Central & Eastern Europe: a market in transition

Greater harmonisation of Central and Eastern Europe’s fiscal, legal and regulatory systems with those of the EU is expected to spark a new wave of inward investment and increased trade attracted by the region’s high growth, low costs and under-developed private sector. So, Angela Sormani asks, ‘what will May 1, 2004 mean for private equity investors and businesses across Central and Eastern Europe?’

There has been a steady trickle of LBOs in the region over the last 10 years but an insufficient number to attract many specialist LBO lenders. With the first wave of accession countries about to join the EU, this looks set to change. Currently, one of the differentiators in terms of doing deals in Central Europe is a lower level of sophistication of the private equity and venture capital industry and a slower take-up of new trends and instruments, compared to Western Europe. There is a relative shortage of indigenous investors in private equity funds and CEOs can be suspicious about the motives of financial investors. Main obstacles for investment in the acceding countries remain lengthy bankruptcy and insolvency regulations, coupled with high taxation.

But a growing availability of bank debt and an increasing sophistication in debt structures has been a key driver in pushing the region’s fledgling private equity market forward in recent years. Chris Buckle of Erste Bank, which has been an active lender in the region since 1997, says: “We are now seeing an increased interest in LBOs and are seeing better quality and larger size deal flow. Transactions in the Central European market may now approach €200m deal size. We expect the LBO market to continue to grow, albeit at a relatively slow pace. There is no reason why these markets should not be significantly more active than the German market, which has continued to disappoint reaching nowhere near the levels seen in the UK or France.”

To leverage or not?

There is a perception that lack of debt in Central and Eastern Europe has held back the evolution of the LBO market, but some do not believe this is true. “The debt is available for the right transactions. However, the transactions have not been suitable for leverage,” says Buckle. The majority of transactions in the region have been value rather than cash-flow driven. Many deals have been turnarounds with a high-risk profile or rapid growth businesses where all the cash flow is required to finance expansion. Other factors Buckle cites, which may have held back the market, are: a relatively expensive debt market (borrowing rates in Hungarian and Polish local currencies have been particularly costly); legal restrictions, such as financial assistance laws; and the disruptive power of deliberately obstructive minority shareholders. The main hindrance, he believes, is a lack of experience of local banks and other professionals in completing such transactions in a timely manner. Things are changing though. Today the majority of the banks are foreign-owned and have the capacity and skills to structure LBOs. Not only that, but there is an increasing willingness among banks in the region to entertain this type of transaction.

Gyuri Karady, managing partner at Baring Private Equity Partners Central Europe, says: “Leveraged buyouts in Central Europe are handicapped because the region is geared towards growth companies. What is holding back LBOs is not the lack of availability of debt, it’s a lack of suitable acquisition targets for leveraging. It’s all to do with growth. When you’re in a growth environment you need the cash flow to re-invest in that business and so your debt capacity is finite. If you don’t have to make new investments, it is easier to borrow. People forget that in Central Europe you operate in an environment where you need to keep up with the market. It is a growth market and that limits your ability to borrow.”

Most investors in the region go to banks for debt financing to facilitate expansion. So most leveraged buyouts in the region are not LBOs in the classic sense of buying debt to finance the company. The investor normally buys the company and then takes on debt to make acquisitions. Robert Conn of Innova Capital illustrates the methodology behind buyouts in the region. “In many cases investors have found a way to make the deal not quite a classic buyout situation. For example, they may have acquired all the equity at the buyout stage and then debt has been used for expansion or acquisitions. There are fewer pure buyouts than you think in the region. Players are now developing a lending class based on a model in the West that hasn’t existed in Central and Eastern Europe so far.”

Karady says: “Leveraged finance only really works if you know you have enough headroom for further borrowing and you plan your capital expenditure projects a couple of years ahead.” Using leverage is nothing new in the region; what has changed it that the Western buyout model is becoming popular, whereas before you would only borrow to make an acquisition to accommodate growth.

Karady compares two high profile deals in the region. In Advent International’s buyout of Danubius, the Hungarian commercial radio station, the debt was taken on upfront at the time of the acquisition as in a typical leveraged buyout situation. In Baring’s acquisition of Polish commercial printer Polygrafia the investors took on debt and lease financing to expand the business and buy further equipment. Over the last four years Poligrafia has made extensive investment in new plants and equipment, increasing turnover by over 211%. Baring chose to use the debt instrument in this way because local banks were more comfortable lending in that scenario. In the more classic LBO scenario the debt would be used to partly acquire the business. Karady says: “Using leverage to increase returns on equity we’ve been doing for many years. Every time you borrow to buy a new piece of equipment you are leveraging the returns of your equity. In both cases the debt/equity ratio can turn out to be the same. It’s just how you got there that’s different. You can end up in the same situation, but following different paths.”

Chris Mruck of Advent International stresses the importance of a reliable legal and regulatory framework for LBO transactions. Like Baring, Advent has traditionally done what Mruck describes as ‘growth buyouts’, companies that are growing and use cash flow to develop themselves and the surplus cash to pay down debt. These are not traditional buyouts, which use all surplus cash flow to pay down debt.

“The use of leverage requires the right sort of legislation to be in place. Whitewash procedures, for example, are insufficiently developed in CEE law making it hard for lawyers to give the clean opinion essential for lending banks. In general, one can say that the structuring side of a leveraged deal is much more complex and you need to choose lawyers with the right mix of legal and problem-solving skills. There is a safety-net for managers being in a purely equity-backed company. Once banks are involved, there’s a third person at the table and managers have to be far more focused on the relationship with banks and not breaking their covenants,” says Mruck.

These are issues that will be solved with time. Accession will require new member states to amend their legal and tax frameworks to achieve greater harmonisation with existing EU members. The adoption of the acquis communautaire, the EU’s body of regulations, often considered to be excessively bureaucratic in Western Europe, is expected to generate more benefits than disadvantages and will serve to boost international investor confidence in the region’s treatment of regulatory requirements. This will create a reduced level of risk in investing in the region, which in turn is hoped will attract more experienced lenders to the market.

LBOs are still complicated and many players are struggling to get to grips with complex structures, simply because there are few and sometimes no previous examples to go by. It can take over a year to negotiate a debt package for an MBO. “Local laws have been unhelpful in the past but over recent years they have been harmonized with EU laws, so in theory they should now be equivalent,” says Mruck. Four main problems remain.

First, the sheer pace of change in the laws is difficult to keep up with and so local legal knowledge is essential. Second, how the laws will be interpreted in the highly unpredictable and inefficient judicial system is a major issue. Third, the bureaucracy in government institutions such as anti-monopoly offices, commercial registers and property registers can cause transaction delays, uncertainties and increased costs. Fourth, is the inadequacy of bankruptcy legislation, which can lead to increased risks for lenders. “Legal issues can be frustrating and can lead to extended transaction times and increased costs. However, they should not prevent transactions from completing providing experienced advisors and financing parties are involved,” says Mruck.

Financial assistance

There are ongoing issues in the region regarding financial assistance. In the Czech Republic, for example, the law prohibits a company from granting advance payments, loans or credits or from securing loans or other obligations relating to the acquisition of its shares – see evcj April 2003, page 52. This prohibition is relevant in a leveraged buyout transaction, both when looking at ways of using the target’s income and cash resource to service the newco’s debt obligations and when devising the security package. And so in the Czech Republic there is a reliance on the merger model to cope with financial assistance prohibition.

Once a legal merger has been registered, the target’s assets and income become the newco’s assets and income by operation of law. At this point it may be possible to extend security to cover the target’s assets and to use the target’s income streams without falling foul of the prohibition on the giving of financial assistance. But use of this structure may depend on whether the parties are able to show there was a purpose behind the merger other than circumvention of financial assistance regulations.

Consequently, any provider of debt finance in a leveraged buyout will have concerns as to how the merger is structured and in particular the impact on any security structures in place. It is obviously important to ensure that any acquisition facility allows a merger to take place following completion of the acquisition target, and it is in the debt provider’s interest to see a merger take place as it will improve cash flows within the group.

Robert Conn of Innova Capital says: “If you do a buyout you leverage the target company in order to buy its own shares. That, in theory, is in contravention to legal regulations. In the West precedents have been established as to how a buyout can be achieved in practice. The problem in Central Europe is that there is no precedent. We are, therefore, still grappling with the financial assistance regulations.”

Chris Buckle agrees: “The rules on financial assistance are tough, particularly in the Czech Republic; you don’t have the simple whitewash procedures you have in the UK. But there are ways to avoid the restrictions and still provide leverage. The legal system here is not as sophisticated as in Western Europe, but it is migrating towards that. This may add to transaction length and deal cost. There are issues with government-controlled institutions, in particular with the commercial register and mortgage register, which are slow and bureaucratic. This adds complications to transactions, but again it doesn’t stop transactions taking place and it doesn’t stop the banks providing leverage.”

Tax treatments

Tax treatment of LBOs is another reason players remain cautious. In Poland, for example, tax treatment is not as favourable as in the UK. Charles Waddell of law firm CMS Cameron McKenna says: “The region doesn’t cope so well with the multi-tiered structures you might find in the UK. It’s a case of the willingness of the banks to understand the structure. But if the business case is right, you can do it.”

Creating a tax group for group relief purposes is theoretically possible, but it is almost impossible to achieve in practice due to the various criteria, which must be met. One of the most problematic requirements is that the tax group must be profitable and the profit must equal at least 3% of the tax group’s income. Failure to satisfy this profits test results in the tax group loosing its tax group status.

In addition, says Waddell, the interest payable by the SPV to the bank on the loan to finance the acquisition of the target is, in practice, not tax deductible because the SPV does not have any taxable income against which the interest payments can be set. Plus, the SPV cannot surrender its tax loss on the interest payments to the target company.


While it is still too early to judge the region on performance with a limited number of exits, specialisation has started with the appearance of buyout- and sector-specific funds and the region’s first dedicated mezzanine fund from Mezzanine Management.

Although there are no current figures on the amount of debt financing available, there is growing interest in the region as a whole. What is interesting is how the region is being tiered. Five years ago a bank would have viewed Central and Eastern Europe as a single region, but today investors expect higher returns from so-called emerging markets such as Russia and the Ukraine, as they are seen as higher risk than the likes of accession countries such as Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia, all of which are set to join the EU in May.

Bank of Austria, Citibank, Erste Bank and Standard Bank are well-respected, active banks in the region, but banks which have no knowledge of Central Europe, even though they may know the LBO market very well, may it find it a tough market to penetrate. Nevertheless, a gradual evolution is taking place. Mezzanine Management’s fund Accession Mezzanine Capital (AMC), the first mezzanine vehicle dedicated to the region, is proof of this.

Anthony Saint of Standard Bank cites a certain reticence in the region regarding mezzanine. “Up to now very few mezzanine deals have been done. One of the reasons is that doing these deals in the region has been complex enough within relatively untested legal and regulatory frameworks, and tranching the financing complicates matters without necessarily making the deal more bankable.” The most common use of mezzanine in the region to date has been as a tool for senior debt providers to increase returns and push out maturities by including a longer dated mezzanine tranche in the mix of financing they provide. Senior debt providers in the region do not generally sell these tranches down to third parties, so there is little scope for conflicts between senior debt holders and mezzanine investors.

Saint adds: “There are a lot of hoops to be gone through in putting these deals together, and adding a mezzanine tranche just adds a few more. As it becomes easier to jump through those hoops, we will definitely see more mezzanine financing.”

Mezzanine Management has carved itself a niche in a region, given that there are few banks willing or able to fill this acquisition finance gap. Accession Mezzanine Capital is a €115m fund, which closed last year and provides mezzanine finance to middle market enterprises in Poland, Hungary, the Czech Republic, as well as the Slovak Republic and Slovenia. The fund can also invest selectively in the second wave accession EU candidate countries of Bulgaria, Croatia and Romania. Investors in the fund asked specifically for the fund to exclude the former Soviet Union countries such as Estonia, Latvia and Lithuania. Next time around AMC expects to have a carve-out for the former Soviet Union that would include Russia.

Mezzanine Management attracted commitments from 13 institutional investors from seven countries, with investors based in Austria comprising around 36% of total commitments. An innovative feature of the fund raising involved the issuance of principal-guaranteed performance-linked bonds, purchased primarily by family-offices and high net worth individuals.

Christian Marriott, investor relations at Mezzanine Management, said: “We did a lot of due diligence on the legal and regulatory regime in the region. Investors like to have confidence in that side of things when investing in a fund. The legal and regulatory environment in the region is actually pretty solid. Some of the protections for mezzanine in Poland are actually better than Germany or Austria. The tough job is convincing investors of this.”

Average investment size is between €5m and €15m in deals with transaction values of between €25m and €200m. The fund’s mezzanine investments are typically structured as subordinated loans with warrants to the equity of the investee company, although AMC may invest equity alongside its mezzanine loans in certain situations. The fund has already made its first investment in the region, providing mezzanine finance for Advent International’s €30m buyout of Hungarian commercial radio station Danubius from GWR Group.

Franz Hoerhager, managing director of Mezzanine Management Central Europe, says: “The introduction of mezzanine to the market will expand the debt capacity of the deals. Another difficulty in Central Europe is the tenure of the loan. Those with long maturities need another pocket of finance. And so the demand for mezzanine is significant, in particular when you have a seven to eight year loan.”

Until now in Central Europe the private equity returns have not been as exciting as Western Europe. The reason for this is the deals have hardly been leveraged. If you strip the leverage out of European buyouts the returns are not going to be as impressive because you are not going to have the financial firepower to achieve aggressive growth. Hoerhager says: “Now private equity players are beginning to get excited that they can put an instrument such as mezzanine into a deal, which offers a higher return, but is less risk than equity. The challenge is to convince financial sponsors that mezzanine works entirely in their favour.”

Kurt Geiger of the European Bank for Reconstruction and Development (EBRD), a major investor in the region and in AMC’s fund, says: “Instruments such as mezzanine are a very welcome tool to the region because local banks aren’t ready to finance with instruments like this and so you really need the experts.” The EBRD has committed over €20bn to over 800 large projects in Central and Eastern Europe and the CIS and has helped finance around 200,000 smaller projects, through loan and equity finance, guarantees, leasing facilities and trade finance.

But for those countries about to enter the EU, the EBRD’s job is done. Tim Green of GMT Communications Partners, which last year joined forces with AIG Emerging Europe Infrastructure Fund to acquire the Hungarian fixed line telecommunications operator Vivendi Telecom Hungary for €325m, says: “It is an interesting scenario because the markets they are set up to serve are ceasing to exist. The emerging markets they are targeting will enter the EU on 1st May and so their potential marketplace is shrinking. It will be interesting to see where they will aim their money in the future.”

Franz Hoerhager adds: “To a certain extent their job is done for the accession countries, but they are a major investor in Mezzanine Management’s fund. The case they used is that they liked the fact Mezzanine Management is introducing a new financial instrument and is adding another dimension to financial structures in the region.”

How EU accession will affect the Central and Eastern European LBO market remains to be seen. In economic terms there are likely to be few dramatic changes as the accession countries are already closely harmonised with the EU. But the process of completing deals in these countries will remain long and arduous relative to Western Europe and time will continue to be spent educating vendors about private equity. There also remains a pricing premium for doing business in Central Europe as it is still a new market and therefore viewed as higher risk. Accession will, however, encourage larger international private equity funds to look at the region and the Central and Eastern European economies are forecast to grow faster than Western Europe, which will also be attractive to lenders.