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Accession provides new opportunities for private equity investment in Central Europe

Ten new members will be joining the European Union on May 1st this year, eight of which will be formerly communist countries from Central and Eastern Europe. The expansion of the EU will be accompanied by a wealth of private equity opportunities in these newly integrated states, but the window of opportunity is narrowing fast, according to Joanna James of Advent International.

Private equity opportunities are shifting east and the window of opportunity is now. The harmonisation of Central Europe's fiscal, legal and regulatory systems with those of the EU, which has taken place in the run up to accession on May 1st, has already sparked a wave of inward investment and increased trade. The region, after all, offers high growth, low costs and an under-developed private sector. And the adoption of the acquis communautaire, the EU's body of regulations, will underpin international investor expectations of the region's respect for the rule of law.

EU membership will lead to sounder fiscal approaches to public finance and a requirement to reduce budget deficits and ought also to confer on the accession states a natural constraint on political decisions. This will reduce the remaining perceptions of risk in the region, thereby broadening the financing options open to the private sector, allowing debt to be used more widely and encouraging further foreign investment.

The prospect of new capital being freed up for Central European projects is attractive to those of us who have pioneered private equity investment in the region. We believe that the best opportunities are available now, before accelerating demand drives up the prices of deals. But this window of opportunity will only remain open for a few years, before moving further east.

A common misconception outside the region is that deals centre on privatisations of state-owned assets. In reality, 70-80 per cent of GDP across this region is already in private hands. The opportunities now are in taking these already private businesses on to the next level.

A good example is Terapia, one of Romania's leading pharmaceuticals businesses. Effectively the original research and development arm of the Romanian healthcare ministry, Terapia was taken private in the 1990s and floated on the Romanian stock exchange. In August 2003, we acquired the company in Romania's first leveraged buyout. Terapia has a great opportunity to consolidate its position in the Romanian market and then to export to the rest of the region. The average person's annual expenditure on pharmaceuticals in Romania is $23, compared with around $90 in Poland, which demonstrates the scale of opportunity for Terapia both at home and internationally.

Whilst in its way symbolic of the times, the Terapia deal also serves to underline the weaknesses of the domestic stock exchanges in the region, where chronic illiquidity is driving publicly quoted companies to look to the private equity sector for more efficient sources of capital. Stock markets may in time change but their current illiquidity offers a source of deals for now.

The availability of bank debt has also been a key driver in pushing the region's fledgling private equity market forward in recent years. Although there are no current figures on the amount of debt financing available, there is growing interest in the region as a whole. As Anthony Saint, head of specialised finance at Standard Bank London, says: 'What is interesting is how the region is becoming tiered. Five years ago a bank would have viewed Central and Eastern Europe as a single region, but today investors will expect higher returns from places such as Russia and the Ukraine, as they are seen as higher risks than the likes of Poland and Hungary which are set to join the EU.'

The increase in foreign direct investment is already helping to drive improvements in living standards and expectations. For example, Peugeot is set to invest more than E700 million in a new factory in Slovenia and there will be countless western businesses watching with interest to see if Central Europe can offer a new hub for their manufacturing requirements.

The drive in the West to outsource to cheaper labour markets will be a major potential source of growth for the region over the coming years. This will provide a significant boost to companies, which will benefit not only financially, but also from new commercial disciplines that this investment will bring. And as the region harmonises its tax, legal and regulatory frameworks, it will become more attractive to investors, driving increased merger and acquisition activity across borders.

Central Europe is poised to shrug off its 'emerging market' tag. Look at Poland and Hungary and it is hard to view these markets as 'developing' - on the contrary, they are well on the road to being fully developed. Companies like Zone Vision demonstrate what is possible. The company began life in Warsaw selling programmes to Central European cable companies, before recognising that the viewing habits of the region were not so different from the rest of the world, so it set about developing its own international broadcasting network.

Private equity funding helped the company develop its own proprietary television channels. Today, three channels - Reality TV, Romantica TV and Europa Europa - are sold into more than 125 markets worldwide and sales approaching $40 million. Zone Vision is one of the best examples of how an operationally led business can develop a franchise that competes effectively against Western rivals.

In common with many private equity-backed businesses, Zone Vision benefited from its ability to develop a strong international management team. It is also reaping the rewards of the reversal of the brain drain of homegrown talent. Previous generations of shrewd people were educated abroad and stayed there to apply what they learned in the commercial world. No more. People who would have taken an international MBA or similar educational kite mark have been coming back to apply their knowledge in their domestic markets. They recognise that living standards in their own markets are rising and they want to be part of this wider development push. Real career opportunities now exist in the region and the quality of talent is rising each year.

Entering the EU will of course also present some major challenges for the accession states. The harmonisation process will inevitably lead to tax increases as rates are brought into line with those of EU members. Companies currently focused on the domestic Polish market place, for example, will have to increase their VAT rate from eight per cent to 22 per cent. They are unlikely to be able to pass this on to their customers immediately, leading to a short-term squeeze on margins. And, although harmonisation of national legislation with EU laws in the accession states has been underway for some years, enforcement - especially in the exceptionally complicated area of competition law - is yet to be tested.

So is it all rosy? Not quite. Despite the changes and improvements, Central Europe remains a difficult place in which to complete deals that generate significant returns for investors. You certainly need local expertise to make it work because you have to buy into growth companies and help them grow. There is still no place here for the financial engineering common to many Western LBOs. Debt-equity ratios seen in 2003 deals included a sizeable portion of equity, so the focus must be on picking investments that can grow. This means selecting investments and management teams that can establish a strong presence in their domestic market and then use it as a platform for wider growth.

Deal origination continues to be a difficult process. Whereas in the West deals are often auctioned, the businesses typically being owned by large companies and conglomerates with public shareholders to satisfy, this is not generally the case in Central Europe. Here, they still tend to be proprietary and in the control of a handful of shareholders. This means that deals can take an inordinately long time, given that there is no formal process and the purchaser is driven by the agenda of the vendor. In the West, deals are regularly priced at a premium, but in the East they can attract as much as a 25-30 per cent discount. The perceived risk is much greater than the actual risk.

In the West there is a deal process. The auction is led by an adviser, who provides a data room. Bids are lodged and that is it. This just does not happen in Central Europe. More rigour will come but it remains a difficult process. The deals that get done will increasingly be traditional buy-outs. There is, as yet, little or no appetite for venture capital and seed financing in the region, although that will come as successful entrepreneurs become business angels and the food chain expands.

Analysts and investors alike believe the real opportunity for investment in Central Europe is likely to last for perhaps two to three years, so established private equity players are moving quickly to consolidate their advantage. And the scope of the market has not been lost on other protagonists in the international financing field. Ratings agencies have been increasing a whole slew of ratings in the region. In November last year, Fitch international revised its outlook on the long-term foreign currency ratings of seven EU accession countries to 'positive' from 'stable'. This is a precursor to their commitments to adopt the Euro.

The influence of Central Europe will become increasingly pronounced across the entire continent, politically, socially and economically, over the next few years. Whereas the current 15 member states of the EU have less than 30 per cent of their collective populations under 30 years of age, the new entrants have significantly more than 30 per cent of their populations under that age. Some, like Slovakia, have nearly 45 per cent of their population under 45. Over the next two decades the centre of power in Europe is likely to shift eastwards, just as its political and creative pulse is doing today.

For those focused on investment, the window of opportunity in this region will narrow. This presents exciting opportunities for those on the ground today and a serious requirement to play catch-up for those still intending to enter the fray.