Private equity’s ESG expertise equips CEE business with more than just finance

Private equity in CEE enjoyed a bumper year in 2021 as deal numbers rose from 319 to a record 399. Values rose from EUR 20.14bn to EUR 23.6bn, second only to 2018 in the past decade, illustrating how private equity has become part of the financial and corporate landscape of the region and accounting for around 20% of M&A activity.

Deals involving financial investors included nine with a value of EUR 600m or more. The year got off to a vigorous start as the pent-up demand that had built up towards the end of 2020 manifested itself in a commitment to pushing deals over the completion line.

CEE business owners are showing a greater awareness of and willingness to interact with private equity. Meanwhile, private equity firms based in the region are growing more ambitious, while those from outside and showing a greater understanding of the opportunities in CEE and a greater willingness than ever to engage with the region’s sellers.

Beyond P&L benefits

One of the key functions of private equity is to grow businesses and take them on to the next level, whether the owner is looking to retire or to bring in additional shareholders to help grow the business. But the focus is not just on profit and loss accounts or balance sheets. In a world where there is growing public concern about the environmental and social impact that businesses have, there is also more awareness among business owners and potential investors of the need for high standards of governance to make sure they are run in the best interests of the wider stakeholder community.

This puts ever closer focus on environmental, social and governance (ESG) issues which has created an additional motivation for sellers to seek out private equity expertise. In the wake of the COP26 summit, the spotlight has been on the environment and ESG provides the tools to comply with or stay ahead of regulations and guidance on topics such as sustainability, energy use, resources, emissions reduction and climate change.

Graham Conlon, CMS partner focusing on private equity in CEE/CIS, said: “Private equity has the skills to grow a business and develop efficiencies. There’s growing pressure to be mindful of the obligations in relation to ESG and especially E-for-environment.”

ESG is at the core of the work done by the European Bank for Reconstruction and Development (EBRD) which celebrated its 30th anniversary during 2021. Tamas Nagy, director and co-head of private equity at EBRD said: “We were set up in 1991 to make companies understand ESG and now ESG has really gained traction and public support. It’s not a fringe theory, it’s more widely understood. We work closely with private equity partners so that ESG is an important part of the whole investment thesis.

“When we work with private equity, they are very much in the financial driving seat, but we are pleased to see more funds reaching out to us with an ESG mandate looking for opportunities where they can co-invest with us.”

As a neighbour to emerging European countries Austria provides an important gateway to the region, particularly from DACH-focused investors. Alex Rakosi, CMS partner in Vienna, said: “Private equity players bring a high level of sophistication, optimise operational performance and development core business ideas. It goes far beyond just providing funds for growth, they bring expertise in business efficiency and in ESG.”

Among the large private equity partnerships based outside the region, but with a keen interest in CEE, is Advent International. Since it was founded in 1984, it has invested USD 58bn in more than 380 businesses across 42 countries, including CEE.

Milan Kulich, Advent director in Frankfurt, said: “ESG is a top priority agenda for us, and we are focused on achieving ESG objectives globally as well as in CEE. Our global investment philosophy is centred around the sustainable growth of the businesses in which we invest. We believe the management of ESG risks and opportunities at all stages in our investment process helps to protect and enhance reputation and financial performance and create stronger, more valuable companies in the region.”

Global capital eyes big ticket deals

The impact of private equity on deal-making could be seen in activity across the region. After Poland, which was the largest private equity market despite a drop from 99 to 74 deals, Russia became close second as it saw the number of private equity deals surge from 47 to 73. Turkiye saw deal numbers rise to 45, while Romania saw an increase to 32 and Bulgaria saw deal numbers almost treble to 29. Hungary, Croatia and Serbia saw more deals than in 2020, while Czech Republic’s volume remained stable at 43.

Graham Conlon said: “It used to be rare to find a deal of a few hundred million euros or more, but there are increasing numbers of big ticket deals and we are seeing more in the EUR 1billion-plus range. Private equity is no longer just about local players because bigger players in London or elsewhere are starting to take the region much more seriously.”

Tamas Nagy at EBRD said: “These markets are developing and growing so that companies are becoming larger and that means they invite more interested investors. A few years ago if you wanted to deploy EUR 100m there were only a handful of companies you could buy, but fast forward to today and those opportunities are coming up much more frequently.”

The scope and ambition of dealmakers is illustrated by the fact that the entry point into the top 10 largest private equity related deals in 2021 was EUR 464m, following a pattern that has become firmly established in recent years. There were increased deal numbers across the three busiest sectors as Telecoms and IT, with 101 deals, overtook real estate and construction, with 83, as the hottest sector, followed by manufacturing with 56.

The region is becoming a prolific location for technology start-ups which play into its strengths in turning out well educated people capable of quickly building businesses that can compete on a global scale, as illustrated by the number of unicorns emanating from CEE.

Milan Kulich at Advent said: “We have witnessed an accelerated shift towards e-commerce exposed business models including customer facing platforms as well as fulfilment providers. In addition, digitalisation has become a must across sectors. At Advent, we invested significantly into internal and external resources to drive this development in our portfolio companies as well as recognising these value creation opportunities when reviewing new deals.”

Deal drivers

In the early days of private equity in CEE, returns on investment were driven by turnarounds and modernising businesses, but there are now broader motivations behind deals as emerging Europe has become increasingly attractive to the private equity sector and attention that might previously been directed towards Asia is now being turned on the region.

Funds can still find companies that have a lower cost of doing business than further west and because they produce goods and services sold into the west they provided an opportunity to benefit from stable and healthy countries in the EU.

The long-awaited flood of succession-driven deals is finally starting to arrive, as founders from the first wave of private companies look at their next steps three decades on when they may find their children do not want to take over the business. However, other deal drivers are coming into play. According to Milan Kulich at Advent, turnarounds still have role, along with corporate carve outs and value creation opportunities and – more recently – opportunities to take minority stakes in high growth assets.

Success breeds success

Emerging Europe is increasingly offering private equity interesting targets thanks to the innovation of its entrepreneurs who have created a host of new businesses that are growing to a size where they are attractive to buyers and can contribute to deal flow.

The creation of unicorns and a pipeline of multi-million euro deals has helped focus attention on the region and means more global private equity funds are screening emerging Europe for opportunities, though those already operating on the ground are by no means a pushover. Healthy competition means private equity looks well placed to account for even more than the 20% of M&A deals it already underpins.

Tamas Nagy at EBRD, said private equity activity was nowhere near reaching a ceiling and added: “To my mind the opportunities for private equity are ever increasing. I believe that entrepreneurship is coming into its own. There are some great stories coming out and success breeds success.”

Further reading

17/06/2021

Summary of study findings

The study focuses on over 300 private, institutional, alternative, illiquid funds (the “Sample Funds”) on which CMS advised between 2017 – 2020 (the “Review Period”). The Sample Funds cover a range of geographies and asset classes, over 2/3 are focused on European strategies, approximately 1/3 are real estate, 1/3 are private equity (“PE”) and 1/3 are infrastructure, debt and other strategies. Our study has been informed by interviews with leading industry participants and over 100 survey responses (both undertaken at the end of 2020). As Sir Ronald Cohen, the international venture capitalist and PE investor, said “The first bounce of the ball everyone can see. To anticipate the second, you need a really deep understanding of the market.” A lot has happened in the recent past, very little of which was predictable, and what happens next may be even more surprising. We now wonder where the uncertain second bounce of the market will be. We set out below some key findings of the study. Key findings Overall fund raising volume reduced in 2020 off the highwater mark years of 2017 and 2018;Although 2020 saw fewer funds established, there was a lot of transaction activity as institutional investors continued their programmes and made new allocations in light of the risks, opportunities and challenges that arose out of Covid;In private equity a strong secondaries market continued to develop as institutional investors looked to streamline their holdings and take an active approach to portfolio management;When material uncertainty over commercial real estate values made it necessary to suspend daily dealing in some open-ended property funds, fund managers worked with the regulators to make this happen quickly and safely; we expect further regulation in this area;2020 saw investors sell off what they perceived to be higher-risk investments and purchase safer investments in perceived Covid winners (principally technology and distribution related as­sets);Lux­em­bourg continues to be the most popular fund jurisdiction for European fund launches, particularly in light of Brexit, with Dublin also starting to garner additional popularity in relation to funds marketed throughout the EEA;Funds with no commitment from managers are becoming less common with increasing manager commitments in closed-ended funds;A hurdle rate of 8% remains standard for closed ended funds across real estate and private equity;Managers in the upper quartile (in terms of performance) kept their management fees steady but there is some evidence that new managers are offering fee reductions or other incentives in order to raise capital; andThe demand for ESG products grows with indications that investors see ESG as a value driver as well as a risk mitigator.

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