Robert Smyth in Budapest -

Central Fund, the first private venture capital fund created under Hungarian law, is scoping the local market for investment opportunities in the severely under-capitalized small and medium-sized enterprise (SME) sector, but it will cautiously shop around rather than just snap up a string of cash-strapped firms.

"The crisis is far from over, and it's entering the second phase. It's not our way to acquire something just because it's cheap," says Zoltan Varga, board member of Central-Fund Management, which manages the fund. "This is a high-risk, turnaround fund and we have to be cautious and sure that the company in question can be saved." Accordingly, Central Fund "might invest in one company this year."

Central Fund is made up of a mix of, for the most part unnamed, Hungarian and international institutional investors based in Hungary, particularly insurance and pension funds. The fund's largest investor and strategic partner is Bakala Crossroads Partners, one the biggest private equity outfits focusing primarily on Central and Eastern Europe, one of whose main owners is the Czech financier Zdenek Bakala. The other large investors in the fund are Hungarian financial institutions; three of the four biggest, it's claimed. "This is the first time that Hungarian institutional investors have had the chance to get access to the SME market," says Varga. "All private equity funds operating in Hungary until now have been registered abroad. The law changed in 2007, providing the opportunity to set up privately owned funds in Hungary."

It has taken a couple of years for the first such fund to emerge due to the difficulty of being the first to set one up, according to Varga. He describes the fundraising process as complicated. "For some of the investors, it is their time investing in private funds and we've had to battle hard with local authorities. To be the first is good and bad - we've had to work hard to clear the way, but this makes it easier for local investors to invest in future."

Under-appreciated, under-capitalised

Central Fund began with registered capital of HUF5.2bn (€18.6m) in April. However, the final size of the fund is expected to increase to around HUF7bn by the time of a second closing, which is planned to take place within the next few months. Given such resources, Central Fund's strategy is to sit back and wait rather than jump into a string of quick investments, scooping up cash-strapped firms on the verge of bankruptcy. "Such firms would require a huge amount of cash thrown at them with no guarantee of survival," says Varga, who also predicts a lot of liquidation processes from here on in as businesses reach the end of the road.

Instead, Central Fund will seek turnaround situations and companies with liquidity issues where the target has significant, but unexploited, values as part of its bid to become a niche player on the Hungarian market. For Central Fund, turnaround investing will entail acquiring an ownership stake and/or injecting capital into the company facing financial difficulties, and then focus on increasing operational efficiency and improving financial performance, in particular.

Despite the high number of undercapitalized Hungarian SMEs, which has been made worse by the further restriction of credit resulting from the financial crisis, Central Fund feels that currently there are no turnaround specialists in the Hungarian private equity industry, as most private equity investors avoid such situations. The likes of Euroventures and Fast Ventures typically make larger investments, according to Varga. "SMEs have always been undercapitalized in Hungary," says Varga.

Central Fund will invest exclusively in Hungary and plans to make six to eight investments in total with an expected internal rate of return exceeding 25%. The targeted investment size is HUF750m-1bnt per investment, with an investment horizon of 3 to 5 years, which could be extended to 10 years. The fund has no sector focus and its operating regulations exclude only a few industries. Varga explains that the fund will seek to acquire majority shareholding positions and, building on the executive management experience of its team, it plans to be closely involved in the operational management of its investee companies. "We can take those steps that the current management can't bring themselves to take because of the social ties they have with the employees. Since we don't know them, we can save a lot of jobs in the long run by taking decisive action and even save the businesses themselves," he says.

One of the crisis lessons SMEs haven't learnt it to take quick steps to scale down their companies to fit the size of the shrunken market, opines Varga. "SMEs are suffering and for some it's too late. SMEs are dominated by personal relationships and they haven't learnt the lessons from the multinationals about scaling down, which can put whole businesses under serious risk."

Business wise, Central Fund will encourage its investee companies to consolidate their market positions locally first and foremost. "Only if we're confident that the business is stable locally, then would we think about them going cross-border," says Varga.

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