Nicholas Watson in Prague -

Private equity funds launched at the bottom of an economic cycle have traditionally yielded the best returns. But for those funds focused on Emerging Europe, this time around things might not be quite so simple.

According to DB Research, over the last 25 years private equity funds have provided their investors with higher average returns than they could have earned from either equities or bonds. "And the rates of return generated by private equity even held up fairly well during the financial and economic crisis, in contrast to equities," notes Thomas Meyer of DB Research.

This outperformance is even more marked if you look at the returns generated from the funds' vintage years (the year in which a fund is launched); it seems that the worse the economic situation in the vintage year, the higher the return (see chart).

This anti-cyclical correlation exists for two main reasons: the lower valuations of companies when the fund starts deploying its capital, and the benefits of riding the economic recovery wave during which the companies in question should outperform. "The gloomy current economic outlook might therefore offer opportunities for new private equity funds with well-constructed portfolios - for example, because the prices of potential buyout targets are falling," suggests Meyer.

As well as this historical trend, private equity funds focused on emerging markets are also predicted to benefit from the general move by investors to increasingly look for targets in higher growth regions as the recovery in traditional stomping grounds of the US and Western Europe remains so anaemic. Some 23% of the capital raised in the second quarter of 2011 was by funds that focus on emerging markets, according to DB Research.

All this would suggest boom times ahead for private equity funds in Central and Eastern Europe. But people in the industry say much has changed in the region since the global crisis broke in 2008, placing a question mark over such predictions.

New days

One of the most important changes has been that private equity, certainly the large-cap funds (which chase companies with an enterprise value greater than €150m), don't perceive the new EU members states like Poland and the Czech Republic as emerging markets anymore. "Poland is no longer perceived as an emerging market, but a peripheral market that's part of the core EU private equity market where the risks are more manageable," says Przemek Szczepanski, partner at Syntaxis Capital in Warsaw.

Brian Wardrop, managing partner of Arx Equity Partners in Prague, calls Emerging Europe outside of Turkey and Russia a "hybrid" market, where you have marginally better growth prospects than in Western Europe, but where there's greater familiarity with the rule of law, management quality, foreign exchange etc., yet it's far from producing the kind of spectacular returns that funds investing in China and Brazil have been enjoying of late. "Should CEE be in the European bucket or the emerging market bucket? Increasingly it's the former," Wardrop says.

At the same time valuations in the region, especially for companies at the larger end of the market, have "remained stubbornly high," says Szczepanski. The private equity market in Poland, for example, has faced stiff competition from the Warsaw Stock Exchange, which provided a home for many small and mid-sized companies that would normally have been fodder for private capital, while also pushing up the value of those companies as the stock market soared.

This makes raising money outside the region for fund, certainly for those chasing larger deals, a tougher sell. "CEE is having a harder time competing for emerging market capital," says Wardrop.

In the mid-market, companies with an enterprise value of €100m-150m, the picture is more encouraging, as strong local or regional players aren't competing with money pouring in from large-cap foreign funds, meaning also the valuations levels for target companies are more reasonable. "In the mid-market segment, those funds that have freshly raised money to invest should have a good chance to perform strongly," says Szczepanski, whose own firm is approaching the final close of its second fund.

Buy-and-build

Furthermore, there are some key features of the market in CEE that makes investing in them still attractive.

For all its development over the last decade, Emerging Europe's industries and sectors are still very fragmented compared with those in western markets and thus provide considerable scope for consolidation. For private equity firms, that means it's possible to buy one of the larger players in the market, and then spend subsequent capital on what's called "add-on" acquisitions. "These relatively fragmented industry structures more easily facilitate the implementation of buy-and-build investment theses... where acquisitions tend to be more readily identifiable and can often be acquired at attractive valuations due to their relatively small size and market shares," says Wardrop, whose own firm has completed five add-on acquisitions so far this year. "This is a feature of CEE's more nuanced 'hybrid' status that we feel is sometimes not fully appreciated by investors looking at the region from outside."

Indeed, Szczepanski argues that the global crisis has actually aided this feature of the market. Before the crisis, these fragmented markets contained many players of similar size and it was a bit hit-or-miss whether you managed to back the right horse. "In many markets, there is now a clear leader because sound companies run by quality management teams were able to benefit from the slowdown and strengthen their market position, so it's less of a casino and more visible whom you should bet on."

Another positive feature of the CEE private equity market are the succession-related buyouts that are becoming increasingly prominent.

Unlike succession deals in Western Europe, the companies in question are not family-owned businesses but rather those that were, like many businesses in Central Europe, started (or privatised) by a group of entrepreneurs in the 1990s after the collapse of communism, who have since grown the businesses and are now in their 50s and approaching retirement age, with some wanting to stay connected to the company, others wanting to leave entirely, and others wanting to take some money off the table and remain minority shareholders.

For private equity firms like Arx, these companies, worth about €50m, provide rich-pickings. "As the first institutional owner of these firms, it's easier to add value. If you're the third owner, the company is probably bigger, more diversified and less risky - however it's also more difficult to add value as PE investor," says Wardrop.

This is a particular theme in the Czech Republic, where the voucher privatisation programme created many companies that are owned by a group of private individuals of the same generation. By Arx's calculations, in 2003 the number of companies with annual revenues of over CZK200m (£6.64m) and at least one owner older than 50 years old was 323; in 2008, this number had grown to 1,080, a compound average growth rate of 27%.