Iain Morse finds private equity limited partners in central and eastern Europe hungry for long-term capital

“I am disappointed by the level of investment we receive from the UK and other pension funds,” says Thierry Baudon, managing partner at Mid-Europa Partners. Few, if any, European pension funds directly invest in central & eastern European (CEE) private equity partnerships or funds. Instead, exposure to CEE is invariably via global funds of funds in portfolios heavily exposed to western Europe, the UK and US. ” We are a bit neglected, under-valued,” says Stanislaw Knaflewski, partner at Warsaw-based Enterprise Investors. “We offer higher returns and diversification away from more developed markets.”

The case made for CEE private equity is that it is more about equity than debt, less about financial engineering than real engineering, and more about adding value through management expertise than in developed markets. This may be true, but there are reasons for caution, particularly by fiduciaries. “The legal issues raised by CEE deals can be complex,” warns Christopher Rose, senior partner with law firm Squire Saunders, which specialises in emerging market and private equity. But there are ways to get around these issues, and deals can be moved out of their country of origin. “On big CEE deals we still use the Dutch or Luxembourg jurisdictions,” he adds. “Both have good double taxation treaties and robust legal and judicial systems.”

Another impediment is cautious investment consultants. “Only the largest European pension funds make a separate allocation to CEE and invest directly into our funds,” adds Baudon. “They can afford to carry out their own due diligence.”

Pension consultants advising trustees prefer to recommend funds of funds where due diligence is sub-contracted to the fund manager. This may dilute investment returns, and the benchmarks used for private equity are typically based on global portfolio exposure. “The question of whether we offer higher risk adjusted returns is often ignored,” adds Baudon. The European Bank for Reconstruction and Development (EBRD) expects annualised returns of 5-6% per annum above more developed markets. Some of the first generation funds have returned 450%, with current funds expected to return 250% on investment.

Convergence, an often rehearsed argument in favour of the CEE region, may be overstated. Proponents have argued that CEE countries would play a quick game of catch-up with richer neighbours after joining the EU. The credit crunch made this look implausible. Nevertheless, in 2009, Poland was the only European country that managed to increase its GDP. The Czech Republic, Slovenia and Slovakia trod water, while Romania suffered an 8% contraction. Bulgaria and the Baltic States, all suffered greater contractions.

“It will take a long time, decades not years, for this convergence to take place, if indeed it ever does,” says Alessandria Pasian, a senior fund manager in the equity team at the EBRD. The bank has been investing in CEE since 1992, and now has a portfolio of €2.7bn, spread among 125 funds and 85 managers. “Eastern Europe is still very small in absolute terms, with under developed capital markets,” adds Pasian. During the credit boom, banks in CEE were far less willing to lend to private equity deals than their western counterparts. “We have never had to compete with banks as direct participants in a deal,” adds Knaflewski. “The cost of deals rarely stretched to long multiples as happened in more developed markets.”

Many enterprises in CEE also have surprisingly strong balance sheets. At formation they often acquired the premises and land where they operated. “These assets were worth little then but in many cases are worth much more now,” observes Pasian. Under Communist rule, factories were often located in city centres and areas where land values have increased, driven by residential and retail demand. “This pool of real estate makes asset-backed lending to expanding enterprises easier, and in some cases less expensive,” adds Pasian. “As yet these assets have not been fully exploited in the CEE, but we expect this to change.”

CEE deal sizes are generally much smaller than those in developed markets but also tend to be different in character. Buyouts and trade sales are common exit strategies, IPOs less so, and sales to other private equity funds rare. “We are at the top end of the CEE deal range,” notes Baudon. “The equity ticket in our deals is in the €100-200m range which, with leverage, implies that our typical company is worth €400-500m.” Large telecoms are near the top of this range, while healthcare - a booming regional industry - has smaller deals in the €40-100m range. Central Europe’s average deal size is in the €100-200m range. Time from entry to exit on deals is also longer. “The average for us is five years across a fairly tight range from four to six years,” adds Baudon.

Poland, the largest CEE private equity market, supports a number of domestic private equity partnerships of which Enterprise Investors is one of the oldest. “To understand the shape of CEE private equity you need to know a little history,” says Knaflewski.

In the early 1990s, unlike the former USSR, Polish and other CEE entrepreneurs had more direct access to western trade credit, banks and business partners. One major consequence of this was that ‘black’ money played an insignificant role in the formation of CEE enterprises, whereas it was often the only available source of capital in the USSR.

“One guy from Warsaw bought lorry loads of bananas in Berlin, sold them at street markets in Poland and built a chain of supermarkets,” Knaflewski recalls. Huge state enterprises, ship builders, steel makers, and national telecoms, were floated away early on fledgling stock exchanges. “It is the small new businesses started in the 1990s, now maturing, that offer huge potential,” adds Knaflewski. “Owners are middle aged and want to retire.”

Consequently, management buyouts are the most common type of private equity deal, helped by rapid change in the quality of local managers. “When we started in the early 1990s, 90% of company CEOs were from western Europe, or other developed economies, but now the reverse is true,” says Baudon. A new, young, Western-educated generation of managers is now available for promotion to CEO and main board status. “These guys will still be here in 10 or 15 years’ time and will end up running much of the private sector in their countries,” says Knaflewski.

Deal multiples rarely exceed seven times EBITDA and equity is nearly always a more important component of any deal than debt. “This is like private equity in the UK 20-30 years ago,” argues Baudon.