A year on from accession, investment in the European Union's (EU's) newest member states has gone well beyond just multinationals. The risk profile of small to medium enterprises (SMEs) has dropped since accession, prompting a new kind of company to ask for advice on acquisition finance in the Czech Republic and in the wider region.

The changing acquisition finance landscape

As in other transition economies, the Czech acquisition finance landscape has been dominated by large, multi-billion euro financings of privatisations and other large-scale foreign investments or restructurings. In their shadow, however, a different world is now booming, one involving the financing of cross-border acquisitions of SMEs by other SMEs, both inward and outward. With most of the 'transformation' acquisitions completed, SMEs acquisitions and acquisition financing are set to become even more important for the bidders, financiers and advisers alike.

The reasons behind the surge are not difficult to find. SMEs are no different from large corporations in their drive to reduce costs, explore synergies and seek entry to the new Central and Eastern European (CEE) markets or even markets further to the east. Czech SMEs often have much to offer in all of these aspects, while at the same time they seek strong partners to succeed against their Western competitors with deeper pockets. The fact that after 10 to 15 years of building new businesses, the 'founding fathers' of many SMEs are considering selling out is also an important factor.

This trend is closely connected with the EU accession, namely the increased competition and reduction of the country risk it brought along, but it has already been apparent for some years in advance. The Czech Republic became closely interlinked with the EU economies prior to accession under the partly liberalised association regime so the accession itself did not amount to a dramatic change.

Distinquishing features

Theoretically, acquisitions and acquisition finance should work in a similar, if not the same, way for SMEs as for other companies.

In reality, however, a number of differences exist which require a different approach by all the parties involved. First generation Czech SMEs are usually owned by a small group of family members or business associates. The whole acquisition process is therefore much more 'personal' than in the case of a large acquisition and good relationships between the parties involved at the shareholders' level are absolutely necessary. This is reinforced by the shareholders and management of Czech SMEs not always being familiar with international business and legal standards, as well as often being secretive and suspicious of the true intentions of the foreign bidder and financiers. Such character traits are understandable given the short and sometimes turbulent history of Czech capitalism and should not be taken lightly by foreign bidders.

Historically, SME acquisitions often did not involve any bank financing as the bidders would finance the acquisition from their own resources or existing facilities. This was partly due to the fact that for Czech banks, lending to SMEs was not a priority. This has changed in recent years as the local banks have recognised that it is an enormous opportunity for both profitability and market share considerations. The relatively modest amounts in question, however, make the parties involved acutely cost-aware, which leads to the desire to avoid complex or novel documentation and long negotiations – standard, simple and short facilities are preferred.

Legal considerations

The legal pitfalls associated with acquisition finance are the same notwithstanding the size of the transaction and the parties involved. To the extent, however, that inadequacies of the legal regime led to a higher cost of credit or require extensive transaction structuring, the resulting cost increase is much more burdensome for SMEs than for large corporations.

These obstacles are more or less typical for the CEE region, but have been particularly acute in the Czech Republic. The insolvency law is generally viewed as outdated, inflexible and detrimental to the interests of creditors. For example, secured creditors receive only 70% of the realised value of their collateral, which leads to banks over-collateralising their exposures. Insolvency procedures are also disproportionately time-consuming: the World Bank has estimated that their average duration is nine years.

Piecemeal law reform has been underway for several years, however, and a complete overhaul of the insolvency regime, based on modern principles, is expected to be put before Parliament later this year. The general law of secured finance is similarly inflexible and inconsistent with modern business and legal practices, generally preferring the interests of debtors to those of creditors. Only recently, for example, did the law permit the creation of a security interest over a participation in a limited liability company, a typical SME corporate vehicle.

Commercial Registers, the court-administered registers evidencing corporate information are often criticised for their formalistic approach, speed (or lack thereof) and absence of transparency. Recently adopted legislation, however, should improve dramatically the situation at the Commercial Registers, possibly as soon as this summer.

The key conceptual obstacle to any acquisition finance lies in Czech regulation of financial assistance, which in the European context is unusually wide and strict, resulting in any legal technique exposing the assets of the target company to the risk of the acquisition debt is in danger of being invalidated. The need for relaxation of this regime is generally accepted, but changes are not expected to be made for another year or even longer until the EU adopts its own liberalised regime of financial assistance and the Czech Republic the new codification of the companies' law.

Looking ahead

Looking ahead, it is likely that the current boom of SMEs acquisitions after EU accession may subside as the larger primary investment opportunities are exhausted. The field will nevertheless retain its importance, if only because of the sheer number of SMEs within the EU or the inevitable consolidation of Czech industries that will be necessary to compete at the EU and global level.

The local peculiarities described above will also gradually disappear as the Czech companies and Czech law accept EU business practices. The SME acquisition market will also mature and become part of the'mainstream' of financing operations, although cost-sensitivity is likely to remain. The various law reforms intended to remove the legal obstacles will continue and it can be expected that the most serious defects will be remedied shortly.

Jaroslav Havel is a partner and Ondrej Petr is a senior associate at Havel & Holasek in Prague.