One Continent, Two Markets: As Western Europe Gets Crowded, Should Europeans Look East? –

Call it growing pains. With Western Europe now littered with private equity firms, deal pros based in the U.K. and on the continent describe many of the same growing pains commonplace to a maturing asset class: growth at the large end of the market, a crowding of the middle market, a quantitative increase of sector-focused funds, pervasive auctions in conjunction with aggressive lending, and a Darwinian-like shakeout among 1999 and 2000 vintage year inaugural funds.

Regardless, native European fund managers still hold that they have the high ground in a geographic region whose long-term potential-already proven as viable and desirable-is still being shaped by pervasive corporate restructuring in Western Europe and an onslaught of new and potential joiners to the European Union from the continent’s east.

Last year Europe saw a total of ?30.62 billion worth of private equity transactions, the largest yearly total next to the ?34.98 billion invested in 2000, according to an EVCA survey conducted with Thomson Venture Economics and PricewaterhouseCoopers. What’s more, the 2004 total represents overall market growth of about 7.4x the amount of PE-backed capital invested since 1990’s ?4.126 billion, the survey says.

But between the restructuring West and the emerging East, there lies the question of where the best opportunities can be found both now and in the future.

Currently the European model of private equity is heavily selective toward EU member states in the continent’s western quadrants. The reason being, deal pros say, is that Western Europe’s financial markets are already global in scope, well developed and-though under the rule of separate governments-commonly structured in a business sense, which allows for easier cross-border plays.

“With the average investment lasting four or five years, you need a degree of certainty with regards to the framework you’re operating in, from a legal, tax and financial view,” says Jens Tonn, a director and head of German operations at Candover Investments plc. “That’s what the [western portion of the] EU offers private equity and that’s why a lot of people are gravitating toward [it].”

Meanwhile, advocates for the Central and Eastern European sectors point to capital scarcity, expatriates returning with business transplants, a growing entrepreneurial base and a large market for privatizations as reasons to invest in the less developed markets such as the Czech Republic, Slovakia, Hungry, Slovenia, Poland and Greece. “The political, economic and currency risks are offset by the growth and opportunity available in the market,” says Jeff Montgomery, a managing partner at GMT Communications Partners.

Room To Play In The West

Historically, the U.K. was the first of Europe’s market to adopt private equity, doing so not long after the asset class took off in the U.S.-and for decades it was responsible for more than half of all of Europe’s private equity deals. Fund managers and deal flow then spread slowly south and east to the point where today France is No. 2 in terms of European private equity market share, Germany is No. 3, followed somewhat in the distance by Spain and Italy for numbers four and five, respectively.

“Deal activity in Western Europe,” Tonn says, “can be related to a state of evolution. It is a younger market and therefore a lot of things still have to happen. In Germany for instance, industry-until the mid-90s-was never under any pressure from outside capital markets to deliver leaner, meaner companies to perform in line with international margins of performance expectations. So this is a fairly new phenomenon that started driving the buyout,” he said, referring to Europe’s ongoing corporate restructuring. “If you do the numbers, it’s an eight- to 10-year-old phenomenon in continental Europe, whereas it is has been happening in the U.K. for about 25 years and in the U.S. for 30 to 35 years.”

Along those lines, Jonathan Russell, head of 3i Group’s European buyout group, notes that Spain, which only sees about 20 private equity deals per year, became a modern economy in 1975, and did not join the EU until 1986. “So building a vibrant corporate finance market, which is the lifeblood of the private equity industry, is not such a fast process,” he says.

This means that despite the recent and rapid growth of EU membership (10 countries including industrial powerhouses Poland, Slovakia and the Czech Republic joined in 2004 alone) some of Europe’s largest private equity managers contend that there are still too many opportunities in Europe’s “Big Five” to warrant the risk-taking inherent to the nascent financial markets to the east.

The general consensus coming from those opting not to participate in some Central and Eastern Europe’s LBO markets is that-aside from dealing with the political, legal and economic uncertainties-the cost of having local teams on the ground who speak the language, who are deeply imbedded and committed to an unproven market, who are willing to go slow and learn from mistakes, is simply not worth the reward at this point.

“If you want to make money and have good internal rates of return,” says Dominique Megret, deputy head of Paris-based PAI Partners, “you have to focus on what you know and what you are able to do… We consider that Eastern Europe is a different part of the world for the time being. It’s too risky right now as far as buyouts are concerned.”

One firm that recently took the region’s feasibility into question is The Carlyle Group. The Washington, D.C.-based buyout shop recently abandoned its efforts to raise a $300 million private equity fund dedicated exclusively to Russia after it spent at least six months shaping up the investment vehicle. “We found that the risk-reward calculus did not fit well in with investors in light of the current situation there,” a spokesman for the firm told Buyouts.

Taming The Beast In The East

Other funds, however, see the sparse PE population in countries east of Germany, Austria and Italy and are more than willing to be among the first players in the Europe’s developing interior. Baring Corilius Private Equity, for example, manages an ?86 million fund dedicated to the Central European region, including non-EU member-states Romania and Bulgaria.

“The ultimate argument for this region is the growth rate,” says Gyuri Karady, a managing partner at Baring Corilius. “There’s been a phenomenal expansion in disposable income and a phenomenal expansion in the alignment of tastes, which is driving consumer spending and consumer attitudes and creating terrific opportunities for Western-type services and Western companies.”

But unlike the markets to the West, Central and Eastern Europe are about 40 years behind in concepts such as customer service and management experience, so “what you have to do before you invest in this part of the world is a lot of due diligence,” Karady adds. “You have to figure out, if worst comes to worst: Would you be able to replace management with a stronger more experienced team? Is the business interesting and big enough to be able to attract a skilled management team?”

The viability of these countries is “crucially linked” to the development of their regulatory, legal, accounting and tax infrastructures, says 3i Group’s Russell, adding that it generally takes between five and 10 years after joining the EU for said infrastructures to become direct-investment-worthy for his firm. In the meantime, 3i tests the waters and builds relationships in these emerging markets via acquisitions through existing portfolio companies. “Eastern and Central Europe is a question of when for private equity firms, not if,” Russell says.

Even the larger generalist funds not willing to invest directly in the region are more than willing to exploit it for portfolio company development. Both PAI and Candover say that most, if not all, of their portfolio companies have Eastern European components to them. A driver behind this trend is Europe’s ongoing corporate restructuring, which is responsible for moving much of the continent’s manufacturing from the more expensive countries in the West to the less expensive, less regulated markets in the East. Labor and manufacturing costs east of Germany can be anywhere from one-quarter to one-tenth of what it costs in Western Europe, PE pros say.

“For some products, Eastern Europe can be more interesting-at least for the time being-than even China, especially when you factor in the reduced cost of transportation,” says PAI’s Megret.