Author: Vedran Obućina

Analyst, journalist specializing in the Western Balkans and Middle East domestic and foreign affairs

Venture Capital funds in the CSE

There are many reasons why Central and Southeast Europe (CSE) is not attractive to foreign investors, most notably high levels of corruption, legal restrictions that prevent or restrict Venture Capital (VC) investment, unsettled property relations and poor corporate governance.
Venture Capital funds in the CSE

(ArtHouse Studio, Pexels, Public domain)

Investing in venture capital (VC) was considered a high-risk investment, but also a profitable one. Investors invested their funds directly, without intermediaries, and thus had more control over the invested funds as opposed to investing in pension funds, for instance. Private equity (PE) is a form of equity investment in companies with active participation in the business of the entity in which the investment was made. VC funds work to improve the operations of companies in which they invest by strengthening management competencies, introducing operational improvements, and helping companies conquer new markets.

Given that pension funds are controlled by state agencies, any funding that involves a higher degree of risk, regardless of the amount of return, is prohibited. Pension funds are owned by individual citizens and created by long-term savings of citizens thus less risk investment is important.

Why is CSE not attractive?

This is precisely one of the problems for the development of Central and Southeast Europe (CSE) venture capital investments. Large amounts of money are trapped in state-owned institutions, in this case, pension funds. In developed economies, investment in PE or VC is an element of the financial market that can significantly contribute to the development of that part of the economy, where financing by borrowing or issuing shares is unavailable or difficult to access. These are primarily new companies, innovative, fast-growing companies, or in the process of restructuring.

There are many specific to the CSE region reasons why this region is not attractive to VC or PE. In particular, the lack of local investors, the high risk experienced by foreign investors and insufficient loan financing for private equity transactions. Investors often complain about slow legal and regulatory processes, inexperienced and insufficient judiciary, and bureaucracy. Common barriers that prevent domestic capital from investing in private equity funds are bureaucracy, lack of market opportunities, a weak bankruptcy framework. In some countries, the list also includes predatory officials, shareholder abuse, weak licensing, and uncertain law enforcement. Policymakers across the region still need to pay more attention to the specific needs of the private capital sector and address obstacles to its development.

The CSE leaders

The absolute leader is Poland, which gained EUR2.4bn worth investments in 2017, followed by Romania (EUR495m), Hungary (EUR200m), Latvia (EUR174m), Czech Republic (significant drop to EUR55m, from EUR168m a year before), Slovenia (EUR21m), Ukraine (EUR19m, Bulgaria (EUR19m), Lithuania (EUR11m), Estonia (EUR8m), Slovakia (EUR4m) and Croatia (EUR3m).

There are signs of significant volatility in the CSE market. The problems are an underdeveloped market, misunderstanding of entrepreneurs and legal restrictions. The investment market is not developed either; there are few active domestic and foreign VCs or open-ended investment funds with a private offering. The recession has also reduced a number of opportunities and available sources of capital. According to Michael Kedzi, Enterprise Investors partner, one of the oldest VC in CSE based in Poland, the region has huge potential for VC development.

The statistical tests done by regional economists proved the connection between the index of corruption and investments in all European countries, as well as the difference between the index of corruption and investments in VC in CSE countries compared to the rest of Europe. Overall, only five per cent of fund’s investments in 2017 went to CSE companies; a third ended up in France and the Benelux countries, and 26 per cent in the UK and Ireland. Policymakers across the region still need to pay more attention to the specific needs of the private capital sector and address barriers to its development, which is a message that EBRD sent already in 2006.

Hungary and Poland are excellent examples of how the government can encourage foreign investors to invest in domestic VC. In 2013, Hungarian economist Judit Karsai explained in an article “Private Pension Funds’ Attitudes to Private Equity in Hungary” how Hungary has become the second most developed VC and PE market in CSE. This points to a strong link between fundraising, investment and capital flow on the Budapest Stock Exchange. In 2010, the Hungarian government established the Jeremie Fund. In addition to its direct investments in the VCs, the government intended to participate indirectly in investments through hybrid funds, which was a proven scheme in international markets. In its first year of operation, Jeremiah funds achieved a similar market share as private sector investment.

Trends in Europe show that interest in VC is growing strongly. last year, investments by various European funds reached their highest level in ten years, exceeding EUR70bn in 2018. Nearly 7,000 European companies received the investment, as the Financial Times reported, and most of them were small and medium-sized (SME). Total investments in VC in Europe in 2019 reached EUR97.3bn. The number of funds that raised new capital fell by 5 per cent to 581. Despite this decline, they achieved a 13 per cent better results than the annual average. Taken as a whole, the funds raised and invested in CSE show a similar trend compared to other countries in the European area, but the capital sizes are significantly lower.

Observing the continuous development from its inception until today, the private capital industry (and entrepreneurial capital) is still young in this region. For the CSE economies financing models through VC could be a driving force of the development. The governments can influence amendments to the Investment Funds Act and take certain measures to reduce corruption. A transparent economy, entrepreneurs’ open access to investors, legal certainty, as well as combating bribery and corruption could significantly affect decisions taken by foreign investors.

Although it is difficult or almost impossible to compare the VC market in CSE with the US and/or Great Britain, it is important to emphasize that the American type of fund financing is exclusively through private investors. They provide capital for risky investments in new and growing companies, while neglecting the role of the state. Although some analysts believe that the state should not influence the development of VCs, the state could significantly influence the market through various support programs, as well as tax reliefs.

Future considerations should include the banking sector and the share of banks in high-tech financing. Entrepreneurship development requires the technology that is extremely expensive. For an entrepreneur to survive in a turbulent environment, investments in new technologies are crucial, and there is no better proof for that than COVID-19 pandemic, which forced many businesses to invest in high-tech development. In the absence of own funds, the entrepreneur will ask banks, but they are cautious in giving high-risk loans. So in many cases VC investment may be the only source of much needed capital. This is why the CSE governments also need to invest in the VCs either by lifting legal restrictions or opening markets to foreign investors by reducing complicated administration.

Vedran Obućina is an analyst and a journalist specializing in the Croatian and Middle East domestic and foreign affairs. He is the Secretary of the Society for Mediterranean Studies at the University of Rijeka and a Foreign Affairs Analyst at The Atlantic Post.

(ArtHouse Studio, Pexels, Public domain)

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