Accessing Europe

Private equity interest in the accession states of the EU and its accession candidates is hotting up. The reason for the interest is not hard to explain: high GDP growth rates, the proximity to a huge consumer market and the political and institutional stability offered by EU membership.

“The fact that countries from the CEE region have acceded to the EU has instilled confidence in the whole region,” says Ted Cominos, head of private equity in the CEE for law firm Linklaters, adding that competition for assets has increased.

“A few years ago, exclusivity was almost a given and if you found an attractive asset you could pretty much be sure of acquiring it, but now there’s more competitive tendering,” he says.

An illustration of the high level of activity is the fact that Mid Europa Partners, one of the main buyout houses, raised €650m for its latest CEE fund, which closed at the beginning of 2006, and has already invested a significant chunk of the money.

The fund, which had an original target of €500m, was the biggest fundraising yet for Mid Europa (formerly known as EMP Europe).

“We’ve already invested 25% of the fund in the first six months, which is twice the rate you’d normally expect a fund to be invested,” says Mid Europa co-founder Thierry Baudon.

The firm has made three investments from its new fund. The first was to acquire the Polish operations of US based Wheelabrator Group, the world’s leading surface preparation and finishing equipment specialist. This was followed by the purchase from Hicks Muse Tate & Furst of Polish media and communications company Aster, and the acquisition of Croatian specialist cement business Heidelberger Calcium Aluminates from Heidelberg Cement Group.

While many investors regard the CEE region as a political bloc, it is also important to understand the different markets. Of the accession countries, the most important private equity market, thanks largely to its population size, is Poland. With its 40m population Poland is by far the largest of the group and this consumer base has made it the largest generator of deals as well as the base for most of the regional private equity funds.

The Czech Republic has also been active, says Cominos, while Hungary has generated a lot of talk but relatively few transactions. The small size of the Baltic countries has restricted their contribution to overall activity.

Among the accession candidates in the CEE region that are hoping to join in the coming years, Romania is the largest (excluding Turkey) and is generating deals, according to Cominos. But there has been little activity in Bulgaria and countries such as Serbia are still seen as quite risky, he says.

Fast economic growth is one of the attractions, says Nigel Williams, chair of private equity firm Royalton Partners. “Spain and Portugal’s experience after joining the EU was a spurt of growth and I think we’ll see that in the CEE,” he says. “Some of the Baltic countries are already growing at more than 10% and in the rest of the region it’s 4%–6%.”

Williams adds that from a private equity point of view, this means investing in businesses with similar multiples to those in Western Europe but offering higher growth. “You’re really buying EU investments at emerging markets growth rate,” he says.

There is also the fact that the accession countries are now part of the EU’s political, economic and institutional stability. This means that investors do not have to worry about unpredictable political decisions that could negatively affect investments, says Mounir (Moose) Guen, chairman of private equity advisers Mvision.

“In some parts of Asia-Pacific, for example, there can be sudden decisions by states that affect private equity houses but that kind of risk is mitigated by EU membership,” Guen says.

Despite these advantages, there are still significant issues that have limited the participation of the larger pan-European private equity houses in the region.

There are effectively only a handful of houses that are highly active across the area, says Thierry Baudon. In this list, apart from Mid Europa, he includes Advent International and Enterprise Investors. Other active firms include 3i and smaller sub-regional and country-based funds.

Among the issues Baudon highlights is the fact that, although the accession countries and candidates represent a relatively large geographical area, in economic terms the region is still under-developed and only represents 60% of the German market.

Baudon adds that it is still a fragmented region in terms of language, culture and institutions. “That makes it a fairly difficult market to get into and explains why so few western private equity funds have come, as much depends on informal networks,” he says.

There is also the fact that historically the region has produced smaller deal sizes and so has not been on the radar screens of the larger buyout houses, although some have shown an interest, such as Warburg and Carlyle.

However, the interest of the larger funds has generally been opportunistic and comes to the fore when there is a large asset to be sold that involves one of the main investments banks.

“The big houses like deals to be handled by a bulge-bracket bank and to have vendor due diligence presented with a ribbon on it,” says Baudon.

But things are changing. First, deal sizes are increasing. Until recently there was very little debt available in the region, which meant that many of the deals were focused on development or growth capital.

“That meant the return profile was lower than buyouts and investment periods longer, which limited the interest of GPs,” says Guen. In addition, he says, an entrepreneurial culture was still being developed in these countries after decades of authoritarian rule.

Linklaters’ Cominos points out that when commercial debt was largely unavailable it made more sense for investors to acquire a slower-growing Western European company, which they could leverage, than a faster-growing CEE company.

“The returns on the western European investment would invariably be higher because of the leverage,” Cominos says.

But the last three years has seen the arrival of a commercial debt market to the region, with CEE banks willing to lend on deals at affordable rates. This development was due in large part to most of the countries in the region becoming investment grade.

“Today pretty much all the medium and larger deals are leveraged,” says Cominos.

The region appears to be on a cusp, with increasing competition for assets and a growing perception of stability and economic growth. According to Baudon, until a few years ago most deals were driven by privatisation in the region or were development capital transactions. Today, privatisation is less important and represents just 20% of deals for Mid Europa.

Instead, there are new sources of transactions. One is corporate spin-offs in sectors where there has been consolidation across the region, such as oil and gas. Another is the fact that many of the companies founded by the early entrepreneurs after the fall of Communism in the early 1990s are now big enough to be on the radar screens for buyout houses such as Mid Europa, which targets companies with an enterprise value of €150m–€750m.

When it comes to exits, different houses have different approaches depending on their strategy. For Mid Europa it is mainly trade sales. “We look to invest in companies that can offer global companies a footprint in this region,” says Baudon.

Meanwhile, for Enterprise Investors, which is Poland-focused and concentrates on smaller deals, IPOs have been a popular exit. One of the issues in the future, however, is that it is only really in Poland that a credible IPO exit route has been developed and this is only because of laws forcing Polish pension funds to invest domestically, and which therefore have propped up the Warsaw stock market.

Elsewhere in the region stock markets, and the IPO markets, are far less developed. That said, IPOs do happen.

“We did a flotation last year in Estonia, which has a tiny capital market, and we’ve done one in Hungary,” says Nigel Williams of Royalton. In the coming years he expects there to be more interest from the pan-European players. “The market will grow over time so that we will end up with a genuine European mid-cap market [that includes the CEE region], but it won’t happen overnight,” he says.

Williams adds that even though there is increasing competition for assets, there is still only a relatively small number of private equity houses active in the region, so proprietary deals can be achieved. “Sellers are still often not sophisticated enough to tender all the time” he says.

Thierry Baudon also expects the region to become part of the mainstream European market within five years. “By then, the big boys will have arrived and so people like us need to make sure we have the networks in place and the track record in order to remain competitive because there’s no doubt they’ll be here,” he says.

Baudon argues that the huge funds being raised by the large buyout houses and the inflation of valuations for assets in the US and Western Europe mean there will inevitably be a movement into the CEE area.

At the moment, the existing players are somewhat protected, Baudon says, by the lack of an intermediary network in the region. “There’s not a single investment bank with a strong presence in the region and that lack of intermediaries is good for firms like us because it deters those firms without a major presence on the ground.”

In the long run, he believes, the region will not be seen as a single bloc but rather that countries will become part of different spheres of influence.

“To a large extent, the CEE description is an artificial creation based on the fact that many of these countries were under Communist rule,” says Baudon. “In the future, I think we’ll see the Czech Republic and Hungary as suburbs of Germany, the Balkans as tied to Turkey and perhaps Italy, and so on.”