CEE the future of Europe

The announcement by Mid Europa Partners last month [23 oct] that it had successfully closed its third fund, with capital commitments of €1.5bn, was a clear vote of confidence by investors in buyout prospects for the CEE region. The Mid Europa fund, which was launched in May 2007, aims to take controlling stakes in leading Central European companies with high barriers to entry. Typical investments will be €50m-€200m in cash-generative companies with enterprise values of up to €1bn.

“This is two-and-a-half times bigger than our previous fund, which closed in May 2005, and reflects the increase in opportunities in the CEE,” says Mid Europa director Zbigniew Rekusz. He says that the growing interest by buyout houses in CEE is not necessarily linked to the credit crunch. “We’ve seen growing attention from PE houses in the last couple of years, although it is possible the credit squeeze is adding to the reasons why people are looking at the region.”

Other fundraising in the region has included Greece-based Global Finance, which has opened offices in Bucharest and Sofia, raising €350m in July for its South Eastern Europe Fund and Romania-based Copernicus Capital aiming to raise €300m. Advent International is believed to be raising around €750m for its next fund.

The heightened interest in the region in recent times is also reflected in office openings. Bridgepoint opened a regional office in Warsaw earlier this year, while in August Carlyle announced it had hired a partner from CEE house Enterprise Investors to head up its new office in Warsaw. Scandinavian house EQT is also planning to open in the region next year.

Carlyle’s CEE team will make growth capital and buy-out investments in companies, the house said. The team’s investment remit will focus on the core CEE countries such as Poland, the Czech Republic, Hungary, Slovakia, Romania, Bulgaria, Slovenia, and the Baltic States. But it will also consider countries that have not yet joined the European Union, such as Croatia, Serbia and Ukraine.

Franz Hoerhager, executive director at Vienna-based Mezzanine Management, says he welcomes this competition among private equity houses in the region: “It’s a catalyst for mezzanine because the more competition there is the more pressure on multiples and valuations, which means the probability of more leverage.

“Since the summer we’ve seen much better conditions for mezzanine as the banks are not as eager to provide debt as they used to be and the risk-return ratio has swung back in mezzanine’s favour.”

But whether the CEE region will be able to soak up all the new funds raised remains to be seen. Stanislaw Knaflewski, a partner at Enterprise Investors, says: “A lot of people seem willing to put money to work in the region currently and that’s in large part based on the excellent record achieved by houses such as Enterprise Investors and Mid Europa. But there is now a different dynamic, with increased competition, and if these houses are expecting to make the kind of returns we made in recent years they may be disappointed.”

But he adds that in certain CEE markets where economic growth and dynamism continue to be very healthy, such as Poland and Romania, there is a good chance that the right investments will reap impressive rewards.

Advent International is one of the pioneers in the CEE private equity market. Joanna James, who heads the firm’s Central European operations, believes that the credit issues in Western Europe are impacting less on CEE. One reason, she says, is that credit terms never reached the same dizzy heights in Central Europe and so the market avoided the need for cov-lite terms, PIK toggle notes and other such products.

“Although we did see covenants become quite limited and were being offered pretty attractive debt packages,” says James. She adds that since the credit crunch the CEE market has gone back to the terms it was seeing at the start of the year, which were already “pretty good”.

Another factor that has helped the CEE region, says James, is that most of the banks specialising in providing finance have not been affected by the subprime fallout, with the possible exception of Citibank. “Debt providers such as Bank Austria have not been exposed to the kinds of syndication problems many banks in the West have,” she says.

The only transaction in the region that may be affected by the global syndication problems is the acquisition in May by AIG’s investment arm of Bulgarian telecoms operator BTC. The €1.04bn deal was Bulgaria’s largest private acquisition but, given the timing, it is possible that some of the banks underwriting the transaction may have been left with unsyndicated debt.

With the mega deals market effectively closed, the CEE seems to be attracting some of the big buyout funds. Blackstone, for example, announced in September that it was investing US$178m to take a 51% stake in Latvian telecoms group Lattelecom. The only reason a fund the size of Blackstone would be considering such a small investment is because there are not enough opportunities in its usual investment bracket, believes James: “We’ll probably see other large funds doing smaller deals in the CEE and elsewhere because they have to deploy their funds somewhere. But we’ll have to wait and see if this is a temporary situation.”

Nonetheless, although debt financing has not been dramatically affected in the CEE, it can still be a challenge. In the Lattelecom deal, for instance, the company’s chief executive said that agreeing terms with debt-providing banks had been harder than expected because of the global market turbulence and concerns over Latvia’s overheating economy. Lattelecom eventually chose Unicredit, Nordea Bank, Parex Bank and DnB Nor to raise around US$400m in Euro and Latvian currency debt.

But Mid Europa’s Rekusz says that, generally, in the CEE mid-market arranging debt is not a major problem. Mid Europa has closed several deals in recent months, he says: “In our niche, where we’re seeking debt of €150m-€250m, or perhaps €300m, we’re not experiencing problems.”

Among the sectors in the CEE that Rekusz flags up is healthcare. Mid Europa has acquired two Polish healthcare companies since July and it aims to combine the operations of Medycyna Rodzinna, the sixth-largest private healthcare provider in Poland, with those of LUX-MED, the second-largest.

One of the main differences between buyout opportunities in the CEE and Western Europe is the fact that, thanks to fast CEE economic growth rates, returns are not so tied to leverage. Average growth rates in the region top 5% and growth in consumer spending has been much higher. Levels of personal debt remain low, but are expected to increase substantially and that will continue to fuel GDP growth.

“Buyouts in Western Europe have been more about leverage, whereas in Central Europe it’s about growth,” says Joanna James: “We’ve done some deals where there is no debt at all and we still expect to make 4 x money because of top line growth.”

Grey Box – Ukraine

With more than 45m people, Ukraine is the largest country in the CEE, if one excludes the European part of Russia. This size, combined with its fast-growing economy and latent consumer demand, is attracting increasing attention from private equity players.

In September Advent International opened an office in Kiev, aiming to replicate its “first mover” success in other parts of the CEE. “We’ve always been a pioneer, from when we went into Romania in 1998 when there was triple-digit inflation to entering Turkey in 2001 at the time of the currency crisis,” says Advent’s Joanna James.

While Ukraine has a large population and dynamic economy, she acknowledges that it is also a “messy” market, but says Advent is used to operating in such an environment. “For example, company accounts are generally not put together well, but that was the case a decade ago in Poland but if you go there now they’ve been transformed,” she says.

But investors need to accept that Ukraine still has a long way to go to create a stable and credible political and institutional environment. However, large strides have been made since the “orange revolution” three years ago in which reform-minded Viktor Yuschenko was elected president. Last year GDP growth was around 7% and similar growth is expected for 2007.

Thomas Fiala, managing director of Kiev-based investment company Dragon Capital, says: “In the past three years Ukraine has made large strides in economic growth, a decline in sovereign risk and increased transparency among companies.” He adds that the first private equity deals were difficult and time consuming to do, but that Ukraine is gradually developing a track record.

He flags up changes in the banking system as particularly important, with foreign ownership of banking assets up from 9% three years ago to about 40% today: “That’s good for the economy because it encourages better corporate governance among domestic businesses.”

The Kiev stock market has also developed dramatically, he says, with a market capitalisation up from US$8bn at the end of 2004 to US$102bn today: “The stock market is second only to Poland in the CEE, and we had around 30 IPOs last year.”

But significant challenges remain, with Ukraine’s annual GDP per capita about a quarter that of Poland and widely diverging incomes between the wealthy and the mass of the population. For private equity investors there are particular problems concerning corruption, bureaucracy and a weak judicial system.

While there have not yet been any traditional-style LBO’s done in the country, there have been some private equity deals involving debt, although generally quite small. Apart from Advent there are not really any international private equity houses with a local presence. There are a number of local investment funds owned by Ukrainian tycoons, as well as some funds that have been developed with funding from multi-lateral agencies, such as the EBRD