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Prospecting for acquisitions.

Look for the laws all over Eastern Europe to be modified further to make acquisition of equity stakes more attractive.

Starting up a new business through joint ventures with East Bloc partners has been the traditional entry strategy into Eastern Europe, but to date Western companies have been much more hesitant about acquiring major equity stakes in existing enterprises and assets. So far, Western investors have announced or completed just over one hundred acquisitions in Eastern Europe. In contrast, they have entered into more than 3,500 joint venture agreements in Eastern Europe, including the U.S.S.R.

Why have there been relatively few acquisitions to date?

First and foremost, the laws in most Eastern European countries have been, until recently, too restrictive to make acquisitions possible. While the legal framework for joint ventures and acquisitions has been rapidly evolving over the last year, the problem lies in the small print. For example, in Yugoslavia, the constitution was changed in 1989 to allow for acquisitions, but the implementing regulations have been slow to be issued.

In Poland, the new laws on privatization and foreign investment allow 100% ownership, subject to government authorization, but it is still not clear whether you can own the land underneath the company. The legal quandaries are compounded by a number of other problems. Most countries have been restrictive about the convertibility or repatriation of profits, making the payback on investments highly uncertain.

There are also issues about what to do with the legacies of the communist era that you inherit with acquired companies. Many Eastern European companies are saddled with a stock of "social assets," such as apartments and sporting facilities, and a bloated work force. Divesting the social assets and trimming the work force can prove to be a difficult endeavor. There is uncertainty regarding liability for past environmental damage.

Another complication is the complete upheaval of the COMECON (Council for Mutual Economic Assistance) trade structure. Leading state industrial companies used to tie up a third or more of production capacity in COMECON's five-year specialization agreements for ruble-based exports to the U.S.S.R. and other East Bloc countries. Now that the system has been dismantled, it is unclear as to where a large portion of future sales will come from.

Finally, there is the issue of valuation. Existing accounting data can be very misleading. Often, prices are regulated, and key cost inputs subsidized, and differ significantly from international prices; balance sheets often do not recognize basic conventions like bad debt, obsolete stock, or depreciation. Moreover, the absence up to now of functioning stock markets or previous equity transactions means there are no comparable market prices.

On the other side, Eastern European governments have their own reasons to be cautious about acquisitions. They, too, are concerned about valuation and fear that the state may underprice its assets. A major stumbling block in Poland's negotiations to sell the Gdansk shipyards was the lengthy independent valuation. Likewise, valuation has proved to be a problem for Hungary. In examining failed deals, some Hungarians thought that the state sold Hungaria Hotels too cheaply, so they nullified the agreement and gave the Swedish company Quintus its money back. Such sentiment may affect upcoming amendments to foreign investment laws and may reinforce some Eastern European governments that would rather promote joint ventures than acquisitions.

Will the environment improve for acquisitions?

Definitely so. Eastern Europe has a great need for investment -- any investment. It is saddled with debt, its technology is obsolete, and its standard of living is suffering. To recover, to successfully introduce market economies, these countries must make Western capital and technology feel welcome.

Hungary, with the largest debt burden per capita in Eastern Europe, has been the first to respond to this message. The new government is committed to accelerating the privatization program. It recently floated shares in 20 companies, including such important ones as Ibusz, Gideon Richter, and Centrum stores. The government is also providing tax incentives. investment guarantees, and allowing profit repatriation. So far, their program is working. Of the 109 acquisitions that have taken place to date, 53 of them have been done in Hungary (see table on page 37). [Tabular Data Omitted]

East Germany has been second with 38 acquisitions. Not surprisingly, West German investors lead with 27 of these, but French investors, followed by U.K. and U.S. companies, also have been active.

Poland is just starting to accelerate its privatization program. On a trip to the U.S. last year, Lech Walesa announced that 80% of the country's industry would be for sale to foreigners. The Polish Council of Ministers stated that it wants to return 15% of the economy from state to private hands by the end of 1991.

Like Poland, other Eastern countries are changing investment laws monthly, or even daily. Even the Soviet Union now allows majority foreign ownership of existing state enterprises.

COMECON, the one unifying factor in the structure of trade and manufacturing, is also changing. It will be reformed with a complete transition to world market prices and hard currency starting January 1991. The development of embryonic stock markets in Hungary, Poland, and Yugoslavia will progressively provide signals to valuations of companies.

In the long run, Eastern European governments all will have to be less restrictive on foreign investment in order to survive. Not only do they need help from Western investors but also there will be increasing competition among the different Eastern European countries to attract the limited pool of foreign investment. Barring major political reversals, we can expect more acquisition opportunities throughout all of Eastern Europe.

Why would a Western company want to make acquisitions in Eastern Europe?

For sound strategic reasons, plus the fact that there are potentially high returns to be made for small investments. Although in the U.S. and Western Europe it is getting increasingly difficult for companies to add significant enough value to acquisitions to justify the substantial acquisition premium required, in Eastern Europe it is a different story. Assets are very cheap, and the need for change is so strong, that it is possible to make very small cash investments if you can offer Western technology, management know-how, or access to foreign markets. It is also possible to operate at a much lower cost. The wage rates are significantly lower (as low as $1 per hour in Poland), yet the skill level is as high as in many Western countries.

Obviously, investing in newly and partially reformed markets poses very significant risks, but there have been enough recent examples of successful acquisitions for both strategic and financial reasons to make it worth a closer look.

The most notable example of a strategic investment oriented toward export is General Electric's purchase of 50% and a controlling interest in the Hungarian light bulb manufacturer Tungsram. GE bought a company with $300 million of sales, a majority of which was in hard currency exports, for $150 million. It increased GE's European market share significantly, from 3% to 10%, just in time for 1992. GE effectively bought Western European market share at Eastern European prices. The company also shielded its investment from risk by insuring $100 million of it against expropriation, nationalization, and inconvertibility of currency, through the U.S. Overseas Private Investment Corp.'s new Eastern European Program.

The British manufacturing firm Hunslet, which acquired 51% of Hungary's Ganz Railway Engineering for $3 million cash, as well as know-how, training, and technology valued at $16 million, also falls into this category. In addition to structuring the deal so it paid very little cash, Hunslet's arrangement also provided a low-cost means to double its capacity at a time when it has a number of major locomotive contracts on the horizon. Its bet has already paid off. In August 1990, it floated 25% of the Hunslet stock for $9 million in cash. It still retains 26% of a growing and profitable company.

Another case is that of Kvaerner, a Norwegian group with shipbuilding, engineering, and ship owning interests, which recently reached a provisional agreement to acquire one of its suppliers, the Gdynia shipyard of Poland. Kvaerner has had a business relationship with Gdynia as a licensor of gas-carrier technology since the 1970s. This acquisition makes strategic sense for Kvaerner because it locks in low-cost capacity at a time when many observers are predicting a worldwide shortage of shipbuilding capacity in the mid-1990s.

Another strategic rationale is to buy companies that give you access to the markets of these countries. In Eastern Europe, there is a population of 395 million and a GNP equivalent to nearly two-thirds that of the European Community, in terms of purchasing parity.

Some of the first Western companies to tap the Eastern European market through acquisitions have been newspaper publishers. In November 1989, Maxwell Communications Corp. PLC acquired 40% of Maygar Hirlap, the Hungarian government newspaper (and traditionally the main party organ). Robert Maxwell took the position that in the long term there will be a growing and profitable market for his newspaper, and in the short term he will exploit a synergy with his existing operations. He has used part of the capacity of Maygar Hirlap to publish the Central and Eastern European editions of The European, the new newspaper that he launched in the spring of 1990. Maxwell later followed with the acquisition of another publication in Hungary, Esti Hirlap, and a joint acquisition of the Berliner Verlag in East Germany with a Bertelsmann subsidiary.

Rupert Murdoch's News Corporation Ltd. was also bold, acquiring more than 50% control of the Reform newspaper, a Hungarian daily newspaper. It was started by Hungarian entrepreneurs with an initial investment of $1.25 million and sold to Rupert Murdoch in less than a year for four times that amount. Moreover, all parties benefited. Murdoch bought a newspaper for 10 times earnings, compared with the 30 times earnings he would have paid in the U.S. at that time, and the founders took out their initial investment, pocketed a profit of $3.75 million, and still retained half of a rapidly expanding enterprise.

Maxwell's and Murdoch's early moves set off a scramble among publishers to buy the remaining assets. There have now been nearly 25 acquisitions, with other leading players like Bertelsmann (stakes in Hungary and East Germany), Axel Springer (Hungary and East Germany), and Eurexpansion of France (Hungary, Czechoslovakia, Poland). No significant newspaper or book publishers remain in Hungary or East Germany, and activity is accelerating in Poland and Czechoslovakia.

Similarly, Allianz and Colonia, the leading German insurance companies, bought up all the major insurance companies in both Hungary and East Germany.

While compelling strategic reasons motivate some acquisitions, purely financial reasons motivate others. There are significant profit opportunities for those companies that want to take only a passive investment position. The Austrian bank Girozentrale, along with the Hungarian Credit Bank, took a short-term position in Tungsram before selling it on to GE for a net profit of $40 million. Girozentrale also took a position five years ago in Novotrade, a Hungarian software firm. In September 1989, it floated Novotrade on the over-the-counter market in Austria at 150 times it initial investment. Girozentrale also purchased 40% of Ibusz, a Hungarian travel agency, which it floated on the Vienna Stock Exchange in May 1990. This offering tripled in value on its first day of trading before leveling off at more than double its flotation value.

The Future

Taken collectively, the investments cited above signal a promising future for acquisitions in Eastern Europe. We predict that the laws all over Eastern Europe will be modified further to make acquisition of equity stakes more attractive and eliminate remaining areas of uncertainty.

The choice available to Western investors will also expand. Strategic investors will now have a real choice in either making new investments through joint ventures or by buying into existing market positions and assets.

Watch for bellwether sales -- such as the GE acquisition of Tungsram -- in the other Eastern European economies to see how serious the different governments are about privatization: whether Czechoslovakia does, in fact, carry through with its intention to sell its national airline CSA; whether the Bulgarians offer shares in Balkancar; or the U.S.S.R. in Kamas, the truck producer. These will send a clear signal to the West regarding the range of choice that will be available.

Risks will abound. In addition to the possibilities of major political reversals, there remain the risks of economic collapse, rampant inflation, and wild currency fluctuations and continued inconvertibility. The newly elected leaders in Poland, Hungary, Czechoslovakia, Romania, and Bulgaria may be bent on correcting some of the recent excesses of capitalism in their countries and protecting the national industrial jewels.

Yet, in spite of the very large downside present, Eastern Europe represents an opportunity for high returns. The lack of information, legal ambiguity, price distortions, inefficient markets, and fast pace of change all provide an extraordinary upside possibility for those Western companies bold enough to seize the opportunities early.

John Lindquist is a Partner and Director, and William Browder is a Consultant, in The Boston Consulting Group's London office. Lindquist is co-leader of the firm's Eastern European practice, and Browder specializes in Eastern Europe.
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Title Annotation:Chairman's Agenda: Acquiring in Eastern Europe; planning investments in Eastern Europe
Author:Lindquist, John; Browder, William
Publication:Directors & Boards
Date:Jan 1, 1991
Previous Article:Assessing the market and the opportunities.
Next Article:From the bizarre to the merely complex: a legal perspective on the changing rules of the game in investing in Eastern Europe.

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