Assessing CEE private equity post Accession

Accession day has passed and the European Union finds itself with ten new members. As the largest single expansion of the EU in its history, things will undoubtedly never be the same again, be that socially, politically or economically. Since 1990, it is estimated a total of between €5bn and €7bn of private equity has been raised in the nascent Central and Eastern European market. ‘Will Accession affect its development, or will it mature at its own pace?’, asks Tom Allchorne.

Accession is a big non-event,” says Przemek Krych of CWC Capital Management in Poland, neatly summing up the feelings of fellow fund managers in the region. “What really matters, is convergence. By this I mean convergence of the economies between Eastern and Western Europe. This will encourage the change in perception, making the region a safer place to invest.”

Vygandas Juras, a partner at Baltcap Management, says: “There is clearly a renewed interest from European and US funds in the Baltic region, most of which were already involved in the market before the Russian economic crisis of 1998. Their growing interest, however, is not based so much on the fact of the accessions to the EU, but on the maturing industries and companies and robust macroeconomic countries.”

Investors will not just invest in something because it’s a bit different. Talking about fund raising for Enterprise Investor’s €300m fund, Polish Enterprise Fund V, partner Michal Rusiecki says: “People invested in our fund not because they were particularly interested in Central Europe but because of our track record. This is what investors are driven by more than anything else.”

“We can no longer sell on geography. The story has to be different and well thought out,” says Ali Artunkal, director at Argus Capital Partner. “Overall, just because May 1st is coming, I don’t see any changes happening. When we went out fund raising a few years ago we sold the convergence process, but this process has been going on for a long time and will continue to do so. Investors took notice of this a considerable while ago; this is a long term business.”

But taken notice of what exactly? The new EU states are growing at a much faster rate than the old guard. Their GDP levels increased by about 3.5% last year and are expected to increase by more than 4% in 2004. Some economists are also predicting Poland, the Czech Republic and Hungary will see higher economic growth on average than Western European countries. These well-performing economies combine with a large pool of low-cost labour, making Central Europe an attractive destination for foreign investment. Although foreign direct investment fell from €16.6bn to €6.67bn in 2003, it is forecast to increase and stabilise to €13bn in 2004 and beyond.

Added to this is the lowering of the corporate tax rate in a number of the Accession countries. This will promote competitiveness and company growth, which in turn will have a significant impact on salaries. The increasing prosperity of the region’s population is consequently leading to increasing disposable incomes, and most fund managers in Central and Eastern Europe (CEE) predict this will mean consumer goods and services become very popular sectors for investment.

This economic growth has been accompanied by an emerging private equity market. After the fall of communism in 1989 and the dissolution of the Soviet Union in 1991, the eight new member states in CEE (i.e., not Malta and Cyprus) took on a free-market model based on the templates set down by Western Europe and the US.

The process of Accession for CEE began soon after the fall of the Iron Curtain, with the official applications coming in the mid-1990s, and it was during years of preparing to apply, negotiating with the EU and finally being given the green-light that the Accession states began to get themselves into line with the existing members, in a fiscal, legal and regulatory sense, so much so that now there is very little difference between the old and the new.

Legal and regulatory problems

What differs is the implementation. Sue Hankey, a competition lawyer at CMS Cameron McKenna, says: “Legislation is in principle on the statute books but that is different from implementation. They have got to develop experience.” Her colleague Charles Waddell, a corporate finance partner, says: “This makes it difficult for lawyers to give advice. It’s been a bit of a cut and paste job. The governments seem to have looked around and picked the pieces of legislation they’ve liked from different countries and then adopted it.”

While this is obviously a deterrent to potential investors, and makes investment in both Accession and non-Accession countries riskier than Western Europe, it is a problem that will fade over time as experience grows. Many private equity firms operating in the region use English or New York state law, and use international arbitration to settle disputes.

The importance of being local

The importance of local links in Central and Eastern European countries is high. One of the main differences between doing deals in CEE and Western Europe is that most are proprietary and take a lot of work from the fund managers. GPs have to work closely with the target’s management team. “You have to be here, you have to be able to see the deals,” says Krych. “You have to craft the deal out of the situation. This is old news for us as we have been out here for 11 years, but a lot of the international firms will, and already do, set up local partnerships.”

The courts in CEE are notoriously bureaucratic, and this could put off firms not used to investing in the area. Krych says: “Going through the courts takes time and this is a challenge, and this makes the court system an issue. It is improving though and it means that you have to come up with efficient structure and solutions. We have learnt this from the school of hard knocks, but from the outside the system will look like a serious challenge.”

A common, and understandable, view is that CEE is a riskier place to do business in than Western Europe or the US. For Vygandas Juras, a partner at Baltcap Management, a PE house focused on Estonia, Latvia, Lithuania and Finland, says this is why links with a domestic firm is beneficial: “There are certain cultural/ethical peculiarities of the way business is done here which does make it riskier for a Western fund manager, particularly in the area of assessing the human capital of a company. However, if a fund manager has a local presence and thus a deeper understanding of the local market, or is investing with a reliable local partner, the risk level in other areas, political, economic, industry, is the same as in Western Europe.”

Outsourcing to CEE

The next few years will undoubtedly see a continuation of the trend of Western European multinationals outsourcing parts their business to CEE. Poland, for example, continues to outperform Western Europe in a number of economic categories. Its average labour costs, at $5.35 per hour, are less than a sixth of Germany’s, making it very competitive in attracting manufacturing jobs. Productivity is expected to increase by over 3.7% in 2004, more than twice the existing EU average.

Krzysztof Krawczyk, managing director of Innova Capital, says: “There are more and more strategic buyers looking at CEE, but not for high growth. Instead they are seeking to locate their back offices or manufacturing here.” Rather than build new factories or offices, Western European trade buyers will buy out existing companies in the region. This is the strategy many funds in the area are adhering to: buying a company, making improvements, often involving merging with two or three other portfolio companies, and then selling to strategic buyers; the classic buy-and-build model. This is certainly the way CWC works. “We don’t believe in the public markets because they can come and go,” says Krych. “We take controlling stakes in anything which has a franchise value to foreign strategics.”

An important factor about investing in CEE is timing. At the moment CEE is converging with the EU but it still has some way to travel. This time lag presents an opportunity for funds to generate high returns on investments because when CEE member states reach the economic levels of the rest of the EU, the investment values will have seen a significant increase.


Ultimately, the success or otherwise of CEE will be exits. Juras, whose firm Baltcap focuses on the Baltic States, says: “Trade sale to a larger European or Scandinavian player is still the primary exit route, but secondary buyouts are also becoming more visible. Many believe that the IPO window is about open, and I share that view. Overall, though, exits remain a major risk in this market.”

One obvious problem for the development of CEE private equity is the size of the public equity market. Warsaw is home to the largest stock exchange with a market capitalisation of $19bn. Compare this to France which has a capitalisation of over $1,400bn or even Italy’s $900bn and it is clear CEE stock exchanges are fledgling. This limits IPO opportunities, meaning investments have to be held onto for longer than they would be in the West.

Public markets have been significantly affected by the pension reforms towards the end of the last decade. So far investments have been limited to government bonds, but a liberalisation of asset allocation rules will encourage pension funds and other institutional investors into the listed markets. At the moment, Polish pension funds cannot invest more than 5% of their assets in closed-end funds. They cannot invest at all in foreign funds, and with most of the funds in the region registered elsewhere, this is a serious problem.

As a way around the limits on pension fund investment Copernicus Capital Partners launched Poland’s first fund-of-funds in September. The fund aims to have a capitalization of around €138m, with the option to trade certificates on the stock exchange as a way of ensuring investors can have some liquidity. The pension funds themselves do not seem particularly keen on the idea of private equity in general, primarily due to the lack of liquidity involved. Copernicus expects 0.5% of its clients’ assets to be allocated in private equity, which does not compare well against figures published by the 2003 Goldman Sachs and Russell Global Report, which gives a European average of 4.2% and the US with 7.5%.

A first close on the fund should be reached in late June/early July, depending on how long it takes to establish a TFI. A TFI is an investment management company that has to be set up in Poland and this takes about a month to complete.

Neil Milne, a managing partner at Copernicus, says: “There is an interest from institutional investors in the asset class in the long term but the legal constraints means they can’t because many of the funds are foreign registered. If these pension funds wish to get into private equity, investing in a fund-of-funds is much more sensible. They are only looking at €15m worth of commitments and so it really is not worth them setting up a dedicated investment team.”

Polish pension funds are estimated to accumulate over €55bn by 2010. Nigel Williams, chairman of Royalton Partners, which manages and advises the Emerging Europe Capital Partners fund, says: “Because of the rules surrounding pension funds, they have to put most of their money in local stock exchanges. This is happening in many of Central European countries. The pension funds are building money up as none of them are paying out yet.”

Problems with leveraging

The history of buyouts in CEE has been dominated by growth/expansion capital. Investors buy a company and then take on debt to make acquisitions, a model which reflects both the local banks’ inexperience with the Western Europe-type LBO model and the fact that many of the transactions are simply not suitable for leverage – see EVCJ March 2004, p44. But it is changing. The wave of bank privatisations in the 1990s saw a large number of domestic banks taken over by foreign strategic investors, which bring knowledge and expertise in LBO deals. In Poland, almost 70% of bank assets are owned by foreigners. In the Czech Republic it’s around 90% and in Hungary it is just over 60%.

Like all member states, the Accession nations are subject to EU company law on financial assistance, which prohibits a target company from providing financial assistance to the newco in the acquisition of its own shares. This restricts LBOs in the way in which the targets’ income and cash resource can be used to service the newco’s debt obligations, as well as placing limits on the security package.

Many countries in the West have come up with systems which relax this ruling. In the UK, for example, the law prohibits unlawful financial assistance to both public (joint stock) companies and private (limited liability) companies. However, a private company can provide financial assistance if it complies with sections 155-158 of the Company Act (the so-called ‘whitewash procedure’.) There is no such procedure under CEE law, but an LBO can be structured in a number of ways to avoid the prohibition. The target and the newco can be merged, at which point it is possible to extend security to cover the target’s assets and to use the target’s income streams without breaking the financial assistance law. But this takes time. It’s unusual for the process to take less than five months, and it’s fairly common for it to take over nine. Another way of side-stepping the rule is converting the target into a limited liability company, which takes approximately three to four months.

There are also issues surrounding taxation. In Poland, the interest payable by the newco on the bank debt to fund the acquisition of the target is not tax deductible, and there is no relief from withholding tax in payments of dividends by the target to the newco. While it can be done in theory, in practice it is almost impossible to create a tax group for tax relief purposes due to the stipulations in place, such as the tax group’s profits having to be equal to at least 6% of its income. The easiest way around this is to merge the newco and the target.

Actual examples of pure LBOs, in a Western European sense, are few and far between. In September 2003, Kingfisher sold Polish DIY retailer Nomi to Enterprise Investors for €9.6m, €4.8m of which was a five-year debt from Bank Zachodni.

June 2003 saw Advent International acquire 100% of Danubius Radio from UK broadcasting group GWR for €30m. It was the first LBO in Hungary to use mezzanine finance, and the use of mezzanine is an important indication of the increasing sophistication of the CE banking market. Mezzanine financing obviously adds another hurdle to the already complicated LBO procedure, but as regulations change, its use will increase. The establishment of a CE dedicated fund, Mezzanine Management’s €115m Accession Mezzanine Capital fund, which closed last year, is surely a sign of things to come – see EVCJ March 2004, p44.

Being a new market, secondaries have been rare. One of the most high profile was the sale of Polfa Kutno by Enterprise Investors (EI.) In 1994 the Polish government began privatising the pharmaceuticals industry, and the following year EI began to buy shares in Warsaw Stock Exchange listed Polfa Kutno, eventually building up to 69% by 2001. It was sold in September 2003 for $79m to Polish pension and mutual funds and EU-based institutional investors, resulting in a 5.4 multiple on the invested capital and an IRR of 23%.


The actual level of competition in CEE is not particularly high, and some are predicting it will stay this way. Certainly outside Poland, Hungary and the Czech Republic, deal sizes are usually fairly small. Joanna James, managing director of Central Europe at Advent International, says: “A lot of transactions are between €20m and €30m. And most of your pan European funds won’t get out of bed for that.” Getting a deal done is also a much more complicated business than in Western Europe. James adds: “You don’t get auctions, you have to nurture things, which a lot of funds won’t want to do.”

Williams says: “At the smaller end you do get proprietary deals. In the US or Western Europe, the market is dominated by the auctions, which obviously makes transactions more expensive. Because these are lacking in Central Europe, deals can be cheaper.”

Conversely, it is at the smaller, sub-$10m end where competition is highest. This is due to the fact that most of the regional funds are small and in order to build a diversified portfolio invest in small transactions. CWC, when launching its Central European Investment Fund, said it believed the “strongest competition for deals will not come from other private equity groups, but rather from the successful local entrepreneurs sponsored by banks.”

For Waddell, the emergence of a large private equity market is questionable: “There are not many assets in the region suitable for leveraging, and a lot of funds are struggling to raise money. A few years ago the fund managers said pile in now and will exit in 2004. This hasn’t happened. The returns are not as good as people thought, and investors have been saying that returns didn’t justify the risk in investing in CEE countries.”

The effect of this, though, may actually be the kick-start the CEE private equity market needs. “A few years ago,” says Krawczyk, “CEE was very competitive for business. Everyone was coming to CEE to take advantage of the growing economy. But compared to Western Europe, it was much more unstable. Then we saw the foreign companies pull out because they were not making as much money as they thought they would. This will encourage and benefit the private equity market.”


The future looks bright for buyouts and private equity deals in the region. Unfortunately the same can’t be said for early stage venture, where opportunities are limited. “Venture is a lot more risky,” says Artunkal. “I can’t see many funds investing.”

The stats bear him out. There are no definitive figures available for 2003, but those for 2002 are bleak. The European Private Equity and Venture Capital Association (EVCA) states that the Czech Republic reported no seed stage financing and start-up investment slumped from €6.5m to just €470,000. In Hungary it’s a similar problem. No seed investment, and start-up was also down, from €16m to €2.3m. Poland again had no seed finance, and a decrease in start-ups from €17.7m to €8m.

Outside Poland, Hungary and the Czech Republic, a further difficulty is the size of the countries. “The Baltics are too small to create a critical mass of VC pipeline and final projects to form a meaningful diversified portfolio,” says Juras of Baltcap. “VC project evaluation and subsequent invested monitoring from outside the country is problematic,” he continues. “To do it effectively you need to speak the local language, understand the environment and have a wide contacts network. The small potential deal flow and subsequently small portfolios is also problematic in that it makes local VC fund management too costly to establish in these countries.”

Everyone is in agreement, but they are equally negative about the larger CEE countries. “I see the equity gap, between venture and later stage, becoming wider and wider,” says Krawczyk. “There is a problem with VC financing and there is no real action plan by the governments to change that. The future for venture deals is limited.” The Deloitte Central European Private Equity Survey, published in November 2003, bears this out, with 79% of respondents saying start-ups are their lowest priority.

“The entrepreneurial environment,” continues Rusiecki, “will only change if the EU provided some funding to make it a better environment. The development of the venture market is a rather longer term thing.”

Go East

With Romania and Bulgaria expected to accede to the EU in 2007, possibly alongside Croatia, the legal and regulatory aspects are fairly similar. One particular problem in Romania is the protective labour code, which is complicated and could cause problems for funds looking at restructuring. There are also a handful of South Eastern European dedicated funds in the market place now. At the beginning of May, Dolphin Capital Partners revealed plans to launch a €100m fund to invest in the leisure integrated real estate sector in Greece, Cyprus, Turkey and Croatia. The general consensus is there is money coming to Romania and Bulgaria and that more opportunities will be seen in the not too distant future.

Elsewhere, in Yugoslavia, Belarus, Bosnia, Serbia, Macedonia, Ukraine and Moldova, the private equity market is much less sophisticated. The country with the most likelihood of embracing private equity is Ukraine, which is unsurprising given its size and therefore better chance of producing a reasonable deal flow.

Russia is far too big a country with far too many important issues arising from the country’s historical context to be able to cover in any depth here, but at the last count there were approximately 40 Russian funds, with an average size of approximately $100m. About one-quarter of these funds are made up of public or quasi-public money, such as the EBRD’s or the $440m US-Russia Investment Fund created in 1995. Legal and regulatory improvements have definitely been made over the last few years, but the reputation of the Russian market in the 1990s, uncertain legal system, dubious accounting standards, ambiguous laws in regards to minority shareholder rights, not to mention bribery, is still enough to affect investment today, despite its (probable) imminent accession to the World Trade Organisation.

Less risky, but more attractive?

There is little doubt Accession will help the private equity market in Central and Eastern Europe, but it seems unlikely to have a big effect, at least in the short-term. With the EU’s boundaries shifting eastwards, the geographical coverage of the pan-European funds has also expanded. The strong and sustained economic growth, the legal and regulatory frameworks and the increasing sophistication of the banking market all make Central and Eastern Europe an attractive location for investment. If Accession only does one thing for the private equity market in the CEE region, it will at least be to remove some of the risk typically, and some would say unfairly, associated with the region.