CENTRAL AND EASTERN EUROPE I

The jitters that Western markets have been experiencing during the credit squeeze has re-emphasised the importance of a diversified portfolio. Unsurprisingly, therefore, many investors scouting for new destinations are casting an eye at the rapidly growing markets of Central and Eastern Europe. In recent years the region has demonstrated to investors that it warrants scrutiny that goes beyond the beautiful architecture of cities such as Prague and Budapest.

Fundraising in the region last year yielded the first €1 billion-plus fund, and a record €2.7 billion ($4.2 billion) in total, according to data from the European Private Equity and Venture Capital Association (EVCA), the European industry body, and Alpha Associates, a European fund of funds manager.

Meanwhile, the European Bank for Reconstruction and Development (EBRD), the largest investor in the asset class in the region, has compiled returns from the 62 fund managers and more than 100 funds it has invested in through $2.3 billion in commitments to funds with capital of more than $10.3 billion. In the five years to the end of 2006, these funds yielded returns of 28.8 percent on a dollar basis and 18.1 percent on a euro basis. This compares with returns of 12.8 percent over the same period by the Cambridge Emerging Markets Venture Capital and Private Equity Index, and of 5.4 percent by the EVCA All Private Equity index.

Henry Potter, a senior banker from the EBRD, says: “There is more investor interest, which is to do with people recognising performance. Many of those managers that are raising funds have delivered good historic returns, and are experienced.”

Market participants point to the region's compelling risk/return profile. EU accession – whether completed or yet to happen – provides a more sophisticated legal framework for business than in other emerging markets. Given the region's comparable growth rate to other more high-risk destinations, positive investor sentiment has been stoked.

EASTERN EUROPEAN (EX RUSSIA & TURKEY) FINANCIAL SPONSOR BUYOUTS – 2003 TO 2008 YTD

FROM EMERGING TO EMERGED
One thing is for sure: the region's confidence has been bolstered by the boom times of recent years, and – as yet at least – it appears to be undimmed by the credit crunch. Should the region ride out any global economic downturn, its private equity market will be well down the road to maturity.

Salesny says: “Not only in terms of the length of track records and the level of experience of local managers, but also in terms of the deal flow, it is not an emerging market any more. It is emerged. Deal flow is dominated by late-stage expansion financing and buyouts. Debt is available, mezzanine is available and the availability of leverage has not been much affected by the credit squeeze in Western markets.”

Market participants point to the lack of exposure of local banks to the US housing market and the continuing availability of financing for deals, which never reached the high levels seen in the West. They say that, compared with Western markets, there has been less push-back by lenders over terms and conditions since the middle of last year.

Furthermore, it appears to be the case that interest from US-based investors in the region is increasing. Joanna James, managing partner at Advent International, told sister website PrivateEquityOnline.com: “One of the big differences in [the latest] fundraising has been the interest from the US where nearly a quarter of the investments came from, as opposed to virtually nothing in the 2005 fund.” (see also “Clever money”, p. 82) US investors have had a volatile relationship with the region having invested substantially in the 1990s, before pulling back following the economic difficulties referred to earlier. Their return would provide a big confidence boost.

Salesny says the development of larger funds, such as Mid Europa Partners' third fund, will attract a different investor base to the region, as some of these investors are looking to write tickets of at least €50 million to €75 million, effectively excluding them from smaller mid-market funds with long-term investor bases.

Fundraising in the CEE looks set to grow as the destination increasingly comes under LPs' microscopes. Given the comparatively modest use of leverage in the region's private equity markets together with encouraging growth rates, hopes are high that the impressive returns that have drawn investor interest can be sustained.