Techniques of Successful Equity Investing in Eastern Europe

by Kevin McDonald

This article was published in the Wall Street Journal Europe on September 1, 1993.

In June 1990, the Hungarian-American Enterprise Fund bought a sleepy printing plant in Budapest, Hungary. It hired a new chief financial officer, increased wages by 50%, reduced payroll to 300 people from 900, arranged debt financing for $6 million of new equipment, and created a mandate to pursue the high-growth market for export-quality, printed packaging. The results: within a year, sales rose 22% to $39 million; exports rose more than 500% to nearly $15 million; and the market value of the business approximately doubled, to $30 million.

The success of the Petofi Printing Plant illustrates a little known fact: over the past three years, private equity investors from the U.S. have adapted their craft to the conditions of Eastern Europe, pouring nearly $400 million into ventures in Poland, Hungary, Bulgaria, and the Czech and Slovak Republics. The capital for these ventures has been invested primarily by "enterprise funds," financed by the U.S. Congress and run independently by blue-chip American managers. Several private, smaller funds - including Caresbac in Warsaw and the Ukraine Fund in Kiev have also been successful. The capital commitment from these funds varies. The Polish-American Enterprise Fund manages approximately $300 million, whereas its Hungarian, Czech, and Bulgarian counterparts each controls around $50 million. They all target investments of between $500,000 and $3 million. The smaller Ukraine Fund and Caresbac manage just under $10 million and seek investments in the $50,000 to $200,000 range.

The success of the pioneering funds in Poland and Hungary has attracted private capital as well. The Polish-Americn Enterprise Fund raised $100 million of private funds this year, and the Hungarian-American Enterprise fund is in the process of raising $20 millioin. The lessons these enterprise funds have learned while setting up and managing ventures in Eastern Europe can provide insights to other fund managers with similar aspirations. Among the most valuable are:

Finding the best deals. Although a highly educated workforce (many of whom have been groomed by years of moonlighting in the underground economy) and a large market have meant there are plenty of good entrepreneurs to choose from, most local managers know nothing about developing a business plan or analyzing opportunities for investors. In the long term, this gap will be overcome with the development of an infrastructure of investment bankers, lawyers, and accountants as well as experienced local staff. In the meantime, several other steps have proven useful.

First, develop templates to guide the entrepreneur in fashioning his business plan. Second, restrict the initial focus to a few promising sectors and develop expertise in those sectors. Third, seek referrals from international agencies involved with local companies. Caresbac in Poland has used such referrals to find virtually all of its good deals, from horticulture to building futons to providing accounting systems.

Helping companies expand. Western investors frequently complain of having only limited impact on the behavior of local managers. In general, enterprise funds have learned to stay close to each company in their portfolio. About 10% of their funds are allotted for technical assistance. "We don't recommend seminars or books," says Bob Faris, CEO of the Polish-American Enterprise Fund, "but instead provide hands-on experts from different functional areas." Adds Tom Claflin, partner in the Ukraine Fund, "We want to guide them, not mold them into American MBAs."

When keeping an active hand in the company isn't enough, some funds prefer majority ownership as a way to nudge entrepreneurs along. "We didn't start out with this policy," says Mr. Faris, "but we learned that it can save 18 months of renegotiating with a wayward entrepreneur. We don't plan to use this control, but we're better off having it just in case." Recruiting resident Americans to sit on boards, or hiring retired U.S.-based expatriates to fly in for quarterly reviews has also proved successful. "They're terrific," says Alex Tomlinson, CEO of the Hungarian-American Enterprise Fund. "They help our companies with strategic planning and other business techniques and also alert the Fund to problems and then help resolve those problems."

Finding co-investors to help manage companies, however, has proven difficult. In successful cases, the key has been to target a Western company big enough to be interested in foreign markets but too small to find the partners and finance them alone. "We started out aiming for U.S. partners that are too large," admits Frank Bauer, CEO of the Bulgarian-American Enterprise Fund. "We have since learned that the most likely company to co-invest with use is a manufacturer in Peoria with 600 employees and sales of $25 million. Now we have several firms actively considering co-investment."

Liquidating investments. A fund's final task is to exit the scene, gracefully and with a profit. Most existing funds are not yet ready to sell their companies. Exiting when they are ready may be difficult since secondary markets remain undeveloped.

In the meantime, funds have achieved liquidity either by dividend streams or corporate sell-outs. For example, the Ukraine Fund's first investment was in the largest private retail chain in Kiev. The fund is receiving a return on equity of approximately 25% a year, in cash. "The entrepreneur is 22 years old, and his business is doubling every year," says Mr. Claflin. "We plan to re-invest our profits immediately, while the opportunity is good. But we can get our money out pretty quickly through dividends later if we want to."

The Czech and Slovak Enterprise fund is in the process of selling a 50% stake in two of its 36 investments, one producing fertilizer and the other a food sweetener. The buyers are Japanese. "We had no difficulty finding a buyer, and we will realize a nice profit on the transactions," says John Petty, chairman of the fund. "The key was focusing on attractive sectors and companies in the first place."

Equity investment in Eastern Europe is not for the faint-hearted. The commitment must be long-term and operating costs can be high. Legal expenses - due largely to underdeveloped laws - can run as high as 20% of overhead, vs. 2% to 5% in the U.S. And there are the hidden costs of expatriate staff turnover, which can be 20% to 40% a year. But the experience of these pioneering funds has shown that the problems encountered can be overcome, and that the returns can be well worth the effort.