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The past and future of venture capital and private equity

The face of the Hungarian private equity industry, and that of Central and Eastern Europe in general, has changed considerably over the last few years. What does the future hold for the asset class in the region given the current troubled climate? Gabor Baranyai of the Hungarian Venture Capital and Private Equity Association puts forward his view.

Since, the introduction of venture capital and private equity at the beginning of the nineties, we have seen venture capital and private equity in a rather short time become an accepted and to most, a very pivotal and important asset class in Hungary.

Maturing companies limited by the financial resources available to them have begun to find that they have to use a variety of techniques to obtain the money they need to continue to grow. The absence of a strong public market and debt prospects have considerably helped shift the way venture capital and private equity is viewed. The dreams of a successful IPO on the Budapest Stock Exchange, currently, present limited financing prospects for businesses of all sizes. Debt has also been hard to come by, limiting small and medium-sized enterprises from exploiting their full potential. This absence, by any measure, has allowed for the venture capital industry to be the primary catalyst for the explosive growth of all spectrums of industry in Hungary over the past ten years.

While Western Europe continues to be an attractive region for expansion capital and buy-outs, Hungary has seen a dramatic shift from the early to the mid 1990s, where privatisation, large turnaround, expansion capital and buy-outs were the norm, to small, start-up and early-stage expansion financing. These facts may be somewhat misleading since the average deal size still exceeds the lower range of investments, but considerably fewer and fewer investments are being reported in the middle and upper range this year. Very recently venture capital and private equity firms with the strategy and capacity to do smaller deals, E0.5m to E2m, have been drawn to the forefront as the popular source of funds, in a sector with very few participants.

Many Western European fund managers see the middle market as the market to concentrate on due to less competition than in the higher end market, where as the opposite is true for Hungary. What was recently dubbed the 'middle weight' category by Venture Capital Partners, E2.5m -E6m, consists of more than half of the HVCA members, representing more than E1bn (both for domestic investment as well as for Central and Eastern Europe). Though some of these funds are industry specific, we can still say this range represents the brunt of Hungarian venture capital and private equity, with only a small but growing fraction of companies investing in start-ups and early stage companies. The Hungarian venture capital and private equity market has become more competitive due to the entry of new players including corporate VC funds significantly increasing their commitment to venture capital, intensive new entry of local (incubator) funds and Western European funds expanding eastward or simply diversifying with one or two holdings.

Competition is apparent and the short-term prospects of serious deal flow are in fluctuation. However, the over all mood is positive. Since 1999, approximately 30 start-up and early-stage enterprises were financed. This impressive deal flow, along with the slight market slow down, has now made the middleweights dependent on the lightweights. The early stage funds are now faced with a very important task of helping build reputable and growth sustainable companies in order to generate attractive second round financing opportunities for other funds, as well as playing a pivotal role in helping the Hungarian economy grow and prosper.

The presence of venture capital in the ownership structure of companies in Hungary has historically both improved long-term performance and opened up new markets and perspectives. Venture capitalists and private equity firms provide equity financing to private companies with considerable growth potential for a variety of purposes, including product development, production, marketing, sales, turnaround and expansion. In essence, venture capital and private equity is relatively high-risk, high-reward finance designed for companies that have different asset structures, cash flows, and growth rates than mature companies. Mature companies offer different opportunities that can at the same time be categorised as viable growth targets, when applying the right type of business approach. Companies backed by venture capital and private equity historically have produced a disproportionate share of new jobs, particularly well-paid and highly skilled jobs as well as introducing a high standard corporate culture. Moreover, on average, venture capital-backed companies generate about two to three times more export sales per dollar of equity than other established companies and are a key source of research and development spending and applied technological innovation. Consequently, we believe the Hungarian government in particular should become increasingly aware that venture capital is an important source of economic growth and a means of developing targeted sectors of the economy.

Industry outlook and growth prospects

It is not easy to pick out a dominant theme for the future when so much has happened in so many sectors to so many companies, but a notable shift has occurred over the past two years toward smaller, often technology, deals in Hungary. A trend that should become evident in the near term future will be the shift in strategies in order to accommodate what can currently be considered a shift in the middle market to facilitate smaller deals in order to diversify and to satisfy investors with deal flow rather than having funds sitting idle. The shift toward smaller deals will supply ample opportunities in the near term future for the middle market participants. VC and PE funds with only a domestic investment strategy will get burned but so will funds who do not explore the additional investment opportunities outside the three most attractive countries of Central and Eastern Europe (Hungary, Czech Republic and Poland). Regional private companies will also be more successful than simple domestic companies.

While year end figures are not yet confirmed, it is projected that Hungarian based companies received in excess of E100m last year for start-ups and growth companies. If predictions for 2001 VC spending are accurate, we should see much more activity but less capital movement due to a significantly active lower market. There will be a return to traditional due diligence in determining investments. People will be more cautious. Though dot-com mania did not see the wave of investing in Hungary the likes of which the West saw, the after shocks have still put caution to the wind. The internet industry's troubles and a turbulent stock market combined to cool off venture capital spending late last year. Now the industry is catching its breath, though most still believe this sector will be an interesting target for many but at much lower valuations.

It is highly evident that the venture capital and private equity industry will go back to the basics: long-term plays, focus on creating value through developing new lasting markets, and not investing in a hype or bubble. It should also become evident that the real winners will be the value-added funds, which specialise in one or two industries and are able to be productive on an executive or expert level. A focused approach may not be necessary for the participants in this market, but it should create a competitive advantage in a crowded middle market. The addition of a sector-focused strategy would allow funds to see and create value by providing their portfolio companies with expert knowledge as well as a specialised network in the relevant field. When said and done the refocusing of funds would help balance the entire industry allowing more space and time for non-sector specific funds to fill the void where certain funds lack a strategic presence.

As the venture capital and private equity market becomes increasingly crowded, more and more firms will look for creative ways to deploy capital, keep returns high and minimize auction situations. The private equity houses in Hungary have started to pay more attention to exit routes than they did in the past as the ability to float the business on the stock market is now effectively not a viable, value added exit route in
Hungary and Central and Eastern Europe. The venture capital community is having to look very hard at how to hold onto their investments longer to achieve a satisfactory return on their capital. With the stock market as an exit strategy losing ground the secondary management buy-out role will gain market acceptance in the years to come.

Regional (CEE) trends

Most fund managers remain concentrated upon the core central European states of Poland, Hungary, the Czech Republic and Slovakia. Romania, with its large population, also attracts interest despite recovering from prolonged recession. Croatia as well as Bulgaria will probably also be in the forefront due to the fact that privatisation only recently began and steadying economic stability is in the later stages.

Fund-raising trends will most likely slow, though last year was a good sign of the impact and attractiveness of Central and Eastern Europe. The EBRD estimates that only a few hundred million Euro have been raised for Central and Eastern European private equity investment this year, far short of last year's estimated record total of E2.5bn. Much of this capital is dedicated to buy-outs of established companies, as opposed to start-up and expansion financing.

A trend Central and Eastern Europe may see sooner than later may be the commercial introduction of new financing instruments, such as subordinate debt or mezzanine financing, creating a further sophisticated structure, especially in the middle and upper markets. Though many industry experts have doubts about the mass use of mezzanine financing in this region, early indications from the West have hinted possible expansion into Central and Eastern Europe. This type of financing will most likely crowd the upper market more than the middle due to the early stage of development in the region.

Giving a solid and accurate prediction of the future of Central and Eastern Europe is not as simple as ABC. The above-mentioned regional trends come with the added ups and downs of global forces. Global economic forces and market and industry trends all make up a whirlwind of forces that somewhat are equally felt in Central and Eastern Europe as in the rest of the world. Three underlying trends to watch for include, mass consolidation, public to private and cross boarder transactions.

Consolidation, a truly global trend will inevitably be embraced on the local level before shifting gears to the entire region. Companies will follow this path in the near future and will embrace the synergies that come with consolidation.

The world has started to witness a steady flow of public to private transactions and if markets do not recover we should see many more to come. Though, currently relatively rare in Central and Eastern Europe, public to private companies will open up new investment and growth opportunities to venture capital and private equity houses.

A final global force, which has picked up speed in Central and Eastern Europe has been an increasing amount of cross border transactions. As discussed above the real winners within this region will be the regional players. A market of ten million people in Hungary is insignificant in comparison to countries of the EU, but add Poland, the Czech Republic and Romania to the mix and now you can compete.

The above three forces are all equally important to the venture capital and private equity world as a source of deal making. These trends have already been felt but there is still more to come.

Conclusion

The reverberations of the recent market adjustments may have signalled a slower pace in the growth of private equity activity to some, but we as well as industry participants are confident that the industry will continue to expand steadily and perform well over the medium and long term, demonstrating its ability to find opportunities in every phase of the economic cycle. VC and PE will continue to be a very important asset class and will continue to make a considerable contribution to economic development.

With the fundamentals of the Hungarian economy looking so good, the venture capital and private equity sector will continue to grow and industries based here will remain appropriate targets of venture capital and private equity funding.

Copyright © 2002 HVCA

Hungarian Venture Capital and Private Equity Association (HVCA) represents virtually all major sources of venture capital and private equity in Hungary and is dedicated to promoting the industry for the benefit of entrepreneurs, investors, its practitioners and the economy as a whole. For more information please visit www.hvca.hu