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Hungarian private equity market showed clear signs of maturity in 2004

Without wanting to state the blindingly obvious, emerging markets are by definition emerging. They do not possess the characteristics of mature and established markets. But the term 'emerging' tends to distort the extent to which individual markets have reached different points on the path to adulthood. Hungary is a clear example of a market that has perhaps been done an injustice by still being termed an 'emerging' market.

There have been clear signs over the last 12 to 18 months that its private equity market has experienced a series of developments that mark it out as being a long way towards maturity. It witnessed its first secondary transaction, saw the arrival of a handful of major international players, recorded a significant increase in activity, and began to enjoy the benefits of a growing pool of experienced and internationally-minded management talent and entrepreneurs. All of these are critical characteristics of a mature private equity market.

The crowning moment, at least with regard to the attention it received, was accession to the EU. The real work in accelerating economic and legal reform long predated the ceremony itself, which was largely symbolic, but it was of considerable psychological importance and had the effect of drawing an unprecedented amount of attention to the region. And this should have the benefit of clearly distinguishing Hungary from other emerging private equity markets at a time when institutional investors are looking with ever-greater seriousness at internationalising their portfolios and committing to regions as yet under-explored.

Looking back on 15 years of private equity

The first venture capital/private equity funds appeared in Hungary between 1989 and 1990. They were mostly government-supported, often US-government-backed funds, and/or government-supported investors. Two to three year later the first Central & Eastern European funds became active in the market and then the mid 1990s saw the first specialised funds, for example sector-specific funds.

Julián Tzvetkov, president of the Hungarian Venture Capital Association, said, 'In the past 15 years about €1.7bn of private equity and venture capital have been invested in the country. Approximately 75-80 funds have been active in Central & Eastern Europe over the years, and currently there are about 35 funds.' Until the mid-1990s the funds active in Hungary were mostly country funds and were generally based outside Hungary, whereas now funds are focusing on Central & Eastern Europe. Most funds are still based outside the country, with only a few Hungary-based funds. Recently global funds have also increased attention towards investments in Hungary.

Just as other countries around the world, Hungary felt the effects of the dotcom crash, albeit in a secondary form given the relatively low level of tech investing at home, and the number of private equity transactions dropped. But the last two years have seen the downward trend halted. And not only did activity level off but 2004 saw the arrival of the first global funds and the country's first secondary buy-out. Both were clearly interrelated and the significance is considerable: the country now has a sufficiently large and well-capitalized investor base to provide an alternative liquidity route. Tzvetkov, said that last year 'the funds often represented international investors, private investors, in a way that previously had not existed in the region.'

As the economy matures, the number of transactions and the number of private equity firms has been going up. In addition to the increase in the number of big international funds, there were also many regional players and smaller funds in the €10-30m range active in the region. Many young private equity firms have been backed by banks, insurance companies and private equity firms in the West. The industry appears to have achieved critical mass.

Joseph Schull, managing director at Warburg Pincus, a US private equity firm which is very active in Central & Eastern Europe, said, 'There is a process going on in Hungary and other Eastern European countries. The maturity of the market that we saw in 2004 was part of a 15-year-long development and not so much a major turning point. The people in the country simply have had many more years of experience with private equity.'

Young entrepreneurs and managers of companies across all sectors often have studied or worked in countries with mature venture capital and private equity markets, and this is only one reason why the new generation of business leaders appears to be more open to alternative asset classes.

The picture today

The data underscores the gradualist evolution of the Hungarian market without picking up the qualitative developments that are more interesting measures of its growing maturity. According to the latest HVCA survey, including data from the first ten months of 2004, investment activity last year was on a similar scale to the previous year. The first ten months saw €96m invested compared with €117m for the whole of 2003. The number of transactions went up slightly from 32 in 2003 to 35 transactions registered by the HVCA between January and October 2004. Preliminary figures show that the number of transactions may have reached 40 by the end of the year.

The most popular destinations for private equity and venture capital investing were the transportation, logistics, business services, manufacturing and pharmaceutical sectors. The highest number of transactions in 2004 was registered in the business services sector.

But perhaps even more important as an indicator of the market's maturity has been the significant increase in exit activity. There were 20 exits in the first ten months of 2004. The HVCA recorded only seven exits (six trade sales and one sale to a co-shareholder) in 2003. Trade sales remained the most common exit route in 2004, while IPOs were still rare.

'The 2004 data reinforce last years' balanced and continuous development trend of the Hungarian private equity/venture capital market, which considerably contributes to the improvement of the financial and managerial culture of the Hungarian companies and the maintenance of capital market liquidity,' said Tzvetkov.

The HVCA also found that in the first ten months of 2004 about 80 per cent of transactions in Hungary were in the segment below €2.5m. However, these transactions account for only 21 per cent of the capital invested. Transactions with a value of more than €5m represent 20 per cent of all transactions and give nearly four-fifths of the total investment value. There were two investments of more than €15m, which is in line with trends of the previous years. The HVCA statistics also revealed that for the first ten months of 2004 the venture capital side of the market remained weak, with few players acting in that market (such as Eclipse, Euroventures and Primus Capital) and few deals being completed.

EU membership opens doors to more investments

The single most important event influencing the Hungarian private equity market in 2004 was 1st May, the day when the country joined the European Union. Deals are now subject to EU legislation and EU competition regulation. This development created a favourable environment for the first global funds, which appeared in Hungary in 2004. Their presence, combined with their investment power and transaction experience, has changed the structure of the industry and helped it mature at a faster pace.

The obvious benefit for the country of joining the EU is the extent to which it mitigates concerns about risk. Schull explained, 'There has been a decrease in the perception of risk in the market. The perceived risk profile is now approaching an EU rather than an emerging markets risk profile.' Hungary's EU membership makes a real difference to investors as Schull summarises: 'We can now see the path the country will be on for the next 25 years, as part of the European Union, with steadily decreasing country risk.'

Accession has also bred a new degree of economic confidence. The private equity firms' portfolio companies in Hungary are judged to have better growth prospects because of their EU membership and the newly acquired membership of other countries in the region. They can now more easily expand across borders and/or work more easily with their counterparts, suppliers and customers in other EU countries and have better access to capital and debt.

Other opportunities result from the still ongoing transformation of the state economy to a private, competition-based economy. Turning former state-owned companies into profitable private businesses remains a continuing task, in which private equity firms can play an important role.

Issues that Hungary needs to address

But for all this development, Hungary remains emerging to the extent that there are still significant obstacles to overcome before the country's private equity industry can be compared with those of Western Europe.

The HVCA is working together with other players in the private equity and venture capital market to change the regulatory environment to increase the number of investors, especially in the middle-range segment. Tzvetkov said, 'The medium segment, €2.5-5m, saw no investors in the first ten months of 2004, which indicated that funds targeting smaller-value investments were still missing from the Hungarian market.'

Changing the Venture Capital Act could create a more favourable environment if the right changes were made. Tzvetkov explained, 'You could ask the question, "Do we need a Venture Capital Act?", but I think this is not the most important question. There are countries in which the private equity and venture capital market functions very well with an Act and others that have made good experiences without a Venture Capital/Private Equity Act. Important is that whatever we have in place, it should match the needs of the market.'

Mainly, the original vision of the Venture Capital Act in Hungary was to protect smaller investors. 'But small investors usually do not invest for an eight to ten-year period. Big institutional investors, on the other hand, have the experience and the structures in place to protect themselves,' said Tzvetkov.

The Act is regarded as being too restrictive because it includes regulations such as that each Hungarian fund has to invest certain percentages of their capital within certain time frames: within the first three years of the operation of the fund 30 per cent have to be invested and within the first five years about 70 per cent of capital have to be invested. This regulation puts investors under pressure and forces them to invest regardless of whether there are good opportunities around or not.

Another heavily criticised point of the Act is that private equity funds in Hungary are not allowed to invest in listed stocks, which can restrict funds' investment strategies.

A case study: FiberNet

An example of a major transaction in 2004 was the deal in which Warburg Pincus acquired the Hungarian cable communications provider FiberNet from Central & Eastern European private equity firm ARGUS Capital Partners for $72m.

FiberNet was established as a start-up in 1999, when ARGUS Capital invested $12.5m for a majority stake. The company became the largest independent cable television operator in the country. 'By 2004 FiberNet had grown to a new stage of development and needed a substantially larger amount of capital to take it to the next level,' said Schull. He explained that FiberNet illustrates a broader development: 'Companies established since the fall of communism have grown and are now ready to take on larger amounts of capital.'

This deal was significant because 'it was the first secondary transaction in the country and one of the first leveraged buy-out transactions in Central Europe,' explained Róbert Héjja from ARGUS Capital.

Commenting on the deal, Schull said that the cable communications market would be a major growth area in Hungary: 'People's disposable income has increased and spending on cable television, the internet and entertainment services will increase. The growth prospects of the cable communications sector in Hungary are much better than in the more mature markets in Western Europe, for example.'

Given the size of the Hungarian private equity market, the FiberNet deal was a very large transaction. This successful deal, in which two major international private equity firms participated, also sent a signal to international investors - the Hungarian market had turned into a potentially attractive target.

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