CEE is still proprietary

In September, Enterprise Investors raised its €658m Polish Enterprise Fund VI. The fund was more than two times oversubscribed and, at more than twice the size of its predecessor, is the largest fund ever raised for the region.

At the end of 2005, Mid Europa Partners raised €650m for its latest fund, while Bedminster Capital reached a first close this summer on its Southeast Europe Equity Fund at US$200m.

In October, Argus Capital exceeded the €200m target for its second CEE fund, raising €213m at its second closing for Argus Capital Partners II.

Less than a year after raising its new fund, Mid Europa has already invested 40% of it in four investments across the region, which reflects the buoyant level of activity in the mid-market.

Reasons for the region’s attractiveness to investors are not hard to find. A key factor is the increasing number of countries in the region joining or hoping to join the EU, with Romania and Bulgaria set to become members in January 2007. Other factors include economic growth rates are high and the fact that it is still possible to pick up proprietary or semi-proprietary deals.

“Private equity players like the region because they see emerging markets growth rates at Western risk levels, thanks to the EU,” says Ted Cominos, head of private equity in the CEE for law firm Linklaters.

But he points out that it is important to distinguish between countries, mainly in Central Europe, that are now part of the EU and those, mainly in Eastern Europe, that have yet to join.

Cominos says: “Our private equity clients say they see Central Europe these days as part of the mainstream European market, with Eastern Europe as the emerging markets part of Europe. But it is in the latter, especially countries like Bulgaria, Romania, parts of south-eastern Europe, and even Ukraine and Turkey, where opportunities for private equity are greatest.”

For Thierry Baudon, managing partner of Mid Europa Partners, there are several factors fuelling deal flow. One is the emergence of a genuine urban middle class with disposable income, which is stimulating demand in sectors such as real estate, consumer finance and retail.

Another factor is intra-regional M&A, as industrial companies seek to expand beyond their domestic markets by acquiring competitors in neighbouring countries.

“This consolidation is creating a lot of opportunities for private equity, as assets are divested or we have the chance to invest alongside acquirers,” says Baudon.

He also highlights the growth in foreign direct investment into the region, with an estimated €40bn–€50bn entering each year.

“A lot of global players are now operating from Central European bases and that is creating opportunities for buyouts,” Baudon says. Examples of this were Mid Europa’s acquisition of Poland-based Wheelabrator in early 2006 and of Croatia-based Heidelberger Calcium Aluminates in June.

It is really since 2003, when leverage began to be available to CEE deals, that the market has blossomed.

“It’s a maturing market that is becoming increasingly similar to Western Europe, to the extent that the London banks now regard a Polish deal in almost the same way as one in the West,” says Nigel Williams, chair of CEE-oriented buyout house Royalton Partners.

Stanislaw Knaflewski, a partner at Enterprise Investors in Warsaw, says that before 2003 private equity houses in the region were generally restricted to expansion capital, but that since then there has been a move to buyouts and particularly LBOs.

Economic growth rates three times those of Western European rates have helped attract increasing investment flows, he says.

“The difference with Western Europe is that companies here are growing fast, so we’re investing in companies with revenue growth ranging from low teens to high teens and bottom-line growth often higher,” says Knaflewski.

Because of these growth rates, leverage levels are often lower than in Western Europe, he adds.

“Typically, debt makes up 40%–60% of the total transaction size, compared with about 70% in the West,” he says, “and that’s because these companies need equity to invest and it’s not good for them to be saddled with excessive debt repayments.”

The value creation in CEE investments, says Knaflewski, is often from company growth and performance rather than from very high leverage and financial engineering.

“We’re delivering returns of 2.5 times money, and almost half the value creation is from companies’ growth,” he says. But the increase in the number of private equity players in the region has helped push up valuations and formal tender processes are becoming increasingly common, especially for larger assets.

A few years ago it was only a relatively small number of regionally based houses that were active, such as Enterprise, Advent, Mid Europa Partners and Global Finance. Today, there is increasing interest from pan-European or global funds such as Warburg Pincus, EQT and Citigroup Venture Capital.

“There’s now a lot more competition for assets and that can be seen in cases such as the current auction for Romanian pharma company Antibiotice, which is being privatised,” says Cominos: “There have been 22 expressions of interest for the company, of which more than half are buyout houses.”

He adds that this increased competition and the frequent absence of indemnities or warranties in deals is a big complaint of many Western funds.

Nigel Williams of Royalton, however, notes that regionally based funds can be at an advantage in these cases.

“In many privatisations, local or central governments are not offering warranties, which favours investors who know the country and market well and can reduce the number of bidders,” Williams says.

But Knaflewski points out that the very large buyout funds have not arrived in the region, even some that had predicted this would happen. The reason, he believes, is that there are just not enough big deals to make it worth their while.

“Most deals are in the mid-market that we focus on, which covers equity investment of €30m–€40m,” he says.

In terms of the CEE countries attracting most interest, the two largest economies, Poland and Romania, are the main focus. Knaflewski says the core CEE region has a total population of around 100m, but that Poland makes up 38m.

“The region’s economy is skewed towards Poland, which has the biggest population and the biggest companies, and has accounted for around 40% of all private equity investment,” he says.

However, Romania with some 22m people, is increasingly attracting interest from houses keen to generate high returns and that believe it is now harder to find attractive deals in more established markets such as Poland.

In terms of sectors that are attracting interest, the trend for telecoms deals is largely over, says Cominos.

“They were the big buyouts two or three years ago, but they have largely come to an end,” he says. “Today, it is pharmaceuticals, and we’ve seen a couple of large pharma deals in Romania, followed by construction materials, because of the real estate activity.”

Cominos says that consumer finance, healthcare and IT are also popular sectors for investment.

Recent exits have included Argus’s sale of Czech printing company Svoboda Press to a trade buyer, Mid Europa Partners’ disposal of two Czech cable companies to Liberty Global and Enterprise Investors’ flotation in Warsaw of IT distributor AB and Skarbiec Asset Management.

Real estate is another area that is attracting investment. In June, private equity real estate developer Macquarie Global Property Advisors (MGPA) and London & Regional Properties acquired Rondo 1, a prime office building in Warsaw.

MGPA is also expected to announce this week a major residential development in Warsaw, with a targeted annual IRR of 30%. The high return is a reflection of the risk of property development.

Managing director Alex Jeffrey says MGPA is particularly interested in the more developed markets of the CEE, such as Poland, Hungary and the Czech Republic.

“Those countries have stable growth and an attractive risk-return balance,” he says. Demand for residential housing in Warsaw, he adds, is expected to remain high thanks to a lack of good quality accommodation built in Communist times and the fact that an estimated 150,000 people a year are moving to Warsaw in search of jobs.

Because of increased competition, there is a premium on proprietary deals in the region.

“Entry level multiples for some deals have gone up so much that they are no longer attracting private equity interest, but only strategic buyers,” says Cominos.

“Because of this buyout houses are looking for primary exclusive deals, where you can still get good valuations,” he says. “There are quite a lot of these but they’re all in the mid-market.”

Knaflewski says there are still significant numbers of proprietary and semi-proprietary deals because many company owners do not use advisers when selling up, or use small boutique advisers rather than investment banks.

“Although the number of auctions is increasing, it’s still significantly lower than in Western Europe,” he says.

Knaflewski adds that sourcing these deals is down to building up a network within the business community.

“We’d like to replicate in other countries the sort of network we’ve developed in Poland, and we’ve started in Romania where we’ve made three investments and exited one,” he says.

But the fragmentary composition of the region, with lots of small countries speaking different languages, will continue to have an impact on activity, says Knaflewski.

“Many of the countries in the region are so small it’s not worth having a permanent team there because they wouldn’t be occupied for most of the time,” he says. “On the other hand, not having people there means you don’t hear about deals so easily. It does mean investments in some of these countries are done on rather an unsystematic basis.”