What do the makers of insulin, modern contact lenses, parachutes, Rubik’s Cube, Skype and several of the world’s leading antivirus software programs have in common? They’re all from Central and Eastern Europe (CEE).
Those significant achievements highlight the need for companies and investors to pay close attention to the region. Although historically overlooked or considered too risky by many investors, the region has come a long way since the fall of Communism.
Across the CEE region, national populations range from 1.3 million in Estonia to nearly 40 million in Poland. Eleven countries in the area are European Union members, all having joined in the past decade; six are candidates at varying stages of accession and displaying varying degrees of determination to join. CEE countries also differ in overall governance, institutional strength and business climates. Understanding these differences is critical for investment and business success in the region.
Notwithstanding intraregional variations, from an investment perspective, CEE offers an attractive set of fundamentals:
• The region has significant scale. Its combined population exceeds 100 million, and last year’s gross domestic product of $1.4 trillion was the same as that of Spain, the 13th-largest economy in the world.
• CEE economies have performed relatively strongly by most measures and far outpaced that of the euro zone. These economies posted average annual growth rates of 3.1 percent between 1999 and 2013, compared with 1.1 percent for the euro zone.
• These countries’ existing and, for some, forthcoming memberships in the EU, the North Atlantic Treaty Organization and the Organization for Economic Cooperation and Development (OECD) have created a more stable and integrated market.
• Because of its location, CEE is ideally situated for building trade links between Western Europe, the Middle East and Asia.
• The region benefits from a well-educated and inexpensive workforce, with particular strengths in engineering and technology.
• CEE also enjoys increasingly supportive tax regimes, with favorable corporate tax rates ranging from 10 percent in Bulgaria to 22 percent in Slovakia, compared with 30 percent in Germany and an OECD average of more than 24 percent.
Yet the global success of CEE companies lags on average behind those in European and international markets. The region also presents some key challenges, including:
1. Fragmented markets. CEE companies face significant obstacles in reaching a large number of customers. The U.S.’s size allows companies to scale up quickly in a single-language market, but the fragmented nature of CEE markets means that rolling out a cross-border business, even through consolidation, remains an often slow process.
2. Limited availability and acceptance of financing alternatives. CEE’s relatively short private sector history means a less developed understanding of the variations among financing sources by local companies. Banks have been the traditional source of funding, but bank loans are often inaccessible — and sometimes not advantageous — for early-stage companies, which often need them the most. Nonbank financial institutions emerged in the 1990s, although given their poorer risk management and more aggressive practices, many ended up in bankruptcy. Public markets are generally underdeveloped in CEE (with Poland being a notable exception); the total market capitalization of the region is about $340 billion, or only 23 percent of GDP, compared with 63 percent of GDP in the euro zone. Private equity and growth capital are generally available in CEE but are less widespread than in Western Europe.
3. Less mature corporate governance practices. Entrepreneurs in CEE have typically not been accustomed to fully developed corporate governance best practices. Many family businesses have only recently started professionalizing management teams, and few companies have invited nonexecutive members to bring fresh perspectives to their boards.
4. Brain drain. Largely because of engineering’s local popularity, CEE is renowned for its technology expertise, yet brain drain remains a concern. Many of the most talented engineers leave the region to pursue advanced studies or more lucrative opportunities abroad. Only a small proportion of this talent makes its way back home.
5. Low interest in and recognition of entrepreneurship. First, much of the present generation of workers did not grow up with local entrepreneurial role models. Second, entrepreneurship has had a mixed public reception. Given that the initial wave of postcommunist privatization often rewarded politically connected insiders, entrepreneurship has had a negative association with corruption. Achieving success in a relatively short period of time is often viewed with suspicion. Third, entrepreneurs in CEE are concerned about not succeeding and suffering the public stigma of failure. As a result, the best students in CEE are often attracted to corporate, banking or consulting careers, rather than setting up their own businesses.
6. Lack of global perspective. CEE companies tend to benchmark themselves more to local or regional peers than to best-practice global competitors. That said, the younger generation is increasingly connected to international markets (often by studying or working abroad), has more international connections and can speak fluent English, whereas older generations often lag behind in those respects.
There are a number of steps that the public sector and companies can take to develop CEE into a thriving region that can produce successful global players across sectors. These include:
For the public sector:
• creating a business- and entrepreneurship-friendly environment
• providing targeted financial support
• establishing regional technology clusters
• creating conditions to stanch brain drain
• increasing education quality.
For companies:
• building on the region’s competitive advantages
• thinking globally
• pursuing inorganic growth options
• strengthening corporate governance and management
• exploring different capital alternatives.
(Please refer to KKR’s longer version of this piece for more details on each of the above priorities.)
The bottom line is clear. A quarter century after the fall of the Berlin Wall and the demise of Communism, we are optimistic about the region’s prospects. We believe that the next 25 years can be marked by further convergence with Western Europe and the emergence of global champions in CEE, bringing valuable innovation to the global marketplace. Rather than being deterred by headline-bannered risk scenarios or stereotypes, investors should pay greater attention to CEE by seeking out opportunities to be long-term partners for the next generation of entrepreneurs and sharing their experience and knowledge, rather than just providing short-term capital. The people of CEE inspired the world in 1989 by peacefully standing up for their dreams. We are confident that in the decade to come they can harness their talents to realize their region’s enormous economic potential too.
Johannes Huth is head of operations in Europe, the Middle East and Africa; Martin Rajcan is a principal of the private equity team; and Tomas Kubica is a member of the Central and Eastern European and technology and communications teams; all at KKR in London.
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