Unimpressive performance of private equity funds in Poland

They are referred to as the “two and twenty” (or “2 and 20”). This business is also present in Poland, although it isn’t playing any major role. In the United States, and elsewhere in the West, these investment funds are now thriving, venturing beyond their traditional domains. In Poland they have a very limited role, and this isn’t likely to change by much.
Unimpressive performance of private equity funds in Poland


It begins, of course, with money – that precious thing we all love so much, especially when it is multiplying. While there may be many ways to multiply one’s money, each method has its drawbacks. The stock market is good for professionals and daredevils. Banks merely protect people’s deposits against inflation, and not even always that – certainly not at this particular point in time. Precious items such as gold or diamonds are mainly seen as a way to store value, not as an investment. Perhaps the gap of moderate profit expectations could be filled by the so-called mutual funds?

The search for the origins of those funds takes us to the Netherlands. They were likely invented by the Dutch broker and merchant Adriaan van Ketwich. The Netherlands was a country of great economic success, quickly recovering from the financial crisis of 1772-1773, when Mr. van Ketwich was trying to come up with an investment tool which would correspond to the needs of the numerous people with considerable, but not enormous incomes. He eventually came up with the idea of a mutual fund. In 1774, van Ketwich launched the first mutual fund. In naming it, he repeated the official motto of the Dutch Republic – the country has not always been a kingdom –  “Eendragt Maakt Magt” or “Unity Creates Strength.” Neat and to the point.

Today there are numerous varieties of so-called mutual funds in operation, with three types being the most dominant. Private equity (PE) funds collect money from legal and natural persons in order to purchase (usually) majority stakes in promising companies which require a capital injection and more efficient management. When the position of a given company strengthens, it is put up for sale at a new, higher price reflecting its improved condition. The investors enjoy the profits obtained as a result of the company’s successful turnaround, and the fund moves on to subsequent projects. Over that last 10 years private equity funds in the United States alone took 94 000 enterprises under their management, and during the same time they sold 52 000 companies (source: FactSet).

One branch of the private equity funds are the so-called venture capital funds (VC), which operate on the same principle, but focus their efforts on so-called startups and smaller companies, whose potential is still underrated.

However, the most spectacular area is hedging. Contrary to the dictionary definition, which suggests that they are supposed to hedge against risk, the opposite is true in reality. Hedge funds are the most aggressive investment funds of all, operating with the goal of achieving the largest possible profit within the shortest possible period of time. For this purpose, they are trading in the most liquid (i.e., easy to sell) assets and instruments, such as stocks, bonds, commodity futures, currencies. They also use arbitrage, that is, take advantage of the price differences on different markets, and they also like derivative instruments. They willingly enter into conspiracies known as “short selling.” The regulatory bodies hold these entities to a looser set of requirements, which means that they are even more dangerous. That is why in the United States only so-called accredited investors are allowed to participate in hedge funds.

Follow the money

What is the source of profits for the fund creators? They are obtained pursuant to the “two-and-twenty” rule. A so-called management fee of 2 per cent annually is typically charged on any amount paid into the fund by the investors. At the same time, the funds have a 20 per cent share in the profits obtained from the sale of the restructured assets, that is, the previously overtaken companies.

While private equity and venture capital funds have a long-term focus, hedge funds are focused on the short term – they are quickly jumping from one prey to the next. The largest of them, Bridgewater Associates, has claimed that it made USD 58.5 billion for its clients since its creation in 1975 (this is the net amount, that is, after deduction of the fees for the opportunity to participate in this business). That’s a lot, and therefore it’s not surprising that new funds are being created in large numbers, while those existing for a long time continue to grow.

A whole loaf of bread in America, a slice in Europe, and nothing more than crumbs in its easternmost parts

The history of investment funds began in earnest some 40 years ago, when the world of capital developed a taste for risk. This ultimately led to the 2007-2009 financial crisis, but back then it was mostly the banks that faltered. The investment funds withstood the storm. In fact, they have actually flourished since then, because it was necessary to somehow utilize all the new funds coming from the intense monetary policy activity of the states and their central banks, that is, from the printing of money commonly known as quantitative easing (QE).

As of 2019, the value of all assets under the management of investment funds is supposed to reach approximately USD 6.5 trillion (that is, USD 6 500 billion). This is an estimate, because due to the secrecy of funds the actual value is not known. It is assumed that private equity funds account for well over a half of that amount (USD 3.9 trillion). The conditions for their expansion are very favorable. As a result of the crisis from a decade ago, banks are now subjected to strict regulations, and they have developed a greater aversion to risk, which was partly forced by the regulations and partly their voluntary response. The low interest rates, which have prevailed for a long time now, are not conducive to the development of the banking business, as they reduce the banks’ profits. This is illustrated by the example of a loaf of bread and a bread roll. If we eat half a bread roll (very low interest rates), we will still be hungry. But if we eat half a loaf of bread (high interest rates), we certainly won’t be starving anymore.

Investment funds, and especially the hedge funds, have filled the gap created by the subdued activity of the banks. However, due to their different business model, we will not deal with the latter type of funds. Besides, they are hardly even venturing into such obscure locations as Poland. private equity funds are quite a different thing. While this business model has never achieved any significant scale in our country, its activity is certainly making some difference.

Venture Capital funds in the CSE

Truly huge business deals are the exclusive domain of the United States. Europe is lagging behind the Americans, while the investment funds operating in Poland are difficult to even notice in this context. The value of assets managed by private equity funds in the United States has exceeded USD 4 trillion (USD 4 000 billion), and the group of approximately 8 000 companies from their portfolio generates the equivalent of 5 per cent of the United States’ GDP. In Europe, the assets under management of the private equity sector are worth roughly EUR 1 trillion (USD 1.1 trillion).

Meanwhile, private equity investments in Central and Eastern Europe were worth EUR 2.95 billion in 2019, accounting for a mere 3 per cent of the funds spent on development and growth in all of Europe. Interestingly enough, in  terms of share of the individual countries, the top spot belongs to the region’s smallest country, Estonia (23 per cent of the total value), and not to Poland, which is the largest state of the region (a 20 per cent share in the total value). However, the tiny Estonian has made it a point to be efficient and supportive, in contrast to the Polish state, which is seen as sloppy and hostile to entrepreneurs.

Banks toiling away, funds reaping most benefits

The fruits of the activity of the investment funds fall into the baskets of their active participants, but they also provide a health boost to the economy as a whole. The general benefit for the economy is reminiscent of an auto workshop – after some work by a talented mechanic a beat-up car can work like a clockwork (although not always, as there are workshops and “workshops”).

The failures of private equity funds are not as numerous as their successful projects, because if it were otherwise, that business would simply cease to exist. Nonetheless, the disasters tend to be spectacular if they do occur. In 2005 three private equity companies bought a large toy store chain Toys “R” Us, which went bankrupt 12 years later, in 2017. Meanwhile, in 2008 the private equity fund Cerberus bought an 80 per cent stake in the automaker Chrysler, which had just quit its failed marriage with Daimler-Benz. The value of that transaction was USD 7.4 billion. Then came the global financial crisis, and Chrysler found itself on the verge or bankruptcy. Cerberus didn’t lose all of the money, however, because it made some profits on the company’s financial arm.

Because the private equity sector has achieved more successes than failures, for many years the centre of gravity in financing has been shifting from the banks towards the capital market and the various investment funds. This process is now taking place all over the world and is no longer a strictly American phenomenon. According to the Financial Stability Board established by G-20, in 2007 the global, non-bank financial assets were worth USD 100 trillion, which corresponded to 172 per cent of the total gross world product at that time, and to 46 per cent of overall value of financial assets. Today, the value of these assets grew to USD 183 trillion (USD 183 000 billion), which corresponds to 212 per cent of the gross world product and to 49 per cent of the overall value of financial assets.

This process complies with basic business logic – the pursuit of profit. According to Michael Spellacy from Accenture, mediation in the global capital market generates roughly USD 1 trillion (USD 1 000 billion) in annual revenues, with banks accounting for about a half of these revenues. This activity brings all its participants total profits of USD 100 billion, but the non-banking businesses, including investment funds, take as much as 90 per cent from this pool. It seems that while the banks are working hard, the investment funds are ultimately reaping most of the benefits.

The private equity sector in Poland might like to expand; the authorities are not too eager

According to the Warsaw-based Chamber of Fund and Asset Management, in March of 2020 the value of assets of the so-called non-public funds operating in Poland – which includes private equity funds, real estate market funds and securitization funds – amounted to PLN 93 billion and decreased by approximately PLN 20 billion compared with the spring of 2018. While the amount of almost PLN 100 billion sounds pretty decent, it is still only about EUR 20 billion, that is, next to nothing in comparison with the amount of EUR 1 trillion in assets under management in Western Europe.

Last year’s (2019) Polish private equity investments reached a total value of EUR 585 million and were four times lower than in 2017 (EUR 2.5 billion).

 The funds operating in Poland do not engage in intensive PR activities, which is probably a conscious choice, as they would certainly be able to do so if they liked. As a result, few people realize that even in our country truly some extraordinary stories occur. Ten years ago, the Enterprise Investors fund – the unrivalled giant of the Polish private equity sector – bought a 49 per cent stake in the Dino retail chain founded by a Polish entrepreneur. The value of that transaction was PLN 200 million. In 2017, the fund sold its stake for PLN 1.65 billion, that is, for more than eight times the original price. Today (as of 5 October 2020) the market capitalization of the Dino chain is PLN 2 billion higher than that of PKN Orlen. If Enterprise Investors applies the “2 + 20” rule, then it made a gross profit of PLN 330 million on the exit from the investment. It is no wonder that the partners at the fund are driving (or at least used to drive) Bentley vehicles.

Because there are very few really big and at the same time promising enterprises in our country, and the private equity funds operating in our market are not particularly powerful, their main target includes small and medium-sized companies. Last year’s (2019) Polish private equity investments reached a total of EUR 585 million and were four times lower than in 2017 (EUR 2.5 billion). The average value of an investment had also decreased, from around EUR 41 million in 2017 to EUR 7 million in 2019. The global average is several times higher and amounted to approximately USD 153 million in 2019.

Without foreign capital, the private equity sector in Poland would come to nothing. In Central and Eastern Europe, including Poland, the private equity sector was created with American money, because 30 years ago there was no locally owned capital and Europe was generally lagging behind the United States in this business.

Now, with a few exceptions (in particular with regard to the so-called funds of funds), there is no financing from the United States in the private equity sector in Poland. There are only European resources available, and there are no domestic sources of money. The resources obtained by private equity funds operating in Poland mainly derive from the European Bank for Reconstruction and Development. Without the EBRD, this business would be even more marginal, as the flow of funds from strictly private sources has narrowed greatly. Of course, this trend could be reversed, someone would to wish for it to happen. The market would wish that. But the authorities wouldn’t.

As a result, the Polish Private Equity and Venture Capital Association (Polskie Stowarzyszenie Inwestorów Kapitałowych) only has 45 members. The small size of the private equity sector in Poland is a reflection of the stage of development of the Polish economy. We have come far, but we could have come even further. Unfortunately, the process of privatization was basically abandoned about a decade ago. Alsoforeign capital fell out of favour long ago. At the same time, the pool of domestic capital is limited and is mostly directed towards state-owned enterprises. The latter, however, are usually rather flightless birds than high-fliers.

The strangest feature of the private equity market in Poland, which truly sets it apart from other international examples, is complete lack of capital supply from local resources. Although Polish capital ultimately engages in this activity, it happens through private banking intermediaries. This basically means that money first flows out of the country, and goes, for example, to foreign investment funds. Through these intermediary entities, a small portion of the funds – in addition reduced by the various fees and commissions – returns to Poland in the form of investments. Meanwhile, the lack of direct flows of domestic resources to private equity funds generates distrust on the part of the Western funds: “if the locals are afraid of something, then maybe this investment should be reconsidered.”

The sale of a family business on the assumption that it will grow even more and become more efficient under the management of an investment fund, may be an appealing solution for a proud founder.

 One factor conducive to the potential expansion of the private equity sector in Poland is the near-zero interest rates, which are discouraging people from investing cash surpluses in banks. Besides, Polish banks are now investing in government debt, so they are leaving a lot of room for other entities when it comes to the financing of the real economy. The EBRD, which is the source of funds for the Polish private equity sector, has been legally obliged to counteract the real and potential consequences of Covid-19 and is not slowing down its activities. This means that this source of financing will continue to provide capital to the market.

The private equity funds operating in Poland have plenty of opportunities associated with the increasingly pronounced problem of succession in family businesses established two or three decades ago. In Poland, the willingness of the “second generation” to take over the family business is among the lowest in the world. The sale of a family business on the assumption that it will grow even more and become more efficient under the management of an investment fund, may be an appealing solution for a proud founder.

One very important investment criterion from the perspective of a private equity fund operating in Poland, is the assessment of the business exit prospects. Selling a business to another fund will not be as profitable as selling it to an investor operating within the given industry. Therefore, the chance that private equity will enter a given industry is much higher if there is visible consolidation activity taking place. The prospect of shortening globalized supply chains in connection with the economic impact of the coronavirus pandemic could also provide a boost to that market in a slightly longer perspective.

At present, despite the poor sentiment on the market, there seem to be few cheap and attractive investment opportunities. The starting prices suggested by the potential sellers are not falling. Meanwhile, the potential buyers have to wonder, for example, whether the decline in sales during the lockdown was natural, or whether it was a sign of an entirely different set of problems, which may be impossible to overcome. The companies have received aid from the state – what may have been its impact on their current condition? E-commerce companies have experienced rapid grown, but is it sustainable? The shopping habits and needs of consumers have changed. But for how long? When will we see inflation, and how high will it get? The assumption that now is a good time for private equity to buy good companies on the cheap is incorrect.

No chance for an investment fund financed directly from Poland

In August of 2020, the US Securities and Exchange Commission (SEC) relaxed the requirements for so-called accredited investors, who are authorized to operate in all areas of the capital and financial markets. The criteria of income and the so-called net worth of the potential investor have been maintained. However, now this status can also be secured through expertise and professionalism in the field of finance. It should be added, however, that it is not the SEC that is ultimately verifying the candidates. This is the obligation of all the companies providing services to retail investors, including private equity funds.

In Poland, the attitude towards investment, private business, and capital from abroad isn’t very favourable. The Warsaw Stock Exchange has become old news, which means that it is more difficult to exit an investment by listing a company on the stock exchange. The potential mobilization of domestic cash resources through their inflow to the private equity sector is facing numerous barriers. One of the main problems are the ambiguous tax laws. On the other hand, there is the highly inefficient court system. Even simple court cases take years to be settled, because the judges have very limited knowledge of taxes and business.

For many years it has been expected that the Polish parliament would pass a law on funds investing in real estate, known as the Real Estate Investment Trusts (REITs). In 2017, these plans were abandoned for good, probably due to the hostility towards private capital in general, and foreign capital in particular. In the case of the classic investment funds, it would perhaps be possible to make them more attractive for domestic capital, which is now seeking profits abroad. However, it looks like this will not take place for years to come.


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