“Accession countries are moving away from the other countries. Five years ago it was pretty unclear who was going to progress and who was not,” says Joanna James, managing director based in London in charge of Advent International’s Central European investment activities. This sentiment is borne out in the way that private equity investors are targeting the region. Gyuri Karady, senior partner leading Baring Private Equity Partners’ efforts in the region, notes: “Country funds are disappearing and sub regional ones are springing up.” Both Advent International and Baring Private Equity Partners have been investing in the region for a number of years and have never operated single country funds.
The sub regional focus, which seems to be broadly centred on those countries likely to achieve accession to the European Union within the next two or three years, is an important one. This is because for investment opportunities to become completed transactions stability and predictability of the domestic economy and its infrastructure is required and those elements are often lacking outside the accession countries. The situation within the accession countries is not perfect, however.
Economic and infrastructure stability as benchmarked by Western European standards is a process that has gathered momentum among the accession countries in the last couple of years. In Poland, for example, some 200 new laws were passed last year to further bring it in line with European Union law. This proactive and time consuming process has been necessary because Central European countries tend to operate under the rule of law i.e. if something is not specifically allowed, you cannot do it. As opposed to Anglo-Saxon law, which takes the view that what’s not illegal is possible and consequently financial and regulatory law can be a mixture of the reactive and retroactive.
As changes to the financial and regulatory law in Central European countries take hold experienced private equity players are in a good position. “You are in a European risk environment where you can pioneer these tried and tested techniques. Steadily every feature and every lending structure makes its way to central Europe,” says Karady.
There hasn’t been an explosion of new players into the market at the development capital and buyout end of the spectrum, although the same is not true of early stage venture investors. Central Europe suffered the same dot.com mania as the rest of the world. Mezzanine Management, in the old economy space, is a new player in the sense that it has recruited a new team led by Franz Hoerhagar, which will invest Mezzanine Accession Capital, a e150 million fund that is in the process of being raised.
Hoerhagar, who used to run Bank Austria’s European business operations before joining Mezzanine Management, is still based in Vienna from where he co-ordinates the Warsaw and Budapest offices. Mezzanine Management is a mezzanine/ equity player and will be applying the same investment criteria as it has done in Western Europe and the US to predominantly old economy companies in Central Europe, specifically in the Czech Republic, Hungary, Poland, Slovakia and Slovenia.
Hoerhagar says the deal pipeline is already full and that he expects to do about two-thirds of the fund’s investing in Poland, one quarter in Hungary and the remainder split between the Czech Republic, Slovakia and Slovenia. This is in line with comments from a number of investors, not surprising given that the population in Poland is over 40 million, Hungary 12 million, Czech Republic 10 million, Slovakia 6 million and Slovenia 2 million.
While Hoerhagar’s pipeline is full, the team won’t be in a position to complete any deals until the autumn when the first closing on the fund is expected. Hoerhagar cites private equity firms, lawyers, auditors and banks as deal sources. The latter has a particular significance in Central Europe. The reason for this dates back to the early 1990s in the post-Communism liberalisation era when banks in the region were lending money like it was going out of fashion. There appeared to be little credit control and eventually as defaults rose the domestic governments had to step in.
Privatisations followed in what in many cases amounted to a bargain basement sale to some Western banks, which were selective about what assets they would and wouldn’t accept on the balance sheet. What they wouldn’t take in the case of the Czech Republic, for example, got left in a State restructuring agency/ workout bank, which had some significant equity stakes in companies that had been unable to repay their loans. As Christian Mruck, a director in Advent International’s Central Europe team, notes: “The countries with more sophisticated banks had most problems because their habits were more deeply engrained.”
So, on the one hand, the equity positions that a number of banks in the region hold in companies that they would rather off-load provide a source of deals for private equity investors. On the other the fact that, generally, it is now hard for banks in this region to lend money on an unsecured basis those banks are passing on opportunities to lend to promising companies that require unsecured funds to private equity investors.
While the precarious state of the domestic bank market might on the one hand prove a good source of development capital deals, on the other it is severely hampering the development of a buyout market in the region because the banks are unable to provide the leverage necessary to get buyouts done.
For the time being there are just a handful of players actively seeking to provide leverage for buyouts. One is Erste Bank, which has a four-strong specialist leveraged finance team based in Prague. The team, which also has members based in London, invests off the bank’s balance sheet and has been largely providing debt and structured debt, and sometimes equity, for the last two to three years. Its primary markets are the Czech Republic and Slovakia and to a lesser extent Hungary and Poland. In terms of its competition Chris Buckle, who runs Erste Bank’s Prague-based team, notes: “Local banks are nervous of leveraged transactions and foreign banks can still view this as a high risk region.”
Buckle’s team will consider taking a small equity sweetener if the risk profile of the deal warrants it, but often this is compensated for by the fee structure on the deal. These higher priced tranches are not mezzanine as such since, as Prague-based Buckle points out: “Legal structures here often don’t make it easy to have intercreditor agreements.” However, he goes on to say that it is hard to generalise about such issues across the region as a whole and consequently each deal raises its own issues. Buckle is confident that Erste Bank is seeing all the deals in the Czech Republic and Slovakia where its profile is strongest, but he says: “There is a limited number of deals to start with and of those there is a limited number that justify high levels of leverage.” He does note, however, that the market for these types of deals is growing.
Jacek Siwicki at Prague-based Enterprise Investors says of the general reticence towards leveraged transactions among the local bank market: “Banks here are used to lending against specific project financing.” For this reason Enterprise Investors had been forced in the past to invent some interesting structures in order to get its deals done. In 1997 when it bought 100 per cent of FOB (Fabryka Opakawari Blaszanych), the metal can manufacturer, from the Polish government it did so by buying FOB’s debt from its bankers and suppliers at a discount and then swapped the debt into equity. Erste Bank and Fortis supported the deal with a $10 million debt package although Enterprise Investors was forced to guarantee the loan because the leverage on the deal was so high. High inflation in many of Central and Eastern European countries means borrowing in the domestic currency is expensive. On the whole though the majority of investing in the region is being done on simple equity structures.
Central Europe is certainly a land of private equity opportunity but infrastructure issues will temper the resulting deal flow and as such it’s difficult to imagine that the flood gates holding back private equity investors are about to open. For one thing the majority of European and American private equity investors are fully occupied by their expansion activities in continental or northern Europe and for another it’s difficult to imagine that raising a fund to invest in the region would be easy.
The majority of limited partners have seen write downs on their investments in recent months and many will be unwilling to back Central Europe when the better understood economies of continental Europe offer plenty of opportunity. Given this backdrop new entrants are unlikely to get credible backing unless, at the very least, they have a considerable track record of investing elsewhere.
If getting into this market is a problem, exiting investments can be equally tricky. This restricts the number of viable investment opportunities since, as a rule of thumb, the investment will be sold to an international, rather than domestic, trade buyer. IPOs are not really a reliable option given the instability and/or illiquidity of many of the region’s stock markets. However, the Polish stock exchange may provide an exit for Poligrafia – see boxed item. Poland is unique in this sense. As George Swirski, director at Advent International, points out private pension funds in the country are creating domestic pools of money that have fund managers, and therefore shareholders, looking to maximise their returns. Given the five per cent limit on overseas stock holdings, as these cash pools grow they will act as a driver for the Warsaw stock exchange.
Poligrafia: case study of a buyout, divestment, PTP and spin off
Poligrafia SA was a company that was created by a Polish construction company in the early 1990s, when big Polish construction companies had plenty of cash. Exbud SA, Poligrafia’s parent, eventually came under shareholder pressure to divest its non-construction assets in the late 1990s.
At the time Exbud was preparing to divest itself of Poligrafia, Baring Private Equity Partners mounted a friendly offer in December 1999 for all of the shares of Poligrafia, which was 100 per cent listed on the Warsaw stock exchange. [Buyout/ PTP/ divestment] Eighty-five per cent of Poligrafia’s shares were tendered to Baring Private Equity Partners and the remaining 15 per cent of shareholders stayed put.
Following a request from the Polish regulator that Baring Private Equity Partners did but delist Poligrafia and that it should not take its holding to over 75 per cent, 10 per cent of the shares received from the tender offer were sold to Polish pension funds.
In spring of the following year Baring Private Equity Partners bought the Polish assets of a Swiss publishing group [spin off], which was financed by a bridge loan. When Poligrafia bought these assets it financed the purchase via a secondary offering on the Warsaw stock exchange in which it raised e8.5 million from private Polish pension funds.
It may be these same pension funds that provide Baring Private Equity Partners with a gradual exit route at a later date.