Baltic businesses ripe for buy-and-build strategies

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While opportunity in the Baltic region is already growing, a strong foundation of local firms is needed for the industry to truly flourish. As deal size is far smaller than western Europe and Scandinavia, this tends to make the region fall off the radar of some of the larger funds located in the north and west. "If you look at Scandinavian buyers, they want to look at companies that are at least €20-30m in enterprise value," says Kaido Veske, an investment manager at Livonia Partners (formerly LHV Capital).

Livonia estimates that there are slightly more than a thousand companies in the Baltic countries that fall within the preferred investment size for the region – within an enterprise value range of €10-20m. "There's definitely a gap in equity investments between €3-15m," says Veske.

Despite the pickings from the region falling mainly into the small-cap market, the opportunities for consolidation across the three states is strong. "The area is small, so one of the strategies that is becoming more and more compelling for firms that are seeking to raise funds for the region is a buy-and-build strategy, consolidating the fairly fragmented markets," says Anne Hutton, a senior banker in EBRD's equity funds team.

"As an investor, you definitely have to operate across the three countries," agrees Veske. "If you had a €50-100m fund to invest only in Estonia, you'll forever be investing it.

"That being said, if you're going to have a €100m fund and you want to do deals across the three countries, it's not going to happen equally. There can be a much greater weight on one country than another. It's often said that Estonia is the fastest runner and leanest of the three, as everything from government operations to healthcare is administered efficiently online, but it's still the smallest economy out of the Baltics. Just from a pure numbers perspective, you're not going to have enough companies if you just look at a single country." 

Ultimately, the Baltic countries' reliance on exporting goods and its central position in Europe, which allows for smoother expansion into a large collection of neighbouring markets, makes the region an attractive space. "As Baltic economies are very much export-driven, there are always possibilities to invest in exporting manufacturing and service businesses – from electronics producers to call centres and aircraft maintenance services," says BaltCap managing partner Peeter Saks. "Actually, the structures of the Baltic economies are very similar to those of the Nordic countries, so one can do more or less similar deals here, although on a smaller scale, but with much less competition."

Opportunities also lie in the aftermath of the mass privatisation of the 90s, with companies needing external knowledge to extend their reach outside of the Baltic states. "Some companies have now been in the market for 5-10 years and are looking for the next phase of development through expansion to neighbouring markets," says Margus Uudam, chairman of the Estonian Private Equity and Venture Capital Association (EstVCA).

Tax & regulations
The Baltic region's links to western Europe and Scandinavia, coupled with very little bureaucracy and a low, transparent tax regime, means the environment for deal-doing is already favourable. Uudam points out that the Baltic states' well-regarded e-infrastructure system also makes the region a straightforward place to do business.

The three countries, already members of the EU, are also on track to all become part of the eurozone. Estonia adopted the euro in 2011, with Latvia following suit at the start of this year and Lithuania on track to join as the 19th country in the eurozone. "This limits monetary risks and allows the countries to maintain investment-grade sovereign credit ratings," says Veske.

In particular, the region's tax system can act as a beacon for attracting private equity investment. "Corporate tax is very low – almost non-existent," says Veske. "In Estonia, for example, there is no corporate tax, so if the company keeps reinvesting its profits it doesn't have to pay tax."

Small distinctions such as this lend further credence to the Baltic region's readiness to establish a healthy, long-term private equity industry. "People like to sometimes generalise over eastern Europe," notes Veske. "But they're all very different in terms of their history and where they have gotten to since the early 90s."

The Baltic region, in particular, has moved quickly to enforce favourable tax regimes, property rights and laws that stand the chance of attracting foreign capital. This is all coupled with very stable government, which has seen the region through a period of austerity during the recession and is now coming out on top as the three economies continue to grow.

However, despite a seemingly ideal framework for private equity, some aspects of the industry still have room for improvement. "While the PE and VC industry is growing, in a wider context there are some systemic challenges across all three countries for entrepreneurs, fund managers and institutional investors that need to be addressed," says Lovis von Andrian, an analyst in EBRD's equity funds team. "Particularly, the need to establish collective investment vehicles laws and, where these are already in place, to simplify the structuring burden on fund managers is a priority to attracting a broad range of investors."

Debt
While a more diverse set of lending options in the region is only now being established, leverage is still available from banks. "Banks are lending again for acquisition finance, although funds have to be careful to avoid the perils of high leverage coupled with typically higher level of earnings volatility in the region," says Veske.

"In terms of debt provision, the banks are relatively active in the region," says Iliya Mihov, an associate banker in EBRD's equity funds team. "We have noted that debt is available for acquisitions or capital expansions primarily to larger companies and existing clients of the banks. In addition, larger financial institutions and private equity firms are also able to access debt from the banks to support either portfolio companies or new transactions.

"However, at the lower end of the market, what we have observed is that small companies that are asset-light and don't have a very long credit history with the banks are not really able to access sufficient financing from banks to support their relatively rapid growth."

The struggle for SMEs to procure leverage and a current lack of alternative options in the Baltic countries was the driver behind the EBRD board approving a new mezzanine fund for SMEs just last week. The Baltic Polish Mezzanine fund, which received a €30m commitment from EIF's Baltic Innovation Fund and is managed by BPM Capital, hints towards non-bank lending for the Baltic region's smaller market becoming more readily available.

Through its favourable law and tax regimes, coupled with a burgeoning small-cap landscape with high prospects for a thriving export market, the Baltic region has crafted itself into CEE's hidden gem for the asset class. What has long been regarded as an emerging market is well on its way to becoming a fully-fledged private equity industry.

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