July 1, 2012
Interviewed by: David Snow
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What Happened to “Convergence”?

Central and Eastern (“Emerging”) Europe were among the most popular destinations for emerging markets private equity because of the “convergence” story. GPs and LPs were excited at how business between East and West would grow and synergize. How does the convergence story look now?

Privcap talked to veterans Baris Gen of the IFC, Robert Graffam of Darby Overseas Investments, and Ralph Jaeger of Siguler Guff & Company about why they remain bullish on the long-term opportunity in Emerging Europe.

Central and Eastern (“Emerging”) Europe were among the most popular destinations for emerging markets private equity because of the “convergence” story. GPs and LPs were excited at how business between East and West would grow and synergize. How does the convergence story look now?

Privcap talked to veterans Baris Gen of the IFC, Robert Graffam of Darby Overseas Investments, and Ralph Jaeger of Siguler Guff & Company about why they remain bullish on the long-term opportunity in Emerging Europe.

David Snow, Privcap: We’re joined today by Baris Gen of the IFC, Ralph Jaeger of Sigular Guff, and Robert Graffam of Darby Overseas Investments. Gentlemen, welcome to Privcap today. We are talking about emerging Europe.

We’ve already gone over the fact that there are some issues in emerging Europe, largely as a result of their neighbors to the west and the rest of the world having gone through a crushing downturn. And so in this segment, I’d really like to talk about how the investment theme for the positive attributes of emerging Europe have changed as a result of the downturn.

Or rather, how the opportunity has been clarified in the minds of all of you. So maybe starting with Baris, I mean, wasn’t one of the big selling points of central and eastern Europe throughout the ’90s and much of the 2000s that there’s going to be convergence with the west, convergence within that region, and even convergence with Turkey.

So how does that look now? How has that not played out at all, or are we just sort of at a bump in the road? What is your analysis?

Baris Gen, IFC: I mean, I think it has played out to some extent. I mean, if you see a number of countries join the European Union, there are still a number of them on their road, although that has now slowed down because of all the troubles in the Euro Zone, the European Union. And maybe also some domestic issues.

But I think that the overall the goal of European unification, or at least becoming closer still continues. So I think the convergence as a theme will still continue. Maybe it’s not going to be in the same pace, that you’re not going to see catch ups as fast as people have expected. And some countries did, some countries did to a lesser extent.

So I think convergence stays as a theme, but again in a more nuanced or differentiated way for different countries. And then you might have separate themes also. For example, you see a number of regional funds, for example, including Turkey and their gamut, so that they can benefit from a higher growth environment in Turkey.

That could be one element, either looking at Turkey’s specific funds, or regional funds that cover Turkey. I think there are interesting things going on in Russia, for example, especially in the venture capital tech side.

The government is really supporting that, so that’s an interesting area where you also see some Silicon Valley firms setting up shop or co collaborating with the Russian government or Russian entity. So I think those are some interesting things that one could think about.

Snow: How about you, Ralph? How do you think that the original themes and reasons for investing in emerging Europe have played out, and what do they look like going forward now?

Ralph Jaeger, Sigular Guff: I think convergence has taken place to a significant degree for the European part of quote-un-quote Central and Eastern Europe. So going forward then, the question will be, OK, well if that was a significant element of returns, if that gap is now much more narrow, then is there still a rationale to look at these central and eastern European geographies?

Or maybe some interesting opportunities to invest in the core Europe, or Euro Zone, might give you a similar type of return profile with even less risk. Further away, and I’m going to echo what you said, Baris, because I agree with that, Turkey has not had the same type of convergence yet compared to more European peripheral countries.

So there’s still much more growth characteristics to be accessed and tapped in Turkey. Even further out, we’re looking at, I agree with Russia. Also, Ukraine has a couple of very interesting investment characteristics, from a pricing point of view, from a competition point of view, from an untapped potential point of view.

Those are yet much further away from convergence with core Europe, as opposed to the closer proximity trip. So those are the markets that we’ll prioritize and look at in the context of eastern Europe.

Snow: What do you think, Robert, as someone who’s invested in Europe for a very long time, heard all the arguments about convergence, how do those sound now?

Robert Graffam, Darby Overseas Investments: Well, no, the discussion today isn’t about convergence. The discussion is about getting out of the Euro, right? That’s the dominant theme today. Read the newspapers, Greek. How are we going to get Greece out of the Euro zone? And this process of convergence, which had enormous benefits, only two of the countries that converged have gone into the Euro itself

And they’re two very small countries, Estonia and Slovenia. So I think if you were to have plebiscites today in most of the other countries, do they want to join the Euro, I think many of them would probably say no. The restrictions outweigh the benefit.

So I think we are no clearer on whether the convergence will reach its ultimate goal in most of the countries that have joined the EU than we are whether the Europeans can hold it together. So it’s interesting hearing my fellow panelists here talking about the theme, and it was very country specific.

In Russia, you have this opportunity. In Turkey, you have that opportunity And what that’s telling us is that there’s not one theme now for the region, which is used to be for over 10 years it was convergence. What is the theme now? Well look, Poland is different from the rest. Or Turkey’s different from the rest.

And that’s the way it should be, like it is in other parts of the world. It’s not Latin American anymore. It’s Brazil, or China.

Snow: But what about the idea that, again, whether it’s through the Euro Zone, or just through these contiguous countries that there can be pan-regional players, in that a regional champion in one area, Slovenia, or wherever, can win business in another area. Is that playing out, and can’t you still build an investment thesis around that?

Gen: I think to some extent. I mean, I guess it depends a lot on where they are starting, where do you want to go to? I mean, there are some platforms that are emerging from ex-Yugoslavia, different states, for example Slovenia or Croatia, and they’re expanding into Serbia.

But those are kind of natural linkages because they were one country 20 years ago, let’s say. So you have those elements, and I think there are companies that want to also do these regional, but I think it’s not that easy. It’s easier said than done.

So you would probably still have more focus on the domestic market or export markets, but a single country investment, and the regional expansion stories will be, I think, more unique rather than the norm.

Jaeger: We’re talking about a set of very, very diverse countries that we like to summarize as central and eastern Europe. But they all have huge idiosyncrasies. Different backgrounds, traditions, culture aspect, languages.

So it’s not always a logical fit to talk about regional platforms. The other aspect is if you look at regionalization in what way they do occur, those would be larger companies then. So if you want to play the regional platform, that would need additional capital, or more capital.

That would mean that you have to go into larger funds, and those funds require larger companies to start with. Which again, then means that oftentimes we see prices and the valuations higher, at the higher end of that. So while you think you’re buying more stability, which is not yet, the jury’s out there, it’s not quite necessary because things do move a little bit in sync.

You’re buying at a much higher price compared to having a quote unquote single country focus at the small end of the market, which will allow you to get into deals at a lower valuation. I don’t know if you’ve seen–

Graffam: I actually disagree a little bit with what the panelist has said here. I think you have to set aside the larger countries. Poland and Turkey as a sufficient domestic market. And Russia, which was never part of converging Europe anyway. Anybody who thinks that Russia is going to become an EU member doesn’t know history very well.

But if you set aside Poland and Turkey as countries that have very significant domestic markets, the whole rest of the region is Balkanized, right? It’s called the Balkans for a reason. So you have a bunch of little tiny countries that, in the past, used to be part of bigger groups.

The Austro-Hungarian empire. The Ottoman empire. The former Yugoslavia. And they do have some affinities, and there is some natural synergy, particularly in some of these sub regions, like ex-Yugoslavia, like the Baltics to have regional expansion. We’ve invested in a company recently that is Estonia based, but most of its operations are in Belarus, Ukraine, and Russia.

And to your question, it’s revenue is about 35 million euros. It’s a small company, it’s the lower end of the mid cap. So we’re seeing maybe not regional, pan regional expansion, but certainly we’re–

Jaeger: Neighboring across.

Graffam: Neighboring expansion.

Jaeger: Yeah, I agree with that.

Graffam: Bulgaria, Romania. You see a lot of that.

Snow: Well, as investors, Baris and Ralph, would you say that you are much more focused, then, on the GPs who can dive deeply into given countries or given clusters, regional clusters? And has that always been a focus, or because there are, again, a few pan regional, pan emerging Europe players that you could back, what are your preferences?

Gen: Well, I mean, of course part of IFC’s rationale depends on the strategy. So it is not maybe fully a totally private sector mindset in terms of seeking returns, et cetera. There’s also developmental mandates that go with that. However, yes, I mean what we would like to see is when we invest in GPs that the team makes sense and the strategy makes sense.

And eventually, I mean basically what happens is given that the countries are quite small, except for Turkey, Poland, Russia, Ukraine, you end up, yes, investing in regional teams that try to cover a certain region. For a country like Turkey or Russia, you might think about having a GP that’s just focusing on that.

But for the Balkans, or for Eastern Europe, it’s very difficult to have a single country, and we actually experimented with that, and it’s not that easy to have single country funds for smaller countries. So inevitably, you end up with regional funds, and then you need to make sure does the regional fund or the regional fund manager really have the tools to be able to execute a regional strategy?

Snow: I’d like to talk about a major component of the eastern part of eastern Europe, and that’s Turkey. I’m wondering how does the development of Turkey change the thesis for the region? Is it really you invest in Turkey because of Turkey, or is there sort of a pan regional play that centers on Turkey?

And maybe we could start with Baris. You were based in Istanbul, and although you invested in GPs across Europe, Africa, Middle East, your base and your home is Istanbul. So what is your vantage point from there on Turkey?

Gen: Sure. I think the Turkey story right now rests on a number of pillars. One of them is really the high growth, and that has been the kind of story for the last 10 years. And even during the crisis there was a downturn, but it’s recovered quite fast. And you’re talking about like return levels of 6% to 10% depending on the year. And that has been consistent, so that’s a strong driver.

A key thing is really the domestic consumption, and that’s a really important element. So I wouldn’t say the Turkey story is a regional story yet, and I’m not sure whether it could ever become a fully pan regional story. But there’s a very strong domestic story. A lot of the private equity funds that you see are actually targeting that domestic growth, and then using that as a base to maybe do other things.

So I think that is the main driver in Turkey right now. Domestic growth, young population, a population size of 75 million. So that gives a very big critical mass, and as long as that growth continues, you can even sustain with just a domestic growth or domestic consumption story, rather than trying to do a regional expansion.

Jaeger: Yeah. I mean, I agree. I’ll focus, when we invest in emerging markets, very much driven by this consumerism and domestic growth. Which is why Turkey, from that point of view is indeed very attractive from a macro story.

However, when you look at the investor universe, and it’s been a huge story, it’s been a huge success story, and it has attracted a lot of capital over the past two to three years.

So we are actually getting a little bit more skeptical at this point in time, when it comes to looking at investments in Turkey, and looking at the GP landscape because of huge increase in funds sizes, as you’ve seen with fund threes or fund fours, that have prior funds 100 million or 200 million, and that has quintupled in fund sizes between one and the next generation, which is rare to observe, and which is different.

It changes the game for these funds. The event of a lot of new funds also, chasing deals. And the deal flow, yes, being there, but not being abundant. We’re looking at what, 30, 35 deals per year, and you’re looking at 30, 35 GPs looking locally. And then you have all the international GPs, of course, and funds looking at investment opportunities in Turkey.

So prices are going up for these types of deals that these GPs are looking at. It could from a micro point of view, from a private equity rationale point of view pose some issues. The other thing I want to say about Turkey, and then I’ll let you maybe chime in. Yes, the growth has been there significantly, but at this point in time, it’s been very much fueled by credit.

So it’s coming back a little bit to the leverage, the issues that we’ve seen closer to “Europe” Europe, but we’ve seen a lot of leverage fueling the consumption in Turkey. And if Turkey’s growth path does hit a roadblock, then it’s going to be interesting to see what happens to the macro environment.

How people will need to diverge, how that’s going to impact consumption. There’s a huge trade deficit in the current account deficit also that Turkey needs to find somehow. So a lot of issues also at the macro level that I think people need to be very mindful when looking at Turkey.

Gen: Just to actually add, I mean, I would actually agree with your assessment as to the deal flow and the fund landscape. I mean, there has been a big change from 2005, 2006, 2007 years where you had really smaller fund sizes, the largest being like 300 million Euros maybe.

And now we’re talking about like funds with close to a billion, or a billion dollars. And so that changes, and if you look at historically, apart from let’s say one odd deal every year on a very large scale of like, about one billion, maybe like around two billion. Most of the other deals are really more small to mid cap, and with a total size of maybe, cumulatively, one, 1.5  billion, yes.

And so the question then becomes is there enough deal flow for all this interest? And because now you’re seeing actually even, as we discussed earlier, the pan European or eastern European team setting up shop in Istanbul, trying to capture some of that. But is there enough deal flow, and what about the valuations?

I mean, the valuations that I have seen through the funds that we have invested in, and also through our own activity, it’s not really cheap. So it’s an issue.

Graffam: OK, if I could just come in on this question of Turkey and the comments that my fellow panelists made. One, there is a lot of interest. We’ve been in there since 2006, we’ve done four transactions so far. And the difference between Turkey and the rest of Europe, I think is crystallized one anecdote.

We have lost deals to funds operating out of Hong Kong, and funds operating out of Dubai. And I don’t think there’s any other country in which we operate where Mideast funds, as well as Asia funds all claim Turkey as part of their target geography. So that’s a very interesting example of why Turkey is in the crossroads, and everybody claims it.

Snow: I have a final question for all of you, and we’re going to try to end on a happy note, given that we’ve already talked about the problems in central and eastern Europe. What makes you continue to be bullish, if indeed you are, what makes you continue to be bullish about investing in emerging Europe? Maybe we can start with Ralph.

Jaeger: I mentioned it in one of our early discussions. I think valuations in certain markets, in certain segments also at the low end of the market have come down significantly. I think there is in certain markets some significant capital scarcity, functioning to a certain extent also of there not being that many GPs of funds able to raise additional capital.

So that’s going to create a very interesting kind of dynamic from a sourcing point of view, and from a valuation point of view in deals. And if you’re able to target the industries that either continue to cater to the domestic growth, which there will be continuous domestic growth in those markets, or that are looking at niche opportunities that cater to export markets on a broader scaling, not just one dimensional. Those could be interesting opportunities that we would be looking at.

Snow: Bob, if you could boil down the reasons why you remain bullish across eastern Europe?

Graffam: There’s a strong entrepreneurial spirit throughout the region. There’s a class of entrepreneurs that have, in the past 15 years since the walls came down been very successful in Turkey. Of course you’ve had a long history of entrepreneurship. But I think this will be a very good vintage year.

2011 was good. 2012 I think should be an excellent vintage year for new funds. There are a lot of opportunities. The cost of capital is high in the region. There’s a scarcity of equity, there’s also a scarcity of bank debt, which creates opportunities for refinancing type transactions.

And I’ll give you one last statistic. The cost of labor, for example in a country I know very well, Serbia, today. Average manufacturing employee makes 380 euros a month. In China they make $400.00 a month.

So China is losing its cost competitiveness. eastern Europe is still, and Turkey still has significant cost competitive advantages. Plus they have the trade links that came through this convergence process.

Gen: I think I agree with my colleagues, entrepreneurship is still quite strong. We see that in Russia, for example, especially in the venture capital space in Turkey, entrepreneurship is still strong. The valuations I think is an important element. I mean, if you see more depressed valuations, that’s something to try to get an advantage of.

And I just wanted to mention from our perspective, we’re also looking at what we can add, what can we bring to the table? And one of the things we are trying to do is focus on areas that we think are still lacking, for example, in the Balkans maybe you could do something there.

Because that still lacks, and a lot of funds do not focus in that area, so that’s something. And we have also kind of pushed the boundary, and have even now closed on a found in the Caucasus, which we are quite interested in. And that’s our mandate also, to start the industry in new regions. And this is, let’s say the east of the eastern Europe, but something that we are excited about.

Snow: So it sounds like even a very expansive definition of emerging Europe is still something to be bullish about. So it’s good to hear. Well, thank you all of you for being part of the Privcap program today.

There’s a lot more to talk about, but I think we should pause for now. So again, thanks very much for joining us today.

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