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Private equity in Central and Eastern Europe

Usually seen by most institutional investors as a risky investment, Central and Eastern Europe's venture capital industry has grown substantially in the last ten years. Kurt Geiger of the European Bank for Reconstruction and Development charts the rise of the industry, the growth of its fund-raising efforts and the prospects for its future.

Private equity in the region of Central & Eastern Europe is considered by quite a few investors, and to a lesser degree by renowned private equity fund management firms, as a somewhat exotic enterprise and activity.

It has recently been called the ‘Wild East'. It is difficult at times with the consistency of established markets, but it offers great opportunities. Those closely involved in the region over the years, however, have been observing a consistent trend towards greater respectability of private equity as a financial product; it is underpinned by the successes achieved by all stakeholders, the investee companies, fund managers and the investors. The returns achieved a pattern consistent with industry expectations, particularly in cases where high standards of private equity principles have been applied.

It now has been more than ten years since the region started its long march towards market economy process and the experiences are very consistent with what one would expect from a completely new market with a unique environment. What made the region somewhat different from any other emerging market was that in many countries, the fundamental institutional frameworks existed before Communism, so the transition process could rely on the historical foundations of a well-established institutional, judiciary and cultural base, except that it had not been in hibernation for the last 50 years. This is particularly true for the Central European countries, but to a lesser degree to Russia and the CIS, which had less of a tradition. At the same time, any investor had to be content with the lack of understanding of the importance and sometimes unwillingness to apply good business practices and adherence to good corporate governance to the development of successful businesses. This challenge applied to all investors, which had the choice to either start greenfield operations or enter into partnerships with locals. Investments with strategic investors and joint ventures became the drivers for good corporate governance, in particular as strategic investors applied their own corporate standards to all of their activities, regardless of which country they operated. The same challenge applied to private equity fund managers. Their position however was not as strong initially, as they also had to educate the market, and in particular the local partners, that the capital they offered was equity and not debt and therefore different disclosures, financial discipline, and most importantly, financial rewards were required.

Recent trends

Most of the available funding for private equity globally went into e-businesses. Central & Eastern Europe as a region did very well in terms of consolidation and attracting new money; in particular we have seen a flight towards quality and the entry of new managers of international reputation and track record. Most of the fund managers, for whom the primary motivation of being in the business was to earn fees, have been marginalised and some of them even forced out of the market. In this context, the events of August 1998 served as a watershed: it forced the fund managers to raise their standards and demonstrate their true commitment to their business and the region. The investors, wary of investing in emerging markets worldwide having attractive alternatives in the new economy and seeing strong demand for private equity in Euroland, required a lot of convincing of the benefits of committing resources to this region. Recent years have seen the entry of new participants and the closing of large funds. Investors had a clear preference to enter markets with a proven track record, particularly Poland, and, to a lesser degree, Hungary and other convergence countries. Other countries in Central Europe, such as the Czech Republic, Slovakia and the Baltics have seen a surge in investment opportunities, meeting the standards set by internationally renowned managers. There are several reasons for this development: first, and foremost, equity continues to be a scarce resource in the region; secondly, strong growth of the economy in most of the countries and thirdly a reduction of availability of credit through the banking system. The latter is significant and is based on a flight to quality and higher standards; this led to a drying up of silly and easy debt available to companies and made the targets appreciate the advantages of well-structured private equity deals. There is of course another side to the coin: the surge of private equity available is leading to some extent to increased competition among fund managers and can contribute to paying inflated prices. In actual fact, some of the fund managers have been complaining about this, but competition is healthy and in some way it is self-regulatory. The best way for investors to protect themselves is to ensure that fees are at levels aimed to cover reasonable operating costs and have the managers focus on adding value in their work with the investee companies and reward the managers through the carry.

Russia, the CIS and South-East Europe are a very different story. All of them face a serious uphill battle to attract good managers and investors and it is also much more difficult to work with the investee companies due to a poor regulatory and judiciary environment. Although they are all very different and are going different ways in their economic development, the lack of political stability throughout this segment is evident everywhere and is a clear indicator that without stability it is much more difficult to engage in private equity business. However, there are obvious opportunities: the potential of the markets in many of the countries is significant; large populations and the prospect of a growing private sector. In a way the very positive developments and experience made by many of the participants in Poland, Hungary, and more recently in the Czech Republic give reason for being optimistic about the prospects. At the same time, some managers have been able to demonstrate some high profile successes, such as those in the Czech Republic, Romania and even Russia. The main reason for these individual successes has been investments in growth areas: be it consumer-orientated, new economy or businesses based on market needs and building critical mass in a sector of the economy. Further, it was complemented by dedication in working with local management and partners, demonstrating to them that managerial and financial discipline, focus on good corporate governance, transparency and sheer dedication to creating value will attract strategic buyers who will achieve significant multiples over the original investment.

The portfolio of private equity funds has a commitment of over E1bn and the total monies raised are approximately E4.5bn. The average fund size is E90m. During the last three years, commitments to the industry have been strong - each year well in excess of E100m. All funds signed and closed up to 1995 are now fully committed and these funds are now in a divestment mode. The initial investment pace of the funds has been slow, which was expected considering we entered into new and uncharted territories. It was about four years and a few have cancelled part of the originally committed capital; this is due to the difficult environment in some countries, the quality of the fund managers, or a somewhat narrow or restricted (i.e. away from the market) investment policy.

Lessons learned

As everywhere in the industry, management of the fund is key to the success - best experiences have been achieved where there has been a good balance between western experience and local management. The importance of developing good local equity fund professionals is the single most important factor for success. They are the key for increased private equity work and transactions and will significantly contribute to the development of successful entrepreneurship.

Successful exits have demonstrated to many entrepreneurs the value private equity can bring to all owners; it is particularly significant that adhering to good corporate governance, applying best principles and a commitment to transparency have built such success. Those are important factors for successful private equity fund managers. Equally, local investee partners have experienced financial and entrepreneurial successes by applying such standards together with the fund manager. The demonstration effect of these success stories should not be underestimated to contribute to a culture of good entrepreneurship in these countries, even those where private equity is still underdeveloped.
 
Close partnership with key investors in funds has proved to be very important; it is crucial to have an on-going dialogue, share experiences and address problems together in a constructive collaboration.

Successful exits come predominately from strategic (trade) sales. The reasons are several: firstly, local capital markets are very under-developed and they have no liquidity; they are not ready for AIM or Neuer Markt type exchanges. Secondly, the investor base is not yet there to invest in such companies; thirdly, there is a clear attraction for business to be built up, to create market share, build a brand and establish a client base; all very attractive factors for trade buyers. They understand better the value of such companies than the stock market.

Where do we go from here?

The outlook is promising and points towards future growth and successes, but it will require hard work.

Our experience of investing in early bird funds has been satisfactory, although the final story will only be told in a few years. The attention now is the accession countries. With the convergence of some these economies, we see a trend to larger funds, which will undoubtedly have a regional focus, but sector and specialised funds have been emerging, particularly in the new economies, but also in the infrastructure and energy sector, or start-ups (technologies). We would expect during 2001 to see the first mezzanine fund being set up in the region. This will add a new product range not only for existing funds, but also for investee companies to support their growth.

The economies will continue to be short of equity capital and the presence of high quality operators will add to increased competition, but, if the incentives and fees are well balanced, this should be a stimulant. The markets in the well-established economies will be served well by high quality fund managers and it will be difficult for first time funds to enter. They will have offered something special to attract institutional investors.

The more difficult countries, however, will offer opportunities particularly in the Balkans, with a significant reconstruction effort underway after the various wars from which the regions suffered over the last seven years, and Russia, provided the reform process follows a path towards better institutional frameworks, transparency and the application of good corporate governance.

Copyright © 2002 EBRD

Kurt Geiger is EBRD's director for the Financial Institutions Group.

The European Bank for Reconstruction and Development was established in 1991 when communism was crumbling in central and eastern Europe and ex-soviet countries needed support to nurture a new private sector in a democratic environment. Today the EBRD uses the tools of investment to help build market economies and democracies in 27 countries from central Europe to central Asia. For more information please visit www.ebrd.com