Bright future: Investment opportunities in Estonia

Talking to Estonian investors and entrepreneurs, almost all conversations make mention of Skype and TransferWise. And it would seem those high-profile startups might well be replaced by others in the years to come, as all signs point towards a continuously improving deal climate. Local and foreign investors are confident of enjoying positive years ahead, both in private equity and venture capital.

There are two key influencers that have and will lead to a positive investment environment in Estonia; the national government and the European Union. Says Martin Kodar, partner at BaltCap: "The government understood several years ago that private equity is important for the economy, because it brings new capital and also the professionalism on the owner side to make it possible for companies to grow and expand."

An indefinite tax deferral for reinvested profits and liberal laws on the taxation of dividends paid from other jurisdictions are two attempts to encourage local investors and to attract more foreign capital to the market. For Kaido Veske, co-founder of Baltic investment firm Livonia, efficient tax systems are not the only attractions: "As an investor, I not only look at the tax structure, but I also ask: How stable is the political system, how proactive is the government focused on reducing bureaucracy and regulatory burdens? The government has done a good job on that front."

Kodar praises the investment environment as well, but he still sees room for improvement: "One thing that hasn't been done yet is creating an environment that enables us to use an Estonian-based fund structure, because there aren't any entities that we can use to establish an Estonia-based fund." He adds that this is apparently in process. Indeed, unquote" recently reported that registering funds in onshore jurisdictions is becoming increasingly popular with European GPs, and Latvia has emerged as a potential new hotspot.

Booster fund
In order to boost growth in the region, the European Investment Fund (EIF) set up the Baltic Innovation Fund in 2013. This fund-of-funds aims to invest €130m in private equity and venture capital vehicles in Estonia, Latvia and Lithuania until 2016, with the hope of attracting additional private finance through this initiative. EIF committed €52m to the vehicle, while each Baltic government provided €26m.

Besides Livonia and BaltCap, newly established BPM Capital is the third GP to benefit from the Baltic Innovation Fund. BPM was only established last year and has raised €70m for its first fund. The Tallinn- and Warsaw-based firm focuses on mezzanine financing, though it has not yet made any investments.

Besides strengthening local GPs, the idea behind the fund-of-funds is to draw attention from a larger number of international investors. This often proves hard for smaller countries, Estonia being small both in terms of geography and population, with 1.3 million inhabitants.

Graham Cope, senior head of northern Europe and CEE at EIF, understands the country's limitations but does not see this as a bad thing: "Ultimately, it is a small economy with a limited number of enterprises. Therefore it is obviously not going to have the same kind of critical mass of investment opportunities as other countries. But that does not mean that there can't be very good investments within that limited universe."

The Baltic region is young, compared to those countries not hidden behind the iron curtain until the 1990s; therefore, the concept of private equity is still relatively new. Veske believes this is one of the reasons the region is still less active: "Compared to the EU, the Baltic countries are seven times under-invested in terms of the GDP. We think that this will increase. More penetration in the next few years is a factor that we are betting on."

Obvious opportunity
In terms of investment opportunities, the startup scene with its early-stage opportunities is the most obvious. The information technology and consumer services sectors, which traditionally produce many startups, were the most active in the country in 2014, according to government initiative Startup Estonia.

And it would seem government schemes aimed at fostering new businesses are finding success. Government-backed investor SmartCap, which has invested around €19m to date, supports entrepreneurs but has managed to decrease its intervention over the last few years. For Mari Vavulski, head of Startup Estonia, this is good news: "In SmartCap's early years, our money was somewhat impactful. In 2011 we invested more than 20% of the total capital; lately our numbers are rather marginal. Circa 1% was invested in 2014. That is how government interventions should work, kickstart a nascent market and then be phased out."

This means today, entrepreneurs are increasingly turning to international investors for finance. According to the Estonian Private Equity and Venture Capital Association, local capital accounted for only 23% of investments in 2014. Looking at a crowdsourced list of Estonian startup deals for 2015, it becomes clear how these growth stories are playing out. Small deals like the €500,000 investment for Funderbeam were mainly backed by local investors. After the company has begun to grow it is common for them to move their headquarters or parts of their business abroad, often to the UK and US, and raise funding from local VCs. Testlio for example raised $1m from a US investor. The startup took part in an accelerator in the US and is now based in Texas, but kept an office in Tallinn.

Size issue
For private equity players, size is key. Many deals in the country are too small to attract foreign investors. "When it comes to larger deals in the area of €20-30m, we get foreign equity funds competing for them. Below that, it's too difficult for foreign players to come to that market," says Kodar. The hope is that with the help of EIF, the country will start producing larger deals over the next decade. In 2014, buyout deals accounted for only 6% of the country's investments, while early-stage and startup deals took up 66%.

While IT startups are one of the most promising attractions to Estonia, the opportunities for private equity are more widespread. BaltCap's Kodar sees a raft of interesting sectors: "The most competitive deals are business related services. Apart from that, some manufacturing sectors, electronics, metal and wood manufacturing were traditionally strong and will continue to be." Veske draws a similar picture, with a particular fondness for the country's manufacturers: "A lot of companies are growing and are doing very well in the export markets. That's also due to the fact that the work has been left undone, creating a lot of opportunity in that space."

For GPs operating outside the Baltic countries, the region might become more attractive over the next decade, if deal sizes continue to grow. However, given the sizes of the countries, they are unlikely to be plentiful. For LPs, the opportunities are there, meaning we could see larger fund investments in the future. EIF's Cope is optimistic on this front: "There are a series of LPs that have invested in the country since EIF became a cornerstone investor. This includes pension funds, Swedbank, SEB and a variety of other private LPs. We see a significant positive development and hope to see more of that in the future."

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