Private Equity in Central & Eastern Europe
The private equity industry in the Czech Republic, the Slovak Republic, Poland and Hungary ("Central & Eastern Europe") has matured considerably over the past 15 years with distinct similarity to patterns of development in Western Europe achieved previously. A comparison between the two markets shows similar growth development in the skills of fund managers, entrepreneurial culture, business acumen of professional managers and the sophistication of deal structures. While the lessons learned in Western Europe and the United States are instructive for investors and business managers active in Central and Eastern Europe, there are several structural individualities that differentiate the markets and that are worth addressing.
This note will address some of these issues. Firstly, by providing an overview of the Central & Eastern European market focusing on issues driving the region's growing private equity market. And secondly, given the interest of the audience, addressing issues particular to venture capital investing in Central & Eastern Europe as well as providing advice to entrepreneurs seeking financing.
Economic Reforms and EU Accession
Recent economic reforms initiated in several of the Central & Eastern European countries, including progressive tax reform and dynamic investment incentive schemes have bolstered foreign direct investment significantly and have contributed to a favorable environment for private equity investors. The so called "flat tax revolution" that has spread throughout Central & Eastern Europe is one example of the sensible change that has bolstered markets in the region and created positive incentives in the labor market, for entrepreneurs and for investors. The Central & Eastern Europeans have managed to develop the right mix of incentives, high skilled labor and growth potential to attract an increasing number of multinational corporations and institutional investors to the region. Meanwhile, the politically more mature neighbors to the west, Germany, France and Italy, continue to struggle with political and social forces inhibiting desperately needed reforms. For many reasons, investors are bullish on Central & Eastern Europe.
The reforms and resulting economic incentives outlined above have contributed to the development of a new generation of Central & Eastern European managers and entrepreneurs (many having western MBAs and experience) seeking to benefit individually in a growing entrepreneurial culture and robust business environment. These developments have created an extensive pool of commercially oriented enterprises that forms the basis for private equity opportunities in the region. Further supporting the case for private equity investors in the region is the economic stimulus of EU Accession. To illustrate this, the GDP of the new members states grew at an average real rate of 4.5% between 1993 and 2002, or 2.5% above the EU average.
Growth increased to 3.7% on a weighted average basis in 2003 and is projected to increase further to 4.5% in 2005. The EU Commission suggests an additional annual growth effect from EU entry of 1.3% to 2.1% in the 4 years after accession. A substantial share of GDP comes from new businesses established in the 1990s many of which were later financed by private equity.
In varying degrees and based on the individual country, the region still has significant work ahead of it, including developing better legislation around public capital markets and in the development of banking services. The former will contribute to a more vibrant IPO market in the region and increased liquidity opportunities for private equity investors and the latter will achieve a more sophisticated and efficient utilization of lending and debt financing for entrepreneurs and private equity backed companies. In the past five years significant progress has been made in these areas and the market is increasingly more sophisticated.
On a country-by-country basis, Poland has the region's most sophisticated private equity market with several of the region's blue-chip investors based in Warsaw. The advanced development of the Warsaw stock exchange and private equity fund management skills (ex-patriot fund managers coupled with local fund managers) developed since the early 1990s has contributed to the success in this market. Hungary has produced several private equity backed technology companies listed on NASDAQ and European exchanges. The Czech Republic and Slovak Republic have vibrant markets with investments including several very successful TMT oriented deals. The spectrum of private equity investors is continually developing and the range includes country and industry specific funds, growth capital and mid-market buyout funds and larger regional funds engaged in buyout and mezzanine financing. The depth of experience among fund managers is continually evolving with individual fund managers having raised multi funds with over USD 1 billion under management and other fund managers working towards these numbers.
The fund of funds and secondary market is actively addressed by 5E Holding, an ALPHA ASSOCIATES managed fund, that remains the only managed portfolio dedicated to the region. ALPHA ASSOCIATES is currently raising its second fund, ALPHA CEE 2005 L.P., pursuing the same strategy developed for 5E Holding: to make direct fund commitments, purchase secondary positions and make select direct company investments in Central & Eastern Europe.
Venture Investing In Central & Eastern Europe
Like in Western Europe, "institutionally backed"1 venture capital investors in Central & Eastern Europe have had limited success in the past 10 years when compared to later stage and buyout oriented investors and when compared to venture investors in the United States. There are varied explanations for this including unfavorable market conditions, the Internet bubble, skewed incentives and lack of the necessary skills to manage small and medium sized company ("SME") investment etc.. The resulting trend in Central & Eastern Europe has been the gradual movement away from investments made in venture style SME with many "institutionally backed" fund managers gravitating towards buyout and later stage investing where the supply of "investable" capital is greater and larger management fees and lucrative carry structures are to be had. While there is a growing supply of successful later stage and buyout investors in Central & Eastern Europe there is a dearth of "institutionally backed" venture investors.
However, Central & Eastern Europe has many success stories involving small to medium sized enterprise across various sectors from technology and retail to manufacturing and media that have been financed in the early stages by the entrepreneur's own capital or private investors seeking venture style exposure. Some of the companies have gone on to raise private equity financing later on in their development, however, a large portion of these companies have bypassed "institutionally backed" private equity as a resource for financing altogether. To a large degree, there is a gap in the "institutionally backed" equity financing market for deals ranging from EUR 1 million up to EUR 3 million, particularly on the lower end of this scale. Furthermore, the regional banks have been slow in providing SME working capital facilities and other debt facilities typically accessible for qualified companies of this size in Western Europe & the United States.
Although the gap in the financing market outlined above does provide a mechanism to naturally eliminate the less viable business venture and only the truly "investable" company eventually receives private equity financing once it has successfully moved beyond its early stages of growth, opportunity clearly exists for qualified venture investors having local knowledge and a keen understanding of what makes SME investments work. In most cases such expertise is not found with later stage investors and buyout firms.
Private individuals investing along-side investment banking boutiques are currently addressing this investment space. The investment banking boutiques have gained expertise with SME after years of consulting these firms and having developed investment managers with a keen eye for value, hands on entrepreneurial experience and extremely developed networks in and outside of the region that are mined to benefit investments. The drive to make investments work when putting one's own capital at risk provides a strong incentive mechanism that is lacking with some fund managers with larger portfolios of venture investments and the discretion to write off investments without immediate out of the pocket loss. Many of these investment boutiques take an institutionalized approach to investing a pool of private money in SME without the benefit of an institutional limited partner and with significant returns on investment and impressive IRR.
For entrepreneurs seeking financing in Central and Eastern Europe in the range of USD 1 million to USD 4 million, the goal should be to establish a relationship early on in the capital raising process with one of the investment boutiques engaged in SME investment. The investment proposal will need to be as sound as any presented to later stage investors and arguably it needs to be even more convincing given that the investor will be putting his or her personal money to work in the company and given the risk/return profile of such investment opportunities. I have invested in and managed a portfolio of SME investments in Central & Eastern Europe and can attest to the extremely selective investment decision process that is taken. I can also attest to the benefits that entrepreneurs gain in having an incentivised group of investors behind the company.
Several smaller institutionally backed investment funds addressing this space do exist and often co-invest with the investment banking boutiques.
Private equity investors in Central and Eastern Europe are positioned well to benefit from the economic stimulus of EU integration and the progressive reforms initiated by many governments in the region. The depth and breadth of quality fund managers will continue to grow and transfer into growing returns for investors in the region. The further development of an entrepreneurial culture stimulated by a robust business environment and supported by prudent incentives will continue to produce commercially oriented enterprises forming the basis for private equity opportunities in the region going forward.
Better legislation around public capital markets and in the development of banking services is needed in order to create a more vibrant IPO market and efficient utilization of lending and debt financing for entrepreneurs and companies. An extension of capital market reformation is the restructuring of the pension fund industry in Central & Eastern Europe, which presently, in all of the countries of the region, is severely restricted when considering investment in unlisted assets. Regional governments will need to continue taking proper steps to render economic growth durable. State deficits of 5-6 per cent as seen in Poland, the Czech Republic and Hungary might eventually put the economic restoration of these countries at risk.
Venture capital investment and SME financing will continue to be the domain of fund managers, institutionally backed or not, with a deep understanding of local entrepreneurial culture, fine-tuned management skills oriented towards SME, extensive deal flow and a keen understanding on how to select winning companies. For entrepreneurs with superior business plans, buyout plans and talent, the options to finance these projects will only get wider.
1 "Institutionally backed" is defined in this note as private equity investment funds that are primarily funded by limited partners such as banks, insurance companies, fund of funds and other organizations generally recognized as financial institutions.
Mr. Richard Seewald has been living and investing in the Central European region since the early 1990s and is a member of the investment team at ALPHA ASSOCIATES, a private equity fund of funds manager based in Zurich, Switzerland, where he manages a portfolio of direct investments and investments in private equity funds. ALPHA ASSOCIATES is the manager for: 5E Holding, the only fund of funds dedicated to private equity investment in Central and Eastern Europe; Private Equity Holding, an SWX listed private equity investment company investing in venture funds and growth companies globally; and ALPHA 2001, LP, a broadly diversified private equity partnership for institutional investors.
Prior to joining ALPHA ASSOCIATES, Mr. Seewald was a partner at Benson Oak, a Central European investment banking and private equity group based in Prague, Czech Republic, where he focused on growth capital and buyout opportunities. He has advised governments on privatization and restructurings throughout the Central & Eastern European region. Earlier in his career, he practiced law in New York City and in Europe. Richard is a member of the board of directors of several European and American based companies and non-for profit organizations. He holds an MBA from the University of Chicago Graduate School of Business, a Doctorate in Law from the New York Law School and a B.A., Business with honors from Pace University. firstname.lastname@example.org - Direct +41 43 244 30 11