Eastern exposure

With its high rates of growth and large, increasingly affluent populations, Central and Eastern Europe is becoming an ever-more important element of private equity portfolios. But while there is much cause for optimism, some reservations still remain. Andy Thomson spoke to representatives of three limited partner groups – Leon Hadass, vice president at Pantheon Ventures; Ray Maxwell, managing director in the private equity division at Invesco Asset Management; and Peter Wilson, managing director at HarbourVest Partners – to glean their views on the region's prospects.

What are the main attractions of gaining private equity exposure to Central and Eastern Europe?
Peter Wilson: We've had commitments in the region since 1997 and have invested in groups such as Enterprise Investors and Innova Capital [both Warsaw-based midmarket private equity funds]. I think the region's private equity markets have matured significantly over the last ten to 15 years. There is now a stronger infrastructure in place for private equity – for example, in the areas of legal systems, investment banking and capital markets. There has also been a maturation of the entrepreneurial environment and a more highly skilled middle and senior management has emerged.

Leon Hadass: Our exposure to Central and Eastern Europe is mainly through regional funds. To date, we've focused more on Western than Eastern Europe but we're looking at the latter with increasing interest. In the four major Accession countries [Poland, Hungary, Czech Republic and Slovakia joined the European Union on 1 May 2004], what's exciting is that you have underlying inflation at similar levels to Western Europe but growth rates at least double those of the Eurozone.

What characteristics are you seeking from GP groups operating in the region?
LH: I think having locals in the team is pretty critical. In Western Europe, as you have seen, the large US funds can enter a market like Germany and don't necessarily have to be staffed with German nationals to do deals – at the larger end of the market at least, they just fly in. In Central and Eastern Europe, you have to understand the social environment and parameters and know who you are dealing with. Having local offices is not necessarily a must but it certainly helps.

Central and Eastern Europe seems to have gone through two “waves” of investment: namely, privatisations and telecoms. What are investors focused on now?
Ray Maxwell: The latest wave is to do with building out the economies – so things such as logistics, infrastructure and retail. There has also been a lot of activity in light manufacturing, such as plastics. The economies are growing and there's increased demand for goods from both businesses and individuals. The need is not export-related: it's about the needs and demands of local populations.

LH: In less mature markets – especially where there's a large indigenous population such as Romania – you have an under-developed retail sector and a consequent need for expansion capital, for example to roll out supermarket chains. There are also competitive advantages to be exploited in sectors such as IT and pharmaceuticals where you have highly skilled workers on wages a fraction of what they would be in the West.

How comfortable are you with the regulatory environment?
RM: A number of countries are now adopting EU rules, though in some respects it's easier to do deals and manage them outside the EU than having to deal with all its rules and regulations. Most ownership issues have been dealt with and, generally speaking, there's a good body of corporate law.

LH: One of the conditions for joining the EU is that you bring your legal framework into line, so in those countries that have acceded you at least have minimum safeguards. Romania and Bulgaria have not joined the EU yet [they are both due to join in January 2007] but they are making efforts to align their legal systems so you shouldn't have too much to worry about. In some former Yugoslav republics there is still political uncertainty so it's a bit more challenging.

Would you be wary of investing in the region's less developed private equity markets?
PW: It all comes down to the track records of the managers investing in those less developed markets. Advent International did a terrific job on the BTC deal [a Bulgarian telecoms company] and made a boatload of money on it. There have also been very successful mobile investments in Romania and Slovakia, so it's not that you can't make money in the less developed private equity markets in the region, you just need to be careful in selecting who you back.

LH: In the “future accession” countries of Bulgaria, Romania and Croatia, the institutional framework is more fragile than in the countries that have acceded but they are forecast to see up to six percent growth over the next couple of years compared with four to five percent in the accession countries. The Baltic states are very small so it's hard for investors of size to commit to Baltic-specific funds because capital commitments would be too small to move the needle.

What do you think of exit opportunities in the region?
PW: You don't have the same degree of confidence in the exit environment as in Western Europe, but it's improving thanks to increased trade interest and more recent successes on the Warsaw Stock Exchange (though this hasn't been replicated on any of the region's other stock markets). These are positive signs, but one of the big challenges for GP groups continues to lie in identifying what is the most appropriate exit for their portfolio companies. You can't simply rely on trade buyers from the West. Many of them have already established first-mover advantage in the region and don't need to build their presence further – they will only buy if the opportunity is right, not just because they need a presence.

RM: Large companies can certainly be listed now because pensions, insurance companies and banks in the region have all become big owners of equity, which means there is sufficient liquidity to sell stock. For small and medium-sized businesses, exits would normally be by way of trade sales – either intraregionally or to a Western European group.

Has the use of leverage caught on in the region – and is this a good or a bad thing?
RM: The debt environment has certainly changed. There are plenty of banks such as Creditanstalt, Deutsche Bank and UBS that will provide sizeable loans in the region now. But while there's leverage, there's not over-leverage – which is definitely a good thing.

If the headline growth remains good, you can still get solid returns without much leverage

Leon Hadass

PW: We are beginning to see leverage buyouts across the region – and as long as the leverage levels remain reasonable, I think it's a good thing. The domestic banks are often owned by, or allied with, Western banks – so, from a credit quality and discipline point of view, loans should be put through the same rigour as in the West. The introduction of leverage ought to provide a boost to returns, so it's a positive as long as it doesn't get ahead of itself.

LH: In Poland, Hungary and the Czech Republic, debt availability is increasing as a large number of Western, and especially Austrian, banks are in fierce competition, and borrowers are securing attractive debt packages as a result. In the less mature markets, however, banks often can't get the covenants that they might require, and which they would expect in the West. This is an issue in the sense that the absence of debt reduces equity returns, but if the headline growth remains good, you can still get solid returns without much leverage.

What are the main pitfalls of Central and Eastern Europe for the unwary?
RM: You shouldn't be seduced by a story. You need to do a lot of due diligence on funds to discover how well placed they are in the market. In parts of the region you have to be local and you have to be respected. You shouldn't back first-time funds unless they can prove they've had great experiences in the region in the past. But the pitfalls are essentially the same as elsewhere. In our view, there's actually no such thing as Central and Eastern Europe: there's just one Europe, with some parts that are more attractive than others.

PW: The buyout market is still rather nascent. We've started to see potentially enhanced returns, but there is still a question mark as to how banks or debt providers will react should things go wrong. The big issue at the moment, as far as we're concerned, is deal pricing. I am a little concerned that the burgeoning strength of the Warsaw Stock Exchange over the last 18 months looks a bit like the run-up in that and other emerging markets in 1997/98. Deals were being done then in what turned out to be a high price environment and were tough to make a good return on. The question that worries us is: are we seeing a mini-bubble?