Private equity puts down roots

Advent International has just closed its third fund for investment in Central Europe, ACEE III, at €330m. The fund is one of the largest ever raised in the region and will invest in high-growth companies in the media, communications, healthcare, financial services and retail sectors.

Deals are also getting bigger. Private equity firms were recently pipped to the post in the 51% privatisation of Cesky Telecom. Telefonica offered €2.8bn for the Czech government’s stake, eclipsing three other offers to acquire Cesky for a figure that surprised analysts.

Telefonica outbid Swiss rival Swisscom and Belgian firm Belgacom in the auction for Cesky. Blackstone, Providence and CVC had been bidding jointly, but thought that the Czech authorities’ expectations were unrealistic on price grounds.

As a result, the buyout of MobilTel, the Bulgarian mobile phone company, is still the largest deal in the region. It was completed in May 2004, with a €450m equity component as part of a €1.2bn deal.

This growth comes on the back of 15 years of development for CEE private equity. In a special paper on the region, the European Venture Capital Association (EVCA) estimated that more than €7bn of funding had been raised through the period, equating to 900 investments and more than 400 exits. Of the funds raised to date, some 75% has been invested through 77 private equity fund managers active in the region.

The business continues to show promise. Former start-ups are becoming more mature market players, in some cases beyond national borders, and in turn are facilitating new investment opportunities. Management teams are also maturing and repeat entrepreneurs are becoming a factor in the market.

“These economies are flexible and dynamic because they have been through so much change,” said Chris Mruck, a partner who has invested in CEE for 10 years at Advent. “In the mid-1990s, every deal was a restructuring. Now there are more buyout candidates emerging and we have worked through most of the privatisations.”

Private equity investment in CEE stands at about €5bn to date, according to the EVCA. It increased by 64% in 2003, compared with 6% growth across Europe as a whole. Buyouts accounted for 50% of activity, a lower ratio than the European average. This is because private equity is so much younger in CEE and expansion capital is still important.

Greater availability of debt financing has also helped in the last few years, although regional management teams are still getting used to living with leverage. Investment professionals say that banks are generally willing to lend on a 50/50 debt to equity ratio. A few years ago, private equity deals were funded entirely with equity.

For exits, local stock markets are proving an attractive route on the back of pension reforms. This is especially true of the eight countries in the region that joined the EU in May 2004 – Poland, Hungary, the Czech Republic, Slovakia, Latvia, Lithuania, Estonia and Slovenia. Bulgaria and Romania are negotiating for entry in 2007.

Exit value for all CEE countries grew by 75% in 2003, to €236m, representing 53% of investment volume. Holding periods have generally been reduced from about five years in the mid-1990s to three to four years currently.

EU accession has also meant that institutional investors have adjusted their perception of CEE risk. This is due to the harmonisation of legal, regulatory and economics policies with those of the European Union.

Advent’s experience with its third fund bears this out. All of the investors in its first two funds returned, with a notable increase in participation from the private sector in addition to the development banks.

The fund set out to raise €300m, but this was increased by €30m. Major investors include Teachers’ Private Capital, the European Bank for Reconstruction and Development (EBRD) and Alpinvest. Generally speaking, participation from regional investors in private equity is low, but post-accession integration will remove many of the restrictions on this source of capital.

Despite the promising start, however, private equity in the CEE is still in its infancy. Many of the larger funds did not kick off until the late 1990s and have yet to complete a full cycle of investments and exits. Fundraising has developed in waves. First came the country funds in the early 1990s, then regional funds in 1997 to 2000 and latterly funds that are a mixture of both.

The EBRD is still an anchor investor in most funds, but the identity of the best performing funds is becoming more apparent.

Pooled IRRs for Eastern European buyouts were compelling in 2004. Based on a small sample of four funds, Thomson Venture Economics found that five-year buyout horizons generated a 66.9% IRR. The 10, 15 and 20-year horizons all generated IRRs of 34%, while the three-year horizon was negative at –14.2%.

Overall returns for private equity in the region were generally below comparisons for Western Europe, reflecting the less mature nature of the fundraising cycle. The nine and 12-month horizons are the most attractive, with pooled IRRs of 20.4% and –1%, respectively. The three-year horizon is –11.2%, the five-year is –4.7% and the 10-year is –3.3%.

Western Europe returned 13.2% and 15.2%, respectively, for the nine and 12-month horizons. The pooled IRRs for the three-year, five-year and 10-year horizons were –1.9%, 1.8% and 10%.

Other funds are gearing up, and so is investment activity. Polish Enterprise Fund V, which is managed by Enterprise Investors, has just bought out Artima, the largest independent supermarket chain in Romania.

The fund’s investment of €17m is the latest in a series of deals that mean Enterprise Investors has managed more than US$850m in nearly 100 CEE companies since 1990.

“We plan to add significant value to the company by implementing proven strategies that we have developed over many years of investing in the retail industry,” said Dawid Walendowski, vice-president of Enterprise Investors.

The firm linked up with Pederson & Partners last October to form Romania’s first MBI/MBO club to enable successful managers to acquire stakes in companies.

Clemens Petschnikar, Artima’s incoming CEO, is EI’s first major partner since the scheme was established. He said he supported the buyout based on positive expectations about the growth of the Romanian FMCG market, and an ambitious plan to open 40 new stores by 2009.

But there are still challenges the region must overcome. Local management expertise tends to be good at the larger companies, but can be in short supply further down the scale.

Some parts of the region also lack political stability. Political parties can have radically different policies and, if governments change fairly frequently, private equity is left with an uncertain background against which it must plan and achieve value creation.

The economies of the region also impose limits. Several countries have populations of 10m or less, and will never be candidates for large buyouts. “We experienced strong investor interest in the region, but were careful to aim for a figure which, while it exceeded our target, was still realistic for investment,” said Advent’s Mruck.