North American and Western European buyout markets are suffering dramatic falls in deal flow thanks to the credit crunch but private equity investment in emerging Europe appears to be holding up. A steady mid market deal flow across Central Europe and a trickle of more esoteric transactions has kept the markets moving, writes Donal O’Donovan.
Central and Eastern Europe is a large and mixed arena; even defining it can be difficult. Depending on your view it includes anything from Germany's eastern border to Vladivostok in far eastern Russia. Stuart Hewer head of leveraged finance for Germany at RBS, whose responsibility extends across Central & Eastern Europe said: "The core markets are the more established EU and EU accession states - Poland, Hungary and the Czech Republic for example, with Romania and Bulgaria potential generating deals and still fairly limited deal flow further east. Russia and Turkey produce some deals but further east markets are largely untested."
The region as a whole undoubtedly holds attractions for sponsors. Much of it is now inside the European Union, resulting in a decreased political risk profile. Economic growth, albeit often from a low base, is more in line with emerging market rates. Generally speaking, the further east you go the higher the political risk – but also the growth potential.
There are a number of reasons why the space has proven more resilient than the more mature markets further west since the start of the credit crisis: a primary factor is the relatively low reliance on leverage across much of the region. Even technically leveraged structures are actually far less geared than western counterparts. Debt to equity ratios in the region are generally lower, and sponsors are prepared to put more equity in when they are looking at higher growth to achieve their returns. Vendor price expectations have been easier to manage than in the west, so the gap between buyers and sellers is narrower.
"Where growth prospects are high leverage may not be appropriate, because growth has to be channeled back into operations rather than into dividends or interest repayment," explained Kestutis Sasnauskas, managing director of East Capital Private Equity.
High growth has its own risks, according to Hewer: "Growth in portfolio companies tends to be premised on general economic growth - still around 6% across the region. Investors need to hedge against inflation and forex risk, particularly as most funds are either dollar or euro and need to be switched in and out of local currency."
The core markets, where leverage is most appropriate and readily available, are inside the EU. Here local, mid market sponsors like Mid Europa Partners, Enterprise Partners and Advent have an advantage thanks to longer track records and stronger links with global sponsors. These funds are increasingly active, and while most deals are mid market they can include hefty financings.
In late 2007 Bridgepoint completed a buyout of Polish rail freight distributor CTL Logistics with revenues of more than €285m. The deal was its first acquisition in Central Europe. Commerzbank and ING arranged Z515.5m (US$214m) in senior facilities and a €40m mezzanine loan to support the deal.
This year Merrill Lynch Private Equity became the latest financial sponsor to buy Euromedic, paying €1.1bn, including €300m of debt backed by after a hard fought auction.
Both deals featured the fairly vanilla senior debt over mezz structure that debt investors prefer – rather than the multi tranche 'alphabet soup' which was a feature of debt markets in 2007. In both cases liquidity for senior debt was found among banks, especially regional and domestic players, and mezzanine went to specialist mezzanine funds.
"Pricing has drifted up and leverage levels have come down, but not dramatically, largely because most deals are mid market anyway and didn't see the loosening that larger deals in the west saw," said Hewer.
Turkey: a market apart
Nestled in the south east corner of Europe, Turkey can seem a market apart, especially from a banking perspective. It has its own domestic lenders that are prepared to back local corporates and buyouts to an extent that global leverage finance specialists simply are not. While it generates one or two bigger deals each year, the US$100m to US$500m range is the core of the market.
From a sponsor perspective, though, it is increasingly a fairly mainstream market, with a mix of domestic and global sponsors vying to do both leveraged and unlevered deals. The US private equity giant Carlyle opened a permanent Turkish office and inaugurated it with an unleveraged deal to buy a 50% slice of TVK Shipyard.
Can Deldag, managing director of Carlyle’s Turkish business, said: "The TVK Shipyard's deal is a buy in to a modern, state of the art facility where a very impressive existing management team has built up the business and we are investing to ensure that this young yard is in a position to grow significantly. We see that as an important part of the Turkish model for private equity for years."
Carlyle's attitude sums up the prospects for investing in the country: "We are also looking at LBO opportunities and where leverage is required Turkish banks have the balance sheet to support deals and also understand the local market in a way international banks simply do not," said Deldag.
That was in evidence in may when BC Partners, a UK-based buyout house, alongside minority investors Turkven Private Equity, a Turkish private equity firm, and DeA Capital, a Milan Stock Exchange-listed investor, completed the acquisition of a 50.8% stake in Turkey’s largest supermarket chain Migros Turk from Koc Holding.
The transaction, announced in mid-February, represents a market cap of YTL3.8bn (US$3.15bn). The deal was funded equally between debt and equity, with Turkish banks Garanti Bank, Is Bank and Vakifbank providing the financing.
TVK and Migros are instructive with regard to where the Turkish deal pipeline is coming from: sometimes spin offs from Turkey's big family holdings, but also partnerships with rising entrepreneurs. Where businesses have grown to the point that they require both capitalisation and institutionalisation, partnership with private equity can be a mutually beneficial solution.
Turkey attracts interest from the south and east as well as Western sponsors. Abraaj Capital, a Dubai-based private equity firm, recently completed its second deal in Turkey, buying a 50% stake in yacht builder Numarine. It followed last year's purchase of a part of Acibadem, an Istanbul-listed healthcare provider, in 2007.
The availability of domestic liquidity goes some way to mitigating political risk - heightened by the stand off between the governing AKP party and the country's secular establishment, which came close to crisis over the summer.
From Russia with love
In Russia the LBO model has been less relevant, but banks and sponsors are using acquisition finance. Lion Capital has made two significant forays this year: it lead a consortium which also included Goldman Sachs European Special Situations Group and Central European Distribution Company, a leading Polish vodka distributor, to buy buyout of drinks business Russian Alcohol.
The deal was backed by debt from Goldman Sachs, ING, RZB and UniCredit as joint MLAs and bookrunners. Total net cash-pay leverage at closing was 2.49x Ebitda, with common equity and equity-like structures accounting for 78.2% of the capital structure, well below what would be found further west.
The deal followed Lion Capital's LBO of juice company Nidan Soki, backed by MLAs on the Nidan Soki debt, Goldman Sachs, UniCredit (CA-BA) and VTB. While there are clearly banks willing to provide debt, syndication has proved difficult, though no doubt banks were well aware this might prove the case before they launched.
Leveraged buyouts constitute only a small part of the market, particularly as you go further east. "There are very few LBO players in Russia,” said Sasnauskas. “Dividend flow in many cases is too low to support leveraging the businesses, the returns are growth rather than leverage focused. There is also competition from local oligarchs who can fund deals themselves without debt."
East Capital Partners sees the challenge for private equity as one of accessing growth in the real underlying economy – especially in the Russian regions, which barley registers on commodities heavy public markets, rather than accessing leverage.
It targets banking assets and real estate in particular: "In the banks space we target strong, unleveraged, minority stakes in banks with strong growth prospects. Bank sector growth remains strikingly high and the ratio of assets to GDP remains below even other East European peers," said Sasnauskas.
"A typical situation for us would be to take a stake in an existing bank owned by its two or three founds, for example, who have taken growth to a level where they find it difficult to finance further growth. Their options than are to sell to a strategic buyer or look to partner with someone like us with more money and more know how."
Since the Georgia crisis, political risk is back firmly on the agenda for western investors and institutions – though less so for domestic sponsors and debt providers.
"That doesn't bring things to a halt, but reminds people that not all markets are the same," said Hewer.
From Poland to the Russian regions deals are flowing but the private equity market in emerging Europe operates at the sharp intersection of risk and reward. It is a great place to be for those with the appetite and the attitude to chase big returns.