Private equity in the Baltic states has a relatively short history. All three countries regained independence and a liberalised business environment at the start of the nineties. The transaction market evolved with massive sell-off of state-owned enterprises within the framework of a general privatisation programme. This programme had a similar structure in all the Baltic states: by a combination of MBOs and LBOs, in addition to listing of privatised shares on a stock exchange, all three exchanges – Tallinn, Riga and Vilnius – are now part of the Nasdaq OMX group.

Seed projects

The privatisation programme was largely completed within a decade by IPO's and the private sale of formerly state-owned enterprises. But many of these enterprises have become targets a second time, for players in the newly developed venture capital industry. The most recent example in 2007 was the acquisition of 82% of shares of Latvian public joint stock company Lode by Capital International for a disclosed deal value LVL16.6 million ($37.5); Lode was privatised by IPO in 1996 to have more than 500 shareholders.

The origins of the Baltic venture capital industry can be traced back to the middle of nineties, when several successful acquisitions of local companies by foreign, predominantly Nordic, investors took place. Successful exiting shareholders decided to capitalise on their knowledge and started venture capital activity by direct investments in risky but promising seed projects. The development continued by setting up formalised investment structures at the start of this decade, incorporating prominent local market participants such as Prudentia and Gild Bankers.

Innovation

This development has led to incorporation of investment funds. For example, Latvian Eko Investors has already established a second investment fund. In parallel to this organic market development the Baltic markets have experienced venture capital activity from the largest Nordic and western European financial institutions, which operate in the region as retail banks, for example SEB and Swedbank. While the private equity and venture capital activity is still in a relatively early stage, it has grown and become more visible, both in the number of market participants and in terms of its weight in the national economy.

In 2003 when the Venture Capital Association was set up in Latvia, it consisted of six members; five years later there are 18 members. It is still a long way from the neighbouring Nordic Countries, which have an exemplary market for private equity, with about 250 private equity/venture capital management companies.

While the Baltic markets are in an early stage of development, the activities of industry participants, and innovations, may bring material change in the private equity and venture capital industry in the Baltic States this year.

No legal ground

At the current stage of development the private equity industry enjoys virtually no regulation or control. In this it differs from more developed economies, for example, Germany. None of the Baltic States has specific statutory provisions for the operation of venture capital companies, their investments, transactions or business conduct.

In determining the legal framework for private equity and venture capital, there are several indicators to be considered. Permission or impediments towards making a risk capital investment are important criteria for assessing how favourable a legal regime is towards private equity and venture capital activities.

Widespread in Europe, though not immune to criticism, pension fund investment in private equity can be made in Estonia only up to 10% of the fund's net asset value. The latest amendments have relaxed this requirement by allowing investment of up to 20% of the pension fund's net asset value into venture capital funds.

Latvian legislation on private pension funds allows the funds to invest in private equity and venture capital with the limitation of 10% from the total assets for investments in each entity. However, the investment regime is not completely liberal, since insurance companies are not allowed to invest in private equity and venture capital. Even though private equity firms have been active in Lithuania for more than a decade, prior to March 1 2008 the private equity market had no legal ground for in Lithuania. Most investors used unsophisticated limited liability company structures to set up investment vehicles or set up private equity funds in other jurisdictions whose legislation was more favourable for private equity, to participate in the M&A transactions.

Transparency, clarity

On March 1 2008 the amendments of the Law on Collective Investment Undertakings came into force in Lithuania. The new statute makes it possible to establish special collective investment undertakings – alternative investment funds, such as real estate funds, private equity funds, hedge funds and other alternative funds. Alternative investment funds, including private equity funds, may be set up as investment companies with variable capital or closed-end type investment companies or funds, which management companies control.

Similarly, in Latvia and Estonia most private equity transactions are performed through regular limited liability companies, although the law also foresees the possibility to establish a collective investment scheme. This instrument enables funds to be raised publicly, which in its turn presumes a transparent structure and numerous restrictions imposed on investment strategy and management.

On January 1 2007, a specific subtype of collective investment scheme, the venture capital fund, was enacted by the amendment of the Estonian Collective Investment Scheme Act. The venture capital fund is defined by law as a fund investing at least 60% of its assets in private equity. The legislator renounced the incorporation of further specifications of investment target characteristics inherent in venture capital (stage of development, innovation) for the sake of legal clarity. Therefore, irrespective of the legislator's terminological choice, it would be more precise to place this new fund under the general category of private equity.

Expectations unfulfilled

Since investments in private equity are likely to be subject to a higher degree of risk than listed securities, only qualified investors or investors satisfying the conditions set forth by the law can invest in venture capital funds. In this connection, legal requirements applicable to the management of venture capital funds are less stringent than the framework regulating collective investment schemes.

However, venture capital funds are still subject to risk diversification rules. Together with the lack of a transparent tax system this creates unease among investors that prefer jurisdictions with more favourable and common private equity instruments (for example, SICAR in Luxembourg). Perhaps for these reasons, the reality did not stand up to expectations. The promotion of investment in private equity and supporting development in innovative companies remained largely unfulfilled. Since January 1 2007 only one venture capital fund has been registered with the Estonian Financial Supervision Authority.

The regime for fund management is favourable in Latvia. Commercial law provides for the possibility to set up a limited liability partnership, which is tax transparent for investors. The management company acts as a general partner while investors are treated as limited partners. In addition to the favourable taxation regime, the limited liability partnership agreement can be structured according to the needs of the particular fund.

Taxes

In Latvia the management fees attributed to the general partner as well as the carried interest are not subject to VAT. At 15%, taxation rates in Latvia are below the EU average for companies and private individuals. Moreover, the fund structure offered in the form of a limited liability partnership is tax transparent.

In Lithuania since May 1 2008 the same tax regime applies for special collective investment undertakings as for other collective investment undertakings. According to the most recent amendments to the Law on Corporate Income Tax and the Law on Collective Investment Undertakings of the Republic of Lithuania, the investment income of variable capital investment and closed-end investment companies operating in accordance with the Law on Collective Investment Undertakings, except for dividends and other distributed profits, shall not be subject to corporate income tax.

Dividends received by legal entities from variable capital investment or closed-end investment companies, in which the recipient controls more than 10% of voting shares (interests, member shares) for an uninterrupted period of at least 12 months, including the immediate distribution of dividends, are not subject to corporate income tax. However, if an entity receiving dividends from variable capital investment or closed-end investment companies, or from the transfer of voting shares of the variable capital investment or closed-end investment companies, in which the recipient controls more than 25% of voting shares (interests, member shares) for an uninterrupted period of at least 24 months, neither dividends nor income from the transfer of voting shares (interests, member shares) are subject to corporate income tax.

Different rules apply to private individuals. Dividends received by natural persons from Lithuanian variable capital investment companies or closed-end investment companies, in which the recipient controls not more than 10% of voting shares (interests, member shares), for at least 12 months, including the immediate distribution of dividends, are not subject to personal income tax.

Furthermore the income of investment funds, including private equity funds, set up under the Law on Collective Investment Undertakings, are not subject to corporate income tax. The most recent amendments made in Lithuanian legislation, including some amendments in the taxation system, will make Lithuania more favourable for the incorporation of the national private equity funds.

Sceptical

Despite broad changes in the regulatory framework in Lithuania, local venture capitalists are careful regarding the reforms. In their view the legal and tax environment is not yet entirely transparent for foreign investors. Equally, international participants in Baltic private equity are sceptical about unsophisticated regulation and unpredictable legislative activity.

The Estonian legislators have created an unexpected impediment for leveraged buy-outs. An amendment to the Estonian Commercial Code has been introduced prohibiting financial assistance by a subsidiary to the parent to acquire shares of the subsidiary. Before the amendment came into force such financial assistance was allowed if it was not prejudicial to the interests of the subsidiary's creditors.

The amendment is based on Article 23 of the Second Company Law Directive (as amended by Directive 2006/68/EC of the European Parliament and of the Council). However, the Estonian policymakers went further with the implementation than most EU states. While the directive states that financial assistance by a public limited company is allowed provided certain conditions aimed to protect minority shareholders' and creditors' rights are fulfilled (including ex ante shareholders' approval and fair market conditions of the transactions), the Estonian legislator imposed a strict ban on the core principle of LBO's – the use of the acquired company assets as security for the debt financing.

The prohibition also extends to private limited companies. However, transactions that breach it are not void. Therefore it is probable that financial institutions financing the acquisitions will still claim collateral in the form of the target's assets, increasing the liability of the acquirer and managerial bodies of the acquired companies.

Hectic development

Growth of venture capital participation in the transaction market has been particularly visible in recent years globally and also in the Baltics. Announcements on completed transactions show the ever-growing presence of the private equity industry; venture capital has facilitated acquisition of pan-Baltic businesses such as the mobile telephone operator BITE, information technology and data processing company Interinfo and construction company LEC.

Even more impressive are the recently announced but not closed transactions, in particular in banking, finance and telecommunications – for example, the designed LBO of Lattelecom. Commentators note that uncompleted deals are not just caused by the stalling of the respective participants, but also serve as early warnings about difficulties for the national economies of the Baltic states. Record inflation (Latvia) and current account deficit (Lithuania) already adversely affect Baltic competitiveness. While each country is rightly treated as a separate economy, for the international private equity industry all three Baltic states often represent one territory.

Foreign investment has fuelled hectic economic development. The global economic slowdown has led banks to reconsider their lending policy. The Latvian Commercial Bank Association reports that lending in Latvia is three times less than in the first quarter of 2007. It may affect the merger market even if the financing of major recent transactions had acquired resources of foreign sponsors and lenders. As a result, in 2008 we may observe a serious decline in the bank financing available for transactions. While the overall impact on the economy will be negative, the venture capital and private equity industry could potentially become stronger and gain a sizeable position in the Baltic financial markets.

The economic slowdown of the Baltic economies, a hot subject in the media, has triggered an extensive supply of potential targets, allowing private equity companies to be more picky in choosing their investment object and more aggressive on the negotiation terms, including price. The reverse side of this is the difficulties encountered at exit. The economic boom is over and potential buyers have become much more cautious. Increased debt cost is another consequence of the recent credit crunch. Banks are more prudent when granting loans for leveraged buy-outs.

Above average

However, private equity firms claim that the difficulties encountered with acquisition finance have not been insurmountable. Some market participants claim to have serious problems in finding a promising target for investments. Neither an institutional framework nor incentive exists to find and finance start-up or early stage projects. The globally famous Skype is a lone shining star, with its origins in Estonia.

One of the potential avenues for development is internationalisation. Many local venture capitalists are playing in a pan-Baltic league. Several have penetrated larger markets, for example entrance of Martinson Trigon Venture Partners into Russia. Eko Investors, Latvia, is considering entering more specific and therefore more complex markets, like Belarus and Uzbekistan.

Locally many issues must still improve. The Baltic private equity market is in an emerging stage and entry level in the market is still low. The development of the venture capital and private equity market depends on a strong infrastructure.

Baltic industry can gain from the proximity of the Nordic markets that have earned a reputation as active and profitable. Nordic equity markets are exemplary in terms of their regulatory conditions and investor-friendly environment. That is achieved primarily by concerted actions of industry participants. In the Baltic states, joint industry representation is established in Latvia only in the form of the Venture Capital Association (LVCA has been a member of European VCA since 2003). Industry consolidation can stimulate joint consent on matters of principle, in particular towards proper governance-driven activities.

The Latvian government authority responsible for allocating EU funding for development and facilitation of venture and risk capital among member states, the Latvian Guarantee Agency (LGA), has taken a first step in that direction. LGA invited members of the LVCA to jointly draft an industry-accepted model agreement partnership and management, which could also be adjusted and used for other private equity funds. As a result the model of limited liability partnership agreement was used by LGA to set up three investment funds with the State and EU structural fund input and funding from private investors. These funds have distributed investments during 2007 up to 2008 and serve as an example to the industry.

The Baltic economies are developing faster than the average European economy and there are many opportunities for the private equity and venture capital industries. The coming years will show how effectively they are used.

Author biographies

Natalja Sidorenko Luiga Mody Hääl Borenius, Tallinn office Natalja Sidorenko, an associate in the firm's banking and finance/capital markets practice, has wide experience in different types of securities, and in securitisation and other financing transactions. Sidorenko also provides legal advice on private equity. Sidorenko graduated from the University of Tartu Faculty of Law in 2005 and obtained a Master's degree in 2007. She has been a member of the Estonian Bar Association since 2007. Lauris Liepa Liepa, Skopina/Borenius, Riga office Lauris Liepa is a partner and attorney-at-law in Liepa, Skopina/Borenius. Liepa advises both international and domestic clients in multiparty transactions, and represents parties in disputes and arbitration proceedings. He served as legal counsel for a bank and practised law at a private law firm before establishing his own law office. Since graduating from law school, he has lectured at the University of Latvia and at the Riga Graduate School of Law. Liepa is member of International Bar Association (IBA), the American Board of Trial Advocates (ABOTA) and Riga Stock Exchange Surveillance Committee. Eugenijus Filonovas Foigt & partners/Regija Borenius, Vilnius office Senior associate in the Vilnius office of the Borenius Group, Eugenijus Filonovas specialises in M&A and corporate law, banking and finance, capital markets, and IP/IT. Filonovas has worked on multiple domestic and cross-border complex M&A deals, and has advised on various investment projects with local and international firms. He has wide experience representing clients in court proceedings. Filonovas was admitted to the Lithuanian Bar in 2004. Borenius Group The mission of Borenius Group is to provide full range of tailored business and corporate law services in the Baltic region and Finland. More than 150 top-tier professionals render legal advice to domestic and international corporate clients. English is our main working language, but the service is also provided in Swedish, Russian, Polish, German, and French. Contact details: Estonia | Luiga Mody Hääl Borenius | +372 665 1888 Latvia | Liepa, Skopina / BORENIUS | +371 6 720 1800 Lithuania | Foigt & partners / Regija Borenius | +370 5 264 9555