Eastern Evolution

In many ways, Central & Eastern Europe (CEE) offers a near-perfect environment for private equity firms at present. The region enjoys an average growth rate of double that in Western Europe, with some parts, such as the Baltics, growing at over 8% a year. A rapidly maturing corporate landscape is producing some highly attractive buyout candidates, while EU accession or the prospect of accession has ensured an adequate regulatory framework in which sponsors can operate.

As a result, the private equity market has been evolving swiftly towards US and Western Europe in the last few years. “The region’s buyout market is maturing rapidly, with plenty of attractive investment opportunities emerging now. With an average GDP rate of 5% pa – and some countries and sectors delivering considerably more – growth is significantly higher than in Western Europe,” says Joanna James, head of Advent International’s Central European team.

Against this favourable backdrop, both the number and volume of buyouts have ballooned this year, as the pace of investment has accelerated. “The market is picking up dynamically. Many more deals are emerging and they have grown significantly in size. We expect the average deal in our new fund could be 50% larger than in our last,” says Robert Manz, managing partner at Enterprise Investors and Chairman of EVCA‘s CEE Task Force.

According to Thomson Financial, there have been 21 buyouts in CEE this year, totalling US$2.3bn. This is significantly up from 2006’s full-year total of US$1.8bn from 57 deals and 2005’s US$1.3bn from 71 deals. “There has been a considerable leap in the amount of money private equity firms are investing in the region in the last few years and in the pace at which they are investing it. We have already invested about ¾ of our second fund (which closed in December 2005), having initially expected to take four years to do this,” says Thierry Baudon, managing partner of Mid Europa Partners (MEP).

Whereas in the 1990s, private equity investment activity was dominated by minority investing, some privatisations and the provision of growth capital for companies – many of which had difficulties attracting bank financing – Western-style buyouts started to take off after 2000. The market has dramatically accelerated since EU accession in 2004 and today, although growth capital is still important, LBOs dominate deal flow.

Venture capital remains a tiny fragment of overall investment in the region though. “Although interest in later stage companies is definitely increasing, there are still hardly any seed and start-up VC deals. Buyouts and expansion capital monopolise investment activity,” says Enterprise’s Manz. EVCA statistics show that in 2005, buyouts comprised 47.6% of total private equity investment in the region, versus 25.9% expansion capital and 1.8% start-up capital, with 0% invested in seed companies.

In fact, some statistics indicate that VC activity has even declined in the past two years. According to Thomson Financial, there have been just three VC deals in the region so far this year, totalling US$18m, compared to 2006’s 76 deals totalling US$234.4m and 2005’s 87 deals totalling US$536.9m – the all-time record in volume terms.

Meanwhile, although the bulk of buyouts are mid-market in size – between €100 to €200m in enterprise value – and while plenty of smaller, sub-€50m transactions are seen, in the last year some much larger deals have also appeared.

Heading the cast of landmark deals is the €1.08bn secondary buyout in May of a 65% stake in Bulgarian Telecommunications Company (BTC) by AIG Global Investment Group from Novator (Advent had initially acquired the stake for €280m in 2004, following a protracted two-year acquisition process). Other notable recent transactions include the 3i-backed MBO of Czech printer Euro-Druckservice AG in March, MEP’s €450m purchase of Baltic mobile operator Bité in January, the November circa €1.2bn purchase of 100% of Ceske Radiokomunikace and 39% of T-Mobile Czech Republic by a consortium including MEP and Permira’s circa €850m LBO of Hungarian chemicals firm BorsodChem in June 2006.

Rising valuations

As is the case throughout the industry, purchase prices for deals over €100m have leapt in the last 18 months. Indeed, while prices in the sub-€50m deal space inhabited by Innova Capital and Argus Capital Partners have not increased too much, one of the dominant themes in the last year has been the major re-pricing of more sizeable assets.

Purchase prices are being driven higher by both the extraordinary liquidity in the debt markets (see box) and by the region’s overall increased desirability to investors. Its new-found attractiveness post-EU membership and its high growth rates are generating great rivalry among sponsors for assets. “Competition has grown, particularly for deals over €100m. The region is attracting increasing attention from the pan-European funds,” says Enterprises’ Manz.

Competitive pressures are being further exacerbated by the increasing propensity to auction deals over about €150m via London-based investment banks. In some cases, up to 30 sponsors are invited to bid, creating substantial price inflation. “Purchase prices have visibly increased in the last 18 months. Back in 2005-06, deals were still sold at a notable discount to Western Europe. That discount has not only disappeared, but some prices even exceed those in the West now,” says Manz.

The rise in competition is exemplified by the fact that two high-profile players have entered the mid-market this year, setting up dedicated Eastern European teams. In February, Bridgepoint announced its entry into Eastern Europe by opening a regional office in Warsaw, poaching Advent’s Polish operations head, Khai Tan to lead the initiative.

3i has also created a new CEE team, headed by Stuart McMinnies. It too is making regional hires, poaching Zoltan Toth from Advent in Budapest and hiring a Polish national in Warsaw. 3i will invest from its new €5bn pan-European fund, with plans to invest at least 10% of this in CEE over the next three years. “We decided to enter the market now because deal flow in the €100m to €1bn bracket is really picking up, growth is attractive compared to Western Europe and competition for assets, whilst still strong, is slightly less intense,” says McMinnies.

To date, Bridgepoint and 3i are the only new entrants that are building a proper business, rather than just flying in and out when an attractive deal surfaces, as most pan-European sponsors still appear happy to do. Yet as the market grows over the next few years, other sponsors will follow, both to profit from the region’s economic growth and because they will find it harder to repeat past returns in Western Europe. Rumours are already afoot that at least one first-time dedicated regional fund could be launched later this year by a pan-European sponsor.

Any further entrants are again predicted to be mid-market though. Most deals in the region are still too small for the larger international firms to invest resources and infrastructure, given the vast funds they have recently raised. The trend for auctioning larger deals from London means these sponsors can still dabble in the region when suitable assets emerge, without actually setting up shop there.

Since many international sponsors have actually gone further away from their space after raising such large funds, the established regional players remain relatively sanguine about the increase in competition in their market. “Competition is on the rise, but not as much as we feared three years ago, when we thought EU accession would attract a great flood of large Western European private equity houses,” says MEP’s Baudon.

Also, proprietary deals still account for much of the established players’ business and prices here have not risen that much. “Two thirds of our deals are not auctioned and prices have not risen too much in the non-auctioned space. Plus, you not only need to be on the ground here to source proprietary deals, but you also need in-depth local knowledge and experience. So although prices have risen for auctioned assets, we are not excessively worried about increased competition in this fast growing market,” says MEP’s Baudon.

Return expectations

Many market specialists are equally optimistic about returns, which they expect to match or even exceed those in Western Europe. This is despite the fact that some statistics show CEE returns have tended to be lower historically than in Western Europe. Although admitting a higher rate of casualties in the region, some players argue that this is also because previous deals were mainly expansion capital, rather than buyouts and that, when comparing like with like, CEE returns have in fact been superior. “When you compare historical Western European mid-market returns with a comparable sample of Central & Eastern European deals, rather than including small expansion capital deals too, you see that premium returns have been delivered,” says MEP’s Baudon.

Many players expect returns to match or exceed Western Europe’s – even if all returns fall due to rising enterprise valuations and interest rates and the unclear global economic outlook – because while leverage is lower, CEE growth is so much higher.

In Western Europe, financial engineering is often a major driver of returns, but CEE returns still rely mainly on increasing growth in portfolio companies. “Today’s higher leverage levels will help boost returns, but the principal driver of returns will be increased profitability in portfolio companies. Top-line growth expectations are far beyond those in Western Europe – and in some sectors can be as high as 30% per year,” says Advent’s James.

This lack of reliance on leverage means that, even if returns fall in the event of a downturn, they could still exceed those in Western Europe. “Our region will continue to deliver premium returns over Western Europe. If there is a downturn, Western Europe will be hit far harder, as deals there rely more on leverage, so the impact when the debt markets go sour will be immediate. Not only does debt play less of a role in value creation, but we also benefit from significant top-line growth and margin expansion in our companies. This and the amount of foreign direct investment flowing into our region means we will be more buffered against a downturn,” says MEP’s Baudon.

Returns will be further boosted by the improving exit environment. Many more exit opportunities are available to sponsors now, with recent successes including Advent’s sale of BTC and MEP’s €470m sale of Invitel, Hungary’s second largest fixed line operator in April.

Secondary buyouts – unknown in the region two years ago – have taken off, while trade sales, which form the bulk of exits, are no longer limited to mainly European companies. More and more Asian, Middle Eastern and US corporates are looking to invest in CEE, as illustrated by Advent’s US$324m sale of Romanian pharmaceuticals manufacturer Terapia (which it bought for US$49.5m in 2003) to Indian generics group Ranbaxy last March.

IPOs remain limited mainly to the Warsaw stock exchange, however. Most other exchanges are still too small, with the 2004 flotation of the Warburg Pincus-owned drug company Zentiva in Prague a notable exception. “IPOs are improving – in 2005 the percentage of IPO exits was higher than in Western Europe. To date, almost 50% of Enterprise Investor’s exit proceeds have been generated through public market sales. But IPOs are still mostly limited to Poland and trade sales continue to dominate for most market players,” says Enterprise’s Manz.

Fund raising frenzy

With significant growth rates, EU membership, successful realisations, good return expectations and the overall increase in institutional investors’ allocation to private equity, the fund raising climate has been extremely positive in the last two years. More LPs wish to support funds targeting the region, both for diversification and to fill their larger allocations to the asset class.

As a result, many players have raised much larger funds than ever before. “Fund raising has been extremely strong in the last 18 months. The region is no longer regarded as high-risk and there is strong appetite among international investors, which is a big change from a few years ago. Our September 2006 fund was 2x oversubscribed and closed in three months at €658m – more than double our 2004 fund,” says Enterprise’s Manz.

According to Private Equity Intelligence, this year US$10.6bn has already been raised by seven firms with CEE as their target region (these figures exclude the increased capital in pan-European funds now allocated to CEE). This already exceeds the US$9.5bn raised in all of 2006 and is significantly higher than 2005’s US$7bn, 2004’s US$2.4bn and 2003’s US$800m. A further 47 funds are currently in the market, looking to raise US$17bn. Argus Capital Partners, Innova Capital, Enterprise Investors, Balkan Accession Management Co and Alpha Associates (first close on its second fund) have all successfully raised funds recently.

The LP base still almost entirely comprises international institutions, however, with hardly any indigenous investors. “65% of our new fund comprises Western European investors, with the rest coming from the US. Local institutions are still not investing in private equity, even though there are some potential big investors. Polish pension funds have over €30bn of assets under management now,” says Enterprise’s Manz.

Not only are many local investors still focused on their equity and fixed income portfolios, which have delivered excellent returns, but also, regulatory barriers in countries such as Poland make it hard for pension funds to invest in LP vehicles.

Despite expectations that pension reform in Poland, the Czech Republic and Slovakia would trigger significant inflows into alternative assets, some governments have instead tried to channel domestic savings into government bonds. “Many countries still run sizeable budget deficits and governments have done all they can to direct domestic private savings to government paper. Some have created disincentives and regulatory hurdles to investing in alternative assets – Polish pension funds cannot invest outside Poland and have difficulty investing outside fixed income and the local stock exchange,” says MEP’s Baudon.

While this has delayed the entry of local investors, it is deemed only a temporary problem, however. When governments get their deficits under control, in about three or four years, they are expected to relax the current obstacles to investing and a great influx of funds from local institutions is then anticipated.

Disincentives to domestic LPs aside, there are few political, tax or other regulatory barriers to private equity investment in the region today.

Culturally, sponsors enjoy a far more positive press than in Western Europe. “Culturally, private equity is much more popular than in Western Europe. It has been a more visible element of positive change, driving growth and job creation,” says MEP’s Baudon. Meanwhile, although the political landscape can be volatile, it is not deemed an obstacle, as, post EU–accession, there is conformity of regulation to EU standards. “Although it sometimes seems like there is hardly a functioning government in the region, EU accession ensures the legal and regulatory framework is sufficient for private equity firms to do business. So ongoing negative political issues are not impeding buyout activity,” says Advent’s James.

Looking forward, most specialists are very upbeat about the next few years. “There is a huge amount of potential and many exciting investment opportunities in the region. It feels very much like Western Europe now, with high quality intermediaries, lots of auctions and competition and increasingly sophisticated financing packages,” says 3i’s McMinnies.

The market has evolved past the point where it could falter. “Barring a global downturn, the outlook is very good. This is a rapidly evolving market that is here to stay,” says Advent’s James.

Although a global downturn would have a big impact, most players expect private equity returns generally to outperform other asset classes, while some argue that CEE returns in particular will be better protected than those in Western Europe. “There are few reasons to be pessimistic about the future. We will be largely buffered from any downturn and there is easily room for the current number of players, despite a few new mid-market entrants,” says MEP’s Baudon.

Bank Build-up

As financiers undercut one another to gain marketshare in the region, PE managers pocket cut-rate loans

Together with the marked increase in funds raised and deployed in the region, the incredible rise in the availability of leveraged finance is one of the main trends to emerge in the CEE buyout market in the past year.

This rise is a direct result of the vastly changed perception of the region since 2004. With highly attractive growth rates and the new-found safety net of EU legislation, banks no longer view CEE buyouts as so exotic or high-risk. “The upgrade in sovereign ratings linked to the EU accession was a key driver in the growth and increasing sophistication of the debt markets. All countries are now investment grade. Also, Western banks have acquired many of the local banks, giving them local know-how and alleviating country restrictions,” says MEP’s Baudon.

A plethora of banks is now looking to exploit opportunities in the region. The virtual monopoly that banks such as ING and Bank Austria used to enjoy has been severely challenged, firstly by German banks and, more recently, by some big US banks, with the likes of Citibank and Goldman Sachs now bidding aggressively to lead the larger LBO financings. To maintain market share, the more established banks have increased the amount of debt they are willing to lend, while also offering far more attractive financing terms.

Not only has liquidity deepened notably in the senior debt market, but there has been significant growth in the subordinated debt space, with the entry of non-bank intermediaries and mezzanine players dedicated to the region, such as Accession Mezzanine.

As in Western Europe, the sharp rise in debt market liquidity has not only allowed sponsors to bid far more competitively, but has also put them firmly in the driving seat when negotiating terms on mid and large-cap buyouts. This is mainly the case for deals exceeding €100m, however. Deals under this can still be harder to finance, according to market specialists. “In the last year, there has been a dramatic increase in the number of banks willing to lend and in the amount of leverage they are prepared to lend. There can be five or more banks pitching for a financing mandate now. That would never have happened a couple of years ago,” says Advent’s James.

On average, bankers estimate that leverage levels have risen from about 4x total debt to EBITDA 18 months ago to around 5x now, with some of the larger auctioned deals attracting levels as high as 8x+. For example, unconfirmed market rumours suggest that the financing backing the buyout of Baltic mobile operator Bité in January carried a total debt to EBITDA multiple of over 8x.

Leverage levels in this bracket illustrate the total metamorphosis that has taken place in attitudes towards financing LBOs in the region, which saw almost no leveraged deals at all as recently as 2002. “For the right deal you can now get the same level of financing sophistication as Western Europe, with debt layers across the entire spectrum of the capital structure, spanning senior debt, second lien, mezzanine and even PIK notes” says MEP’s Baudon. Most recently, this was illustrated by the financing supporting the Bité buyout, which instead of the more traditional senior debt and mezzanine structure, was entirely backed by a high-yield bond.

Yet although debt levels have jumped, barring the more competitive, auctioned deals and buyouts in more popular sectors, in general leverage is still below that seen in Western Europe, where some deals are emerging at over 9x total debt to EBITDA.

This is because most buyouts in the CEE region involve companies with significant growth potential, which therefore require far greater levels of capex than most Western European companies. These deals simply cannot be levered up so sharply.

Also, although the region’s risk profile is greatly improved, many debt investors still deemed risk in CEE to be higher than in Western Europe, while the number of debt providers active in many of the countries in the region still remains far below those in the West.

Even so, some market experts feel leverage levels should in fact be higher in CEE than in Western Europe, arguing that, as growth rates in the region are so much stronger, a case could be made for applying more leverage to buyouts there.

Either way, the incredible rise in the availability of leveraged finance today has played a major role in the price inflation that has arisen in the last 18 months. Indeed many market experts say that the overheating LBO financing market is the principal driver of today’s rising purchase prices. “Debt multiples have leapt in the last year and are the main culprit for pushing up purchase prices,” says 3i’s McMinnies.