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.”
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“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 EBRD is the largest investor, or limited partner, in private equity in the region by a huge margin. It has been investing in the market since its inception in 1992, and is now invested in between 30% and 40% of all private equity funds in the region. The development bank has posted returns in the low teens across these investments, and excluding those funds that have failed that number rises into the high teens. This is a significant outperformance of western European funds. “Recent performance has been quite stunning,” says Potter. “Things dampened in 1998 with the Russian default and again in 2001 and 2002 with the dotcom crisis, but since then, three-year returns have been up around 40%. That’s by far the best-performing private equity region worldwide, and people are slowly waking up to that.” 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.”
In a survey of more than 100 CEE private equity participants published by legal firm Squire Sanders in October, 48% of respondents said that lack of quality people was the most significant hurdle to the market’s development.
However, the lack of quality people is already showing signs of alleviation. As the next generation of managers come in with more western-style ideas and education, the region’s business culture and therefore its private equity market are beginning to see the benefits. “We see very well trained young people,” says a fund manager. “But there is a clear generational gap. Anyone raised in Communist times is spent fuel.”
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“We need the combination of local and western European presence for optimal efficiency in our market segment” |
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The private equity firms themselves are now employing more young people native to the region. The need for a combination of local knowledge and structuring skills, and a good understanding of the western way of doing things, is the ideal mix for the funds. Many have likened this period in the CEE private equity market to the time in western Europe when Spain, Greece and Portugal joined the EU, in 1986. But it is not the same. CEE is developing much faster, as it is able to benefit from the expertise of those fund managers that experienced the growth of western Europe’s private equity market. As one limited partner says: “If you look at the founding partners of CEE private equity funds, they all used to work for 3i.” With the benefit of this experience, combined with the economic stability that EU accession or at least moves towards it bring, private equity firms are able to hire young, dynamic managers and set them loose on a burgeoning market. “I would be surprised if there were many westerners left in our team in 10 years’ time,” says Baudon. “Most of our team already comes from central Europe, especially at the younger end of the age scale. We need the combination of local and western European presence for optimal efficiency in our market segment.”
Baudon points to three advantages that CEE holds over other, especially emerging, markets. First, its growth rates, although similar numbers can also be seen in emerging Asia and parts of Latin America. Second, the visibility and predictability that came about through EU accession, and the lack of currency risk. Also, there is political stability to the point where it is highly unlikely that governments will start nationalizing investments. The last advantage is the consolidation process taking place between west European and CEE firms.
Another issue, especially in the mid-market, is the lack of secondary deals. When a company goes through the hands of several different private equity funds, the potential for top-line growth is limited, and there is a tendency to load up with debt in order to benefit from leverage. That is far less of an option these days, to the detriment of more developed private equity markets, such as in western Europe. But in CEE, most deals are still about adding value, and so are less likely to be adversely affected by the credit crunch than secondary deals. “One of the things I love about this space is that there are relatively few secondary deals,” says the EBRD’s Potter. “Historically, secondary deals have been so insignificant that we didn’t even have a category for them.”
Trouble brewing
But the locals might not have it all their own way for long. Competition is picking up in the mid-market as larger, debt-dependent deals become rarer. In order to maintain activity, the bigger buyout firms, such as Mid-Europa, Advent and Enterprise, as well as the pan-European funds that want to invest in CEE, will be forced to look more at the mid-market level. “The number of very big deals is limited, and the situation now is that you have several players bidding for those deals,” says Aichorn. “I feel that some of the bigger funds may do smaller deals going forward.”
This will cause problems for the local players. Not only will competition rise but the big European buyout houses need just as much local knowledge and experience as everyone else if they are to compete at this level. Those moving into the region can acquire this in several ways – through dedicated teams and funds, hiring staff to chase deals or operating as an opportunistic player. All methods need local expertise, and this is putting mounting pressure on the smaller local players.
“Those big funds moving in can attract people from other funds in the region,” says Martin Lang, head of Raiffeisen Centrobank’s private equity business, which is a large fund of funds investor in the region. “If these funds don’t have CEE experienced staff they need to lure them from local funds. It will be a challenge for smaller local funds in the region to prevent brain drain as sometimes they can’t compete with offers of big players with deeper pockets.”
So although it is true that the CEE private equity market is a nascent one, with great potential for growth and for high returns, it is not without its difficulties, both established and emerging. It is not enough to be in the right place at the right time – a fund manager must be wary of the pitfalls. With valuations and competition increasing at all levels of the market, the market will continue to be one that requires much in terms of time and capital investment but one with the potential to richly reward those that make that commitment. “You have to do a lot of groundwork,” says Baudon. “To have a history and a good reputation in this market creates tremendous advantages.”
