Structuring of Growth Funds with the Purpose of SME’s Evolution
under the JEREMIE Initiative
George L. Shahpazov and Lyubka A. Doukovska
Institute of Information and Communication Technologies, Bulgarian Academy of Sciences
Acad. G. Bonchev str., bl. 2, 1113 Sofia, Bulgaria
Keywords: Growth Funds, SME, JEREMIE Initiative, Energy Efficiency
Abstract: Recent surveys in regards to Country’s economy development and especially SME’s progress in the past
few years, shows the decline in development. The recovery and restructuring of the economy would go
through rehabilitation and modernization of long-term value creating industries. Continuous development of
already established SME’s in some of the analysed sectors of the economy is backed by the identified
potential for above average growth. Initially targeted favourable sectors, subject of investments would be
under the main focus for investments in the upcoming future by any structured fund under the JEREMIE
initiative, but will not limit the exploration of other opportunities depending on market developments.
1 INTRODUCTION
Between 2000 and 2008 Bulgaria faced its first real
boom period for the last 25 years. The EU accession
plan, the currency board and western oriented
governments combined with booming banking
industry and cheap credit resources created an
investor friendly business environment that attracted
in total more than EUR 25 billion of FDI and
assured steady growth of the economy with rates
double than the EU average. Unfortunately more
than 70% of these investments went into non-
productive, highly speculative and cyclical
businesses or were triggered by arbitrage
opportunities in privatisation deals. Manufacturing
and service industries (excl. financial services) did
not benefit proportionally from the growth. Looking
back in a period of 25 years Bulgaria has lost more
than 50% of its light and heavy industry production
and more than 60% of agriculture production,
turning from a net exporter into net importer for
many goods.
Statistics show that the next growth wave in the
country will be driven by the rehabilitation and
modernization of long-term value creating industries
led by the manufacturing sector, which will profit
from a boost in the local agriculture sector and
foreign demand (e.g. exports are surpassing pre-
crisis levels). Modernization of production assets is
closely related to the implementation of
Government’s initiative for energy affiances
improvements. Service industries, excluding
financial services and telecom, are currently
underdeveloped, and will grab higher share of the
economy and outperform.
Manufacturing was heavily hit in the last few
years due to strongly decreased internal and external
(export) demand, out of date business processes and
weak financial management. The liquidity reserves
of the sector decreased significantly, fresh liquidity
is scarce on the local market and hinders the fast
recovery of the sector from the crisis. This situation
creates good entry opportunity at low-to-reasonable
valuations enabling investors to extract maximum
return on the provided capital.
Bulgaria slowly recovers from the crisis; signs of
recovery in selected industries are already visible.
The Bulgarian government expected GDP to rise by
3.7% in 2011; foreign institutions and banks were
more moderate and forecasted an average annual
growth of 1.5%. Even though prognoses for a new
Recession in Europe is close to becoming a
reality, our expectancy is that after 2013 a partial
recovery and additional growth of the export goods
demand from Western Europe will be anticipated.
Combined with recovery of local consumption and
resumed capital inflows this should result in an
average GDP growth of 5.0% yoy over the next 10
years.
159
Shahpazov G. and Doukovska L.
Structuring of Growth Funds with the Purpose of SMEâ
˘
A
´
Zs Evolution under the JEREMIE Initiative.
DOI: 10.5220/0004462301590164
In Proceedings of the Second International Symposium on Business Modeling and Software Design (BMSD 2012), pages 159-164
ISBN: 978-989-8565-26-6
Copyright
c
 2012 by SCITEPRESS – Science and Technology Publications, Lda. All rights reserved

Table 1: Development and future Economic Forecasting of most Sectors of Economy of Bulgaria.
Forecast by Sectors
2004-2008 2009 2010f 2011f 2012f 2013f 2014-2019f
Agriculture -4.3% -4.2% 2.6% 2.6% 2.6% 2.6% 2.6%
Production 5.6% -8.1% 2.0% 8.8% 9.6% 8.0% 5.8%
Extraction
1.5% -18.6% 4.8% 6.6% 7.6% 6.5% 4.7%
Manufacturing
6.7% -8.2% 3.5% 9.6% 10.3% 8.2% 5.8%
Utilities
2.4% -4.8% -3.5% 6.3% 7.0% 7.5% 5.8%
Construction 12.4% -6.4% -8.9% 5.5% 9.1% 8.7% 6.3%
Services 6.9% -1.7% -1.5% 1.6% 4.6% 6.6% 5.9%
Exports 2006-2009 (BGN bln)
23
26
30
23
‐
5
10
15
20
25
30
35
2006 2007 2008 2009
Expor t s Q1' 09 - Nov ' 10 (BGN bln)
5.2 0
5.97
5.36
7.43
5.98
8.61
2.34
2.84
2.13
2.83
‐
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
Q1'09 Q1'10 Q2'09 Q2'10 Q3'09 Q3'10 Oct'09 Oct'10 Nov'09 Nov'10
Figure 1: Data of BG export.
Manufacturing output growth is forecasted to be
faster than GDP growth over the next decade.
Manufacturing output is expected to rise by 9.6% in
2012 and on average by 7% yoy over the next 10
years.
As a result, the share of manufacturing output in
GDP is projected to rise from 18.0% in 2009 to
20.9% by 2014 and rise to 21.1% by 2019. Over the
same period, the share of service sector output in
GDP is expected to fall from 63.4% in 2009 to
61.0% in 2014 and rise to 61.5% in 2019. (Oxford
Economic Forecasting)
Figures show that the timing for investment in
Bulgarian SME’s growth from the manufacturing
sector is perfect for the following reasons:
•
Rising external demand for the
manufacturing sector is already visible in the
increase of exports which surpassed pre-crisis peak
levels. The decrease in local demand is slowing
down to zero, and the reverse trend is already visible
in the past year, along with pick up process expected
to continue in 2012. This means that the economic
cycle will support the investments.
• Most of the companies in the targeted
industries have been privatized or established in the
period 2001-2007, which makes them attractive for
different kinds of growth investments categorised
mainly into 2 types: a) expansion – e.g. in
production or product range, b) developing the
company to the next level – e.g. vertical or
horizontal integration or new markets strategy.
The service sector growth prior to the credit
crunch was dominated by financial services,
telecommunications, and real estate related
activities. This led to disproportionate allocation of
capital and investments leaving other promising
segments of the sector underinvested. Each fund’s
management should see the potential for above
average growth coupled with demand for capital in
two major industries, namely: energy efficiency and
healthcare.
2 TARGETED MARKET
SEGMENT AND ENERGY
EFFICIENCY
The analysis seeks to locate and target the most
attractive for investments, important and
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underdeveloped segment of all sectors of the
economy, including several major industries within
these sectors. The development of these industries
will support sustainable growth in the country’s
economy in general. The segment will be in the
main focus for investments in the upcoming future
by any structured fund under the Jeremie initiative,
but will not limit the exploration of other
opportunities depending on the market
developments.
The Energy Efficiency space is an attractive
investing segment due to the enormous lag of
Bulgaria to achieving EU-wide standard and the
active supporting policies implemented over the last
years. The government, in line EU targets and
initiatives, has provided financial and legislative
incentives for improving energy affiance, lowering
overall energy consumptions and increasing
renewable energy in the total consumptions mix.
The country occupies one of the places in terms of
energy intensity in Europe with energy intensity
coefficients of the GDP standing approximately 90%
above EU averages.
The latest Energy Strategy drafted by the
government in line with European 20/20/20 goals
envisages reduction in green-house emissions,
raising the share of RES contribution to 16% of the
final consumption, and reducing energy intensity of
GDP by 50% by 2020. The interim target for
reducing energy intensity of GDP is 25% reduction
by the year 2013. The state plans to reduce the
energy intensity of GDP from 913 toe/M€05 in 2005
to 456 toe/М€05 by 2020. According to different
estimates, the country needs to invest approximate
BGN 4.2-4.5 billion to reach the outlined targets and
to lower the overall energy intensity of the economy.
The achievement of the targets requires
implementations efficiency and savings solutions
and investments in industry (38% share in total
consumption), households (21.8%), transportation
(28%), and services (9.4%) and it has opened a
market niche for business with above average
growth opportunities.
Energy efficiency in Bulgaria is a segment,
which is below the average in the EU, not only
because it has not received the much needed
improvement, but also because priority development
was given to targeted industries that are generally
energy intensive.
The market of energy efficiency solution
providers and services companies is relatively
fragmented and consists primarily of SMEs in earlier
stages of development, thus offering ample
opportunities for investment in innovative
technology applications, engineering companies, and
complex service providers specialized in the
household and industry projects.
Prioritized SMEs in terms of energy efficiency
improvement will be businesses, focusing on
investments into new machinery, equipment,
technologies of higher-energy class, аnd reduced
emissions, along with companies looking for energy
efficiency achievement by switching fuel
consumptions (gas, etc.). (Bulgarian Small and
Medium Enterprise Promotion Agency)
3 INVESTMENT STRATEGY
The individual investments in each fund’s portfolio
should be selected based on the combination
between the mandatory and at least on of the
optional criteria:
Mandatory Criteria:
• Management team and human resources’
potential;
• Profound market and industry knowledge;
• Business model scalability;
• Distinctive competitive advantages;
• Double digit growth potential of the companies
revenues;
• Clear Exit Route.
Optional Criteria:
• Value-adding opportunities through process
optimization, strategy fine-tuning;
• Market scalability of the products (export);
• Potential for horizontal or vertical integration.
The majority of SME companies in Bulgaria
experience difficulties in maintaining a normal life
cycle and tend to suffer from early maturity and
decline without being able to materialize its full
potential. There are many reasons for this, with the
most common being – poor management and lack of
financing. The Fund will aim in this cases at
eliminating these factors with different optimization
strategies, so the company converges to its natural
development path and then seek expansion
opportunities. Companies that have already
accomplished this stage of their life cycle will be
prepared for the next level.
Business cycle stage of the investment targets:
By providing equity financing, business
expansion and optimization can be achieved
primarily through the implementation of various
strategies: production capacity expansion; new
product or a new line of products launch;
Structuring of Growth Funds with the Purpose of SME’s Evolution under the JEREMIE Initiative
161

Figure 2: Expansion and optimization.
commercial network development, process
improvement and efficiency.
More than 80% of the companies are managed
with outdated structures, based on personal skills
and single person’s authority. We believe that
implementation of modern business processes and
process management would increase significantly
profitability.
Optimization of the marketing strategy and
establishment of adequate financial management
will be in most of the investment cases the other
substantial driver for successful expansion.
• Upgrading to the next level
The step to the next lifecycle stage of the
company will be achieved by providing equity
capital and financial structuring of the
implementation of one or several of the following
strategies:
o Organic growth for companies with
interesting and multipliable business models;
o Non-organic growth, horizontal
integration;
o Non-organic growth, vertical integration
across the value chain;
o Creating regional leaders and
consolidation plays.
4 EXPECTED NUMBER OF
INVESTEE COMPANIES
PLANNED INVESTMENT
RATE INCLUDING FOLLOW-
ON POLICY AND ENVISAGED
STRATEGY FOR RISK
DIVERSIFICATION OF FUND’S
CAPITAL
The size of established Funds under the JEREMIE
initiative should be between EUR 45-60 million,
thus utilizing the whole amount available from the
OP Competitiveness. The amount of the funds
should be planned to be at the maximum level in
order to fulfill the main targets of each Fund
manager, with a main focus on:
• Fund diversification to be aimed at
mitigating the various risks.
• Private investor commitment – based on the
already confirmed participation by private
investors (Banks, Insurance Companies,
Mutual Fund and local companies) – the
indication should be that the overall
commitment of Private Investors will
exceed EUR 30 million for each fund.
• Built – in Pipeline- the fund managers will
dispose with an immediate pipeline of 15
potential deals with total investment of near
EUR 70 million, which should be the base
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for the first few executed deals in the first
year. In our case the pipeline is partially
represented by the described investment
cases.
• The demand for financial growth
instrument in the SME segment is at its
peak. Traditional bank financing remains
currently hardly accessible for SMEs, due
to the ongoing cautious approach by the
banks to lend investment loans with longer
tenors following the continuing process of
deterioration of the banks’ loan portfolios.
Banks are currently predominantly focusing
their efforts in consumer and mortgage
lending.
Therefore, it is considered that managers of each
fund should be in a position to grow private equity
portfolio of companies within 3 years surpassing the
set target of the growth fund of EUR 60 million.
Investing in growth capital in the SME sector
involves substantial risk in general and particularly
in emerging markets like Bulgaria.
A significant portion of this risks results from the
lack of business ethics in the market and a
legislation, which doesn’t support in particular this
kind of investments. Several cases from the
experience of international PE players in Bulgaria
have shown that even a complete loss of the
investments is possible due to fraud and weak legal
execution. We believe that the combination between
the accumulated experience in each fund’s team,
combined with previous successful financial deals in
the local business environment and the necessary
understanding of the peculiarities of the execution of
financial deals in Bulgaria will be crucial for
mitigating the legislative and fraud risk.
In order to mitigate the business and industry
risks, it is necessary to achieve a relative
diversification in stages/ types of investment,
industries, size and number of portfolio companies.
We believe that each fund needs to be able to invest
in no less than eight companies in its total lifetime
and not more than twelve at any moment of it.
The main purpose of these funds per definition is
to support SME growth and not to takeover
companies. Therefore the general intention under the
initiative of the fund is to hold not more than 50% of
the company’s equity. Although, as the mentioned
negative experience of other PE investors in the
country shows, even as minority shareholder it is
appropriate to implement irrevocable control
mechanisms over the decisions process of the
company’s management as guarantee that the
invested capital is used for its original goals.
Attendance in the management board meetings of
each company will be just one of these mechanisms.
Generally the management processes of the
companies will be reviewed and if needed adjusted.
Preferable to invest in companies that have already
existing or are willing to implement modern
business and management processes, which are
detached and independent from individual talent
skills and single persons authority. The latter is
unfortunately still the business standard for the
majority of SMEs in Bulgaria, and bares a high
potential business risk in the cases of disloyalty of
this key people. (Bulgarian Small and Medium
Enterprise Promotion Agency, Bulgarian National
Bank).
As funds will be investing in growth, the equity
investments as a general rule should be done as a
capital increase and not as a partial or full
shareholders exit. Exceptions to this rule can be
evaluated if one or some of the shareholders hinder
the development of the company.
Considering the required experience of each
developed structure and the targeted industries, the
ideal investment sizes should be between EUR 1.5
million (smaller investments) and EUR 8 million
(large). This numbers show the initial investment
size. For follow-up capital increases funds are
advised to keep special reserves of 10% to 15% of
the total fund capital. Ideally, capital injections
should be scheduled in tranches tied to performance
and/or investment cornerstones.
The general holding period of an investment is
projected to be around 5 years, depending on the
industry, life cycle of the company and the general
economic cycle. Overall targets should be an IRR of
18%. Some of the companies might need to be
prepared for acquisition by international buyers due
to the natural limitation of the local market. Such
companies need to have grown to a size and stage
that will make such acquisitions possible.
Additional investment rules have to be made
applicable, in order to cover the principles described
above:
• A single investment should not exceed
EUR 10 million, and if it does, then a
decision of the supervisory board will be
needed. Single investments below EUR 1.5
million will be not evaluated.
• To assure diversification of companies, Top
4 investments should not exceed EUR 30
million.
• To assure diversification in the targeted
industries, the limit per single industry will
be 30% of one funds capital.
Structuring of Growth Funds with the Purpose of SME’s Evolution under the JEREMIE Initiative
163

• A balance (50/50) between the two types of
investment will be targeted.
Each fund is to aim and complete at least 3 deals
from different industries and different investment
types within the first year of structuring. The
investment cases show a generalized summary of
some of the existing projects/ deals under the
specific pipeline. In the following years,
performance speed should be kept at 3-4 deals per
year (set as target). (Bulgarian Small and Medium
Enterprise Promotion Agency, Investor.bg)
5 CONCLUSIONS
It’s been proven that given the development stage
and nature of the SMEs in Bulgaria the most suitable
instruments created by Funds management have to
be as plain and simple as possible. Sophisticated
financial products generally create mistrust on the
local market. Thus each Fund must intend to use for
its investment needs primarily direct participation in
the companies via investing in common stock and in
certain cases trough a combination with investments
in preferred stock of the company.
Structured Funds under JEREMIE most likely
will aim at purchasing a significant portion of a
particular company in order to be able to have a
larger influence in its governing and to speed up its
growth via the experience and know-how of its
investment team. Typically Funds will seek to
participate via a capital increase aiming at further
strengthening the shareholder’s equity, and support
the continued growth through acquisitions as well as
organic growth.
In order to protect its investment each Fund
might seek also participation trough preferred stock
as it has many advantages including a greater claim
of the assets than common stock thus limiting the
downside of the investment. Buying preferred stock
could include the option of converting them into
common stock at any point of time, in which case
the owners will lose the right of a dividend, but will
gain the ability to participate in the decision taking
process. Preferred stocks could be flexible in terms
of the dividend rates that they hold, which could be
adjusted along the way so that it does not interfere
with the company’s sustainable growth.
In limited number of cases each Fund have to
aim at lending different types of hybrid loan
products, suited to best fit the business needs of each
company. A common type of debt product that
Funds will be looking at will be the convertible debt,
where the loan is secured via the right to convert it
to common stocks at certain predetermined
conditions. This will reduce both the risk to each
Fund and the requirement to the company to provide
collateral, which as we have mentioned before
proves to be a major obstacle for the SMEs on their
way to receiving a proper financing.
Each structured Fund must target an investment
with a clear potential to generate above 30% internal
rate of return (IRR). As some of them could be
expected to not realize their full potential and reach
all financial targets at the predefined time horizon,
managers should expect that the overall performance
that one Fund will be able to achieve will be
equivalent to IRR of 18%.
REFERENCES
Oxford Economic Forecasting
www.oxfordeconomics.com
BNB (Bulgarian National Bank) - www.bnb.bg
Bulgarian Small and Medium Enterprise Promotion
Agency – www.sme.government.bg
www.Investor.bg
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