CEE: full steam ahead

Funds have been flooding into CEE and while domestic institutional money is still hard to come by this has not stopped the influx of funds to the region, which reached record amounts in 2005 at US$820.9m compared to US$753.6m in 2004 and US$332.10m in 2003, according to data from Thomson Financial. And these figures exclude the pan-European buyout funds targeting the region such as 3i and Advent International. Figures for this year to April have already surpassed last year’s fund raising exceeding the US$1bn mark at around US$1.175bn

Among the more notable fund raisings last year were Baring Vostok Private Equity Fund III, which closed on US$400m, accounting for the lion’s share of capital; 3TS Capital Partners’ second fund 3TS Central European Fund II on €100m; and Spanish GED Private Equity’s GED Eastern Fund II, the first Spanish fund with Spanish investors for Eastern Europe to be registered in Spain rather than in the region and which raised over €50m.

Thierry Baudon, of Mid Europa Partners, formerly known as EMP Europe, which closed a €650m fund dedicated to the region earlier this year, says: “CEE seems much more attractive than it’s ever been. Investors such as Alpinvest, who invested in both our funds, were quite sceptical a few years ago when they first committed to our fund. I think such investors are a good barometer of where the market is heading.”

Mid Europa Partners Emerging Europe Convergence Fund II was launched in May 2005 with an original target of €500m and closed in early 2006, significantly exceeding that target, with MVision Private Equity Advisers acting as global placement agent. The fund secured commitments from a number of leading existing and new investors, including ABN AMRO, AIG Global Investment Group, AlpInvest, AXA, Citigroup, GIC, MetLife and MN Services. Commitments were also secured from the European Bank for Reconstruction & Development, the European Investment Bank and the International Finance Corporation. Approximately half the commitments came from pension plans and government-related entities, with the remainder evenly spread among fund-of-funds, banks, insurance companies, and endowments and foundations. European investors provided about 60% of total commitments and US investors 30% with the balance coming from the Asia Pacific region.

Baudon, together with partners Craig Butcher and Colin Hewett, leads a team of 12 investment professionals operating from offices in London, Budapest and Warsaw that has worked together since 1999. Commenting on the fund raising, Baudon said: “We are very pleased with the quality and diversity of investors who committed to our second fund, the first one we raised as Mid Europa Partners. The size of the fund reflects the recognition that significant opportunities exist in Central Europe, which is set to enter a new growth phase as integration with Western Europe deepens.” The fund welcomed several new investors, many of which were making their first commitment to Central Europe and which Baudon anticipates seeing more of in further fund raisings.

Mid Europa typically invests between €25m to €100m in cash flow generative companies with enterprise values of up to €1bn, which are typical mid-market deals in the region and also the most competitive space for deals. The firm’s most recent deal is the acquisition of Aster, a provider of media and communication services in Poland, from Hicks, Muse, Tate & Furst (now called HM Capital).

Much of the capital for funds in CEE in the past traditionally came from the European Investment Fund (EIF), a member of the European Investment Bank. The EIF was created in 1994 as the European Union’s specialised vehicle to support innovation and small to medium-sized enterprises across CEE. To date, the EIF has authorised capital of around €200m, subscribed by the European Investment Bank (59.45%), the European Community (30%) and some 37 public and private banks and financial institutions (10.55%). The larger, international players, such as AlpInvest, which have traditionally played a smaller part in allocations to the region in the past, are now, albeit slowly, increasing their allocations and this is reflected in the uplift in fund raising figures.

Chris Mruck of Advent International says international appetite for funds in the region is increasing. “Central Europe wasn’t necessarily at the forefront of LPs’ interest when we raised our last fund, but that has changed dramatically. The accession of the countries in 2004 has helped. There is now definitely a stronger interest in that area especially because of the fact that if you operate in a higher risk region, you should generate higher returns.”

Ernest Lambers of AlpInvest Partners, which has a relatively small allocation to CEE as part of its investments in the ‘rest of the world’ category, says: “Our allocation for CEE is resolutely small, between €25m to €50m per year compared to around €300m for our yearly investment programme for emerging markets. We allocate capital to regions and countries relative to the size of the private equity markets. CEE has seen a total of yearly fund raising of €400m to €500m in the 2003/2004 period and has only recently seen a healthy increase. Until 2005, the funds targeting the region have been smaller than some of the mega buyout fund raisings traditionally seen US and Europe-wide.”

Lambers continues: “There have only been a few large funds raised for the region in the last few years. Mid Europa, which we have committed to, was among these. We usually do not focus on funds below €80m. So far we have seen the larger funds to show the best performance. Furthermore, we also keep the number of fund relationships to an acceptable size. We have commitments with some of the major names like Advent International, Mid Europa and Enterprise Investors and we feel that most of these are well established in the market, all having built up a strong team of professionals and a good number of successful exits.

AlpInvest’s primary funds allocation strategy is targeting approximately 45% for investments in the US, 45% for Western Europe and 10% for the rest of the world, which includes Asia (including Japan and Australia), Latin America, Israel and also CEE. Lambers says: “The new EU members are still part of the rest of the world for AlpInvest. This has mainly to do with the fact that many of the fund managers in that region for us are still emerging managers, although this is changing rapidly with the successful exits in the last 18 months and several managers having raised their third (or even later) generation of funds.”

LPs investing in the region may be put off by the currency risk, certainly in the CEE countries that are not yet members of the EU. “There is still of course some currency risk. What is important is there is a clear path on where the economy is going and what the government is doing. We feel there is still significant risk in these countries and so we are not entirely comfortable with a huge exposure. We make approximately one commitment per year in the region and that fits well with our portfolio,” says Lambers.

Domestic money targeting the region is still minimal. Part of this is due to regulatory issues and underfunded or non-existent pension schemes, but it is also a case of knowledge of the asset class. Mruck says: “The size of the pension pool in practically all of the countries is tiny and if you take the small percentage of those pension funds actually reserved for private equity, then the amounts currently available become insignificant.”

The fact that there has been an attempt in the region to raise a fund-of-funds suggests potential, even if the time isn’t right now. That fund-of-funds was Copernicus, which was the first Polish fund-of-funds established under Polish investment fund law launched to encourage pension funds to invest in the asset class. The vehicle did attract interest and some pension funds, but not enough shares were subscribed to make the fund successful. Also, according to the founders, the timing of the fund was unfortunate as the Warsaw Stock Exchange was witnessing something of a revival and so some pension fund managers held a substantial percentage of shares in their portfolios and also didn’t have time to consider a new vehicle such as Copernicus and an asset class that was totally foreign to many of them. However, Copernicus says it has not abandoned the project and it will be resumed when the time is right.

Robert Manz, partner and member of the board of Enterprise Investors and chair of the European Private Equity & Venture Capital Association’s Central & Eastern Europe Task Force, cites Poland as the main potential pool of capital for private equity funds in the region, but also recognises the challenges that legal and regulatory restrictions are imposing on pension funds in the region. “In Poland there is a robust pension community, but there are various restrictions for them to invest in private equity, something the Polish Venture Capital Association is working hard to change. Polish pension funds have about US$29bn under management, which is a sizeable pool. The problem is the pension funds have to invest in certain types of securities, generally regulated securities, which does not match the typical way private equity funds are organised.”

Thierry Baudon sees challenges ahead attracting domestic money, but is also confident that it will come with time. “The market is growing fast, deal flow is increasing, the structures are in place. It is clear that in Central Europe domestic LPs don’t exist on a massive scale because of legal and regulatory issues. There is a built-in disincentive in the short term? In a nutshell, it’s in the interest of the Government to mop up local savings in government paper. Until they manage the transition to the euro they don’t have much incentive to divert domestic private savings into alternative assets. But we can safely assume that within four or five years that will change.” Until then the region will remain a hunting ground for foreign LPs and investors.

Mezzanine making a difference?

Mezzanine offerings seem to have taken off in the EU accession countries in the last few years. Previously, although banks such as Erste, HVB, ING and KBC had been providing some debt with mezzanine-type risk alongside senior debt, volumes were low and traditional mezzanine, with both a cash coupon and warrants, was almost unheard of. All that changed when the first fund dedicated to providing mezzanine to the accession countries, Mezzanine Management’s Accession Mezzanine Capital (AMC), was launched. Since then, several other independent mezzanine providers have emerged, including Vienna-based Darby, the Balkan Accession Fund and Investkredit Bank’s Invest Mezzanine. In addition, local banks such as OTP in Hungary have joined existing bank lenders such as KBC and Erste to offer the product.

There has even been a break-out of existing team members from Mezzanine Management’s AMC to create their own offering, Syntaxis Capital, which was formed earlier this year by Ben Edwards, Przemek Szczepanski and Thomas Spring. Edwards has been active in the European leveraged finance market for over 17 years. He was one of the original team members at Mezzanine Management, joining that firm in 1988 shortly after its formation. More recently, Edwards was one of the founding members of the team at Mezzanine Management responsible for its Central European fund, Accession Mezzanine Capital (AMC). Przemek Szczepanski and Thomas Spring were also both previously involved in the management of AMC and all three individuals have significant experience in the field of mezzanine capital and leveraged finance for Central European companies.

Syntaxis Capital has formed a strategic alliance with Indigo Capital, a well-established provider of mezzanine capital to European businesses. As part of the alliance, Indigo Capital will take a minority stake in Syntaxis, and Syntaxis and Indigo will work together on developing investment opportunities and implementing investments. Indigo Capital will provide funding for the venture on a deal-by-deal basis.

The sudden increase in mezzanine providers is being driven by a sharp rise in demand; from private equity houses looking to expand in or enter the region for the first time, and also within the region, from Eastern Europe’s own rapidly growing corporates. And it is not only the increase in buyouts in the region driving mezzanine volumes. With CEE’s economies growing rapidly and GDP rising, the region is undergoing a wave of consolidation and development and corporates’ financing requirements are changing. For this reason a need has manifested itself for mezzanine as expansion capital, to help fund acquisitions, the launch and development of new products, the buyout of minority shareholders and other strategic goals.

The most notable buyout with a mezzanine tranche in the region to date has been Advent International’s €230m LBO of Bulgaria’s BTC in 2004 (which included a €40m mezzanine tranche, the biggest yet seen in CEE). Mezzanine in the accession countries does carry higher pricing than in Western Europe, at roughly 16% all-in, compared to 12%, or substantially below for the bigger deals. Also, with the exception of the odd jumbo deal, such as BTC’s €40m tranche, average deal sizes are far smaller in Eastern Europe. Tranches typically do not exceed €10m and are often as small as €2m, compared to the average Western European mezzanine deal of between €80m and €100m.

Ben Edwards says: “Private equity funds have been successful in raising money and deal sizes are naturally increasing and therefore so will the need for mezzanine. With Western European funds coming into the market and with appetite for such a product, it should be a great boost for mezzanine. One of the things we’re definitely seeing is a greater use of structured products and we think it makes sense to offer a buy to hold product as most banks in the market just underwrite mezzanine, with a view to subsequent syndication.”

Edwards is confident about deal flow. “When we first started with mezzanine products in the region a few years ago we would see a lot of interest, but few deals actually happened. We have seen just under €200m of mezzanine demand for deals in the region and believe the hit rate, or the number of deals which close as a proportion of total enquiries, should escalate, as the market continues to develop,” he says.

Until recently, Advent International and 3i have been the only major international buyout firms frequently active in the region. Volume has been driven by these two groups and by regional and local private equity firms such as Baring Corilius Private Equity, Enterprise Investors, Innova Capital, Mid Europa Partners, Royalton Partners and Vienna Capital Partners. Not only have most deals been too small to interest many big Western private equity firms, but the availability of debt just hasn’t been there and so most deals have fallen below the radar of the big international sponsors.

But the debt market is maturing and not just with the increasing use of mezzanine. Adam Levin, corporate partner at Dechert LLP, says: “The London banks and the bulge-bracket banks, for example, Morgan Stanley and Citigroup, are starting to have significant teams focused on that area.” He also mentions a trend being seen in refinancings in the region. “With the refinancings we’re seeing, the original deals are being done by those local or regional banks with the willingness to accept the risk of the deals. Once the hard work has been done, the London and bulge-bracket banks seem to be keener to back these deals.” If that trend continues, he says, you’ll find two markets developing. “The London banks and the bulge-brackets just don’t seem so interested until a more local or regional bank has assessed the risk for the first time and only after the original deal has been done.”

Robert Manz, of Enterprise Investors, says: “Debt is a recent phenomenon in CEE. It’s still relatively conservatively applied compared to the rest of Western Europe. So far, you rarely see the high multiples of debt being seen across the rest of Europe.” But he adds, importantly, that the availability of debt and the pricing is reasonable, efficient and readily available. “There has been no strong impact on valuations of deals in the region because of this. We are definitely seeing debt becoming a more important part of the toolbox for private equity in CEE. The debt is there, the banks are interested and the players are ready to use it in their transactions.”

Enterprise Investors has done a number of leveraged deals to date. DGS, a Polish manufacturer of metal closures for alcoholic beverage bottles and for glass jars, is the firm’s largest to date. In 2005 the fund bought an 80% stake from the company’s shareholders in a leveraged buyout transaction. Debt comprised some 45% of the transaction, all was senior debt raised in local markets in Poland. Manz says: “We got very favourable pricing on the deal. The company is a market leader and sizeable so there weren’t many concerns from the bank and that is a reflection of the kind of deals we’re doing in the region.”

Nigel Williams of Royalton Partners reflects on a change in deal strategy for many firms operating in CEE. “Virtually everyone active in the region has been doing development capital because interest rates were too high and there wasn’t much debt available. But this has now changed and these markets still have a high GDP and economic growth and by leveraging this growth you can get superior returns. So many deals which didn’t start out as looking like an LBO have since gone down that route as the market has developed.” He cites Starman, a development capital deal Royalton backed in 2000, as an example. That business was leveraged in 2004 in order to buy a competitor. Estonian bank Uhis Pank provided the debt and Royalton exited the company in 2005 on the Italian Stock Exchange.

But while doing LBOs in CEE is becoming more mainstream there are still obstacles the industry faces that need to be ironed out. For example there is still some uncertainty surrounding minority shareholder rights. Duncan Weston of law firm CMS Cameron McKenna explains: “Squeeze out rules are still poorly defined and there is still a degree of uncertainly surrounding mandatory offers for minority shares in relation to the price and this can impact the financing of the acquisition.”

He adds: “There is often frustration about the uncertainty of procedures such as obtaining competition approval and delisting from a public to a private company. One needs to remember, however, that regulation can often be less strict than in Western Europe and the US.”

A fundamental issue for LBOs is the law against financial assistance, which states a joint stock company cannot provide assistance for the purchase of its own shares, which includes granting security to a bank to secure an acquisition loan. Such restrictions are often found tucked away in a small paragraph of the code without exceptions to the strict rule and with little clarity on how it is actually to be applied in practice. Weston says: “All these issues, however, are to a large extent tried and tested across Central Europe and with the right guidance there shouldn’t be a problem in overcoming them. There will continue to be uncertainty as to how the law can be enforced throughout the Central European markets and there are no doubt some exciting challenges to come, further East.”

Exits on the up

Robert Manz says options for exits are increasing, which in turn is leading to shorter holding periods and higher valuations. He says: “When we started exiting deals in the mid 1990s there were really only two exit options, foreign trade sale and the occasional IPO. Now there are at least five: foreign trade sale, domestic trade sale, IPO, secondary sale [to private equity funds or financial buyers], and management buybacks.” Manz notes this broadening market activity is helping push multiples in CEE toward Western levels. Last year was a record year for Enterprise Investors, in particular through listings on the Warsaw Stock Exchange (WSE), which has been going from strength to strength. In 2005 funds managed by Enterprise Investors invested nearly US$200m and returned just under US$300m to investors, a figure unprecedented in the firm’s history. The firm exited investments in Stolica, Netia, LPP, Orange Romania and Orange Slovensko, among others, all generating more than a threefold return on investment.

Last year, Enterprise Investors floated three companies on the WSE and led a secondary offering. In April, the firm took the energy company Polish Energy Partners public generating a partial exit of US$4.5m. In June, Opoczno, a Polish producer of ceramic tiles, achieved a successful flotation with Enterprise Investors retaining its stake in the business. In November, Teta, an IT firm, went public, generating US$9.3m for investors. The Teta transaction was Enterprise Investors’ 22nd IPO and the firm’s cumulative proceeds from the WSE now total US$467m.

A landmark exit for the region earlier this year was Warburg Pincus’ divestment from Czech pharma company Zentiva. The firm recently sold its remaining shares to Sanofi-Aventis for approximately €430.3m. The sale of its remaining 19.6% stake means overall Warburg made a 9x return, generating a total of US$1.2bn from its US$125m investment. Warburg made its first investment in May 1998, when it took an interest of almost 70% in Leciva, which was privatised just a few months earlier. In August 2003 the company merged with Slovakofarma and began operating under the name Zentiva. Following an IPO in 2004, Warburg held a 54% stake and has gradually been selling shares.

Another recent strong exit for the region was Advent International’s sale in under three years of its 96.7% stake in Romanian generic pharmaceuticals manufacturer Terapia, to India’s Ranbaxy Laboratories Limited for US$324m. Advent is reported to have made 10x return on that investment. The acquisition of Terapia in August 2003 for US$49.3m was the first ever take-private LBO in Central Europe. The company floated on the Bucharest Stock Exchange in 1997 following its privatisation, but suffered because of a lack of liquidity on the market. Advent paid US$44m for the shares, and a further US$5.3m to cover deal costs. The company was bought through Advent Central & Eastern Europe II.

The fundamental reason for good potential returns in the region that most players stress is not the increasing availability of funds and debt, but that CEE remains a region where there is still room for growth in many underdeveloped industries and this is where the returns are going to be made. Advent International’s Chris Mruck says: “We tend to generate our returns through adding value and not from financial engineering. Looking at our 22 exits in the region, the majority of the return has come from growth. Of course financial engineering helps, but it is not the major value driver.”