After 2017's 'Goldilocks' conditions for the private equity and venture capital market, limited and general partners are starting to see signs of a changing environment.
Last month I had the pleasure of moderating a panel session at the CEE M&A and Private Equity Forum in Warsaw. The topic of discussion was how the private equity and venture capital market has changed since its 2017 'banner year' and what trends we are seeing in Central and Eastern Europe.
2017 certainly set the bar high. Assets under management globally reached $2.83tn by June 2017, setting a new record. Horizon returns for private equity were the best out of all private capital asset classes, and private equity was the strongest long-term performer for pension funds globally. Investor satisfaction was close to all-time highs, and the net balance of investors planning to increase their immediate and longer-term allocations to the asset class was at record levels.
We have the now-established cycle of strong fundraising + deal flow + exits – leading to a massive net flow of cash back to limited partners (LPs), with distributions in excess of cash calls. 2017 not only saw a record $453bn raised globally, but also a strong majority of these funds closing at, or above their targets, and relatively quickly.
A changing market
The aforementioned 'Goldilocks' conditions cannot be expected to continue indefinitely. What are the implications for LPs and general partners (GPs) alike? While it would be premature to call a turn in the market, in 2018 we have seen signs of the changing environment.
Sources of funding
I asked the forum panel how LPs and GPs in CEE are sourcing funding.
Brian Wardrop, Managing Partner at the Prague-based ARX Equity Partners explained that for smaller funds of less than €150m, local private LPs (institutional and non-institutional) are becoming much more relevant. "The Czech Republic appears to be the leader in this regard due to a number or specific factors, such as the European Bank for Reconstruction and Development's (EBRD) exit from the country, coupled with other local factors. I see this as a natural evolution and maturation of the CEE PE market over the long run. The region should start to look more like Western European LP bases gradually with more local capital."
Marco Natoli, Head of Lower Mid-Market, Northern, Eastern & Southern Europe at the European Investment Fund, added that the role of International Financial Institutions (IFIs) is crucial for smaller funds, emerging managers and first-time teams. He also pointed to the EIF's fundraising experience as an LP; "we're mostly raising resources for the region from public origin/NPIs (National Promotional Institutions), typically with policy objectives attached. More recently, the EIF has developed a private fundraising strategy, with pension funds, Sovereign Wealth Funds (SWFs) and so on, and CEE is embedded as part of the offering."
Polish Development Fund Limited Partner Annemarie Dalka told the panel that a strong local investor base is crucial, especially to the small and mid-cap funds. It's why they set up a PE Fund of Funds (FoF) programme earlier this year. Next year there will be a new source of funding for PE funds in Poland - the private pension plans, known as PPK.
Returns, risk profiles and specialisation in CEE
Our discussion turned to the themes appearing in fundraising in CEE in terms of returns associated with risk profiles and specialisation.
Ondřej Vičar, General Partner at the Prague-based Genesis Capital, said there is one specific trend appearing in the region (strongly present in the Czech Republic). It's the increasing number of newly-established family offices/financial groups that administer capital often linked to the previous entrepreneurial activity of their founders. "As part of their activity they usually randomly and opportunistically try to invest in companies (creating potential competition in specific deals for GPs), but on the other hand they tend not to have any clear vision or strategy in doing so, often lacking the experience and best practices." He expects that gradually, these groups will become a new source of capital for PE funds as they will find it more comfortable, cheaper and less risky to deploy their capital into the PE indirectly, through professional fund managers."
Mr Wardrop said that firms at the smaller end are becoming more specialised either by geography or sector/situation, or both. "The days of a smaller, lower mid-cap-focussed GP effectively covering the entire CEE are over. Simply put – the need to differentiate and specialise is clear."
The panel discussed whether these themes are unique to fund raising in CEE or if there are similarities to what we are seeing globally.
Mr Natoli said that CEE cannot escape global fundraising trends. "The region has partially benefited from the large availability of money but not at the level that would have positioned it stably on the radar of international investors."
He pointed out that fundraising results in CEE are still linked to just a few successful names. "Last year's relatively positive figures were the outcome of only five funds closing. A broader (and more evenly spread) base of active players would be desirable. CEE is currently undergoing an evolution from 'developing' to 'developed' market. While it's closer to Western Europe on a macroeconomic level, in the allocation of LPs, CEE is still placed alongside other developing PE markets such as LATAM, MENA and SE Asia."
Ms Dalka highlighted that some of the global trends are driven by the LP type and their specific needs. "For insurance companies, it is about efficient use of Risk Weighted Assets, hence their focus is on flattening the J-curve, for instance through subscription lines. For FoFs the focus is on increasing the overall return, hence increased appetite for co-investments."
Common issues for Limited Partners investing in CEE
As the CEE market develops we see rising costs – such as for labour, how much do these increases dampen the investment appetite of LPs?
Ms Dalka believes the rising costs are balanced by the region's ample GDP growth, the generational change creating market opportunities.
Mr Natoli said that CEE is not perceived as a homogenous region, and specific country circumstances may affect perception and LP appetite. He also made the point that rising costs is only one element for concern. "It's also about the effectiveness and differentiation of the various investment strategies. A number of players in the region, who were initially successful to attract money with early generations of funds, have failed to prove their ability to move from generalist strategies driven by the theme of economic convergence to specialised strategies tailored to each country's opportunities."
Mr Vičar said that the size of most of the CEE markets would definitely be an issue for a LP, along with their fragmentation, different currencies, different cultural and legal environments and variety of languages. "On the other hand, economic convergence, succession and some other positive macro trends still speak for investing in the region. In this respect it makes sense for LPs that want to invest in CEE to seek country funds – fund managers that specialise in covering one or two countries very closely, with the value added in understanding the specifics and ability to overcome the aforementioned barriers and limitations."
How are local and international investors interacting with the market?
Local investors naturallly have a stronger local presence in CEE than international investors. Mr Vičar said that in practice, this often translates into a broader scope of activities in the local market. "Often, investing into PE is a form of cross-selling of other services for local investors – services such as bank financing, M&A services, high net worth individuals networking. In some cases, alongside their fund investment and a pre-agreed co-investment arrangement, they may actively seek in parallel, their own direct investment opportunities. This can sometimes constitute a potential conflict of interest or at least result in an unclear position from the local GP point of view."
Mr Natoli believes local investors are still missing in the market. "We see some signs of improvement, for example PFR in Poland, some NPIs in other countries, but this is not sufficient yet." He said the substantial presence of local investors is crucial to attract international LPs, as they provide much-needed local endorsement for foreign investors.
I was interested in the panel's views on placement agents. Are international GPs using placement agents to fundraise in CEE? What are the benefits to using local placement agents?
Mr Wardrop said the best agents want to place larger funds, and his personal view is that the top tier of elite agents are arguably worth the fees they charge for some specific reasons.
Mr Vičar said top tier agents would be unaffordable for most of the smaller funds but also that these agents would be hesitant working for them because of their opportunities costs. Using B-class agents may not be delivering the results and become even hazardous, as the agent may damage the reputation of its client, if not behaving professionally and/or pushing too hard on the investors to provide capital.
Mr Natoli said that only a portion of GPs use placement agents in CEE and it may be primarily linked to costs. "The benefits brought by capable placement agents span from boosting the preparation of the GP to the fundraising exercise, to managing the process efficiently and to developing a targeted approach to different classes of LPs at the different stages of fundraising."
Ms Dalka reiterated the point that a lot of LPs have certain allocation and size limits that the CEE based managers cannot meet, hence using a placement agent is understandable. "We just want to see a GP paying the associated costs out of their own pocket. I think the work done by associations like Invest Europe or ILPA, that we are members of, is helping with transparency and unification of reporting."
The main fundraising specificity of CEE is its current evolution from 'developing market' to 'developed market.' The region is perceived as still commanding a risk premium (mostly associated to the different country risks. The specialisation and differentiation of GPs in CEE is key, and a local LP base is crucial for small to mid-size funds in CEE. One constant factor in the industry's development is the need for the best possible information to help LPs and GPs alike decide on and execute their strategies.
Globally, we are seeing the private equity and venture capital market concentrating, with the largest funds capturing a growing share of assets. Despite this, there remain many opportunities for first-time funds, which on the whole have delivered somewhat better returns than their more established peers. ESG is of growing interest, not just on grounds of principle, but as a route to higher and more reliable returns. And routes into private equity are proliferating, as LPs seek alternative structures that match their individual requirements, and GPs seek to offer matching products.
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