July 1, 2012
Interviewed by: David Snow
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Eastern Shock

An outside observer might surmise that private equity in Emerging Europe (primarily Central & Eastern Europe) is tough-going. But long-term investors in these areas say the economic picture is more nuanced.

For expert insight on the important macroeconomic facts affecting Emerging Europe, Privcap talked to Baris Gen at the IFC, Robert Graffam of Darby Overseas Investments, and Ralph Jaeger of Siguler Guff & Company.

An outside observer might surmise that private equity in Emerging Europe (primarily Central & Eastern Europe) is tough-going. But long-term investors in these areas say the economic picture is more nuanced.

For expert insight on the important macroeconomic facts affecting Emerging Europe, Privcap talked to Baris Gen at the IFC, Robert Graffam of Darby Overseas Investments, and Ralph Jaeger of Siguler Guff & Company.

David Snow, Privcap: We are joined today by Baris Gen of the IFC, Ralph Jaeger of Siguler Guff, and Robert Graffam of Darby Overseas. Welcome, all of you, to Privcap today. Thank you for joining us.

Hot topic we’re talking about– emerging Europe. Obviously, Europe generally is on everyone’s mind. And emerging Europe has always been one of the most popular and heavily trafficked private equity strategies. And so I’m fascinated to hear all of your viewpoints on this region of the world, since all of you invest in emerging Europe.

But I think the number one topic on everyone’s mind is what is going on in emerging Europe with the global crisis and also the very acute crisis in Western Europe. And maybe starting with Bob, your firm, Darby, invests across Eastern Europe as well as other parts of the globe. What are you seeing, and how bad is the situation in Eastern Europe?

Robert Graffam, Darby Overseas Investment: Well, we’re coming into our fifth year of a very weak economic landscape generally throughout the region. Before I address the question of the most recent problem, which is the euro crisis, I’d say that the original credit crisis cum global financial economic crisis, rather, hit emerging Europe very hard, harder than other emerging markets in which we invest. And I think there are many reasons for that.

But the primary reason was leverage, that there was a substantial amount of credit, cheap credit, that flowed into the region. About 80% of the banking system in emerging Europe is owned by Western European banks. So they funnelled a lot of money during the bubble years of 2006, 2008 into emerging Europe, and in many cases, engaged in unhealthy, unsound lending practices, in particular in the retail market, by lending in hard currencies for mortgages and things like that, and particularly in Swiss franc.

So this process of de-leveraging, painful process that we’re experiencing in other parts of world, for example, in Western Europe, in Greece, has been going on in Eastern Europe now for several years. And that, combined with weak growth in the West, and many of the countries in Eastern Europe depend particular on Germany for export markets, that’s been a very difficult combination, which has led to substantial dislocation, economic dislocation and weakness.

Now, sort of the icing on the cake has now been the euro crisis, which has created a new, I think, threat, which is the fact that these banks, these Western European banks that own 80% of the banking system in Eastern Europe– and Turkey, by the way, is an exception to everything I’ve said so far. We’ll come back to Turkey later. But these banks are in the process of massive de-leveraging. It’s estimated that they’re going to sell between $1 trillion and $2 trillion equivalent in assets in the coming year or two. And Eastern Europe is experiencing outflows of capital rather than inflows of capital.

So I think the crisis in Western Europe threatens Eastern Europe in two very significant ways. One, and the most immediate way, is the banking system and how the banking system is reacting to it. And the second, of course, is whether the contagion that’s going to spread from Greece to other countries in Western Europe will also spread to the East.

Snow: So Ralph, of course, we are going to get to the impact specifically on private equity in emerging Europe. But sticking with the macro theme, I’m interested in your analysis of what is going on there in the wake of the big downturn in Western Europe.

Ralph Jaeger, Siguler Guff: Well, I think I echo much of what’s been said. We looked at emerging Europe and go back five or six or seven years, and this aspect of conversions had a number of positive aspects to it. On the other side, we also saw the increasing leverage in the system, which is part of also the conversion story– credit being available, fueling consumption, raising the middle class significantly, actually, in most of these parts, but introducing also this element of risk. Leverage equals risk. So we were very hesitant to commit, broadly speaking, to emerging Europe, and with hindsight now, essentially, have been reaping the benefits from being somewhat cautious of it.

I think going forward now– you were talking earlier, in the wake now of the financial crisis– I think going forward, the story could be different. I think it presents very attractive opportunities from an evaluation point of view. Right now you have some capital scarcity, as a matter of fact, as a result of the de-leveraging that’s been going on significantly. And that presents interesting investment opportunities.

Snow: Baris, what is your view? Why do you think that emerging Europe has been particularly vulnerable to the downturn in the rest of the world, given that other emerging markets have done reasonably or comparatively well through the crisis.

Baris Gen, IFC: Yeah, I think it is mainly dependent on two or three elements, one being the strong linkage with Western Europe in terms of exports and industrial production that goes into Western Europe. So that has been hit. The other aspect is the banking sector. As was mentioned, you have levels of 80, 90% in some countries, of foreign ownership of banks. And that really impacted these countries at the time when credit was pulled. This was also pulled from these markets in a very significant way.

And actually, that’s an interesting comparison and explains why maybe Turkey has been a bit of an exception, because integration of Turkey, while still quite high with Europe– so around 50% of export-imports are happening with Europe– it was still a bit more diversified than the periphery, essentially, Eastern European countries. So when the crisis hit, I think Turkey was able to diversify a bit more to Middle East, to other places.

And also the banking sector– Turkey had its own domestic banking sector– although, with foreign ownership, as well, but not at the high levels of Eastern Europe. Yeah, around 20, 30%, something like that, rather than the 70, 80% that you see in central Eastern Europe. So I think those are the two important elements– the strong link with exports and industrial production and the banking sector. And then, once you have trouble in both of them, basically, you end up in a very difficult situation. And then that explains, I think, the reason why Eastern Europe has been performing worse than some of the other emerging markets.

Snow: It almost sounds like it’s been a victim of its own success, where because it has been forging ties with its Western neighbors and adopting and having access to many of the same capital market tools, it is now suffering almost in equal measure with its Western counterparts.

I’m interested in talking about– all of you have a view to the underlying portfolio companies– you, Bob, directly, and both of you, Baris and Ralph, see across GP portfolios. How are private equity GPs faring in the downturn in Eastern Europe? How bad is it for them? And then what kind of tools do they have to help their portfolio companies make it through the downturn? Maybe starting with Ralph.

Jaeger: Yeah. It’s by and large not a very pretty picture, I must say. The more recent funds that were raised from five years ago, six years ago, four years ago, have invested at fairly rapid paces and are now suffering from the rapid pace of investment, generally speaking. Oftentimes, targeting investments that catered to the rationales of the respective geographies, namely, the export centricity, or financial services, we had some scarcity in financial services. And those are the sectors that have been really, really hit very badly. So that clearly transpires in the performance of these funds.

Now, what tools do they have? This where you see the difference between good managers and managers that are just trying to muddle through. The good managers have upped their portfolio operations very massively, have definitely looked at increasing managerial talent, are in the weeds almost on a daily basis with the troubled investments, and are making the good decisions in the context of follow-on investments, or, quote, unquote, “rescue” investments, we’ve seen work in some cases and not in all cases. We’ve seen also that they don’t always work out as you would expect.

But that’s the type of situations, all of a sudden, that these companies and these GPs face and to step up to the plate really, really fast, unexpectedly fast. So it created a situation where you needed extreme skill sets in a situation where people didn’t have those necessarily. So it’s the ones who were able to swim fast who were able to rescue a lot of the value. But not everyone was able to swim as fast, because it was a new reality that most of these GPs face.

Graffam: Can I have a follow-up question for Ralph? Could you be a little bit more specific in terms of where you’re seeing carrying values for the private equity funds and what you’ve invested in central Eastern Europe during these bubble years? Are they generally, for example, below cost? Are they carrying values below?

Jaeger: Yes, they are. Very specifically, they are. And I think the jury’s still out there as to how much of a recovery we’re going to see in some of these funds.

I think we’re hopeful, and so are the GPs hopeful. And there’s still some element of reserves that these funds luckily have. But it’s not going to be a great performance that we’re going to see coming out of these funds.

Gen: Yeah. I agree, actually, the focus has shifted to, really, portfolio management. And I guess one aspect is if you cannot actually grow revenues or edit the– I mean how do you control the costs, basically? That becomes really the focus, cost cutting.

Another interesting element is the emergence of some mezzanine/special situation funds, I think that has started a bit more in Eastern Europe now. Also, NPR portfolio or asset restructuring attempts. So you see some activity there.

But I guess, in the mainstream private equity funds, you will have some winners, some losers. I would say Southeast Europe, from what we observe, is doing a bit worse in terms of performance. Turkey is doing pretty OK, although, because of the crisis, there was also a bit of an impact in Turkey, as well, at times. But still, compared to Southeast Europe, for example, Turkey has been much better.

Russia, there are some interesting developments. Some funds are really doing well. And I think Poland is also doing OK. But again, it’s kind of a mixed picture. You cannot probably say overall.

Jaeger: Actually, Poland, I have a different opinion. I think it’s mixed, more mixed than doing OK at this point, based, at least, on whatever we’re seeing.

Graffam: I think there are three main ways in which private equity managers have tried to deal with adversity. Two of them have been mentioned. A third has not. One is to take more operational control of these businesses and manage them themselves.

A second is to, through that process, reduce cost. And the third that hasn’t been mentioned is– forgive me for saying this– but screw the lenders, basically try to engineer restructurings or refinancings where some of the subordinated classes– and I speak as a subordinated lender, as a mezzanine lender. There have been some high-profile cases where private equity has worked with senior lenders to take the companies through a prearranged bankruptcy so that entire classes of lenders were disenfranchised.

Jaeger: But I think that goes back to the experience, or the lack of experience, that we have across the GP universe in dealing with these adverse situations. When you look at these financial structures, those are new to many of these practitioners. Introducing leverage is all good while the going is good. No one probably looked at reading all the documentation of these things. Leverage was there.

The moment you have a situation where you all of a sudden need to renegotiate, that’s when you start focusing on these contracts. And if you don’t have that experience, it’s a very new world that you need to face. But I agree with you. It’s an area which wasn’t sufficient–

Snow: Well, does the legal framework exist across emerging Europe for these kinds of restructurings? Or does it only work in certain of the geographies?

Graffam: Well, we’ve had a lot of experience there. We manage a mezzanine fund. We previously had a small private equity fund. But now we’re on our third mezzanine fund. So we’re primarily a mezzanine lender.

Our last fund was a 2006 fund, which is a very difficult vintage for reasons we were just discussing. We made 16 investments. 72% of those were made pre-Lehman. So clearly, we were investing during the period of hot money. Of those 16 investments, seven of those companies have experienced severe enough difficulties, as a result of all the things we’ve been discussing, they required restructurings, in some cases multiple restructurings.

In three out of those seven deals, we, as a mezzanine lender, have taken equity control of these companies. So we’ve morphed from becoming a mezzanine lender to becoming control private equity as a defensive mechanism. So in a couple of cases, we got, as I said, totally disenfranchised by the private equity investors or by the senior lenders or some combination of the two. And in one case, we suffered some substantial losses.

The defensive mechanisms, obviously, as an equity investor, is different from being a subordinate lender, a mezzanine lender. But what we’ve found throughout this process is actually that the legal framework in Eastern Europe was more beneficial to us than in Western Europe. Some of the more adverse cases took place in the Netherlands and in the United Kingdom, where there were court decisions that were reached that were very disadvantageous to certain categories of lenders.

What we found, actually, is being in Poland or in Turkey– well, we haven’t had a situation like that in Turkey– but particularly in Poland and also in Hungary, that being subject to the local laws made it more difficult for adverse action to be taken against us. But to answer your question, there are no Chapter 11, pre-cut, neat bankruptcy laws in any of the Eastern European countries that work.

Snow: Final point, and then I think we can pause. And you alluded to this earlier, Ralph, which is kind of the separation of those GPs with the skills necessary to help their portfolio companies make it through, and those that just do not have the wherewithal to do that. Although emerging European, Central and Eastern Europe, is, in many ways, a more advanced private equity market, at least among the emerging markets, it still does not have the several cycles, or many of the GPs in those markets do not have the several cycles of experience behind them. So is it safe to say that this is a real testing ground, that this is going to be a gauntlet through which not every GP will pass?

Jaeger: I think so. I think so. If you overlay to that, the increasing difficulty of fundraising, generally speaking, across all markets, also for emerging markets, I wouldn’t be surprised if you had a number of names– some of them even names that have been around for quite some time– that have just had so many difficulties, they will say, look, let’s called it a day, and won’t be able to raise additional capital next time around.

Gen: Yeah, I think, actually, you kind of see that the fundraising is quite difficult, as you said, everywhere, but also emerging Europe. It’s pretty difficult for first-time fund managers, also difficult for maybe second- or third-time managers that don’t have a great track record. So I think you’re going to end up with, really, differentiation. And maybe some teams will have to leave or some sort of consolidation in the sector, as well.

But yes, I think this will be a period of test. And I think there are still too many funds maybe coming to market. And that is still more than the available capital that would like to invest in emerging Europe, because right now, actually, the hotter replaces are Brazil, still China. Turkey, especially for a couple of funds, has been really good. So it’s not that emerging Europe is in the top of LP lists.

Jaeger: So actually, let me add to that. The one thing investors need to understand and also GPs need to understand is that investors are not forced, or don’t have to invest specifically in emerging Europe. So you’re competing with other emerging market funds across all emerging markets. And you’ll be compared, rightly or wrongly so, with the possibility to invest in Brazil, with the possibility to invest in China. And investors that are selective can choose also the timing of the commitments, when it is that they want to support funds.

And like Baris said, you have a situation now where you have been hit hard by a crisis. So if you look at your track record, or if an investor looks at a GP or the fund track record, going back five years, It’s not going to look very good. But on a write-off basis, it’s going to look even that much worse when you look at a Brazilian fund that you’re looking at or a Chinese fund, because we haven’t had these issues, this cycle, yet.

It may well come in five years’ time, and then we’ll see what happens, or in 10 years’ time. But at this point in time, you’re comparing a scenario was very difficult for emerging Europe with much more benign environments for other emerging markets. And that’ll look that much worse.

Snow: Well, the good news is that, for our next segment, I’m going to ask you why you all remain bullish about Eastern and Central Europe. But for now, I thank you for your analysis of what’s going on right now, which is not uniformly great. And I look forward to our next conversation. Thank you very much.

Expert Interview With Peter Wells, Partner, Ernst & Young (Prague)

Privcap: What should investors understand about the performance of the economies of Emerging Europe throughout the downturn?

Peter Wells, Ernst & Young: You would start with looking at the growth potential. What we see is that economies in this region generally have slightly higher growth than the countries in Western Europe still. And I think that’s expected to continue for the next few years. That differential isn’t, obviously, as great as it was.

Many of these countries have now sort of emerged, let’s say. And there is a lot of differences across the region when you look at those countries. So for example, we take Poland, which basically got through the crisis without actually going into recession. There were various reasons for that– the high level of domestic demand, the flexible currency arrangements they had, low levels of private debt, that sort of thing. Poland is still very attractive for private equity or other strategic investors.

And you can say similar things about Czech Republic, Slovakia, and Turkey. Obviously, Turkey’s a different situation. But certainly, that’s very attractive. But then you have those other countries, like Romania, Bulgaria, Ukraine, Hungary, where the growth story really isn’t there, or there are other factors that mean that investing in those economies is quite difficult at the moment.

Maybe some another points to mention, as well, would be access to finance. We’ve seen many leveraged transactions in Poland and the Czech Republic. So banks still have an appetite to provide credit here at relatively interesting rates. That obviously helps. But again, in some of those other countries going east, access to acquisition finance is pretty difficult.

Privcap: What are some bright spots for private equity right now across the region?

Wells: There are certainly some sectors, or niche sectors, where there is opportunity for consolidation. We’ve seen a lot of interest recently in the health care sector, in some retail assets and consumer product companies, where, basically, you’re selling ultimately to the CEE consumer, who is becoming increasingly affluent and middle class. So there is certainly demand there.

But I think what many private equity funds are telling us is that they need to do more work. So typically, deal slices might be a smaller. Therefore, they need to be a bit more active. There are many buy-and-build strategies that are being adopted within the community. And finding add-on acquisitions across quite a disparate region can be quite challenging.

So we’re seeing some of the PEs adding to their teams. So they’ve got more deals across the region to take advantage of those opportunities.

Privcap: In what countries has your team been most active?

Wells: It would be Turkey and Poland. Which are quite different in a way. Turkey, you’ve got extremely interesting demographics, huge population, very young population, where consumer spending is expected to increase quite exponentially going forward. So there are certain obvious sectors to invest in there. But the amount of interest in that country means that competition is driving valuations. And therefore, it’s a question whether you’re still getting good value in the deals there.

Poland, as I said, high level of domestic demand. They’re not as reliant on the exports as some of the other countries, like Czech Republic or Slovakia. And again, large population, high level of consumer demand, low levels of private and public debt still. So extremely interesting economy.

Again, a question about valuations, because there are many IPOs on the Warsaw Stock Exchange which give people maybe the wrong sense of where the valuations in companies lie. So given that, that doesn’t help the private equity community in many ways.

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