Ben Aris in Moscow -

Kestutis Sasnauskas, a partner in East Capital

bne talks to Kestutis Sasnauskas, a partner in East Capital and manager of the private equity business, about the rise of private equity in CEE.

There is an odd mismatch in Central and Eastern Europe at the moment. On the one hand economies across the region are buzzing with growth. On the other hand equity markets have been pummeled as the US subprime credit debacle plays out in slow motion.

Investors into Emerging Europe must be frustrated as they are being punished for mistakes their peers in the developed markets made rather than for the flaws of their own markets. So how do you make money in this environment? The short answer is private equity.

Take Russia as a concrete example. The Russian economy is going from strength to strength and GDP growth is still accelerating. GDP growth was 7.7% between January and August of this year and the Ministry of Economic Development and Trade has upped its end of year forecast to about 7.3% -- well ahead of the 6.5% it was predicting at the start of the year.

Yet the leading RTS index started this year at 1798 and while it set a new all time high of 2175 on October 11 (and looks likely to go higher before the end of the year), this is still only a return of about 17% on the year - well below the 50%-70% Russian stocks have been earning every year since 2004.

The economic growth looks better than at any time since 2000 and yet the stock markets are putting in one of the most lackadaisical years in the last decade.

Private equity is the way round this problem. Indeed as most of the growth in CEE is now coming from companies in the retail sector that are not listed there is a growing disconnect between the performance of the stock markets in the region and the returns on investment available.

"There are many sectors in each of the economies that are growing faster than the economy itself. For example, retail turnover in most of the countries of CEE is growing twice as fast as GDP and banks in Russia grew at 25% in 2006, way ahead of the economy," says Kestutis Sasnauskas. "There is more opportunity in private equity as most of these sectors are not represented on the stock exchanges."

Emerging markets used to be the purview of the specialist investor, but with all the hype over countries like China they are moving steadily into the mainstream to the point where Newsweek ran a cover story in October entitled: "New Giants: why the world's hottest, richest companies are rising out of the poorest countries."

As more and more investors chase the limited number of stocks, valuations are being pushed up and beyond their "fair value."

For example, while banks have been the most popular share class in the last year, Russia has only two significant listed banking stocks - the state-owned Sberbank and VTB, which floated at the start of this year.

There are a couple of other listed banks with buyable shares like URSA bank or Vozrozhdenie Bank, but their free float is extremely small and their prices already ramped by the mismatch between the demand for banking stocks and the supply.

"It is a small universe, which is already crowded towards this short list of names and so you get the high valuations," says Sasnauskas.

The problem varies from country to country. Poland's Warsaw Stock Exchange saw 38 companies raise $2.5bn with IPOs last year and has already had over 43 IPOs by the start of October this year so the stock market is becoming fairly representative of the economy.

However, somewhere like Ukraine or Kazakhstan has had virtually no IPOs and what listed companies there are suffer from extremely small free floats and horrible corporate governance problems.

The Funds

Despite the size of the region you can count the number of private equity firms working in CEE on one hand. East capital has a total of 12 funds with about $6bn under management and all of the funds have some element of private equity to them, while only two funds - the East Capital Financial Explorer and Amber funds -- are pure private equity.

The Amber fund was the company's first fund and set up in 2002 to targeted consumer orientated companies in the Baltic's. It currently has $15m under management and is now in exit mode.

One of the fund's best deals was to set up the Baltic Cosmetics Holding (BCH), which gathered together a series of local cosmetics producers and created the biggest cosmetics chain in the region. BCH was recently sold to the international cosmetics company Douglas earning East Capital, "double digit" return on investment, says Sasnauskas.

However, private equity in CEE is very different from the increasingly fashionable private equity business in the west. The likes of America's Blackstone or Carlyle Group have yet to arrive in Russia (the Carlyle Group came and tried to do a deal with Vladimir Potanin's Interros but pulled out again). And the model is completely different: most private equity firms in the west buy into a company and borrow heavily to restructure the company and so extract a bit more value.

"We don't borrow at all. What we do is look for companies with a strong growth story, strong cash flows, run by a strong management team of entrepreneurs that is going to keep growing. It demands a different set of skills," says Sasnauskas.

By far the biggest and most successful fund is the Financial Explorer Fund, set up in February 2006 and raised €350m just before the recent craze for banking assets got going.

The fund was quickly disbursed, buying small stakes in about a dozen medium-sized fast growing banks through out CEE. The fund was extended last summer when another €150m was raised and has returned a healthy 32% a year since inception. However, as many of the assets are still valued at cost, the real return is probably much higher.

Amongst the more notable investments were the stakes the fund took in banks like Bank TuranAlem (BTA) in Kazakhstan, Nadra Bank in Ukraine and Bank of Georgia in Georgia.

BTA is Kazakhstan's second largest bank and has been expanding fast as its strategy is to move out from its home market and build up the first truly pan-regional bank in the CIS. By passing the already saturated Moscow market, BTA has concentrated on Russia's southern and eastern regions where most of the fastest growth is now to be found.

Nadra bank has been a star bank in Ukraine and has also grown very fast. The bank's assets were up by half over the first half of this year to $3.1bn and the president of Bank Nadra, Igor Gilenko, said at the start of October that the bank will probably IPO before the end of this year, or early in 2008.

And the Bank of Georgia turned out to be a spectacularly successful investment. East Capital was an early investor in the bank, which has come from nowhere to become one of the darlings of emerging market investors.

"We invested when the young team arrived in the bank, which was on the verge of bankruptcy in 2005," says Sasnauskas. "The team has completely turned the bank around and made it into the most successful bank in the country."

The pay off came in November 2006 when the bank became the first Georgian company ever to be listed on the London Stock Exchange, raising $160m in the process and netting East Capital triple digit returns from a country that barely has a functioning stock market at all.

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