M&A transactions in Central and Eastern Europe

​​​​published on 26 July 2022 | reading time approx. 6 minutes

The War in the Ukraine as a Turning Point for Europe

When Russian troops crossed the border of Ukraine on 24 February 2022 and the war began, this military strike shocked the entire world. In addition to the inconceivable human tragedies that occur in Ukraine every day, the destruction of production facilities and infrastructure, the ban on all military-aged male Ukrainians leaving the country and the disruption of all kinds of logistical transport had a significant impact on the economies of the neighbouring states as well.

In addition to these economic restrictions, the sanctions packages adopted by the EU, the UK and the USA result in further significant legal risks for the continuation of business relations with Russian and also Belarusian companies and entrepreneurs, which are only exacerbated by the counter-sanctions introduced by Russia.

Sanctions and their consequences

The main sanctions imposed by the EU include:

• Freezing the assets of certain entities or bodies (in particular the Central Bank) and persons, and prohibition to make funds and economic resources available to entities or bodies and persons, as well as natural or legal persons associated with them,
• Exclusion of certain Russian banks from the SWIFT payment system,
• Export ban on certain goods (in particular semiconductors, aircraft parts or goods for the energy industry),
• Import ban on certain goods or raw materials (in particular crude oil and coal after the expiry of the transitional periods; steel, iron, wood as well as caviar and vodka) and
• Closure of airspace for Russian aircraft, closure of ports for the Russian merchant fleet and ban on the entry of Russian and Belarusian transport companies.

In return, Russia also imposed corresponding counter-sanctions, the most important of which was the roubles-for-gas demand, i.e. the demand to pay for Russian gas deliveries (which had not been subject to sanctions within the EU either) in roubles. Should this demand not be met, Russia threatened to freeze or reduce gas supplies. Western companies still present in Russia are particularly concerned about frequently changing foreign exchange restrictions, export bans on inventory, significantly increased censorship and the threat of criminal prosecution for leaving the Russian market or complying with Western sanctions.

All these measures lead to significantly higher risks with regard to the acquisition of companies: For example, an examination of the target company's compliance with all sanction and export control regulations and the introduction of corresponding (possibly IT-supported) processes is of decisive importance within the compliance check as part of legal due diligence, the effects of a possible restriction in gas supply must be examined in technical due diligence, and the uncertainties resulting from all these risks with regard to the target company's sustainable earnings make financial due diligence significantly more complex as alternative scenarios must be presented.

Possible courses of action with regard to Russian subsidiaries

Due to the aforementioned circumstances, however, it can be assumed that Russia will lose its position as a raw material procurement or supply market, but also as a sales market in the foreseeable future. Therefore, investors are confronted with the question of what steps they can take with regard to their companies located in Russia. As a rule, the sanction specifications are the starting point for examining the possible options. In many cases, the Western sanctions lead to a situation where the business model of the Russian subsidiary ceases to exist, leaving only the option of liquidating it. However, such a liquidation is not an easy undertaking – in particular, Russian counter-sanctions may mean that, for example, the inventory may no longer be exported to Western Europe and a sale in Russia will lead to the violation of Western sanctions. As a rule, a time frame of 1-2 years should be planned for an orderly liquidation. The sale of the company, e.g. as part of a management buy-out, is also a frequently encountered option. However, a pre-condition to this is that the subsidiary operates based on a business model that is able to perform without support and supply from the Western parent company. Frequently, call options are agreed for such share sales, in order to enable a return to the Russian market at a later date, as the case may be. It should be noted, however, that these options should not be structured in such a way that the seller de facto continues to have the economic control over the Russian company. Because in that case there is a risk that, despite the sale, beneficial ownership will be deemed to remain with the seller. This would lead to a situation where the participation would still have to be accounted for in Germany and, if applicable, the seller would have to ensure that the sanctions are adhered to. For this reason, caution should also be exercised with regard to the fiduciary models that were much discussed at the beginning. Also reducing the Russian company to a “rest mode” only makes sense in exceptional cases, for example, when real estate property is involved. This is because such a company continues to incur ongoing costs but hardly adds any value if one wants to re-enter the Russian market in a few years' time under changed circumstances. For companies operating in non-sanctioned areas (e.g. food, pharmaceuticals or medical technology), it is in principle possible – from a legal point of view – to continue involvement in Russia. However, this is likely to involve significantly higher costs in the areas of compliance and logistics. Furthermore, the potential impact on the image of the company as a whole should be considered.

Trend towards nearshoring 

However, the disruptive element associated with the war in Ukraine also acts as a catalyst for a development that could already be observed over a longer period of time: The political and social development in China, the questions regarding effective corporate governance in subsidiaries in Asia, the massive effects of the COVID-19 pandemic on production sites and logistics chains, which were further exacerbated by the blockade of the Suez Canal by the damaged container ship “Ever Given” in March 2021, put the potential cost advantages of distant locations into perspective.

Also, the requirements for supplier verification and the related liability regimes associated with the implementation of the Supply Chain Act led to a renewed focus on opportunities to develop operations in regions closer to the parent company.

For German and Western European companies in particular, the Central and Eastern European countries represent a logical target region, which has always been the starting point for international development of many current world market leaders and is becoming more attractive again in view of the social criticism of a globalised economy. This development is now being further intensified in view of the consequences of the war in Ukraine.

Criteria for a location decision

In addition to the general positive “track record” that many of the Central and Eastern European countries have enjoyed over the last thirty years, there is a number of factors that make it generally worth taking a closer look at the countries of Central and Eastern Europe when making investment decisions:

• geographical proximity,
• still existing differences in salary levels (although no longer to the same extent) compared to Western European locations,
• in many cases, membership in the European Union,
• minor cultural differences,
• legal systems often based on the same principles, and
• existence of a pool of highly qualified staff with a good command of languages.

All these reasons become even more relevant in the event that a company decides or is forced to cease its business activities in Russia, Belarus or Ukraine due to the impact of the war in Ukraine and, if necessary, relocate to another country.

In such a case, it can be assumed that a relocation decision will primarily be based on whether a company already has a subsidiary or other branch in one of the countries of Central and Eastern Europe. This is because the development and expansion of an already existing location can, as a rule, be carried out with considerably less effort than a relocation to a new country whose legal system and local peculiarities are unknown. Since, as a rule, the business activity to be relocated will already be carried out by local competitors, market entry in the course of the relocation will result in increased competition, which, in our opinion, will lead to consolidation, especially by way of M&A transactions.

Other positive factors in Central Europe

Due to the enormous development that the countries of Central and Eastern Europe have undergone since the fall of the Iron Curtain, these countries are no longer interesting only as workbenches, but also as sales markets.

As a result of the emergence of highly profitable companies – especially in the areas of digital products and services – these countries are not only interesting for strategic investors, but also for financial investors.

But other sectors and industries are in the focus of investors, too:

• IT and Shared Service Centre: Due to the large pool of highly qualified and IT-savvy potential employees, the CEE countries (Central and Eastern European countries) remain a preferred region for locating such central functions,
• Farmland and agriculture: Romania, as one of the EU’s granaries (along with France), will play a much more important role in this area following the disruption of agricultural production in Ukraine; but other countries are also interesting for investments in this area,
• Renewable energies with a focus on photovoltaic and wind energy projects: The progressive expansion of the energy networks in the region opens up opportunities also for larger projects, especially in the countries of south-eastern Europe,
• Infrastructure: Expansion of the transport infrastructure in the CEE countries, e.g. development of the capacities of the ports on the Black Sea and the Danube, ongoing expansion of motorway connections in the states of the former Yugoslavia.

It is to be expected that certain opportunities for the acquisition of companies will arise as a number of entrepreneurs who have successfully established and developed their companies since the beginning of the 1990s will put their companies up for sale as part of succession planning.

Conclusion

The war in Ukraine and its immediate economic impact on companies operating in Russia, Belarus and Ukraine will, in our opinion, lead to business activities being relocated to the states of Central and Eastern Europe. This development is reinforced by the fact that economic globalisation is being replaced by a trend towards nearshoring. In this context, the already existing activities will often be the basis for further development, which will also be realised through M&A transactions.