and more the answer is yes. But in many cases it is still a hard sell, and requires the building of strong relationships. The region’s management culture is still predominantly one that does not dovetail with private equity investment, despite the consensus that management competence has risen sharply in recent years. "One of the criteria of fund managers for selecting investments is management talent," says Aichorn at UniCredit. "But even if a company has good people in place, people who have successfully grown a business, they might not be the right people to organize a company in terms of turning it into a transparent business. Most fund managers either replace people or strengthen the team."