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Hungary's venture capital industry

Hungary has played an important role in the development of the venture capital industry throughout Central and Eastern Europe. Here, law firm Nagy és Trócsányi outlines the legal structure of Hungary's venture capital industry and some of the underlying trends over the last few years.

Hungary's venture capital industry has grown rapidly throughout the past decade. With more than $1bn invested in about 500 portfolio companies during the past 12 years - and with over 25 per cent of the sum allocated in the whole of Central and Eastern Europe having been invested in Hungarian portfolio companies - the country is playing a dominant role in the region's venture capital market.

The venture capital act
By the end of 1998, venture capital investments - the overwhelming part of which had come from foreign sources - made up 6.5 per cent of foreign direct capital investments, and their rate within the total volume of the working-capital inflow for 1998 amounted to more than 10 per cent.

It became ever clearer to Hungarian governments that private equity and venture capital investments could play an essential role in long-term economic growth. To foster the creation and improvement of advanced and competitive enterprises, the Hungarian Parliament passed the Venture Capital Act (Act XXXIV of 1998) in 1998.

The Act regulates the operation of all venture capital entities, and accordingly applies not only to venture capital funds and to venture capital companies set up in Hungary, but to branches of foreign companies registered in Hungary as well. These entities serve as intermediaries between investors and the target companies.

A company may, of course, make investments in Hungary without complying with the rules of the Act and without fulfilling the obligations. In such a case, the company is not entitled to certain tax and accounting benefits granted to venture capital entities. One of these benefits is set out in the Act LXXXI of 1996 on Corporate Tax and Dividend Tax, according to which venture capital entities need not pay corporate tax, under the condition that the rate of the entity's capital investments is higher than certain limits (see below).

The most important provisions of the Venture Capital Act are:

• Licensing procedure. Both the venture capital enterprise and the venture capital fund must be licensed before commencing activities. During the detailed and arguably severe licensing procedure, the entities must provide the Hungarian Financial Supervisory Authority with documents such as their Deed of Foundation, the Rules of Organization and Operation, and a document describing their investment principles as well.
  
• Terms of existence. Venture capital companies may be set up either for an indefinite period or for a minimum period of six years, and funds may be set up only for a definite period, with a minimum of six years.
  
• Subscribed capital requirements. The subscribed capital of a venture capital or fund must be at least Ft500m ($2.1m), and - another disputed provision of the act - the total amount has to be paid upon subscription: commitments only are not accepted.
  
• Rules of investment. The main activity of the capital investment entity - capital investment - is both encouraged and restricted by the Act. On one hand, a fund must invest more than 30 per cent of its issued capital within 24 months of its subscription, and this percentage must not fall below 30 per cent for four years. In addition, the percentage of capital investments against the venture capital's entity's issued capital must reach 50 per cent on average in the first six years, and 70 per cent in at least three years over the same period. On the other hand, the maximum investment a venture capital entity may make in one undertaking is also regulated: it must not be greater than 15% of the entity's own equity.
  
• Certain investment restrictions. Venture capital companies and funds cannot acquire interests in financial institutions, investment service providers, asset managers, clearing houses, insurance companies and gambling companies. With only a few exceptions, funds may not acquire real estate, and venture capital companies have only a limited right to do so. The acquisition of stock-exchange-listed securities is ruled out.

As described in the preamble of the Act, the legislative aim was to stimulate investment into small and medium-sized Hungarian companies and to regulate and encourage investment by venture capitalists. But the act suffers from a number of limitations. The registration procedure is too cumbersome and complex. Much remains to be done by the government.

Despite the controversial legislative changes introduced in 1998, the venture capital and private equity market has flourished during the past few years.

The legal structure of target companies
With or without venture capital entities acting as intermediaries, private equity participation is usually (in the former case, compulsorily) held in corporations limited by shares, so-called ‘Rt', (corresponding to German Aktiengesellschaft or French Société Anonyme) or in companies with limited liabilities, ‘Kft', (corresponding to German Gesellschaft mit beskräncter Haftung and French Société á Responsabilté Limité), both regulated by Act CXLIV of 1997 on Business Corporations.

Fundamental characteristics of both are their separate legal entity and their limited liability to their capital. This means shareholder's of the Rt and members of the Kft are not liable thereof.

Only an Rt has shares representing the holding in the company. The Business Corporation Act distinguishes between public and private Rts. An Rt qualifies as private corporation if its shares are not issued publicly.

Recent results
Because the Hungarian market is still small compared to the EU, and therefore was strongly affected by the most severe market correction in the history of the venture capital industry in 2001, the overall health and maturity of the local venture capital industry should not be overlooked.

Rises in 2000
In 2000 Hungary saw record levels of activity in the venture capital and private equity industry. 47 back-up deals were completed by 35 venture capital funds and similar entities in 36 companies. This represented an outstanding increase on 1999, when 12 transactions were realised in 11 companies. The amount invested more than doubled: $103m compared with $40m in 1999. Investments in later stage companies increased.

While the number of investments rose only slightly, the amounts invested grew much more. With $53m going into already established companies, these so-called follow-on investments represented over half of the amount invested in total, and thus dominated the market.

But the most exciting event in the industry was the growth of start-up investment activity. This part of the industry did not exist in 1998. Even in 1999 there were only four transactions in 1999. But start-up investments exploded in 2000 with 36 back-up deals.

The slow-down in 2001
Like most capital markets, the Hungarian venture capital industry experienced a notable slow-down in 2001 compared to the 2000 results. As you would expect, both the number and the volume of transactions saw a significant - 40 per cent - decrease compared to the record 2000 numbers: a total of $64m gathered in 28 transactions, including buyout transactions.

Nevertheless, increasingly grim global market conditions affected different branches of the venture capital industry in different ways.

Start-up investments fell by a third. Still, because 2001 had only been the second year so far of the existence of such deals in the domestic market, it is fair to say that technological start-up investments held-up well, especially compared to the EU market, which suffered a far greater decline during 2001. This is all the more important because start-up investment was in better shape than the less risky later stage investing. This clearly demonstrates the entrepreneurial climate in Hungary.

It is also important to note that by the end of 2001, buy-out investments constituted a well defined and independent branch of the domestic venture capital industry: five buy-out deals have been completed, two of them public-to-private transactions.
The targets of the venture entities registered in Hungary remained the same: half of the investments in 2001 were financing the domestic operations of foreign companies.

But an increasing proportion of investment - a third of the total - went to regional companies, signalling not only Hungary's integration to join the European Community, but also more broadly its desire to integrate into the global market economy.

Trends
While the growth of the venture capital and private equity sectors slowed in 2001, the past 12 months have been a strong year for the industry once again, with more than $80m invested. If we look at the new trends and the developments of the market, some important facts stand out.

First, as an HVCA study shows, it is becoming ever clearer that with the emergence of a powerful and well-trained management class, the time has come for management buy-outs. These have brought discernible benefits in several western countries, including at the macroeconomic level. A survey of the European Venture Capital and Private Equity Association in 2001 underlined the fact, that private equity-backed management buy-outs lead to better than average performance, competitiveness employment and remuneration, increased employee involvement and the creation of additional value.

Second, the increasingly noticeable trend in he venture capital industry is the growth of investments that can solve, on a business basis, the financing problems of small- and medium-sized companies.

And also, as the Venture Capital Act is now widely recognised as having failed to achieve its objectives, the government is making efforts to amend the legal framework of the industry, and therefore to provide a more attractive legal environment for the private equity sector. One proposal is that after three years of investment, capital gains from venture capital are tax-free.

We are sure the Hungarian government is determined to make some of the most welcome reforms in the domestic venture capital and private equity industry. This will strengthen the country's position as a centre of the industry in Central and Eastern Europe.

* (The figures in this article are based on statistics produced by the Hungarian Venture Capital and Private Equity Association.)

Copyright © 2003 Nagy és Trócsányi

Nagy és Trócsányi is a Hungarian law firm engaged in the international practice of commercial and business law. Its practice from the beginning involved exclusively corporate & commercial, merger & acquisition, antitrust & competition, banking & project finance, insolvency & financial restructuring, securities, customs & international trade, intellectual property & technology, media & telecom, real estate & property, litigation & arbitration and tax. For more information please visit www.nagyestrocsanyi.hu