Private Equity Issues and Eastern Europe

Introduction

Since the fall of Communism in the early 1990s, the former Eastern bloc states have attempted to transition their economies and polities following the democratic Capitalist model provided by the West.  This process is partly necessitated by the requirements of membership in the European Union (EU).  A number of Eastern European countries have sought this membership in hopes that greater integration with the West would usher in a new era of economic prosperity and development.  There is no doubt this deeper integration into the global economy has opened up new opportunities for foreign investment in Eastern Europe.  But how much of a role has private equity played in the emerging markets of Eastern Europe?  The thesis of this paper is that private equity's role and performance in Eastern European economies have been somewhat disappointing and may continue to be so.  Some reasons for this, and potential solutions, will also be explored. 

This paper is divided into a number of sections. The first and present section is the introduction.  This section will include a brief introduction to the concept of private equity investment.  The second section will discuss performance management issues between private and public equity investment.  The third section will discuss the role of private equity in Eastern Europe.  It should be noted that in many sources Eastern Europe very often excludes Russia. Also considering the size of Russia and its importance in the world economy, a discussion of this country might be outside the scope of this paper.  The final section is the summary and conclusion. 

It should be noted that this paper is limited by the availability of data in the research.  Most researchers only have information for less than a handful of countries.  The countries most often surveyed are Poland, Hungary, Slovakia, the Czech Republic, and Romania. Therefore this paper is limited to the countries for which cross-national research is available.  Even for these countries data are not consistently available (Wright, Kissane & Burrows, 2004; Sato, 2011).  It also appears that Poland is the best-documented Eastern European state for private equity purposes.  Not surprisingly it is also the most successful from the perspective of attracting private equity investment (Klonowski, 2011).  It should be noted that Hungary has also had some success.  As mentioned above, the cross-national research has omitted Russia from their overviews.  Additionally, many cross-national researchers supplement their studies of Eastern Europe by including some Central European countries as well.  As such these emerging markets will be defined by their shared experience of transitioning from Communist to Capitalist economies.

Private Equity: A Review

Before continuing it's helpful to define what public and private equity are and how each is different from investing. First, public equity is as an asset class where individuals and organizations can purchase shares of a company's stock through means of a publicly available exchange.  One example of such a market or exchange is the New York Stock Exchange ("Public Equity," 2004).  In contrast, private equity is an asset class of equity securities and debt that is not publicly traded.  Private equity investment is usually conducted by firms specializing in private equity, venture capital or an angel investing.  The goals and objectives of the investment remain the same: to provide capital for product development, expansion or company reorganization. 

Private equity is considered one of the most expensive forms of capital investment.  The profile of the typical private equity issuer comes in one of two forms.  The first is a new or emerging organization that can't afford to raise funding on the public equity markets.  The second is a formerly public company that is going private and needs to raise a high volume of capital to fund operating expenses. A major expense incurred when evaluating private equities involves determining proper pricing of the assets.  The public exchanges provide a very handy and accessible method for making this determination.  But private markets, by their very nature, are much more difficult to evaluate. Market efficiency is lacking in private equities and the prices of securities don't reflect all publicly available information. 

Private equity instruments may not have liquidity as they are held closely and are not traded often (Anson, 2007).  Since markets for private equities are virtually non-existent, appraisal is the key means of determining value.  Private equity market appraisals can be a particularly laborious task and this accounts for their market pricing inefficiency.  The role of intermediaries in private equity markets further complicates the pricing methodology.  All but 20 percent of private equity capital is managed by limited partnerships.   These limited partnerships are managed by private equity specialists or general partners who aggregate capital in pools.  The general partner has considerable latitude in determining the fair value of private equities.  Since publicly available prices are not available, the general partner enjoys wide discretion in marking prices.  The general partner's profit-sharing or incentive fees are dependent on which way the limited partnership's portfolio trends.  

Some researchers believe this leads to some pernicious manipulating of asset prices by the general partners. That is, they use a methodology called "market supportive accounting".  This allows the general partner to slowly mark down the value of its portfolio decisions in response to reasonable estimates. But on the other end, these assets are typically marked up rather rapidly (Weisman & Abernathy, 2000).  Anson (2007) has found the reverse is true, however. Private equity managers are quick to mark down the value of their losses and rather slow to mark up their gains.  This may be because regular audits, reviews by consultants, and advisory boards provide efficient and effective monitoring and quality control of private equity managers.  In addition, private equity managers are rather mindful of the damage even the perception of unethical business practices can do to their reputations.  Thus they are proactive about carefully estimating losses and gains in their portfolios.  

Indeed, many general partners will hold off on revaluing their portfolio positions until some basis for an objective re-pricing of assets occurs.  Such an occurrence could be an initial public offering (IPO), a trade of some portion of the securities on the secondary market or another round of private equity financing (Anson, 2007). However, these market events may postdated by as much six months to a year. This means pricing lag is an issue in private equity markets. 

Firms that receive private equity capital from limited partnerships often remain private for quite a few years. As such these companies no longer have an objectively observed price with which to use to value their assets.  The technique of marking to market may also be particularly difficult for portfolio investments.   In order to compensate, private equity firms will use a conservative estimate of their assets by retaining their book value, or the value of the asset that is carried on a balance sheet ("Book Value," 2013).  This value is calculated by taking the cost of an asset and then subtracting the accumulated depreciation.  However, this method is also quite imprecise as it may not incorporate the value fluctuations in the private equity portfolio.  

Performance Measurement: Private versus Public Equity

These different methods of financing also provide evaluation challenges to investors.  These challenges center around the lack of information available about private equities. There is also the general difficulty of establishing objective means to value private equities.  The measurement of private equity manager performance, also called the alpha intercept, is also a critical problem that is not seen by public equity investors (Anson, 2007).  In performance measurement, the choice of benchmarking is crucial to establishing how to assess and allocate capital to a private equity manager.  Performance measurement of equity portfolios is also critical in determining bonuses at endowments, pension funds and foundations (Anson, 2007).  

Researchers in the world of public equities often begin from the perspective that such markets are efficient.  That is to say, asymmetries of information are non-existent in public equity markets.  However, in private equity markets such asymmetries are quite prevalent and mean that the acquisition of information is the basis for competitive advantage.  Anson (2007) compared the pricing effect of private equity portfolios with their public counterparts.  He reported that a significant lag effect was found in pricing in private equity markets relative to public equities.  The lagged effect was introduced by private equity portfolio managers practicing a technique called managed pricing.  

This is different from the usually assumed and expected difference which is stale pricing.  Stale pricing refers to book value that is not fresh or current in terms of market value and may be using market valuations that are significantly outdated.  In other words, stale pricing means the private equity values are probably lagging behind price fluctuations in the easily observable publicly traded exchanges.  This phenomenon can undervalue estimates of systemic risk of private equity securities when compared with the public equity market.  When lagged public stock exchange returns were incorporated into the performance analysis, the alpha intercept or the measure of private equity manager skill declined noticeably.  

While an established industry standard for valuing private equities doesn't exist, private equity managers generally follow the principle of conservatism.  As mentioned above this means, private equities are only marked to market after some market event has occurred.  This event is then used as a benchmark for both valuation and performance.  This methodology can make returns across private equity funds comparable.  However, they fail to make meaningful statements in regard to comparisons with public equity markets.  Also the alpha coefficient can suffer from biases inherent in the ways private equity managers valued their portfolios.  Stale and managed pricing can also directly lead to estimates of private equity manager performance that are simply incorrect.  Anson (2007) found that estimates of the alpha coefficient lagged significantly and resulted in performance below the lower end of estimates.  

Another alternative methodology is to use a periodic basis to mark each investment in a portfolio to market.  The periodic update is performed usually once per quarter.  While very time consuming and labor-intensive this method has reportedly produced some quality results (Anson, 2007).   It doesn't appear to be the standard methodology, however.

The Role of Private Equity in Eastern Europe

Funding Post-Communist Transition

As noted in the introduction, since the early 1990s Eastern Europe has been in a long-term transition from the Communist to the Capitalist economic system.  A number of authorities report, that while considerable progress has been made in the first decade since the fall of the Soviet Union, the transitional phase is still not complete (Wright, Kissane & Burrows, 2004; Sato, 2011; Farag, Hommel, Witt, & Wright, 2004).  There is even evidence that progress since the early 2000s has stalled.  

The requirements of accession into EU membership has driven the transition, of formerly centrally planned economies of Eastern Europe, into free-market-oriented economies.   A key component of this shift has been the transfer of state-owned companies, or parastatal organizations, into private ownership.  Naturally, the mechanism of this transfer is the selling of publicly owned assets into the ownership of private individuals.  This is a mechanism that private equity has been expected to play a central role in providing financing. The liberalizing of Communist economies into Capitalist ones is also meant to facilitate the free flow of foreign investment into post-Communist Eastern Europe.  A second role for private equity in Eastern Europe is similar to that in established Western Capitalist states.  That is, private equity is also expected to play a role in providing financing for startups.  

The sale of parastatals has provided much of the opportunity for private equity investment in Eastern Europe.  For instance Poland, during the late Communist period, had an estimated 8400 state-owned enterprises.  These enterprises were responsible for roughly 75 percent of GDP.  By 2003, all major publicly owned industrial enterprises had been sold to private investors.  Another 3000 enterprises had been either liquidated or reassigned to more private sector-oriented organizations (Wright, Kissane & Burrows, 2004).  

In the states of former Czechoslovakia (Czech Republic and Slovakia), the contribution of state-owned enterprises to the national economy was estimated at 95 percent.  The process of privatization proceeded quite rapidly so that the economic control of parastatals had declined to 60 percent by 1995.  Although it should be pointed out this percentage rebounded to 75 percent by 1999 (Wright, Kissane & Burrows, 2004). 

In Hungary, the state contribution to the economy was about 85% in the late 1980s.  By 1998 nearly two-thirds of the country's 1850 public sector companies were transferred to private ownership.  The remaining one-third was liquidated.  As mentioned above, Hungary is the next successful country for private equity investment after Poland.  This is due to the governmental emphasis on private banking, taxation, investment, and liberal trade policies and regulations that functioned under "Goulash Communism" even during the height of the Communist era (Wright, Kissane & Burrows, 2004). 

In Hungary and other Eastern European countries, Goulash Communism allowed for the participation of small-scale enterprises in the national economy.  This, in turn, allowed a group of successful local entrepreneurs to develop.  These entrepreneurs could take particular advantage of the opportunities privatization presented in the 1990s.  At the same time, many transnational corporations established greenfield operations in Hungary and other Eastern European countries to take advantage of lower business costs.  The most successful entrepreneurs saw considerable growth of their business ventures into large and diverse enterprises.  While there were many failures as well, even these contributed to human capital.  This happened by building up an experienced management pool that could be recruited to help run other businesses. These post-Communist transitional developments have been successful in creating a collection of privately-owned, free-market-oriented enterprises that provide the foundation for the supply of private equity opportunity in the region (Wright, Kissane & Burrows, 2004).

Private Equity Development Factors 

A number of factors affected the development of private equity in Eastern Europe.  These factors include the supply-side opportunities, demand-side opportunities, available infrastructure to successfully conduct deals, and gains realization (Wright, Kissane & Burrows, 2004). As an example of the breadth of available deals, this section will explore private equity opportunities in terms of the major supply-side activity drivers.  These drivers include mergers and acquisitions (M&A) and deal opportunities, completed deals and potential deals, and sources of deals.  

M&A and Potential for Future Deals

Since a great deal of private equity activity in Eastern Europe is driven by M&A the level of activity for these deals can be taken as a good benchmark for the potential of the market (Wright, Kissane & Burrows, 2004). The majority of M&A deals in the region have occurred with only local participation.  In fact, only about 30 percent of deals have involved foreign investors.  About 10 percent of the deals involved intra-regional investors. M&A activity was noted for its resilience in the period between 1998-2002 and remained flat while similar activity in Western Europe and the US experienced steep declines.  As a point of comparison, M&A activity in Poland was 1.6 percent of GDP in 2002.  The same year M&A activity was 3.3 percent in the Czech Republic and 3.0 percent in Hungary.  In the US in 2002 M&A activity was 4.4 percent of GDP.  This indicates the contribution of M&A activity to the national economies of the top three post-Communist states is not far below that of advanced Capitalist states and with some potential for improvement.  

There are also forecasting models for continued M&A growth in post-Communist countries.  Indeed the lower cost of labor and materials combined with improving purchasing power makes post-Communist states promising for future economic development.  Also, the accession of these countries into the EU seemed to presage another period of restructuring in which M&A and private equity would play roles.  

Completed Deals and Potential Deals

The European Venture Capital Association (EVCA) provides total venture capital and private equity data to select Eastern European countries.  Please refer to figures 1 and 2 below for a cross-national, time-series comparison from 1998-2002.  The data incorporate both initial and follow-on investments (Wright, Kissane & Burrows, 2004).  They also include the full scope of investment stages, including start-ups, expansion capital, and management buyouts.  As can be seen from the tables, Poland is clearly the largest market among the post-Communist emerging markets during the period.  Poland is the leader in both total volume of activity and absolute value.  During the four year period,  Poland's total number of private equity investments grew from 120 to 200.  Annual investment amounts, denominated in euro, impressively grew from 166 million EUR to 396 million EUR. 

According to Wright, Kissane & Burrows (2004), the majority of buyout stage deals originates from just three countries: Poland, Czech Republic, and Hungary.  The proportion of deals grew from half in 2000 to two-thirds just two years later.  Hungary and Poland are clear leaders in completed deals with total deal value over $630 million and $440 million for each country, respectively.  It's believed there is still room for growth in deal activity.  This is the case if the private equity investment relative to GDP average is to approach the average for the EU.  This is unclear at the present time if this is, in fact, a financial possibility. 

Sources of Deals

The first phase of private equity in post-Communist countries was funding the sale of parastatal organizations to private entrepreneurs and funding startups of new companies.  The second phase of private equity was initiated n the late 1990s and involves improving the efficiency and competitiveness of existing private sector enterprises. This is generally facilitated by transfers of new technology, consumer goods and marketing services from the West and the US.   During this second phase, private-equity deal-making has expanded to include capital opportunities, buyouts, spinoffs of non-core business units, and industry consolidation.  Major sources of deals tend to involve firms that have successfully completed privatization and are undergoing a period of reorganization.  This also includes startups that have successfully grown into established enterprises. 

(Figure 1 & 2 omitted for preview. Available via download)

Forecast Evaluation of Private Equity Market 

Not all the news out of Eastern and Central Europe has been good news.  Indeed according to Sato (2011), there are a number of reforms that post-Communist countries have still yet to undertake or complete.  These issues are serious enough that they could provide limits on how far post-Communist countries can successfully develop as fully-fledged, and economically well-integrated, Capitalist states.  The focus, in this case, is on the tax and legal environment in the Eastern European states.  Sato (2011) reports a table produced by EVCA, that compares the tax and legal environment in select European states over a short time series. It shows that post-Communist states still have a way to go before they achieve the type of business-friendly culture that is common in the United Kingdom. 

(Table 1 omitted for preview. Available via download)

Table 1 suggests that post-Communist states have a tax and legal environment for venture capital that is poorer than the European average. Although it is notable that Germany is also not much better than Slovakia and the Czech Republic. According to Sato (2011), post-Communist countries need to undertake serious pension reform before a financial crisis emerges.  Other changes that emerging post-Communist states need to undertake to improve the investment condition include:

Legislation and tax conditions regulations governing finance and venture capital must be simplified. The legal framework and fiscal regulations governing venture capital investments must be improved in order to successfully harmonize with their Western European counterparts in the EU. Investment and operating costs must be reduced to allow investors to achieve higher capital yields. Tax obstacles to venture capital operations should be sharply curtailed to prevent double taxation and allow for secure transparency of tax reporting. 

Summary and Conclusion

In sum, the section on private equity showed that this asset class is much more difficult to value than public equities.  It also showed that trading in the private equity market carries much more risk than the public equity market.  Private equity is also much more expensive than public equity.  A key problem for private equity is that an objective standard for valuation doesn't exist.  Instead, private equity managers must use methods that produce a best guess for valuing the assets they hold.  This may or may not produce accurate results. Indeed, the methods that private equity managers use will never provide an adequate substitute for the type of objective valuation that publicly held assets enjoy.  

Due to stale pricing and managed pricing, there is often a significant lag in the valuation of private equities relative to the public equity market. This lag can be as much as one year.  This means that the precise value of private equities may always be in doubt.  Some methods such as periodic benchmarking may help mitigate this.  But it does not appear that this method is widely used by private equity managers.  Instead the established method of valuing assets is by way of managed pricing.  The accuracy of the estimates may vary depending on whether the private equity manager uses the principle of conservatism.  That is, the revenue of private equities are marked down rapidly and adjusted up slowly over time.  Although Anson (2007) found that private equity managers were conservative in their asset revaluations, other research suggests, at least some private equity managers are taking the reverse approach.  That is, they are marking assets down slowly and marking them up very rapidly (Weisman& Abernathy, 2000). 

The section on private equity in post-Communist Europe's emerging markets shows the role of this asset class in financing the transition to a Capitalist economic system.  Private equity has played a crucial role in privatizing parastatal organizations in Eastern Europe.  It has also provided financing for startups in the region.  The willingness of the EU to admit the former Communist states to membership has also provided private equity with more opportunities.  These opportunities involve financing crucial restructuring of privatized and fragmented industrial sectors.  Opportunities are also available for financing technology transfers and the introduction of new products and services into Eastern Europe's emerging markets.  On the other hand, post-Communist countries still have many tax and legal regulations that make financial transactions more difficult to undertake than in most Western countries. 

Finally, the discussion on private equity and its role in Eastern Europe seems to suggest that the real value of the assets of post-Communist countries is itself in some doubt. State-owned enterprises originated in an era in which planned economies were the rule and market valuation in the Capitalist sense was nonexistent.  In addition, parastatals are widely known for their inefficiency, corruption, and mismanagement.  Even in the post-Communist era it seems unlikely that these assets would carry over that much value in comparison with public or private equity assets in a consolidated free-market, Western economy.  Unfortunately, the pricing methods used by private equity managers are often not adequate enough to provide a truly objective picture of how valuable these assets should be. 

References

Mark Anson, "Performance Measurement In Private Equity: Another Look" (2007) 10:3 Journal of Private Equity 7. 

"Book Value," online: Investopedia.com  <http://www.investopedia.com/terms/b/bookvalue.asp>

Hady Farag, Ulrich Hommel, Peter Witt  & Mike Wright, "Contracting, Monitoring, and Exiting Venture Investments in Transitioning Economies: A Comparative Analysis of Eastern European and German Markets" (2004) Venture Capital 6:4 257. 

Darek Klonowski, "Private Equity in Poland After Two Decades of Development: Evolution, Industry Drivers, and Returns" (2011) Venture Capital 13:4 295.

"Public Equity." Online: Washington State Investment Board  <http://www.sib.wa.gov/financial/io_pue.asp>. 

Alexej Sato, "Private Equity Investment in Central and Eastern Europe" (2011) International Journal of Management Cases 13:4 199.

Andrew Weisman, & Jerome Abernathy, "The Dangers of Historical Hedge Fund Data" (2000) Nikko Securities International Working Paper, 4:1. 

Mike Wright, Jonathan Kissane, & Andrew Burrows, "Private Equity in EU Accession Countries of Central and Eastern Europe" (2004) The Journal of Private Equity, 7:3 32.