Friday Letter: Following the bear

The conventional wisdom is that private equity investing in Russia is a risky business.  

The economic crisis of the late 1990s, the recent legal and political fallout of Yukos, which left the company a shadow of its former self and the CEO in prison, and a long-held concern about government’s involvement in matters of business have done little to win over many private equity hearts or wallets in the past.

Although the legal and political risks remain, the last year has seen enough economic and private equity activity to warrant renewed interest. Compared to the period 1998 to 2001, when the $60 million Fleming Real Estate Fund and the $205 million Baring Vostok Private Equity Fund were the only two foreign funds investing in the country, the past twelve months have already seen the close of two new funds.

In February, old-hands Baring Vostok Private Equity Partners closed its oversubscribed third fund on an impressive $400 million, focusing on the oil & gas, media, telecoms and financial services sectors. And last month, Moscow-headquartered Delta Private Equity Partners closed its new $120 million fund dedicated to Russia and Ukraine.

Significantly, the Delta fund was the first it has raised from private investors, its now fully invested US Russia Investment Fund having been set up and funded by the US government. According to the firm, which sold mortgage lender DeltaCredit Bank and cable firm National Cable Networks (NCN) in the past week, the latest fund attracted commitments from investors in the US, Europe and Japan.

Along with NCN, Delta’s prior fund invested in Compulink, sandwich shop chain Prime and retail operator Vesch: a diverse portfolio of domestic, consumer-facing companies. This is something that Patricia Cloherty, chairman and CEO of Delta (and former president and chairman of the US National Venture Capital Association) is keen to emphasise. “We’re not talking about oil companies here, the traditional image of Russia, but grocery chains and drugs stores,” she says.

Domestic consumption has been one of the key drivers to a revival in the Russian economy. According to the OECD, the annual Russian economic growth fluctuated between 4.7 and 10 per cent between 1999 and 2003 (an average of just over 6.5 per cent per annum). There has also been a recent IPO boom on the Russian stock market that Cloherty says is “greater than that of the previous ten years altogether”.

Most Russian private equity funds – and most Russian companies too – still lack an essential factor that can only be remedied over time though: a robust track record. The economic crisis of 1998 took a couple of years to shake out, with few realisations or investments of note until around 2001 and 2002. Cloherty says that any sense of a track record is irrelevant prior to 2001, but that the numbers are beginning to stack up now, with market activity picking up and a number of companies reaching the stage where they require capital to grow. It is “a nation coming to grips with its past, present and future,” she says.

Russia is going through a period of marked change, notes Cloherty, and it is not the country itself, but others’ perception of it, that is struggling to keep up. “It is an image problem,” she declares. “There is a real risk [of this] in any emerging market, but as Russia has been isolated from the rest of the world, the perceived risk is greater than the real risk, and largely predicated on a lack of knowledge.”

Perceptions nonetheless matter, especially when a skeptical international media is prone to accentuating the negatives. Private equity practitioners around the world could also not fail to notice that erstwhile fund-raising machine The Carlyle Group could not close its $300 million Russian fund due to insufficient investor support. This was in the same week that Delta closed its latest fund. For aficionados this was a blip not a trend – says Cloherty: “They had some bad luck. They’ll be back.” But it was a useful reminder that emerging market private equity – and in this instance, the Russian variety of it – requires more than just confidence and commitment from the GP.