In Association with Dresdner Kleinwort Capital
The former communist countries of Central and Eastern Europe (CEE) are becoming fertile grounds for venture capitalists.
Compared to private equity activity in Western Europe, the region is at an early stage of development. Apart from larger deals made possible by the privatisation of state-owned assets, the industry in this region is largely focused on start-ups and expansion capital transactions worth between $1m-15m. Despite investor’s reluctance to talk about performance track records, the growing number of success stories indicates that there is increasing momentum in the region.
“I think it’s too early to say that private equity has played a significant role because it’s really in its infancy in the region”, says Janusz Heath, Head of Central & Eastern European Private Equity at Dresdner Kleinwort Capital (DKrC). “But what I believe you are now witnessing is an increasing influence of private equity going forward.”
Now is the time to take a look
This year the European Venture Capital Association (EVCA) for the first time officially included Poland, the Czech Republic, Hungary and Slovakia in its Annual Survey of Pan-European Private Equity and Venture Capital Activity. Between them, the four countries accounted for E786m of new funds raised last year and E375.1m of funds invested, with Poland and the Czech Republic making by far the largest contributions. Bulgaria, Estonia, Latvia, Lithuana and Romania were also covered in the survey, albeit as “pilot countries”.
Against E48bn raised and E35bn invested in Europe as a whole over the past year alone, these numbers are indeed small. But they do signal that investors have begun to take a serious interest in the region, one that looks set to grow stronger going forward.
Robert Manz, a partner at Enterprise Investor, one of the largest private equity fund manager in the region, says North American institutions are interested in taking a position in this market now. “They believe the convergence of this region into Europe will produce some very good returns, as we do.' Manz’s core investors are primarily insurance companies and pension funds from North America as well as Western Europe. The company, which has been investing in the region since 1990, now manages over $750m of capital.
Heath of DrKC says the region is not an easy one to sell to investors because, predictably, returns in this young market have been lower than elsewhere. But, given strong fundamentals, he also thinks that this will change, which in terms of asset allocation makes the region a very important one for investors to look at: “It’s a mistake to ignore it because this part of the world is growing so rapidly to be part of Europe. If you hang around waiting for it to mature, it actually might mature at a point where it is going to be difficult to be related to the superior fund managers there, because they will have built relationships with very loyal institutions early.”
Strong growth ahead
Such comments speak of the confidence both investment managers and institutions have in the economic future of CEE. The convergence of the region’s economies is underpinned by a continued strong inflow of foreign investments from international companies seeking to take advantage of a well-educated workforce, with high skills in engineering, computing and the sciences and a market of over 100m consumers.
Industry is modernising after the stagnating effects of Communism, and privatisation, especially in the banking and telecom sectors, has got to an advanced stage. At the same time the cost structures, particularly for labour remain substantially lower than in the rest of the EU and that represents an attractive basis for many manufacturing activities. As these countries are becoming more and more wealthy they are representing increasingly attractive markets for both domestic and foreign investors.
The transition in the last eleven years has come far and continued real growth can be expected in the next few years. Having become members of NATO in 1999 the frontrunners in the region are Poland, Hungary, the Czech Republic, Estonia and Slovenia. Leaders also in terms of economic development and GDP per capita they are now in the midst of accession negotiations with the European Union (EU).
Throughout these countries there is support among the population and political parties for EU membership, which is likely to take place within the next five years. Thanks to governmental reform programmes that have taken place within individual countries, intended to prepare them for EU admission, they are enjoying the most robust economic growth in the area.
The European Bank for Reconstruction and Development (EBRD), in its Transition Report Update for 2001, reported a positive development, where for the first time since the fall of the Communist bloc, the entire region – CEE and the Commonwealth of Independent States (CIS) – is reporting a growing economy. Foreign direct investments increased during the year by 13 per cent to $26bn and the bank anticipates a further increase of around $3.4bn for 2001. As a whole, the region posted GDP growth of 5.4 per cent for 2000, up from 2.1 per cent in 1999 and significantly higher than the EU average of 3.3 per cent.
A fast-emerging infrastructure
Capital market infrastructure in CEE has also developed significantly and boosted the region’s appeal to private equity. Although debt financing for many companies is difficult to access and can be very expensive, secondary markets have proven attractive exit routes for venture capitalists.
Also the legal and banking systems have moved forward steadily. For instance the regulatory frameworks now existing within Poland, Hungary and Estonia are considered by some to be the most developed in the region, with the banking systems also gaining strength. Some even rate the Polish accounting policies, in terms of transparency, to be superior to their French and German counterparts.
Exit routes are shaping up as well. International stock exchanges have been receptive to the region and local companies have listed on Nasdaq or the London Stock Exchange. But listings are still few and far between at the best of times, with many companies too small to undertake a floatation. Hence trade sales provide the most common exit route, often to a large multinational.
Historically trade buyers have been of Western origin. As local businesses gain critical mass in their home markets and start looking for a presence in other countries, they play an increasingly important role as acquirers of private equity backed companies.
Non-linear transition across the region
These trends are obviously conducive to private equity investment in the region – and should have a positive impact on returns. So can the CEE outperform its Western counterpart?
Bill Watson of Baring Private Equity says the return record in the region is already improving from the early days when the first generation of funds was launched. “Larger fund and deal size, increased opportunities for investment and the possibility of using leverage, all managed by more mature teams, will drive returns above those found in the West, where increasing competition has bid up prices without the same underlying growth potential central European companies will experience. I wouldn’t be surprised to see several of the current generation of funds returning well over two to three times their money,” he says.
To share this optimism is to question whether it still makes sense to classify the region as emerging. Says Janusz Heath at DCK: “In our view it is converging. It is on the borders of Europe and in a number of years will form part of Europe.
“Our investments focus on pan-European businesses, ideally businesses that are in more than one Central European country or that have a management team capable of building out regionally and possibly internationally,” he explains. His latest fund – the Dresdner Kleinwort Benson Emerging Europe LP – is a general fund that aims to build a portfolio of investments across a broad spectrum of industries in countries that are on the verge of European Union entry. This is in contrast to the mass privatisation Victoria Fund it managed in Poland until 1999, one of 15 Polish national investment funds that saw over 500 companies privatised.
Some countries will obviously produce the goods faster than others. The past decade has shown that the process of transition is non-linear. While countries such as Poland and the Czech Republic are moving steadily forward others are lagging behind. For example, Romania has finally started to come out of a recession, but a lot still needs to be done to improve structural reform.
According to Ben Atkins of the EBRD the pace of foreign direct investment is lower than it should be for a country of Romania’s size. But, “with the right steps it could grow as it is an attractive market,” he believes. Next year the EBRD will be having its annual meeting in Bucharest which is sure to attract attention by the world financial community.
For now some investors may not feel attracted to pursuing Romania while others may see it as a window of opportunity. For instance, Enterprise Investors is now concentrating much of its efforts on this country, which it says is showing signs of “turning the corner”. Robert Manz says that considering how little foreign investment has so far gone into the country, there is indeed much scope for further inflow.
Russia, by contrast, generally appears to be out of fashion because of the risks associated with it. But again, there are exceptions to the rule as was recently demonstrated by Baring Vostok Capital Partners who announced in February that it had raised $102m for its fund focusing on investments primarily in Russia and the Ukraine.
Michael Calvey, managing partner of Baring Vostok, believes the economic, political, and business environment is healthy and steadily improving. At the same time he says that entry prices for private investments are much lower than in previous years due to global market conditions and the lack of competition in Russia at present. “This combination creates potential for extraordinary returns as asset prices in Russia go through a major re-rating over the next 5 years.”
And the momentum is set to increase as EU accession is getting close. Heath says that over the next five years country funds will receive more capital from domestic institutions rather than from foreign ones. Mezzanine will also be coming into the market and the start of a real MBO/MBI market. “The MBO/MBI market will follow the European model, and possibly even be more Anglo-Saxon, where the legal structure and accounting polices are a bit more transparent than in other European countries”, Heath predicts.
The CEE is a young market that has so far shown remarkable signs of maturity. As it rapidly grows to become an integrated part of Europe, so too does its investment potential. To ignore this region could well be a mistake.