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Alternative investments in CEE: Europe's (not so) new Eastern Frontier

Viera Kucerova and Glen Lonie  of PricewaterhouseCooper's Prague office outline the alternative investment trends and opportunities in Eastern Europe.

The alternatives markets in Central and Eastern Europe (CEE) are true growth markets, with investor interest and deal volumes increasing year on year.

Significant developments are occurring in both real estate and private equity, and encouragingly also to the tax and legal infrastructure in the CEE region.

Real estate
The real estate markets of central Europe - particularly in the Czech Republic, Hungary and Poland - have been on investors' radar screens for some time.

By some estimates, there are between EUR 12-15 billion of raised investment funds, either in specific CEE funds or CEE allocations of pan-European funds, looking to invest in real estate in CEE.

This compares with an annual transaction volume of between EUR 5-6 billion in 2005. This supply-demand imbalance has had a number of impacts.

First, as with the more mature markets of Europe, the real estate markets in CEE are generally sellers' markets. Competition among investors for properties is high, resulting in significant reductions in returns for investors, particularly in the core markets of Central Europe.

This has meant that yields have rapidly converged to levels approaching those of Western Europe.

As a consequence, investors are looking further east to the emerging markets of the Baltics, Russia, the CIS, Bulgaria, Romania, and other South Eastern Europe markets where higher returns can be achieved.

Second, given the difficulty of sourcing properties, investors are looking at a wider range of property types and classes. To meet this demand, there is a great deal of development in all types of property - office, retail, industrial and logistics, residential and tourism.

Third, rather than only buying standing properties, investors are also looking to get involved in projects at an earlier stage by participating in their development or by committing to forward purchases of new properties, both to secure investment opportunities and to maximise returns.

Private equity
Private equity is now also keenly chasing opportunities within the CEE region. It is estimated that over the last 15 years, more than EUR 7 billion of funding has been raised by private equity funds that are dedicated to the CEE countries. In 2004, fundraising increased by 59% compared to 2003.

Various global private equity funds have recently set up CEE dedicated private equity funds while others are continuing to explore the investment opportunities throughout the region.

The majority of the funds raised are being invested in Poland, Hungary, Romania and the Czech Republic.

To match this demand for transactions, an increasing number of commercial banks are focusing on acquisition finance and there is enhanced activity of mezzanine funds in the CEE markets.

CEE legal challenges for alternative investment
The local tax and legal platforms are developing to address the issues typical for leveraged private equity and real estate transactions.

Over the past few years, the tax and corporate laws in all CEE countries have undergone significant developments to harmonise their local regimes with EU regulations. Though most of these changes have not been specifically aimed at regulating leveraged transactions, they have improved the investment infrastructure for investors.

Due to the relatively young history of real estate and private equity throughout the region and the consequent absence of precedents, investors need to be very careful when designing acquisition structures to be put in place.

Local tax authorities have little experience with sophisticated instruments and acquisition structures.

Also, the wording of tax laws often leaves large scope for multiple interpretations. The tax treatment of leveraged acquisition structures is not yet being properly addressed in all territories. Careful attention needs to be given to the deductibility of the interest on acquisition loans and transaction expenses; the amortisation of goodwill within multi-tier structures and recently introduced loss carry forward restrictions for change of ownership/business.

With the increased competition in the region to secure deals and the enhanced availability of secure debt financing, more sophisticated acquisition structures will be implemented. The expected improvements in the tax environment in the region will bring more confidence to investors wishing to move into the CEE region.

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