Europe’s biggest LBO of 2009 was a CEE deal, reports Joseph Mariathasan. But it is difficult to see the region becoming a core emerging market private equity market like Asia

Private equity in central and eastern Europe (CEE) faces a dilemma. Emerging markets may give high returns, but that reflects high risks such as political instability and a fragile legal framework. But, as Alessandra Pasian, a senior banker in the European Bank for Reconstruction and Development (EBRD) funds team, observes, for many investors CEE countries are not really seen as emerging markets at all, but part of Europe. “As such they cannot be expected to give the same growth rates as Asia and Latin America,” she says.

CEE encompasses a range of countries that are on the convergence path to joining the EU, or have already done so. Moreover, as Thierry Baudon, founding Partner of Mid Europa Partners points out, they are relatively stable and benefit from the visibility, the regulatory structure and the markets that their closeness to the EU gives them. On the other hand these fragmented and poorly understood markets that presented high barriers to entry for private equity investors when Mid Europa was founded in 1998 still do so today. “Convergence will take at least up to 2025 and maybe two generations,” says Baudon.

As a result, there is still plenty of time for investors to take advantage of whatever opportunities the road to convergence may bring. But how attractive do those opportunities look compared to alternatives elsewhere?

The CEE region does have its attractions for investors in terms of its closeness to developed Europe, both geographically and culturally. But there are also many overwhelming disadvantages that can be summed up in one word - Asia. In comparison to the growth rates, the dynamism of the population and the sheer size of the Asian markets, CEE looks anaemic - and this perception is increasing. In a survey of limited partners (LPs) conducted by European mid-market specialist Acanthus Advisers in late 2010, whilst 67% of respondents thought they would increase allocations to the region over the next five years, only 26% viewed it as more attractive than other emerging markets - down from 35% in 2009. Meanwhile, the percentage actively viewing it as less attractive has increased from 25% to 39%.

“A few years ago, everyone was pushing you to have something in Eastern and Central Europe,” recalls Bruno Raschle, CEO of fund of funds manager Adveq. “Today, they don’t like it.”

One of its problems - shared with the rest of Europe - is that its strengths in areas like science compete with cheaper markets (and indeed cheaper currencies) in Asia. “There is good science in CEE, but when you look at the application of science commercially, the region falls down,” says Raschle. “When you go to Beijing, there are thousands of people who jump on every opportunity at a much lower cost.”

There are countries within the wider region that could conceivably compete with Asia. Turkey in particular has incredible opportunities, according to Pasian. “The country is massive and the population is young with a very entrepreneurial spirit, so there is huge growth potential,” she says. “It is one of the best economies in this part of the world.”

Urbanisation and a growing middle class are driving demand for telecoms, food, healthcare and other goods and services. “There are really only two large economies in the region - Poland and Turkey,” says Martijn Bruins, head of ING’s structured acquisition finance team for CEE. “But whilst Poland may be more mature in terms of private equity participation, Turkey is more interesting because of its growth potential.”

The EBRD has been the catalyst for the development of private equity in CIS and CEE since its foundation in 1992, as well as being the biggest private equity investor in the region. Around €3bn has been ploughed into 135 funds with more than 80 managers, many of which it has committed to as the cornerstone investor, taking up to 25% of the initial fundraising. Pasian reports a 12.3% per annum IRR from inception to the end of 2009 - or 20% if fully realised valuations alone are considered. Russia and the rest of the CIS has had higher returns than CEE at 24%, which Pasian attributes to the fact that Russia was less mature and so many firms took early-mover advantage in sectors such as telecoms and retail where there were very low entry multiples.

But the EBRD, with its remit to stimulate economic development in the most needy regions, is reducing its investment in CEE in favour of frontier markets in Russian Central Asia and the Balkans. “That is the bank mandate, to go where other investors have not been,” Pasian observes. “The CEE now has well established players who can attract international investors.”

The majority of businesses in the region that are potential investments for private equity firms are family-owned, and need outside investment to grow and consolidate. For Mid Europa and its peers in the region, the key strategy has been buy-and-build, finding local companies that can achieve premier position in its domestic marketplace through competitor acquisitions, before selling on to a global player. As a result, the majority of exits have been trade sales to a wide range of international companies, with few IPOs.
As well as growth capital, private equity investment has encompassed leveraged buy-outs. “Deals of significant size began in the region in 2004-5,” explains Bruins. Although the majority of trades are likely to have enterprise values of less than €200-300m, Bruins sees the region as likely to give rise to two or three large transactions a year of over €1bn. These will be predominantly in Poland and Turkey, which have economies and populations large enough to sustain transactions of this size, with a few also seen in the Czech Republic and Hungary.

A couple of firms such as Mid Europa and Advent International have been active in the region for well over a decade. More recently, many of Europe’s mid-market buy-out firms have started getting involved, as well as a few of the larger US firms such as CVC Capital Partners, Providence Equity Partners and KKR. ING, with a few other mainly French and Austrian banks such as BNP Paribas, SocGen and Unicredit, are very active in providing debt finance for leveraged private equity transactions. “Even in the nadir of the market in 2008 and 2009, we continued to do transactions in CEE,” says Bruins. “The largest LBO in Europe of 2009 was actually a CEE deal: the acquisition by CVC of AB-Inbev’s beer assets in the region. Poland is now getting very competitive in the leveraged finance market.”

A beauty competition between CEE and Asia may not be a fair way to judge the worthiness of CEE private equity. But the fact that Adveq have launched a specialist Asia/China fund but see little prospect of launching a CEE fund suggests that it is diversification rather than returns that are going to be the justification for investment. That is, unless the region takes Raschle’s experience in its frontier markets to heart: “I have been travelling a lot in Turkmenistan, Kazakhstan and the surrounding countries,” he says. “Leaving aside wealth generated by those close to the ruling political class, wherever I find Chinese is where the economy is vibrant.”
Within the region, perhaps only Turkey can hope to emulate that.