M&A in Eastern Europe

In 2005 the aggregate value of M&As in the region reached $90bn, a 76.5% increase over 2004's level. With deals valued at $52.5bn, the Russian Federation was by far the largest generator of M&A activity, followed by the Czech Republic ($9.0bn) and Poland ($7.8bn).

Reflecting its large domestic market and EU accession path, Romania reported $5.8bn in M&As, surpassing the total of one-time regional champion Hungary ($4.6bn). Bulgaria, which along with Romania is scheduled for admission to the European Union in 2007, registered a four-fold increase in mergers and acquisitions 2004-05.

The profile of M&As in the region displays several important features:

FOREIGN DIRECT INVESTMENT

Continuing the trajectory of the post-1990 period, foreign direct investment plays a significant role in the M&A portfolios of the former socialist countries.

While Poland, Hungary and the Czech Republic still capture the lion's share of FDI reaching Eastern Europe, the Baltic Republics and Balkan countries are receiving increasing volumes of cross-border investments.

FDI-driven transactions are likely to grow as forthcoming rounds of EU enlargement boost the region's allure to market-seeking foreign investors. Meanwhile, fossil fuel-related investments are mounting in Russia and the Caspian states in response to rising energy prices and the launching of new pipelines connecting the region to western markets (e.g, Baku-Tbilisi-Ceyhan).

COUNTRY ORIGIN

Following the pattern of previous years, the bulk of FDI reaching Eastern Europe in 2005 originated from the USA (12% of regional inflows), Germany (11%), Austria (10%) and the UK (10%). But the region is drawing significant investments from other countries, including other emerging European economies (e.g., the $3.6bn acquisition of Czech Telecom by Spain's Telefonica).

While large multinational firms remain the leading investors in the region, small and medium enterprises are displaying growing interest as the EU accession states and candidate countries enact business-friendly reforms.

SECTORAL DESTINATION

Manufacturing received the largest share of East European FDI (20.8% of regional inflows in 2005), followed by financial services (13.5%), energy and utilities (10.9%), and food and beverages (8.9%).

The pull of manufacturing-related investment in East-Central Europe illustrates the region's locational advantages for proximity-sensitive investors (motor vehicles, chemicals) seeking operational platforms to service the pan-European market.

Equally significant, the technological content of FDI in Eastern Europe is rising, demonstrating the region's rich endowment of skilled labour and the declining risks of technology-intensive investment in the accession countries that are enacting EU-style intellectual property laws.

In this connection, the current international bidding for East European pharmaceutical companies (Croatia's Pliva, Lithuania's AB Sanitas, Poland's Bioton, Slovenia's Krka DD) underscores the region's competitive advantages in high-technology industries.

INTRA-REGIONAL INVESTMENTS

Rising volumes of intra-regional M&As—particularly evident in banking, energy, and telecommunications—demonstrate the increasing financial depth, operational scale, and strategic sophistication of multinational firms headquartered in EE/FSU.

DOMESTIC TRANSACTIONS

Notwithstanding the pivotal role of foreign direct investment in Eastern Europe, domestic deals represent a majority of mergers and acquisitions in several countries (Hungary 52%, Poland 53%, Russia 72%), signalling a deepening of local capital markets; an increasing penetration of western-based financial institutions available to support domestic transactions; and an expanding cadre of local professionals trained in due diligence, structured finance, and other M&A activities.

In short, Eastern Europe occupies a key position in the global M&A market, whose resurgence illustrates the utility of mergers and acquisitions as corporate growth vehicles. For western companies seeking international growth opportunities, the region confers important advantages over other emerging markets:

• Geographic centrality in Europe, which broadens access to both the giant EU-25 market and the large emerging economies on the European periphery
• High-quality infrastructure, which benefits from inflows of EU structural funds
• Skilled labour force, which facilitates investments in high-technology and advanced manufacturing
• Rising labour productivity, which helps neutralise the wage cost advantages of China, India and other Asian countries
• EU-style legal / regulatory environment, which lowers the risk premium of IP-sensitive investments

EUROGEMS

Reinforcing these observations, RSM International's EuroGems Index 2006 surveys the M&A environment in East Central Europe and Russia. By comparing the historical and projected cash flow growth of individual companies to sectoral averages, the Index permits identification of undervalued assets.

Publicly traded companies whose growth rates exceed peer group averages but whose valuations are lower than market levels are designated as 'EuroGems'.

Using this methodology, the Index finds that Russian companies exhibit Europe's largest growth / value discrepancies.

Strong cash flow growth is enabling some Russian firms to undertake IPOs on the London Stock Exchange (e.g., Rosneft) and positioning others to launch M&A campaigns in the EU-25, Southeastern Europe, and non-Russian Soviet successor states. Listed companies headquartered in Hungary, Poland and the Czech Republic also show strong cash flow performance relative to market valuations.

These findings suggest the following:

• The regional economic gap between Western and Eastern Europe remains wide, and will not be fully closed in coming decades even with a large GDP growth differential. But individual companies headquartered in East-Central Europe and Russia are steadily narrowing the competitiveness gap with EU-15 firms, expanding the stock of high-quality acquisition targets in the region.
• Discrepancies between cash flow growth rates and market valuations of publicly listed firms in Eastern Europe / Russia reflect persistent uncertainties over political, economic, and regulatory conditions in the region. But investor risks are falling in the transitional economies, particularly in the EU accession countries that are adopting the acquis communautaire and preparing for Euro zone membership.
• The growing visibility of East European companies in outbound foreign investment boosts demand for strategic, transactional, and advisory services in the pan-European theatre.

PRIVATE EQUITY

In addition to the publicly traded companies addressed in RSM International's EuroGems Index, privately owned firms are assuming a growing role in Eastern Europe's M&A market.

With the partial exception of Poland, private equity has not played a significant role in East European M&As. But private equity activity is quickening in the region.

Hungary was Eastern Europe's leading recipient of private equity investment in 2005, reaching 163% of GDP—much lower than the private equity ratios of the UK, the Netherlands, and the Scandinavian countries but higher than the ratios of Austria and Ireland and comparable to those of Belgium and Portugal (Source; European Private Equity and Venture Capital Association).

Private equity raises a number of challenges not salient in public security markets, notably low levels of financial transparency that frustrate valuations of acquisition candidates.

However, Eastern Europe's private equity markets are poised for expansion as a consequence of increasing average transaction sizes, which enlarge the universe of acquisition targets within the threshold of West European and American funds; the growing number of East European-based funds (e.g., Innova Capital, Mid Europa Partners) with premier local staffs and extensive regional networks; and the deepening of regional stock markets, which broadens IPO exit opportunities for private investors.