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What's up in Central and Eastern Europe?

The risks and rewards of private equity investing in Central and Eastern Europe are examined by Neil Milne of Copernicus Capital Partners, Tod Kersten of Enterprise Investors, and Bill Watson of Baring Private Equity Partners Central Europe in the latest AltAssets roundtable.

	Neil Milne is a managing partner at Copernicus Capital Partners. Founded in 1994, Copernicus Capital Partners is a manager of private equity and restructuring funds in Central and Eastern Europe with offices in Warsaw, Zagreb and Belgrade. Funds managed by Copernicus have invested in excess of E40m in over 25 businesses in the region.
	Tod Kersten is a partner at Enterprise Investors. Enterprise Investors was founded in 1990 and has invested more than $750m in 93 companies in Poland, Romania and Slovakia. The firm’s most recent fund closed on E300m in June this year.
	Bill Watson is a partner at Baring Private Equity Partners Central Europe. The Baring Central Europe Fund is an E86m fund raised in 2001 for investment in Poland, Hungary and other Central European countries.

What would you say are the main advantages of Central and Eastern Europe with regards to private equity investing?

Kerstern: ‘There is nothing unique about what we do here, relative to other private equity firms the world over, except for our location and perhaps our success. We simply take familiar models and adapt them for the local reality. The result, so far, has been some surprisingly good returns.’

Watson: ‘I would summarise the advantages of the region by saying that you get Europe with a plus. Since May 1, and the bulk of Central and Eastern Europe’s accession to the European Union, there has been a dramatic reduction in the level of risk inherent in the region. At the same time, these countries continue to record levels of growth and economic development that are convincingly superior to those of the older EU members.’

Milne: ‘I think that Central and Eastern Europe has a number of very positive characteristics with regards to private equity investing. Firstly, the stock markets still represent a relatively small slice of the economy. This means that there are wide, open spaces remaining for private equity players to explore. There are whole sectors of the economy which are only accessible to private equity players and that creates a very interesting environment indeed for doing deals.

‘Secondly, the region is less competitive than Western Europe and deals are rarely competed for through an auction process. This means that we see a more realistic pricing of transactions in Central and Eastern Europe compared to that found in more mature markets. And lastly, in macroeconomic terms, the region is certainly enjoying rapid growth. A combination of all these qualities means that we have a very attractive environment indeed in which to invest.’

What impact has May 1^st had on private equity investment in the region?

Milne: ‘We have actually been surprised at the extent of the reaction we have seen, because from a legal and regulatory point of view the reforms associated with accession to the EU were all completed several years ago. We assumed, therefore, that the markets would have already taken this into account. But, in reality, what has happened is that a great many firms have been sitting on their hands, waiting to see what would happen.

‘There has undoubtedly been a real pick up, not only in private equity investments, but also in mergers and acquisitions and corporate finance activity across the region this year. It is difficult to identify how much of this accelerated activity can be attributed to accession on May 1 and how much is, in fact, related to the improved macroeconomic situation. But I think a combination of obvious superior economic growth in this part of the world plus the reality of accession and the level of publicity that this has generated, has put Central and Eastern Europe firmly on everybody’s map.’

Watson: ‘I think the biggest impact has not actually been within the region, but outside it. The issues of accession have been a major topic of conversation in our area of the market for a long time. So in many ways Central and Eastern Europe has been adjusted to that reality for quite a while. What is new is that all of the publicity surrounding accession has really brought home to Western European countries that this region has arrived and that it is now a part of Europe. We have seen quite an exciting awakening of interest from Western strategic investors and Western players in the Central European market and that is fantastic news for all of us who are looking for exit opportunities for our portfolios.’

Kerstern: ‘There were a lot of people out there who were simply waiting for accession before they were willing to place their faith in the currencies here. EU membership has therefore welcomed a lot of new investors into the fold. Many people have been watching the region for quite a while but have simply been waiting for these countries to be within the European Union before they flipped the switch and made their move.’

What are the risks associated with investing in the region?

Watson: The adoption of the Euro is a risk that remains post accession. Having successfully entered the EU, all the entrant countries have now, inevitably, set their sights on joining the common currency. We believe that this process, while providing a fundamental straight jacket for the politicians, obviously represents some risks as well. I think the other potential challenge we face is that of over heating in these markets. When you have economies that are growing by five to six per cent a year, this risk is bound to be simmering below the surface and is something we will be watching.

Kerstern: ‘I think there will inevitably be some volatility as these countries begin to struggle with the budgetary criteria imposed by the EU. But these countries are not struggling alone. Many, if not most, of the older EU members also battle with these ongoing challenges.

Milne: ‘Politicians always have the ability to mess things up. I certainly don’t think that this is peculiar to the Central and Eastern European region but I think it is inevitable that each of the accession countries will face some form of budgetary, economic or political problems at some time. However, I don’t wish to exaggerate these risks. These economies are now largely private sector driven. That, combined with EU macroeconomic guidelines, severely limits the havoc that any individual government could cause.

‘There are obviously some macroeconomic risks as well. It is certainly true that it is unlikely that the level of economic growth that Central and Eastern Europe is currently experiencing will be able to be sustained indefinitely. There is also always the risk that too many people will raise too much money and start chasing around the region trying to do deals. This has certainly not happened yet, but as the region becomes increasingly high profile in the private equity world, it is a very real concern.’

How would rank the countries in the region with regards their attractiveness for private equity investing?

Kerstern: ‘I would certainly put Poland in first place. Poland represents approximately half of the region’s population, half of its GDP, and also has by far the most robust stock exchange with a market cap of nearly $50bn. Historically Poland has commanded around 60 per cent of the $4bn of private equity investment throughout the region and this dominance is unlikely to change in the near future. I would say that Hungary is the second most exciting market in the region, followed by the Czech Republic and Slovakia, which have limited but interesting opportunities. Some firms have had success in the Baltic States, but for us the markets there are simply too small.’

Milne: ‘I would also place Poland at the top of the league, simply because of its size and the breadth of its commercial activities. After that, I would rank Hungary and the Czech Republic along side each other, followed by the Baltic States. And then I think the non-accession countries such as Romania, Bulgaria and former Yugoslavia are bringing up the rear.’

Watson: ‘Poland clearly has to be one of the most attractive markets. It is large, it’s liquid, and it has a rapidly developing capital market structure that is very well funded by the domestic pension funds. We also think Romania has a lot of the potential for the future. It is at the stage that Poland, Hungary and the Czech Republic were in the mid to late 1990s, and it has the advantage of being a very sizeable market.’

How would you describe LP appetite for the region?

Milne: ‘I would say that LP appetite for the region is very spotty. Having said that, it is certainly on the increase. Big name funds such as Enterprise and Advent have helped to widen the pool of investors prepared to look at the region. These funds have the track record and credibility to bring in new LPs both from the US and Western Europe. But these sorts of mainstream investors are only prepared to look at the very established players, who are operating at the highest regional level, and who are focussed on the very biggest deals.

‘More interesting from our point of view is the evolution of the domestic institutional investor. We are currently working with a number of local pension funds, providing them with their first exposure to the asset class. I think as the size of these institutions’ portfolios increases, and as their search for new opportunities widens, they will become significant investors in the asset class going forward.’

Watson: ‘We are also certainly excited about the sizeable pool of domestic capital that is growing in the region. On a global level though, I would also say that we have moved from what I would call selective interest to mainstream interest. This region used to be perceived as a specialist play only suitable for the most sophisticated LPs. Now that these countries are safely within the EU, a wider spectrum of investors are willing to look at the region, to try and understand it, and in Europe, at least, to commit to it. US investors remain somewhat more sceptical’

Kerstern: ‘A lot of people were waiting for EU membership before they would look seriously at Central and Eastern Europe. We have just raised a fund ourselves and we were significantly over subscribed. This is largely as a result of accession. Other markets such as Spain and Portugal appreciated significantly after joining the EU. Investors are feeling more and more secure in terms of where these countries are heading and so they are now ready to take the plunge.

How would you describe the deal flow that you are seeing?

Watson: ‘Deal flow is certainly encouraging. The global economic decline definitely slowed things down here for a couple of years, but growth is returning and deal flow with it. We are seeing a lot of exciting ideas coming from local businessmen and entrepreneurs. In addition to that, a growing number of firms that have ridden the convergence wave are now looking to dispose of their interests and move on to fresh pastures. This is generating a big pickup in buy-out activity, which I think is one of the more exciting trends in deal flow in the region.’

Kerstern: ‘I would describe deal flow as robust. This is particularly true in Poland, which has been a market economy now for almost 13 years. There are a great many Polish entrepreneurs that have grown and developed their companies for over a decade and who are now deciding to realise the value of their hard work. This is very different to what has happened in a country like Germany where the owners of family run businesses are notoriously reluctant to sell, preferring instead to hand the company down to children and grandchildren. Poland is a lot more like America in this respect. Companies were built to make money. This has created a very significant and exciting source of deal flow for private equity houses.’

Milne: ‘The nature of deals in the region is certainly changing. Privatisations are definitely yesterday’s game. We are seeing more and more buy-outs and the use of leverage is becoming increasingly common. But despite the increased maturity of these markets, we are still seeing a high level of owner-developed businesses, where the company has grown to a significant size without making the transition from an entrepreneur-led business to a corporate style management team. This means we are faced with venture style issues, but in fully-grown companies. This is a very different style of private equity activity than is commonly found in more developed markets. ’

Is there any kind of venture industry in Central and Eastern Europe?

Milne: ‘The venture industry in Central and Eastern Europe is very small and underdeveloped. There is some isolated activity, particularly in Hungary, but I really don’t see there being any significant LP appetite for investing in venture funds in the region for the foreseeable future.’

Kerstern: ‘We have invested in some early-stage deals ourselves. But the majority of transactions in the region continue to be at the buy-out and expansion stages. Hungary probably has the most significant venture industry in the region at the moment. Poland is very strong in fundamental sciences but has yet to master the transfer to commercial development.’

Watson: ‘There is a venture industry here but it is still very much focussed on picking up cheap engineering talent, or residual ideas, from the communist days. It is time the region’s venture industry recognised that Central and Eastern Europe boasts a lot of highly educated people and that it is well able to operate on the same level as venture capital markets across the rest of Europe and across the world.’

How do the deal origination and transaction processes differ from those in more mature markets?

Kerstern: ‘Things are not all that different. The infrastructure surrounding the private equity industry here is actually very sophisticated. We have international law, accountancy and consultancy firms working with us, and we have a comprehensive and thorough regulatory system that governs the transaction process.’

Watson: ‘There is very little in it in many respects. The level of professional advice is just the same. All the major service providers are over here now. It is a strongly intermediated market as it is in the West. What differs is that in Central and Eastern Europe, it is still possible to use your networks and understanding of industries to identify unique opportunities that haven’t been heavily intermediated. It is still possible to find a diamond in the rough.

Milne: ‘The infrastructure and regulatory environment surrounding the private equity industry in this region has come on in leaps and bounds, but there is still some way to go. The laws are all in place but the performance of the local courts and the speed at which the legal systems work is still below the European average.’

How are you finding exit opportunities in the region?

Watson: ‘The exit environment in the region is looking increasingly favourable. Accession has really awakened the interest of strategic buyers in the West. We are regularly receiving unsolicited enquiries regarding our portfolio companies and I am having to do far less of a sales job than was the case three or four years ago. We are also now seeing companies being sold to domestic corporations for the first time. This makes our job significantly easier and means that exit possibilities are more numerous and exciting.’

Milne: ‘These accession markets are increasingly being targeted by multinationals. This is creating extensive start-up opportunities, but even more significantly, it is opening up possibilities for exits. You can be fairly confident, when signing a deal in the region, that you will be able to sell it to a strategic investor further down the road. We also have strong capital markets at the moment. So, from the perspective of exit opportunities, it is a very positive environment indeed.’

Kerstern: ‘For the last ten years, the great complaint about private equity investment in this region has been that while there have certainly been good businesses, there have been very few possibilities to sell them. But we are now seeing a very healthy market for trade sales and positive capital markets too. The exit environment is very strong and I think this will continue to be the case.

What do you think is required in a private equity manager to succeed in Central and Eastern Europe?

Milne: ‘There are very significant cultural barriers to entry when it comes to investing in this region. There is no doubt that most of the private equity practitioners working here now, including the large internationals, have specialised Central and Eastern teams that have been active in the region for a long time. This kind of in depth local knowledge and presence is essential. Teams need to employ local professionals, speak the local language and understand the cultural and commercial environment they are operating in.

‘In addition, most of the transactions that we come across in this region do not arrive in attractively wrapped packages. There is normally extensive input required in terms of restructuring the business, recruiting management, and developing and fine-tuning the business plan, if indeed there is one. There is a far greater degree of consultancy and corporate reorganisation required than is generally found in more developed markets. The skill sets within the management team must reflect this need.’

Watson: ‘You certainly need in depth local knowledge and strong local networks. This is true of any market you are operating in and Central and Eastern Europe is no exception. I also think it is very important to really get involved in the running of your portfolio companies. It is vital that a management team is hands on if it wants to capture the opportunities and seize the value that can be created in this region.’

Kerstern: ‘What is required is experience and that is something that cannot be manufactured overnight. The firms that will succeed here are those that were active in the region when LPs were much harder to find and deals were much harder to find, when the public markets were nascent and nobody was sure about regulation and the rule of law. I think you have to have that kind of understanding of the market written into your corporate DNA.’

How does the region compare with other emerging markets such as Asia?

Kerstern: ‘I wouldn’t describe Central and Eastern Europe as an emerging market. It is a convergent market and that is something quite different. These countries are on a path that is taking them progressively closer to the heart of the European Union. That is the ultimate difference between this region and emerging markets such as Asia. We know, with a fair degree of certainty, just where these countries are heading.

‘We can safely predict that these markets will struggle with some fiscal difficulties over the next few years, overcoming them one would hope, before moving ahead to join the EMU, a move which will probably be accompanied by some currency turbulence. This is a track of normalisation, which is perfectly comprehensible and manageable. These countries will continue to look more and more like old style European countries, albeit with faster rates of growth and exceptional opportunities for private equity. The fact that we now have a customs unity with Europe has also been an enormous fillip to businesses in Central and Eastern Europe which can now trade freely and export goods to the West.’

Watson: ‘If you buy into the view that the Anglo-American business model is one that works, I would say that Central and Eastern Europe is the one market in the world that has the most cultural affinity to that model. It is also probably the one that is furthest ahead in adapting it in terms of institutions, in terms of regulations and in terms of culture. There is no other emerging market where Western investors can feel as at home as in Central and Eastern Europe and I think that this is a very important point when considering the risk-return trade off of investing in different emerging markets.’

Milne: ‘You often hear Central and Eastern Europe referred to as an emerged market and I think this is a pretty good description for the region as a whole as it falls somewhere between the two camps. Having said that, the region itself is very varied. I would say that South East Europe is still an emerging market, for example, but it would be very difficult to describe Poland in the same way. But regardless of their varying stages of maturity, the general perception of these markets as emerging means that all of these countries still command some level of risk premium.’

What do you think the future holds for private equity investing in the region?

Watson: ‘Bigger and better. The markets themselves are growing and so is the size of the deals that we are seeing. Companies that were $50m in turnover just a little while ago have now rapidly grown to be over $100m. This, in turn, is making it a much more efficient industry and an industry better able to realise returns. I also think that the industry will continue to diversify in terms of deal types. We will see more and more buy-outs and this will be accompanied by an increased use of leverage.

‘However, I do think that it is important to bear in mind that the region’s phenomenal growth and the positive fallout from the accession process will not make every company and every industry a winner. Private equity firms will have to look very closely at what is happening in each enterprise, each industry and each country and be highly selective in their investments.’

Kerstern: ‘What the future holds for this region is growth. I don’t think there will be any radical changes but I think progress will be incremental and consistent.

Milne: ‘I think that the future for the region is one of further growth. I think we will see greater volumes of cash entering the region and the significance of private equity in GDP terms will continue to creep towards the European average. Deal size will also continue to grow. I think there will be consolidation within the industry. There will be less players around in five years time than there are today. On the other hand I think that more and more global players will try and move into this region.’

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