PRINT THIS PAGE The private equity market of South Eastern Europe10/05/2006. Source: KD Private Equity. Gavin Ryan
Gavin Ryan of KD Private Equity looks at the markets of Albania, Bulgaria, Moldavia, Romania and the ex-Yugoslavian countries - Bosnia, Croatia, Macedonia, Serbia and Montenegro and Slovenia - and finds opportunities for those with local capability. The South East European region consists of Albania, Bulgaria, Moldavia, Romania and the ex-Yugoslavian countries - Bosnia, Croatia, Macedonia, Serbia and Montenegro and Slovenia. In their approach and policy making, major international financial institutions, such as the European Bank for Reconstruction and Development, divide the former European socialist countries into three main groupings - Central Europe, consisting of the northern countries such as Poland, Czech and Hungary; CIS, consisting of Russia and other former USSR countries and SEE.
Compared to Central Europe, the SEE region has a consistent set of characteristics which do distinguish it. None of the countries are EU members, the average GDP per capita at around €2,000-3,000 is about a third of that of CEE, GDP growth rates at around 4-5% average are significantly higher than in CEE, all the countries entered into the transition process to a market economy much later and were also affected by the Yugoslavian conflicts of the 90s in one way or another. EBRD estimated that between 1989 and 2003 total FDI was $32 billion compared to $125 billion in CEE. Most SEE FDI comes from European countries such as Austria, Greece, Italy and Germany and is concentrated in the manufacturing sector.
There are also some historical differences with CEE which have given the region an identity of its own. These were the effect of the Austro-Hungarian empire in the Northern part and the Ottoman empire in the southern part. SEE business culture has a distinctly more "Southern European" flavour to it than that of CEE. Like comparing Italy to the UK, family ties, personal relationships and informal links play a much greater part in the way business is done. What SEE does have in common with CEE is the fact that all its constituent countries are former socialist countries making the transition to a market system, albeit at different speeds.
What this means from a private equity perspective is that a pure "cut and paste" approach, as has been up to now practised by some PE funds coming out of CEE and which are trying to expand south, will have significant limits: what worked in Poland will by no means be appropriate to Serbia, for example. A number of CEE PE funds have set up offices in SEE, mainly in Romania, but up to now these have been small listening posts often created as a PR story for fundraising.
The domestic SEE PE industry has most of its roots in developmental money from institutions such as US Aid, EBRD, IFC and others. Many funds were initially created around the mid nineties, a full decade after the CEE PE industry began to take shape. The development of the industry was rather slow. The slowness had two main causes. The first was that the investment climate in many of these countries was not easy, the main problem being weakness of law enforcement.
This was successfully managed by those funds which focussed on acquiring controlling or significant stakes in companies and which had a local, hands-on capability. The second main reason for the slowness was due to the less than ideal management setup of the funds themselves. At the beginning, most funds were staffed by a mixture of absentee senior Western staff who tried to operate on a fly-in basis from outside the region, and inexperienced local staff. As time passes, we are observing the welcome development of experienced local management teams and the shedding of non-value added out-of-country headquarters and staff.
I frequently hear my colleagues in Western Europe complaining of too much money chasing too few deals, and how private equity is becoming more of a commodity type source of capital, as scores of PE funds bid against each other to win a large MBO deal, for example. The situation in SEE could not be more different! There are many opportunities and not enough capital and I expect this situation to continue for the foreseeable future. I also often hear it said that people have difficulty finding deals. This is not the case: although bigger deals in the €20m plus range are less frequent, there exists an abundance of deals in the €5-10m range. What PE managers in Western Europe often miss is that in SEE - and I believe also in CEE - the approach to developing a pipeline of deals needs to be totally different. One will not find interesting deals by flying in for a couple of days, or by relying on the local service industry to feed one opportunities.
Most good SEE PE managers will have developed a proprietary pipeline of deals, mostly through personal contacts and by virtue of being part of the local business community. Another aspect is that the lead time to develop deals is much longer than in Western Europe. A year would not be untypical. Time is needed to develop relationships and trust, to educate those parties unfamiliar with private equity, to work through bureaucratic obstacles, to manage political issues.
What are the particular skills an SEE fund manager needs to possess? In finding deals, the emphasis is on prospecting skills, finding "diamonds in the rough" and seeing a way to carve out a deal from a messy group of assets. In analysing deals, the value added is in extraction skills; having the ability to obtain information which is not publicly available or otherwise easily obtainable, rolling up ones sleeves and getting to grips with non user friendly accounts. In structuring deals, the emphasis is less on complex financial engineering and rather more on enforcement mechanisms.
Essential to this is minimising the number of situations that would put an investor in a position to be at the mercy of local court decisions and their patchy enforcement capability of an eventual favourable ruling. In monitoring deals, the emphasis is hands on and a deeper involvement with management as well as a watchful eye for things that may happen as a result of the weaker corporate governance of the region. Exits are still mostly to strategic buyers rather than through the stock markets, which remain shallow and illiquid.
One very significant advantage the SEE region possesses compared to other emerging markets in the world, such as for instance the BRIC countries - Brazil, Russia, India and China, is that the countries in question are smaller and all aspire to join the European Union. This means that in the medium term the direction of these countries is mapped out and also that they are obliged to behave in a manner which does not prejudice their eventual entry into the EU. The majority of public opinion in all these countries is in favour of joining the EU, despite occasional grumbling and the attempts of local politicians to use the EU as the bogeyman for unpopular policy decisions.
Thus the political risk of SEE is structurally and inherently lower than other emerging market countries in the world whose path is not as easily predicted. In fact the general perception of the political risk of SEE countries being higher than reality is a great source of future upside to PE funds in the region, a rising tide which can often compensate for a mistaken bet, given time. Ultimately the basic job of a PE fund manager is that of making correct bets rather than passively benefiting from an across the board revaluation, but the current situation of SEE with many countries just about to join the EU is a great window of opportunity for those which will be able to move quickly in the next 2-5 years.
The sectors that have proved to attract the most PE investment are those that face the emerging SEE consumer. Investing in a factory that exports all to Western Europe is not a winning strategy. The lower labour costs and other cost advantages will inevitably be eroded by other emerging markets in Asia and other parts. As the SEE middle class develops, demand for services and products will rise. Therefore breweries, telecoms, food and other consumer products, construction materials, health care financial services are some of the sectors which should see continued strong opportunities in the future.
Over the last 8 years I have been involved in PE investments in most of these sectors in SEE; exits have accelerated and returns have been very good. For those investments that prove successful, the chances of an interested West European company coming along and acquiring will remain high and provide the most common exit route going forwards.
Another very important factor for the future development of the PE market in SEE is the ability of SEE countries to "borrow" West European financial markets. West European banks, in particular Austrian, Greek and Italian banks, have been very quick to expand into SEE both organically and through acquisitions. There is even an element of hubris at the current time, recently the largest Romanian bank BCR was sold to Erste Bank of Austria for 5.8 times book value and people are talking about acquiring Ukrainian banks for up to 7 times book value! As credit becomes more widely available and banks develop a better understanding of acquisition finance, the leverage element of transaction should become more prevalent and increase equity returns.
In developing investee companies, the main challenges are perhaps also those shared by CEE companies in their time. The main hurdles are usually the result of the economic organisation under socialism. Typical issues faced by companies are that often management is good from a technical point of view, but the marketing and financial function in particular needs attention.
A typical corporate cultural issue is that too much power is concentrated in the hands of the CEO and efforts must be made to develop the wider management team and ensure each individual manager is given sufficient space to take decisions. There can often be a generational conflict within companies when an older manager, formed under socialism, is retained for his or her contacts and profile and this alienates the younger, Western educated locals who are in an enthusiastic hurry to move to a modern corporate culture and see this as a negative overhang from unhappier times. In Romania, for instance, this generational schism is very pronounced.
For a properly organised PE fund, opportunities in the €5-15m investment size range will continue to abound. The formula to maximise success is based on three factors. Firstly, all the offices should be in the investment region only. Secondly, all principals should be long-term residents of the region with a reputational stake in the local business community. Thirdly, as business is as much about communication as anything, everyone should speak at least one local language.
SEE is an exiting, fast changing region where opportunities abound for those with the ability, flexibility and local knowledge. In the future I have no doubt the region will continue its rise towards becoming one of the future engines of growth of Southern Europe.
Gavin Ryan is Partner of KD Private Equity, part of KD Group, a Slovenian asset management group with €850m under management in SEE. He was previously Managing Director for SEE of Soros Investment Capital and Executive Director of an Advent International affiliate fund in Croatia. He is based between Belgrade and Bucharest and speaks, inter alia, Serbo-Croatian and Romanian.
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