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Central and eastern Europe: a growing market for private equity

Private equity investment in central and eastern Europe could be set to increase as investors look to capture the region’s potential as its economies return to growth. 
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Central and eastern Europe: a growing market for private equity

Private equity activity in central and eastern Europe (CEE) is going through a revolution. What started as strategic plays on specific economies in the region through growth-sector investments is transforming, as specialised CEE firms see new opportunities arise, a trend that could lure more big international firms to the region and ultimately raise the profile of the market place.

Still a very young market for private businesses and investments, CEE-focused private equity firms such as Mid Europa Partners and East Capital started their funds to get exposure to a market that was new and expected to grow.

East Capital makes its move

Sweden-headquartered emerging and frontier market asset manager East Capital started as an eastern Europe-focused asset manager investing in public equity in 1997, but decided to add regional private equity operations in 2001, “to capture the growth of the middle class and their income potential”, says Kestutis Sasnauskas, the company's head of private equity.

“At that point in time, if you invested in Russian stocks, 80% to 90% of the index was [companies related to] natural resources. [If you were investing in the stock market], you were basically buying natural resources exposure with Russian risk,” he adds.

Once the fund was set up, East Capital invested in what is now known as Melon Fashion Group, a St Petersburg-based fashion retailer, growing it from 13 stores to about 650 across six countries, taking advantage of the continuing boost in consumption after the collapse of the Soviet Union.

Mid Europa's focus

UK-headquartered Mid Europa Partners took a similar approach. Having previously worked for the World Bank, the European Bank for Reconstruction and Development (EBRD), and a large multinational corporation, Thierry Baudon founded Mid Europa Partners in the late 1990s, “with an initial focus on sectors that had been totally neglected during the communist era and then a gradual move towards consumer-facing sectors across the region, as the urban middle class was bound to converge towards western European income and consumption patterns”.

For Mid Europa, that meant investments predominantly in telecoms and media sectors, and later private healthcare and medical laboratory services, food retail and distribution, leisure, and transport and logistics, with a geographical concentration on the most advanced countries in central Europe. The consumer-related strategy allowed CEE investors to get more exposure to the region’s economies, many of which were growing quickly.

Yet, with the global financial crisis of 2008 and 2009, growth in CEE economies slowed and 2010’s private equity investment activity fell to €1.275bn, significantly below the €1.381bn from 2009, according to data from the European Private Equity and Venture Capital Association (EVCA). CEE buyout and growth investments then dropped to €717m in 2013.

Sources of deal flow

Deal flow volumes could be set to increase, however. It has been 25 years since private enterprises started to emerge in the former Soviet Union region and many of those businesses are now facing a management generation shift.

“Quite a lot of the companies that emerged in the early 1990s are now in situations where there are succession issues as the people who founded these companies are coming up to retirement age and are thinking of disposing of them,” says Sebastian Lawson, partner and co-head of the CEE/Commonwealth of Independent States group at law firm Freshfields Bruckhaus Deringer. “That drives deal activity in some markets, even if businesses are in an economy that is relatively sluggish, which means that you can still see one or two deals coming out of these countries this year.”

Mr Baudon agrees that the higher number of entrepreneurs looking to sell their businesses represents the “number one change in the structure of the deal flow”. He says: “Over the past four or five years, the proportion of deal flow coming from entrepreneurs has mushroomed. These types of deals have been present in the smaller market segments for longer, but in our typical deal size range of between €100m and €500m enterprise value, such deals were few and far apart.”

These new targets are especially interesting for the regionally focused private equity firms, as their local expertise and presence give them a head start. Take East Capital, with its regional offices in Estonia and Russia. It is mainly focusing on the Baltic region.

“Whereas most of the investment community is forgetting the Baltics, we see a lot of interesting opportunities there,” says Mr Sasnauskas. “The economies have gone through quite a significant amount of deleveraging. Before that, we had very high competition from the banks competing to invest because leverage was readily available – too available and too cheap – while leverage is still available now but for a limited number of players.”

Global interest

But some portfolio business sales are going into auction processes – typical in western Europe and the US. Where the assets for sale are attractive, demand from larger UK, European or even US funds can come in and compete.

“The difficulty private equity faces is a shortage of good-quality assets, which means that when some do come along, there tends to be very heavy competition indeed,” says Mr Lawson. “SBB Telemach – the landmark private equity transaction for the region in the past couple of years, which was ultimately bought by KKR – attracted a lot of interest.”

The Serbian-Slovenian telecoms business SBB Telemach was one of the region’s few secondary buyouts. Created by former owner Mid Europa Partners, which merged the Serbian cable TV and internet provider Serbia Broadband with its Slovenian telecoms business Telemach, SBB Telemach was sold to US private equity firm KKR for about €1bn in October 2013.

“If you bring to the market a company that has shown significant sustainable growth, displays fully Westernised management and control systems, and can be easily integrated by a potential buyer into a larger platform, you will have a lot of interest, not just from industrial players but also from the big private equity players,” says Mr Baudon.

“We have seen a number of global private equity firms competing for our assets at exit. What has changed over the past few years is that some of the pan-European or global private equity firms have started to win against trade buyers, whereas trade buyers used to be pretty much on their own to buy big assets from us.”

Sales of private equity portfolio businesses to other private equity firms have significant growth potential. In 2013, only 5% of all exits in CEE were through secondary buyouts, while the overwhelming majority with 60% went to trade buyers, according to the EVCA.

Selective funding

KKR’s SBB Telemach transaction showed something else: that for the right asset, leverage is available – and not only from the bank market. KKR financed its acquisition with a B rated €475m seven-year, high-yield bond, expanding the universe of traditional European high-yield bond investors further east.

But despite the ambitious financing package, capital market transactions are still significantly outnumbered.

“Currently only about 6% of corporate financing in the region comes through the capital markets, which is a very low number compared to western Europe, let alone compared to the US. And it is not expected to change in the short term,” says Mr Lawson.

“There is still a very strong focus on the bank market and a number of issuers [have found] it very hard to [achieve] debt capital markets issues over the past 12 to 18 months. The debt capital markets tend to be only available for sovereign credits or blue-chip corporates, which makes you worry that the sovereign success may be soaking up some of the investor demand for exposure to the region and therefore perhaps crowding out corporates.”

The availability of funding depends strongly on the asset, as well as its country of origin. In the Baltic countries of Estonia, Latvia and Lithuania, bank funding is available and the main source of debt for East Capital’s acquisitions. “In the Baltics, you can lever up to about four to five times earnings before interest, taxes, depreciation and amortisation and the interest rate margins are competitive,” says Mr Sasnauskas. “In Russia that is not possible. So generally we have significantly lower or no leverage in our investments in Russia.”

Russian market

Russia is a tricky market for private equity firms, agrees Evgeny Fetisov, chief financial officer at the Moscow Exchange. “There is definitely demand for private equity investments and we would like to see more of it happening because we need a source for companies to go public. The exchange is the natural exit route for private equity investors,” he says. “Apart from the lack of private equity firms in the first place, there is an issue of size – there are companies, where private equity guys don’t want to invest because those are too small, and there are large companies, which would not necessarily want the private equity money.”

Mid Europa has decided not to invest in Russia after one initial transaction, a joint venture with glass producer Pilkington in 2003, which it exited in 2010. Yet, for its central European core and eastern European region, Mid Europa has “never had any problem to raise debt, even during the crisis”, says Mr Baudon.

“If you want to raise more than €300m to €400m it becomes more of a challenge, although we and a few others have done it in selected cases. For a few deals with the right features, it is possible to stretch to somewhere between €500m and €1bn of debt. And the terms are not that different from what you would get in western Europe, which in my view is possibly the best market test to prove that the risk profile of private equity assets in our region is actually pretty low,” he adds.

With support from the EBRD, Mid Europa has recently invested in several Serbian food businesses, including Imlek and Mlekara Subotica, the largest independent dairy business in the region on a combined basis, as well as leading Serbian confectioner Bambi, and Knjaz Miloš, the leading Serbian producer of mineral water and other non-alcoholic beverages.

Some CEE countries are offering additional opportunities for private equity through further privatisations. One of the largest Serbian banks, Komercijalna Banka, is expected to come up for privatisation this year or in 2016. Private equity bids will be accepted in this transaction, according to Mr Lawson, as they will be for assets of Slovenia’s telecom privatisation.

Trade competition

Still, trade buyers are also increasingly competing for assets, as the acquisition of Slovenia’s leading brewer, Pivovarna Lasko, by Dutch brewer Heineken in mid-April showed – a target Mid Europa was also bidding for.

“The fact that we focus on companies that can be grown and transformed into prime assets for trade buyers means that sometimes – especially for fairly large assets – those trade buyers leapfrog and disintermediate us,” says Mr Baudon. “In most instances, however, the companies we tend to focus on are still too small, too complicated, too peculiar to attract strategic investors and that gives us the opportunity to be the value-creation bridge between that asset and the ultimate trade buyer four to five years later. With 17 trade sales out of 22 exits so far, trade buyers have been and remain our number one exit path, but also our most feared competition.”

Public equity markets can also snap up potential targets, and especially in the case of privatisations, initial public offerings (IPOs) are often the preferred route. For small and medium-sized businesses, IPOs also have been one of the main sources of private equity exits for a long time, according to Mr Baudon.

Warsaw’s attraction

“The Warsaw Stock Exchange until a few years ago was a major exit path for a number of colleagues in the private equity industry, who operate in the small mid-market segment,” says Mr Baudon. “Paradoxically, stock exchanges in our region have been a more prominent source of exit for small deals than large ones, whereas in more developed markets you would expect the opposite.”

Mr Lawson says the Warsaw Stock Exchange is the real stand-out performer in the region and has tended to dominate everywhere else to the extent that many non-Polish issuers in the region have tended to look at Warsaw just because the level of liquidity available there has dwarfed anything available on other exchanges.

Though the Warsaw Stock Exchange has been seen as the leading exchange in CEE, its attraction is declining. Changes to the Polish pension system will result in a large number of assets held by private pension funds being transferred to the Polish state, sowing doubts over the future liquidity of the equity and bond markets in Warsaw.

“There is also a sense that the Warsaw investor base was becoming a bit more sceptical of non-Polish issuers on the stock exchange, in particular in relation to Ukrainian issuers – and this pre-dates the crisis – so many of them had underperformed and there was a steady flow of more and more Ukrainian agriculture companies coming to the exchange and investors just got a bit bored of them,” says Mr Lawson.

Strength in unity

This could mean that companies may be less likely to go public or may seek a listing in London, or on other CEE exchanges such as the Vienna Stock Exchange. Vienna has teamed up with exchanges in Prague, Ljubljana and Budapest to form the CEE Stock Exchange Group (Ceeseg), offering investors and market-makers easy access to all four exchanges, aiming to further increase liquidity and regional attraction for new listings.

“We had a record intake of capital increases and IPOs in 2014 – roughly €4.6bn within the group, which was more than the previous three consecutive years taken together,” says Michael Buhl, chief executive of the Ceeseg and the Vienna Stock Exchange. “We had a few very big capital increases, altogether 28, and had three IPOs: one in Prague, one in Budapest and one in Vienna.”

While Vienna previously targeted an acquisition of the exchange in Warsaw, it is not looking for further acquisitions and there has also been talk of the Ceeseg considering a sale of its Ljubljana exchange after potential buyers showed an interest. However, the group deems tie-ups in technology-intensive business fields as areas of growing significance and co-operates with exchanges across the region in data vending and index licensing.

Meanwhile, Bucharest Stock Exchange is preparing its own regional push. “Bucharest is the place that has the best potential for growth, partly because the Romanian government is looking at increasing the scale of local exchanges, many of them in conjunction with the local privatisation programme,” says Mr Lawson.

The stock exchange in Bucharest has poached the former Warsaw Stock Exchange chief executive Ludwik Sobolewski to run the Romanian exchange to learn the lessons from Poland.

Still, public equity markets can only benefit from CEE private equity activity if the firms decide to exit their businesses through the stock exchanges, and not every firm is keen to do so.

“In life, you tend to do what makes sense for you to do,” says Mr Baudon. “If we can sell our companies after four to six years of ownership to a Vodafone, an Orange, a Liberty Global or a BUPA, why would we bother with an IPO?

“But IPOs are a very convenient way to exit when you have a partnership with a local entrepreneur who wants to stay invested in the company and continue for another cycle. We do have one or two such cases coming up.”

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