Private Equity: is local presence in Eastern Europe necessary?

I have always claimed that Russian beer is superior to German (although Russian breweries use German equipment anyway). We have our mini-arguments about it at home, especially when I get the treat from a local Russian supermarket.

This week however I was pleased to learn that the battle around the Russian Baltic Beverages Holding is heating up. Carlsberg and Heineken are fighting with Scottish & Newcastle as to who will end up owning it.  Blackstone and TPG have both stepped in to finance this joint venture buy-out on S&N side.

In my work I see many PE firms forming Eastern Europe-focused strategy out of the local offices: Poland (3TS), Ukraine (Advent), Russia (TPG). Other firms, such as Blackstone however build their East European teams within their existing teams in the West.

There are arguments for both approaches. Local presence offers a better chance to find a good deal while minimising the likelihood of a competitive bidding which occurs when deals are advertised by investment banks. It offers an ease of networking, a better chances of doing due diligence, an access to the local advisors and a much better availability of the executives at a short notice. But it comes at a price, especially when the dealflow is scarce and really good deals are are hard to come by.

Russia is perhaps still such a country where despite the economic growth risks are perceived high, preventing many investors from playing an active role there (few will remember a murder of Baltic Beverages’s CFO in 2000). Both Blackstone and TPG name Russia amongst their regions of interest. Blackstone, which started actively looking at Russia only a few months ago, does it out of its London office. Texas Pacific however went all the way to establish local Russian presence with the former British Olympic athlete Stephen Peel running it.

Should S&N win the bid for Baltic Beverages Holding, Blackstone would justify its strategy based on a pan-European team structure. but Mr. Peel would question whether moving to Russia was necessary.

Scottish & Newcastle’s Russian buyout

January 13, 2008  Sunday Times

 John Waples and Louise Armitstead

TWO private-equity groups, Blackstone and Texas Pacific, have held detailed talks with Scottish & Newcastle, the brewer, to help buy out Carlsberg’s £4 billion share of the Russian joint venture Baltic Beverages Holding.

Blackstone and Texas have made separate approaches to S&N’s chief executive, John Dunsmore. Both groups have said they are prepared to invest as much as £2 billion. The approaches form one of the key reasons why the S&N board last week rejected a revised offer of 780p per share from a European brewing consortium comprising Carlsberg and Heineken, valuing the company at £7.6 billion.

Dunsmore is confident he can generate significantly higher value for his investors by buying out Carlsberg’s interests in BBH, rather than selling out. However, some big investors are concerned that his determination to see off the bidders will result in a big share-price fall if he is successful.

A top five shareholder said: “There will be a severe backlash against the board if they let this deal fall through.”

Another said: “There is real commercial sense behind this deal. The board might say it can go it alone, but so far it has failed to do so.”

Blogosphere is invaded by Pro-Kremlin Oligarchs

Russian pro-Kremlin Oligarch is reported to have purchased a US blogging site Live Journal. Russians are amongst the largest user base of the firm- 28%. More than 2 million bloggers use the website, but now there is a concern that Live Journal will be censored.

It has been used by many outspoken critics of the Kremlin as I have been writing about previously. Let’s wait and see what happens but I believe Russia is a few steps behind China in censoring the Internet, not the least because Mr. Putin is known not to even own an email account. All can change with the arrival to power of Mr. Medvedev, who is told to regularly read electronic news channels.

Prices rise in Russia

Natural resources export, not supported with the proportional growth of the other sectors of Russian economy is likely to cause last year’s price increases. In Russia, according to Interfax, the inflaction for 2007 reached 12%.

This perhaps would also be reflected in the corresponding salary increases of IT personnell, making offshore outsourcing less attractive proposition for the Western customers.

But so long as the population keeps its savings in a stable currencies (albeit salaries of many employees are still measured in declining dollar), the impact of the price increases on savings would not be anything like hyperinflation of the mid-90s.

Outsourcing to Ukraine: Why the US$246 Million Industry Is Expanding to the Provinces

This is one of my latest articles which appeared in December 07 issue of Outsourcing Journal.

By Natasha Starkell for Outsourcing Journal

December 2007

When the executives of Rotterdam-based ISM eCompany decided to expand its software development capabilities outside the Netherlands two years ago, little did they know their core development team would be based in a small town of Zhytomyr 140 kilometers away from Kyiv, the capital of Ukraine.

The Netherlands is experiencing a shortage of IT engineers, so ISM eCompany, an Internet solution provider, had to find alternatives to hiring locally. “We looked at 20 countries and came up with India, China, and Ukraine as the top three locations to set up a captive operation,” says Michiel Schipperus, the company’s COO.

The company’s decision is not surprising. Ukraine, the second largest Eastern European country after Russia, with a population of 47 million people, is a popular outsourcing destination in Eastern Europe. A key attraction: according to the Ukrainian Ministry of Education, over 670,000 technical students are currently enrolled in Ukrainian universities.

Offshore Outsourcing Industry in Ukraine

In its recent study Goaleurope, an Eastern European advisory firm, estimated the size of the outsourcing industry in Ukraine reached over US$246 million in 2006. Ukraine is not a member of the EU, so Ukrainians cannot take jobs freely outside their country, unlike Polish, Czech, and other nationals of the new EU members. So the Ukrainian software developers stay in their homeland, where the prices are low; work comes from offshore outsourcing customers.

According to Schipperus, ISM eCompany chose Ukraine because it has a large pool of highly educated people and the geographical location was convenient. He found the English competency of his employees was better than in China. And the cultural differences were less noticeable compared to those in India and China.

Ukrainian Capital and the Provinces

Ukraine still maintains a low cost of living. An average salary in the capital of Ukraine, Kyiv, is only US$329 per month; in Kharkiv, the second largest city, is only US$186, according to the State Statistics Committee of Ukraine.

However, the property boom resulted in higher real estate prices, primarily in Kyiv, and that impacted the salaries of those living in the capital. The salaries of the IT professionals there rose to the level of US$800-$1500 per month, which differs significantly from the salaries in the provincial towns.

For example, the salaries for IT engineers are set around US$600 in towns like Lviv, Kharkiv, Dnipropetrovsk, and Odessa, according to the Web site developers.org.ua. In addition to salaries, the high prices of real estate and the tougher competition in Kyiv were reasons why ISM eCompany decided to look outside of the capital for a location for its development center.

In fact, many outsourcing companies already established their subsidiaries in provinces. While Kyiv is still responsible for over 50 percent of all development resources, according to Goaleurope, 18 percent are in Lviv and 13 percent in Kharkiv.

After a careful analysis, the company went to Zhytomyr, which has a population of just under 280,000 people. The reasons behind choosing Zhytomyr included availability of a technical university, which provided a high quality of education, and its location, which is a short drive from Kyiv, notes Schipperus.

Ukraine Advantages

There are many good reasons for choosing Ukraine. It is well situated for doing business with Western European countries. There are no visa requirements for Western European and North American citizens. Ukraine is relatively well connected to the rest of the world, as it has international airports in Kyiv, Kharkiv, Dnepropetrovsk, Donetsk, Odessa, and Lviv. Kyiv is within a two-hour flight from the European capitals, and other cities are connected to the rest of the world via Vienna, Warsaw, Kyiv, and Munich.

Maybe that is why over 60 German companies outsource their software development to Ukrainian companies, accounting for six percent of all employed engineers in the industry, according to Goaleurope.

As for the labor pool, qualified resources are in abundant supply, despite the high demand. Many experienced engineers are already employed by software development firms. To hire IT professionals, recruiters look to hire university IT graduates.

They need to be trained in the new technologies and processes before becoming valuable to the industry, as the universities are not always up to date with the new trends in the IT industry. Some outsourcing executives even teach university courses and use them to find the best new talent for their organizations.

To improve the level of education, the Ukrainian Minister of Education Stanislav Nikolaenko announced the government plans to spend 6.52 percent of its GDP on education. This compares favorably with the education budget in Romania, reaching 3.5 percent of GDP, and 3.8 percent of GDP in Russia, according to the CIA World Factbook 2006.

The Challenges of Outsourcing to Ukraine

Disagreeable politicians are still scaring off some foreign investors. First, the Orange Revolution brought the expectation of the bright future for the country and attracted US$10 billion of foreign direct investment, according to Globe and Mail’s interview with the President of Ukraine Victor Yushchenko. Then continuous disagreements between Yushchenko and the government resulted in the recent parliamentary crisis and questions about democratic consolidation.

Software developers’ level of experience is another issue if a company sets up a software development center outside the capital. Most of the software developers with experience are in Kyiv, says Schipperus. In Zhytomyr they are mainly students with minimal work experience. This is why ISM had to invest in training its employees since it hired many straight from the university.

Now ISM eCompany employs 50 people, who represent the core of its software development team, although the growth was not without challenges.

Communication was the major challenge. “At first we had to learn how to understand each other. In practice, it can be really complicated. Some tasks here are often clear, but they weren’t clear at all to the Ukrainians,” says Schipperus. Workers who interface with the Ukrainian team must understand how Ukrainians think so they can explain something to get the results they want.

To improve communication between the teams, the representatives of the Ukrainian office work at the Dutch office for a few months, and ISM eCompany has kept two Dutch managers in the Ukrainian branch from the beginning.

Employee retention is also a recent inconvenience. As the demand on experienced IT professionals grows, people seek higher salaries to compensate for the rising rental costs and cost of improving their living standards. Employers have to make extra efforts in helping their personnel develop their careers, improve their knowledge, and establish strong social ties to the organization. Outsourcing centers in the provinces also help retain employees, who value their local environment and do not want to move to Kyiv to make a living.

Alexander Farstad, the CEO of eZ systems, which owns a development center in Odessa, treats his Ukrainian employees exactly the same as employees in the Norwegian headquarters. The open-source content management company pays “white salaries” and offers the same benefit packages, including maternity leaves.

The company also makes its Ukrainian group feel like members of the larger eZ family. “We organize annual employee conferences when everybody comes to our headquarters to Norway. Our Ukraine team has high stability because we involve them in the company,” says Farstad.

The Future of Offshore Outsourcing Industry in Ukraine

Given the number of small players, the outsourcing industry will inevitably go through the consolidation process, which is already happening in smaller Romania. There Techteam purchased Akela, Endava acquired AGS, Adecco bought IP Devel, CGS bought EasyCall, and Adobe bought Interakt. In Ukraine, the consolidation of the industry started with a large Norwegian IT company EDB buying two local software development companies.

With the assurances of the larger firms investing locally, more companies will outsource to Ukraine. Ultimately though, Ukraine will occupy a niche in the international outsourcing business, focusing on highly complex software development projects delivered by smaller teams.

Finally, customers looking for the best quality of service for a good price will shift further into the provinces. The question is: which will be the next capital of outsourcing: Lviv, Odessa, Dnipropetrovsk or Kharkiv?

For ISM’s captive development center in Zhytomyr, the future is bright but challenging. “The last year and a half were an investment because we had to devote a lot of extra attention to the Ukrainian subsidiary. It might take us another year until we can reap benefits,” concludes Schipperus.

Lessons from the Outsourcing Journal:

• For a captive operation, do your research to find the best location that will sustain cost advantages over a longer term.
• Invest in training to ensure growth of your development team.
• Prepare your communication process well in advance and engage teams from both countries to learn more about their culture and approach to sharing, understanding, and interpreting information.
• Develop a set of incentives other than salary and bonuses to keep your team motivated to remain a part of your team.
• If you are setting up a captive operation, be prepared to spend a year before it is up and running.