Private capital markets in Poland: A third wave of opportunity and challenge

More importantly, two significant new exit avenues are becoming more readily available. This article will provide a survey of fund activity, an overview of market changes, and several considerations for investors seeking to participate in this market.

Overview.

As uncertainty and transaction risk generally settle down throughout Central Europe, Poland is increasingly viewed as the emerging market of choice for institutional investors seeking superior yield with moderation.

We see the private capital markets in Poland as now representing a third wave of development: following the end of communism in 1989, Poland saw its first, less-than-fully mature wave of activity, as a significant portion of the industrial sector -- usually the poorly performing portions -- were sold in the "shock therapy" of privatization.

The second wave was characterized by more sober corporate development along a steep learning curve, with a pullback in the public markets and the advancement of a tier of skilled corporate managers who learned through experience.

Today, fundamentals appear to be sound -- in June, inflation was recorded at 0.8 % year-on-year, down from 0.9 % the previous month. The equity markets continue to go through growing pains -- among other limitations, true LBO activity still has not arrived in any appreciable way. Nonetheless, current activity shows many of the hallmarks of mature western-style growth investing.

Partnerships Active in Poland.

Poland represents perhaps the most promising market in the east: the population of 40 million is generally well-educated in technical fields, and Poland's national income comprises more than 50% of the entire Central and Eastern European zone. However, investors should recognize that Poland's GDP is still only about a third larger than Wal-Mart's (sales of about $312 billion, compared to Poland's 2004 GDP of $463 billion). Limited partners interested in this potentially crowded space must make their allocations carefully.

Accession to the EU in May 2004 accelerated both the westward flow of goods and services as well as capital moving eastward to support deals. Today, about 40 funds report they operate in Poland. These vary from bank-sponsored groups with no capital at work as yet, to active teams with well-developed portfolios. Few have had fixed investment criteria or industry focus: Enterprise Investors, for example, now seeks larger deals in a regional focus, while others such as Krokus Private Equity continue to deliver superior value by concentrating on its market specialty in Polish growth sectors.

While private equity in mature markets tends to focus on generational succession, private equity in Poland is still mainly mature venture capital or expansion capital. The market has not yet seen industry specialization, and most managers tend to seek balance with assets from different industries.

Krokus Private Equity, for example, has seen success in diverse industry sectors -- notably, its investment in Helios Cinemas, a chain of cinemas in smaller cities throughout Poland, and with Praterm, SA, a district-heating company that has grown through the acquisition of municipal heating systems. The group believes its country focus encapsulates its value proposition: "Polish growth rates are about twice that of the Eurozone," observes Witold Radwanski, the group's President, "and inflation is the lowest in Europe."

In the cinemas deal, Krokus built an entertainment company that tapped into strong buying power of the Polish middle market entertainment consumer. In the district heating deal, the group brought badly needed management and capital improvements to municipal heating systems - an essential resource in a country with hard winters. Krokus is now in the market with Nova Polonia Natexis II, its fourth fund, with a target of € 75 million. Of this, Radwanski said that € 40 million is already committed by institutional investors.

Working with larger deals is Innova Capital, active in Poland since 1994. Innova's current fund, now in its eighth year, is Innova-98, a $125 million fund focusing on Poland, Romania, Hungary and the Czech Republic. The group's favored sectors include specialized media, financial services, telecoms, and commercial manufacturing. As an example, in May 2005, Innova acquired EBCC Poland S.A, a producer of aluminum brake components. In February 2006, the group took an innovative approach by acquiring an interest in Fuchosa, S.L, a brake components company in the Basque region of Spain. In the initial deal, debt financing of € 20 million was provided by Acquisition Finance Erste Bank, and for the add-on, € 16 million was advanced by a syndicate of Spanish banks.

Another active participant in the middle market is Oresa Ventures, a private investment group with Swedish roots, with offices in Poland as well as Romania. The team has invested E 100 million in the region since 1996. Its Polish team is led by Erik Hallgren and Marcin Radziwill.

Enterprise Investors is the largest and oldest private equity house in Central Europe. Describing itself as a generalist regional fund with a primary focus on Poland, the firm has about more than € 500 million under management and thirteen years experience in the market. In 2006, it had two highly reported exits: in June, it sold the remainder of its investment in Sfinks, a restaurant chain in an IPO on the Warsaw Stock Exchange. EI reported that the sale yielded a 6.8x investment multiple and gross proceeds of $25.5 million. In January, EI sold the second half of its initial 79% stake in Polish IT company Teta on the WSE, yielding a 2x investment multiple. Enterprise Investors is believed to be actively fundraising in North America.

In February, 2006, Société Générale Asset Management/ Alternatives held a first closing of SGAM Eastern Europe on € 80 million toward its target size of € 150 million. The firm expects to announce the final closing by the end of this year. SGAM Eastern Europe will target investments in expansion capital and buy-out transactions in Eastern and Central Europe.

In late 2005, Mid Europa Partners announced the closing of an € 650 million fund for Central Europe dedicated to Central Europe. The firm formerly known as EMP Europe has closed the largest private equity fund aimed at Central Europe, and said that it would deploy "up to € 100 million" per transaction. Mid Europa will need consistent deal flow of substantial volume to put that amount of capital to work. We see this new tier of private equity participants as fueling the private capital markets. In early August, Mid Europa Partners announced it had sold Czech cable company Karneval to an affiliate of Liberty Global Inc. for € 322.5 million. The investment return on the deal wasn't reported publicly.

London-based media fund Veronis Suhler Stevenson, has had good experiences in Poland but doesn't yet dedicate resources specifically to sourcing deals there. The fund, based in New York and now sitting on $1.3 billion closed in 2006, had media assets in the market through its acquisition of a telephone directories business that later became Yellow Brick Road, the pan-European phone book company sold to Macquarie Capital Alliance Group in 2006. The deal garnered VSS some good press: Thomson Financial named it "Exit of the Year".

VSS Managing Director Marco Sodi likes Central Europe. "Emerging markets will provide higher growth at the top line… along of course with higher risk" he says. He rates Poland and the Czech Republic as the top two markets for growth "given the risk-return equation." Sodi said that opening an office in the region is "certainly a possibility over the next five years." He said VSS is currently looking "at two standalone investments" in the Polish market.

Other groups tend to participate in Poland through local deal-sourcing teams. Vienna Capital Partners, traditionally focused on Austria and Croatia, announced last month that it was dedicating € 500 million to sourcing deals in Poland. VCP is not a committed fund, but seeks deals for its well-capitalized partners, which include Permira, the European mega-fund.

Finally, active bank-sponsored private equity teams are being operated in the market by KBC Bank, CAIB (the former Creditanstalt/ Bank Austria) and Raffeisen Bank.

Limited partners tend to seek exposure to the growth characteristics of Poland through fund-of-fund vehicles. These include Mandatum Private Equity of Poland, Nordea Bank, the pan-Nordic banking group acting out of Copenhagen, and the French group AXA Financial. Active limited partners acting in the market through funds of funds include Swiss funds of funds, US pension funds like California (a limited partner in the newest Enterprise Investors fund), and private equity partnerships in Denmark, Sweden and Finland.

There are also two providers of mezzanine finance, but the region is generally not yet mature to accommodate a widespread market in cash-flow oriented lending.

New York City's Riverside Company has a significant allocation to Poland, and a dedicated deal team managed by Tony Cabral and Piotr Misztal in Warsaw. Riverside is executing its tested buy-and-build approach in various industries in Central Europe. Within Poland, the group's portfolio includes MK Chimney Systems Zary, the leading producer of chimney systems and chimney liners in the country, and an exporter to Western Europe.

In April 2005, 3TS Capital Partners closed on its € 100 million fund for deals in Central Europe. At that time, reflecting the general maturation of the private capital markets, the group changed its name from 3TS Venture Partners. The group has historical roots in technology, media and telecommunications, and its first deal in the new fund was an investment into ClickAd, an online marketing company.

London-based Bancroft Group also has an allocation to Poland and has several deals currently in the pipeline, according to Investment Director Slawomir Ludwikowski.

New Avenues for Exits.

Poland's state-owned exchange, the Warsaw Stock Exchange, is providing new opportunities for smaller companies to exit through public listings. Under new rules, Poland's pension funds can allocate certain aspects of their portfolio to listed equities, provided these are listed in Poland. There are fewer than ten major pension fund investors in Poland, and so these are all seeking now to allocate assets to growth-oriented stocks, and to participate in new issues. The result has been sustained strength in share values -- five record highs were met between April 1 and June 30. Our recent survey indicated that media companies listed in Warsaw trade at about four times turnover (two internet companies are included in this sample.)

An important, fundamental reason for interest in WSE is the greater liquidity and generally better accounting transparency compared to other CEE markets. In pre-1989, most eastern-style accounting did not recognize accrual concepts of net income or non-cash concepts of depreciation or amortization: accountants focused on keeping track of inventory so that it wouldn't be stolen. Today, however, corporate managers Poland can talk in generally recognizable terms about operating metrics and ratios.

Additionally, the nation's privatization timetable has slowed, and so domestic institutional and retail investors are eager for any product they can get their hands on. Companies as small as pln 75 million ($25 million) in enterprise valuation are finding a receptive audience among pension fund managers in initial offerings.

The strength in the WSE, moreover, is making life more difficult for private equity managers like Slawomir Ludwikowski, Investment Director for Bancroft Private Equity, who said that business owners now ask him why they should sell to a private equity fund at all, and not go directly to public investors. The answer of course, is that private equity resources can maneuver more quickly to enable a portfolio company to acquire other strategic assets in the market, and build greater value for the owner.

Given the recent high levels achieved on the WSE, we actually feel the private capital markets present lower risk for investors than do the public markets. Private companies are valued at a discount to their public comparables; the long-term growth curve favors growing private companies; and, exits are available through trade sales or the second, increasingly visible exit -- the secondary sale to a larger private equity fund.

At present these exits remain in the minority, but they are on the rise. A 2005 survey published by Innova Capital rated those fund's exits as: 15% trade sale, 26% trade sale, 16% write-offs, and 33% others, which it described as mainly private equity secondaries. Large private equity groups are getting active in the market, as we saw with the entry of Mid-Europa in late 2005. We expect to see the pace of secondary sales increase as smaller market funds seek certainty of close, and larger international funds seek greater exposure to the market through an allocation to Polish portfolio businesses.

Considerations for Limited Partners.

Investors seeking optimal returns with balance will probably wish to allocate funds to an emerging market like Poland. Part of the challenge in a smaller market involves finding managers who can meet and exceed expectations on a variety of factors. Here are six considerations we are hearing from experienced LPs in the market:

1. Seek a seasoned team and evaluate succession issues. Limited partners should always look for teams that have worked together before. This is even more advisable in an emerging market, where a team's effectiveness depends on how well they make tough decisions under pressure. And, when senior managers are older, it is also critical to ensure that the team has sufficient midlevel talent who will have the experience in seven to nine years to organize exits effectively.

2. Fee structures can be aggressive. Most venture funds today charge management fees of 2.5%, up from 2% in past years. Including audit, insurance, meeting/ report and diligence expenses, nearly 30% of committed capital could go to things other than investments. Lead limited partners sometimes recommend that fees be moved back to 2%, but with a carried interest increased to 25%, in order to make the deal attractive to everyone.

3. Appreciate infrastructure limitations. Certain important legal structures remain somewhat undeveloped in key areas. Among these:

(i) Certain corporate structures remain novel. For example, "With certain exceptions, a Polish joint stock company cannot buy its own stock, or provide assistance to the acquisition of its own shares," notes Michael Davies, of Siemiatkowski & Davies, a Warsaw firm with English law and Polish law expertise.

Since a target cannot provide credit support for its own acquisition, a buyer usually cannot access traditional forms of acquisition financing. This is the core of most LBO financing in the west. Buyers instead tend to make acquisitions on an all-equity or mostly-equity basis, but then later can dividend cash or pay fees to the fund after the portfolio company accesses a bank line. Davies says that Polish banks are wary of lending into an acquisition, and there is less of a tradition of banks teaming up with equity funds, as is common in markets in London, Paris, Brussels or New York.

Moreover, Davies says "there is an even more limited tradition of confidence-building and courtship between buyer and seller, and less transparency than would usually accompany due diligence in the west." Sellers usually expect a buyer to sign a "preliminary agreement" very early in the process. Unlike a letter of intent, the preliminary agreement can legally bind the seller to consummate a sale. The problem is that sellers limit the due diligence at this early stage, treating their P&L like state secrets.

It is particularly difficult for public companies to sell divisions to a private equity buyer, since it is legally unclear whether a public company can legally disclose segment information to a private equity buyer if that information is not disclosed to the market in general. It takes a really savvy and well-advised private equity investor to build the confidence with a seller to make a transaction a "win-win" scenario.

Often, says Davies, if a fund team doesn't proactively court management, "a transaction can simply remain stalled in the discussions phase."

(ii) Governance mechanisms are still poorly understood. There still exist few if any protections for minority investors, and growth capital investments can be a particular challenge. Investors in a minority posture must be careful to secure their rights by contract. For example, managers of private companies should all be paid according to pre-set formulas, with certain discretionary bonus amounts, as it is not uncommon that a single director can act legally in the name of the company.

4. Limited availability of banking infrastructure. As we've noted, the market is evolving from an expansion capital market to a buyouts market; investors should recognize that there are still relatively few experienced lending professionals. Some banks have made commitments to provide deal-related loans, but commitment committees are only gradually getting used to the concept of cash flow/ mezzanine lending, particularly for smaller deals. As they come to appreciate the value proposition of a credit backed by the "full faith" of a private equity owner, the pace of acquisition finance should catch up with the enthusiasm of private equity deal teams. Until then, the limited availability of debt remains a constraint to achieving LBO-like returns.

5. Focus on prudent growth sectors. We identify six sectors as particularly receptive to private equity investment and likely to provide superior returns:

o Financial services. Despite the development of the financial sector in the last sixteen years, the financial sector remains in need of improvement, both in the products and services offered to consumers. Many Poles still do not have bank accounts, and most homes today are purchased without a mortgage. Many leading Polish banks have a non-Polish partner, and we feel that banking services, IT products, and other payments system infrastructure will be a successful sector in the coming period.

o Public infrastructure. There is still no national highway system in Poland, and this is beginning to be a serious problem. Poland has the highest highway mortality rate in the EU; two lane roads are crowded with truck traffic and youngsters overtaking them in 4-cylinder Opel Astras. Poland recently raised E 3 billion on international markets to finance infrastructure improvements (including roads), but improvements are needed mainly on the voivodship level. We expect that businesses associated with this sector will do well.

o Health care. Like the rest of Europe, the Polish population is generally aging, and as middle class incomes increase, we believe that funds will be spent disproportionately on medical care. The aspects of the health care industry that are privately managed (medical equipment, hospital supply, private medical care) will thrive in a time of continuing shortage.

o Real estate and contracting. Real estate activity remains the most visibly dynamic area of foreign direct investment. The Warsaw central business district is undergoing steady development and seems to be coming out of a boom-and-bust cycles. South of the city center are numerous stretches of new residential construction. Suppliers of building products, electrical products, construction and energy equipment, and "white goods" for kitchens and baths should see success in the future.

o Supply and logistics. Supply and logistics companies should also probably see above-average growth. Polish business is still highly fragmented; just how fragmented was made clear to me one sunny Friday afternoon at Szparka, a bar in Warsaw, where I encountered the man who sells sugar packets to all the restaurants in Warsaw. Restaurants tend to buy supplies -- sugar, forks, plates, tablecloths -- from different vendors. I have no doubt that one day the sugar packet tycoon will be managing a private equity-backed restaurant supply consolidation.

o Media and information. The Polish media consumer has only just begun to get a taste of high quality news, information, and entertainment. A capital-efficient sector, media companies should outpace general economic growth. Youth markets are showing strong growth in demand for magazines, newspapers, films, television, mobile telephony, and electronic games. As the market is relatively homogeneous, television and radio broadcasting can efficiently reach a nationwide audience. Business media is also receptive to growth, as suppliers seek more efficient ways to reach their customers, and procurement goes online. While advertising budgets remain somewhat low by comparison to the west, we expect these to increase as well.

6. Political activity may affect private equity exits. Institutional investors would be prudent to ask about the effects of recent political controversy on business. The center-right government has said that (like the U.K., Denmark and Sweden), Poland would remain outside the Eurozone, a move that the OECD actually approved. The government has encountered criticism for not distancing itself from extreme-right elements among its governing coalition. We expect the "pro-Poland" rhetoric to be reflected in continuing government efforts to keep key industries out of the privatization program, and in continuing objections to the sale of major corporate assets, perhaps to include banking and telecom, to non-Polish investors.

Summary.

We view the private capital markets in Poland as representing the most dynamic and promising opportunity in the emerging markets. Economic growth, stock market outlook, monetary policy, inflation rates and public and consumer debt consistently compare favorably over metrics in the west. Poland joined the European Union in May 2004, and with its lower labor costs and rich sources of commodities, inbound FDI will likely continue its steadily increasing pace. Investors seeking superior returns with balanced risk are well-advised to include a prudent allocation to private equity in this market.

Michael Alcamo is President of M.C. Alcamo & Co., Inc., a New York-based merchant bank and private equity adviser. The firm works with institutional investors and business owners in the United States and in the emerging markets. Mr. Alcamo is also president of Baltic Investments Limited, an institutional fund that holds real estate assets in Poland. More via http://www.mcalcamo.com