Following five years of negotiations, the deal to partially privatise Estonia's largest power plants fell apart in the final hour on January 9. Fingers have been burnt but investors want to know how far the failure will reverberate. Does this signal the Baltic darling's fall from grace?

Estonia has been hailed as a success story in making the transition to a market economy. Successive governments following independence embarked on aggressive restructuring programs. The country became seen as a Central and Eastern European hot spot for foreign investment, achieving the highest FDI per capita in the region. IT and engineering sectors have developed at an unparalleled rate.

Privatization was set in motion and in 2000 this culminated in the national railway being split up and sold off. The privatization agency was disbanded following this, its work believed to be over.

The only major sector left in state control was energy and that also appeared to be leaving the government's grip. In 2000 NRG was named preferred bidder to purchase a 49% stake in Narva Power from the state owned national power company, Eesti Energia. Narva Power was established in 1999 and comprises twinned oil shale plants Eesti and Balti. With a generating capacity of 1610MW and 1390MW respectively, together they feed more than 90% of the country's electricity needs. A slice of the oil shale mining company, Eesti Polevkivi, was thrown into the package as well.

The second half of 2001 saw SG, KBC and BTM scoop the mandate to raise Eu285 million of project debt but by year-end rumours hinted at trouble. By the end of January 2002, a month that also witnessed Prime Minister Mart Laar's resignation, the plug had been pulled.

?They may well have shot themselves in the foot by allowing this deal to break down,? says a source involved in the deal. ?Estonia has had a very good economic record and been seen as very progressive. But now people might think more carefully before investing.?

But the general consensus of international onlookers is more upbeat, with many echoing that one privatization failure is not going to damage the image of an essentially successful privatization program. The most important point is that the government has always maintained transparency and as such Estonia will still be viewed as a good investment. The same cannot be said of all its contemporaries. ?Estonia was the first of the transition economies to try and privatise its energy market and the deal falling through is not going to damage international opinion on the privatization process in general,? predicts Kristel Richard, analyst at Standard & Poor's.

Along with many industry players, Richard sees considerable private sector activity and growing foreign investment into Estonia in the short- to medium-term. As the market matures, opportunities for large-scale financings will emerge and financing techniques will diversify.

Since the end of 2000, two industry projects have opted for limited recourse financing. HypoVereinsbank lead arranged $94 million of senior debt partially backed by SACE for the Galvex Galvanising Line Construction plant, which syndicated in 2001. It is also nearing financial close on a pulp plant sponsored by Norwegian company Larvic Cell. Hypo says that, although happy to retain the whole amount, it has received a number of expressions of interest and may sell down a portion of the Eu64 million.

?There is considerable lending appetite for Baltic States, especially Estonia,? says Marc Thumecke of HypoVereinsbank. ?People are willing to put up uncovered debt and we are likely to see more projects.?

Privatization

The Privatization Agency was set up in 2002, modelled on its German equivalent. It has raised a total of K5.5 billion ($310 million) for the state over its nine year life and been praised for promoting significant foreign investment. Industry was the first sector to be targeted, the hit-list including chemical companies, hotels, toy factories and textile plants. After these so-called ordinary enterprises had gone, focus turned to larger state utilities and infrastructure. A high was reached with the sale in 1998 of 49% of Telekom shares to Sonera and Telia, after which the role of the private sector rose to about 70% to 80% of GDP.

?Estonia's privatization program has been successful, largely because the government knew what it wanted and stuck to it,? explains Meelis Kuusberg, head of UK office, Enterprise Estonia. ?It has been very flexible,? adds Sabine Schlorke, senior investment officer, IFC. ?A number of methods have been employed depending on what is suitable. Estonia also has a well-developed legal system.?

For their part, many investors are attracted to Estonian assets because the motivation for privatization has primarily been to raise money, to encourage foreign investment, and in some cases expertise, and to foster competition. It has not been a last-ditch attempt to save debt riddled and inefficient companies. For instance, compared to some of the railways that have been privatised in Latin America, Estonian Railways was not in desperate need of investment. Traffic volume is already fairly high and the tracks are in fairly good condition.

It has not all been plain sailing, however. Despite the numerous stories of success, there have been some hitches in the deals leading up to Narva's breakdown. Railway privatization in particular threw up a number of problems, directly contributing to the fall of the former minister of economic affairs Mihkel Parnoja.

The state railway, Estonian Railways, was split into two key companies and tenders were issued. Eesti Raudtee (Estonian Railways Ltd.) took on freight traffic, and AS Edelraudtee (South Eastern Railways) the domestic passenger routes. 66% of the former was sold to American-English-Estonian consortium Baltic Rail Services (BRS) for $56 million (K1 billion), while 100% of the latter went for a mere $0.56 million (K10 million) to GB Railways Eesti, a subsidiary of British firm GB Railways. This disparity in prices is due to the fact that Eesti Raudtee, which ferries considerable trans-national traffic from Russia to Western Europe, is profitable on a stand-alone basis. Domestic routes, on the other hand, rely in part on government subsidies.

When Edelraudtee changed hands at the end of 2000, a dispute over liability for earlier transport loans and cutbacks in government subsidies caused an immediate suspension of some services. This was not fully resolved until the second half of 2001 and GB has subsequently sold a portion of its stake.

Eesti Raudtee's sale ran into problems in the negotiation stage. Delays followed a competitive tender when it emerged that the highest bidder could not raise pledged funds. BRS was then chosen as the next highest bidder. ?There were issues with the tender process,? confirms Schlorke. ?It is difficult to make all the necessary checks and in a bid to see the transaction through quickly, some decisions were not made properly in this instance.?

Schlorke is keen to stress, however, that overall the privatization of Raudtee was carried out well. Financial close was secured in August 2001 on the back of shareholder funds. The IFC was then involved indirectly through an AIG loan drawn down in January 2002 and directly in Febuary 2002 through a $50 million facility for investment in rolling stock. Under the privatization agreement, BRS is obliged to invest at least K4.7 billion ($265 million) within 10-years. The state has a put option to sell the 34% of shares it has retained.

The mechanics of company restructuring during privatization is an issue that could cause problems ? in particular, whether it is possible to establish an orderly way of restructuring a labour force. But perhaps the major obstacle to privatization of major state assets, however, is often domestic political resistance. This is certainly not confined to Estonia, with the private management of traditionally public services contentious in all corners of the globe. But it has been true in Estonia, with the government resisting considerable pressure to drop the railway sales.

In the case of Narva, however, it proved insurmountable. Domestic opposition to the sale was exceptionally vocal, centring on the Narva region itself, which lies very close to the Russian border. The proposed sale of mines, viewed as of strategic national importance, with the power plants served to add fuel to the fire. In addition, many people felt that Eesti Energia does not need a strategic partner, already having a very good management structure and expertise in oil shale engineering.

Most significantly, these objections were hitting a government coalition that was crumbling. On 8 January 2002 Prime Minister Mart Laar, of the centre-right Pro Patria, resigned. A day later, partial privatization of Narva was called off. If he had survived, he might have kept the deal afloat with him. Siim Kallas, former finance minister was sworn in with a new government comprised of his Reform Party and the leftwing Centrist Party. Kallas, as a former employee of the Central Bank, is seen as fully committed to promoting private sector activity, even though he arrived too late to salvage the Narva deal.

Baltic Promise

The Estonian's private sector image may not have been permanently damaged by this political fallout, but there is still one pressing issue. Narva needs cash. Burning oil shale has a notoriously detrimental effect on the environment and Estonia is under considerable pressure to address this as a condition for accession to the EU. With NRG's pledged investment out of the picture, Eesti Energia is back to the drawing board. ?It was not just cash that NRG had to offer,? points out Martin Jones, a finance official at NRG. ?We have considerable expertise in CFB [circulating fluidised bed] technology, which significantly improves environmental performance of oil shale plants.?

This notwithstanding, Eesti Energia are not likely to be looking for another strategic investor in the near future. It is likely to go it alone in looking for funds. ?Options are still being considered,? says Andrew Cox, of SSB/Citigroup, advising Eeesti Energia. ?They may appeal to the syndicated debt market. A bond issue is also an option.? A rating would have to be sought for the latter.

Elsewhere private sector activity is likely to continue. ?In the short to medium term, we expect to see FDI to continue growing,? says Meelis Kuusberg. ?Expansion of SME activity is likely to be particularly prevalent in the IT and electronic sectors.?

Project financiers may also get a look in. Small industry projects will continue to trickle through but there could also be some bigger deals on the cards. A number of observers believe that there could be significant opportunities for investment into infrastructure, particularly transport, and steel. One player even points to the health sector. Reforms are currently underway and it is projected that billions of Kroons are needed for new hospitals. The private sector could provide the answer.

Another potential source of financing activity could also be mergers and acquisitions. As the Estonian economy continues to develop, it is likely to increasingly start to reflect the pattern typical of maturing markets, which witness M&A as well as greenfield projects.

Domestic project financing capabilities are building up. Currently, the major obstacle for local banks would be length of tenor, but this is changing. A wider problem with potential non-recourse financing in Estonia is availability of private equity, which is very important for leveraging any larger deals. Some say that interest amongst such lenders is growing, but others voice concern that the economy is too small to be a huge attraction. Accession to the EU could actually exacerbate this concern.