The untapped potential of CEE

Anne Fossemalle (pictured), director of equity funds at the European Bank for Reconstruction and Development (EBRD), believes the CEE region is still one of the more under-penetrated emerging markets. "One of the reasons for this is the global flow of money nowadays. LPs are getting nice returns from global US funds, which means there is less incentive to have this added complication of having to understand the emerging markets. And within the emerging markets, CEE does not seem to be at the top of many people's lists," she says.

In August last year, one of CEE's largest firms, Mid Europa Partners, closed its latest fund 20% below its €1bn target. The firm had revised the hard-cap of Mid Europa IV to €850m at the request of its LPs and subsequently closed the fund on €800m. This followed Advent International's notable exit from the market in 2013, essentially draining around €1bn of dedicated funds.

Further adding to the fundraising problem are the difficulties a firm may face when trying to procure local capital for its funds, which can have a ripple effect and cause unease among foreign LPs. "When you start looking at the flow of money within the emerging markets, that money seems to be going primarily to Asia at the moment," says Fossemalle. "Some of the local money does not necessarily invest in its own market. And if a Polish pension fund does not invest in its own private equity industry, why would foreign investors?"

Another of the difficulties faced when investing in the region is the imbalance in growth – CEE encompasses several types of economies, which are in various stages of progression. "If you assess the GDP growth across the CEE region, it has been uneven," says Kaido Veske, an investment manager at Baltic firm Livonia Partners. "Some countries are growing very well – Poland essentially did not have a recession – yet some are doing considerably worse. And it is not just economic growth, but also regulatory standards, political grounds and so forth."

Industrial clout
But investors are missing a trick by ignoring the region. Its geographical positioning alone puts it in good stead. "The European population is more than double that of America, and the big benefit of CEE is its strategic geographic location," says Veske. "It has got the scope to serve a very big market and when growth in wider Europe stabilises again, the CEE region will reap the benefits."

Anne Hutton, a senior banker at EBRD, describes CEE's industrial manufacturing industry as one of its strongest features: "One of the defining elements of this region is that there is a very skilled, well-educated workforce that is able to deliver this type of business." Thanks to its reputation for high-quality labour, coupled with lower labour costs than the west, CEE has been busy carving out its fundamental place within sectors such as outsourcing and industrial manufacturing – creating an attractive landscape for investment in the process.

"The CEE economies are still largely dependent on exports to varying degrees. In the case of Poland, exports are about 30-40% of GDP, but in other countries it may be higher – around 70-80% of GDP," says Jacek Siwicki, president of Enterprise Investors. "But these are mostly EU exports – Poland and other CEE countries are piggybacking on the growth of the German export machine. Polish exports have been growing 6-10% annually over a number of years now."

As a result of these strengths, parts of CEE are faring much better than some countries in the west. Poland and Lithuania have some of the EU's highest GDP forecasts for 2015 at 3.2% and 3%, respectively. Further south, Romania, Hungary and Slovakia are expected to experience year-on-year GDP growth in 2015 of 2.7%, 2.4% and 2.5%, respectively.

Unique opportunities
Beyond impressive growth prospects, CEE offers private equity unique opportunities: "There are countries in the region that have the advantage of EU regulation plus the advantage of still being an emerging market," says Fossemalle. "As these are European markets, there are not the typical risks that investors might have with some other emerging markets. But at the same time, we still see structural deficiencies, although this, in turn, allows private equity to make returns out of working on these deficiencies."

As well as this, some governments are making an effort to boost private equity activity. In the Baltics, for example, the European Investment Fund raised a €100m Baltic Innovation fund-of-funds with support from the three countries. But as EBRD's Fossemalle points out: "It is a case-by-case basis and still evolving. In the Baltics, they look at the private equity industry very directly. Some other countries are trying to develop private sector activity more generally, which automatically has a positive knock-on effect on the private equity industry."

Large-cap lure
As CEE's strong industrial sector matures – aided by local GPs in some instances –certain assets are catching the eyes of the larger global players. "It is still only a handful, but some of the big global funds are buying companies in the region that have been consolidated or professionalised by local fund managers," says Hutton. "To date, the secondary transactions market in the region has been very limited compared to western Europe, but now we are beginning to see these opportunities become more prevalent."

Mid Europa notably sold Serbian telecommunications company SBB/Telemach Group to KKR for an estimated €1bn in 2013. Mid Europa reaped a 3x return on its investment through the sale, which represented KKR's first investment in eastern Europe.

The arrival of the big players has yet to cause a problem for the local industry players – mainly due to the mid-market mentality of domestic investors, when global funds tend to focus more on the upper-mid and large-cap playing field.

But as Innova Capital managing partner Krzysztof Krawczyk points out: "Generally, the industry is not all that happy with the level of dealflow. There are very few deals in the upper end of the market (i.e. enterprise value of €100m or above), but the well-established players are able to keep closing deals. The dealflow problem is less of an issue for the mid-market players, which in CEE is below the €100m EV mark."

Despite the low level of activity, the impending uptick in the secondary buyout market driven by foreign investors is sure to offer some encouragement to local players, knowing that more options for exit avenues are opening.

Look out for our CEE regional breakdown tomorrow.

Enjoyed reading this article? Listen to private equity firms and LPs discussed in this article at the upcoming CEE Private Equity Forum, held in Warsaw on April 16. Click here to find out more and to register your place.

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• Topics
• CEE
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• EBRD
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• Advent International
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