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Private equity outlook in Central and Eastern Europe

| BY CHRISTOPHER ROSE, GUIDO PANZERA AND CLAIRE SCOTT-PRIESTLEY

s 2010 begins, many in the private equity industry are licking their wounds and reflecting on the past years challenges. However, there are some glimmers of hope for new opportunities and a fresh start this year for private equity in Central and Eastern Europe. While largescale leveraged buyouts are still expected to be very limited, opportunities should exist for those firms who have a specialist focus on CEE, particularly in mezzanine and the lower-mid and distressed markets. On the other hand, the outlook for CEE private equity in 2010 is not entirely rosy. Fundraising will continue to be a difficult challenge, and deal valuations will be subject to increased scrutiny. This dose of reality is reflected in a recent survey of attendees of the 14th Annual C5 CEE Private Equity Forum, held in London on November 5 and 6, which showed that 53 percent of delegates expected the overall economic climate to stay the same in 2010, with only 31 percent expecting an improvement. Here are some positives and negatives that CEE private equity players expect to see in the coming year. Things to look forward to in 2010 Private equity firms that were able to keep their boots on the ground in CEE, even as the financial crisis wreaked havoc, can expect to have a distinct advantage in generating deal flow. Daniel Lynch of 3TS Capital Partners, for one, is optimistic that CEE opportunities in 2010 will exist for a regional dedication of funds. That strategy is endorsed by Anne Fossemalle of the European Bank for Reconstruction and Development, who says her organisation always invests in funds that have a local presence. Ms Fossemalle emphasises it is essential to work with someone who understands the language and the local market. Mr Lynch agrees, asserting that private equity firms need to get much closer to the portfolio and need to have local offices and people who can actually respond in real time to the business. He notes that many of the huge pan-European funds that had moved into the region seeking large deals, such as CVC, Blackstone and Carlyle, have now departed. That exodus has left more room for specialist CEE-focused funds, particularly in the mid-market. In fact, lower mid-market transactions in the 10m to 50m enterprise value range are expected to generate significant transactional volume in 2010. Brian Wardrop of Arx Equity Partners believes that the Central European lower mid-market represents a large addressable market. He sees opportunities for focused lower mid-market funds specialising in growth buyouts and expansion capital, particularly in complex, succession-driven situations where there are owners with differing deal objectives. Due to that unique transitional ownership structure of CEE lower mid-market companies, Mr Wardrop is confident that private equity is ideally positioned to provide transaction solutions. Mezzanine players have been busy in 2009 and expect even greater deal flow in 2010, especially due to the continued challenges expected in the LBO market. With the absence of LBOs, mezzanine plays a cru-

cial role in the region. In fact, LBOs frequently do not mix well with mezzanine in the current economic climate. Sean Glodek of Darby Private Equity recounts that the senior terms involved in a leveraged buyout more often than not prohibit any kind of other debt on the company, which leaves no room for mezzanine to play. Chris Buckle of Mezzanine Management Central Europe is not too concerned about the current lack of large LBOs, stating that from our point of view mezzanine has never just been a capital layer in LBOs; it is flexible and can be used in a number of other situations such as financing expansion and add-on acquisitions. Since mezzanine is essentially a long-term, non-amortising loan, it eases a companys cash flow. It also aligns the interests of the mezzanine lender with investors through a small participation in the equity upside. In short, Mr Buckle sees mezzanine as not a product, as such, but a solution. Likewise, Thomas Spring of Syntaxis Capital believes mezzanine can add the stability in a capital structure that helps a company get through tougher times. Accordingly, even if the economic downturn and lack of available financing persist, mezzanine providers expect a significant number of deals in 2010. The expected and much-discussed opportunities for investment in distressed assets never fully materialised in 2009. However, Thierry Baudon of Mid Europa Partners expects to see more distressed transactions in 2010 as corporate disposals become more frequent. Mr Baudon pointedly states in jurisdictions like the Czech Republic and Slovenia there are disasters waiting to happen as some tycoons will be forced to sell assets in order to satisfy the margin calls of the banks. Those distressed sales should generate opportunities and stimulate deal flow even if the economy fails to rebound. Challenges to expect in 2010 The fundraising climate is expected to continue to be difficult in 2010. One of the main challenges will be to change the perception of CEE, which suffered a significant blow from the financial crisis. According to Warren Hibbert of MVision, one of the challenges of raising capital in emerging markets is reality versus perception, and the perception gap has grown quite significantly. He avers that enticing investors to the region to actually perform due diligence and get comfortable is a hurdle to be surmounted. Helen Kenyon of Preqin, citing one of her firms surveys, says the amount of actual dry powder at the disposal of fund managers based in Central and Eastern Europe is 5.7 billion. The survey highlights the fact that a number of investors have committed capital to funds. However, since those investors are waiting to fund their commitments, deal flow needs to pick up before they will be willing to invest more in the region. Due to these challenges, fundraising in 2010 is expected to be limited. Those firms with smaller funds tailored to be more investor-friendly may have the most success. According to Scott Penwell of Parish Capital, the terms and conditions of new funds will need to be as LP- 8

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This article first appeared in Financier Worldwides January 2010 Issue. 2009 Financier Worldwide Limited. Permission to use this reprint has been granted by the publisher. For further information on Financier Worldwide and its publications, please contact James Lowe on +44 (0)845 345 0456 or by email: james.lowe@financierworldwide.com

friendly as possible, particularly with regard to the GP commitment try to put in more than 1 percent and prove to LPs that you have conviction in your fund. He adds that those steps should help decrease investment risk for potential investors. At the same time, however, they will put more pressure on private equity firms. Regardless of the types of transactions that will get done in 2010, we can expect increased diligence, longer timelines and heightened scrutiny of valuation levels. Mr Lynch believes private equity firms will be selective and put much more scrutiny into the pipeline. He expects increased due diligence, including management audits, integrity

background checks and quantitative commercial due diligence, so the diligence process will take quite a bit longer than it used to. However, he ultimately remains positive, noting that historically, the firms that manage to keep investing through a downturn are the ones that, when the market recovers, are much better positioned to reap the benefits.
Christopher Rose is a partner, Guido Panzera is a senior associate and Claire Scott-Priestley is a senior associate at Squire, Sanders & Dempsey. Mr Rose can be contacted on +7 495 258 2853 or by email: crose@ssd.com Mr Panzera can be contacted on +421 2 5930 3450 or by email: gpanzera@ssd.com Ms Scott-Priestley can be contacted on +44 207 189 8116 or by email: cscottpriestley@ssd.com

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