Is Russia ready for private equity?

To those who have known Russia for a long time, the country's recent economic performance is a staggering success: international sovereign bond yields are less than seven per cent; a fifth consecutive year of GDP growth is projected; foreign currency reserves are estimated at over $70bn; and Moody's has issued an investment-grade rating. All this has been achieved in a country that defaulted on $40bn of domestic debt just five years ago. On the basis of its recent performance, Russia appears to be a very attractive destination for private equity capital.

At the same time, however, international investors remain wary of Russia, deeply concerned about the country's commitment to private property rights and its intention to uphold the rule of law. This is hardly a new concern. International investors played an important role in Russia's development for a few decades preceding 1917, when a political system hostile to private capital slammed the door to foreign capital. It wasn't until the 1990s that international investors again returned to Russia, willing to risk limited amounts of capital in search of extraordinary returns.

Businesses do not trust banks, and the banks are slow to trust businesses

In 1991, then US Ambassador to Russia Robert S. Strauss summed up the views of many international investors at the time: “If I had $10,000 to invest, I'd put it in Russia. If I had $10m, I'd still invest $10,000.” His remark seemed particularly perceptive in August 1998, when the Russian devaluation and ensuing financial crisis demonstrated that the country's economic, legal and political environment was insufficiently developed to support investment.

In the years since 1998, Russia has made steady progress, to which Russian and international investors in private assets have responded with enthusiasm. Private capital has re-emerged as a driver of growth, with Russian and international investors looking to longer-term, domestic investment as a way to participate in one of the world's fastest growing markets. Noting Russia's progress, a half dozen leading international private equity groups between them are reportedly considering committing $1bn to the country.

But, as is often the case in Russia, progress is more complicated than it first seems. In late October, the Russian Government arrested Mikhail Khodorkovsky, one of Russia's leading businessmen, and froze his stake in Yukos, the world's fourth largest oil producer. The episode triggered an international media furore.

Many commentators wonder whether Khodorkovsky's arrest is an isolated incident meant to resolve differences with a potential threat to the authority of President Putin, or whether history will repeat itself and laws will be used as tools by a government intent on dominating every aspect of economic and political life. Can the country – so rich in natural resources and human talent – reconcile its remarkable economic recovery with its seeming inability to create political conditions to foster the growth of private enterprise? The answer to this fundamental question may help potential investors determine the fortunes of international private equity in Russia.

A country recovers
Since the August 1998 financial crisis, Russia has made notable, but sometimes uneven, progress in developing an economic, legal and political foundation to support domestic and international investment in private assets. On the economic front, Russia has kept inflation under control, managed its revenues and expenses to maintain a budget surplus, and taken important steps to regain the confidence of the international investment community. International investors have responded by buying Russian corporate debt, recommitting to Russia's public equity markets, and increasing direct investment.

Although Russia continues to benefit from high oil prices, its economic development has also been driven by laws supporting foreign investment, private ownership of land and property, and the resolution of commercial disputes.

“Over the last several years, Russia has steadily strengthened its judiciary system, raising judges salaries by 60 per cent and providing practicing judges the opportunity to participate in continuing legal education. As a result, it is more and more likely that judges will have the skill and independence to make fair judgments on merits, even in litigation between foreign and Russian parties,” says Randy Bregman, a partner with Salans, an international law firm which has represented Russian and international clients in Russia for over 20 years.

Russia is also beginning to benefit from critical civil reforms, including changes in tax laws that have substantially increased compliance and receipts. Although still a work in progress, the Tax Code provides some transparency and predictability for investors as they seek to evaluate, and to capitalise, on investment opportunities.

Key banking legislation still awaits passage by the Duma, Russia's parliament, but retail lending, including mortgages and consumer loans, has grown by 60 per cent in the first eight months of 2003, according to Moscow-based investment bank Renaissance Capital. This result is almost entirely driven by Russia's higher-income earners, but underlines the potential of the banking sector to drive economic growth.

Commercial lending by Russian banks to domestic companies remains limited, however, with most large Russian companies accessing international capital markets through Eurobond offerings. Small to mid-sized companies still must finance operations through equity.

“A major part of the problem is the lack of regulation and trust – businesses do not trust banks, and, given problems involving murky finances, collateral, and loopholes in bankruptcy laws, the banks are slow to trust businesses,” says Richard Hainsworth of Renaissance Capital.

More positive is the fact that the geopolitical disarray of Russia in the 1990s appears to have passed, with the Kremlin re-exerting control over Russia's regions. Many argue, though, that this has come at the expense of an independent media and open political debate. Even Kremlin officials have agreed with Russia's constitutional court that recent attempts to limit news media coverage of elections have gone too far.

Despite the fact that the Russian constitution prohibits censorship and guarantees the freedom of press, “it is hard to say that mass media is truly independent in Russia,” notes Oksana Bogatyreva, former managing editor for The Russia Journal. “On one side, the government has control over the main TV channels and some print mass media. On the other side, several major newspapers and magazines are owned, controlled or supported by big business.”

In addition to exerting partial control over the country's media, the Russian government also has an important role in commercial decision-making, particularly within certain sectors of the economy, and, even before the arrest of Khodorkovsky, in relation to high-profile transactions involving business leaders who compete for political influence. Ongoing negotiations by Russia's leading businessmen to sell portions of their vast holdings are the result of government pressure to curb their power, according to reports.

However, despite the government's continuing influence, the net effect is that the rules of economics generally have become more important than the rules of politics in most sectors of the economy. Although serious uncertainties remain about political risks, especially in the natural resources sector, the overall business climate is fundamentally more transparent and supportive of investment than even five years ago.

As perception of Russian investment risk has decreased, domestic and international investors have reacted by investing in private transactions throughout the country. Today, Russia is awash with liquidity, driving strong growth in turnover and valuations of public equities. In the first three quarters of 2003, mergers and acquisitions activity totalled $19.2bn, four times the total reported in 2002, according to data cited by Bloomberg.

Russian capital returns
Throughout the 1990s, headlines on Russia in the international financial press regularly told of capital flight abroad, which, according to some reports, reached more than $25bn per year. While capital still leaves Russia for offshore accounts, a rising portion is currently being deployed at home and the near abroad in an array of investments, from private equity limited partnerships to direct ownership in private companies to growth capital injections into already established businesses.

In Central and Eastern Europe, bidders and sellers in private transactions increasingly meet Russian investors. To the dismay of international strategic and financial investors in the region, Russian investors have on more than one occasion outbid their rivals from the West for telecommunications, energy and other key assets.

Russian capital is routinely courted by international private equity groups. Group Menatep, for example, Naturally, however, it is at home where Russian investors are making their most significant mark. “The vast majority of private investment in Russia is from Russian sources. Foreign private equity represents less than two or three percent of the total,” according to Michael Calvey, Co-Managing Partner at Baring Vostok Capital Partners.

Who invests?
Investment from Russian sponsors essentially takes place at two levels. Only a handful of well-capitalised asset management groups and companies are capable of executing medium and large-sized transactions, ranging from $25m to the hundreds of millions. A growing number of very successful mid-market investors are focusing on small investments of up to a few million dollars. Early stage and technology investment remains quite limited.

Financial and industrial groups. Russian corporate and private investors currently do not manage third-party private equity capital, but asset management groups associated with the country's leading companies and businessmen invest actively in private assets. Often, these groups work hand-in-hand with companies and banks controlled by their sponsors to invest in assets that support a strategic interest or deploy capital into projects of personal interest to the sponsor. Examples of the largest investment groups include Oleg Deripaska's Base Element, Vladimir Potanin's Interros, Roman Abramovich's Millhouse, and Vladimir Yevtushenkov's Sistema Corporation.

“The current investment strategy of most financial and industrial groups is to separate their investment portfolios into two parts: the core, or strategic assets, and non-core, or portfolio assets,” said Yuri Belomestnov, a senior manager with Sistema. “Large Russian industrial investors manage strategic assets for the long-term, while they position portfolio assets, generally minority stakes or troubled companies inherited from privatisation, for exit.” Sistema is one of the largest Russian diversified industrial corporations with core assets in telecoms, real estate, retail and consumer electronics.

Corporate investment. Large Russian companies also make substantial equity investments, generally in connection with a strategic interest, but also in other assets in regions where their operations are located. For example, large Russian energy companies have been active both in Russia and the near abroad in securing refining, transportation and other assets.

Smart money looks for what is happening on the ground, not what is being said

An increasing number of highly successful mediumsized Russian companies also are investing in private assets. For example, Transasia Trade, a consumer products distribution company based in Krasnodar, has grown its revenues from $20m to $110m from 1998 to 2003. In addition to reinvesting in his business, Vladislav Valashin, President of Transasia, has committed capital to a variety of local projects that are thought to be generating very attractive returns. There is little to no international institutional activity in this segment of the market, and medium-sized companies are often well positioned to follow up on local opportunities of limited size.

Venture investors. Russian venture activity remains limited, particularly because capitalising on early-stage technologies requires cross-border reach, especially for exits. This is an area of increasing focus for international venture funds that are seeking to partner with local groups to access Russian technologies.

After Khodorkovsky
As the fortunes of Russia's business elite rise with the country's economy, the interests of government and big business are not always aligned. Throughout Russia's history, its record of reconciling competing state and private interests has been decidedly one-sided in favour of the state. Unfortunately for international investors, Khodorkovsky's detention suggests that post-Soviet Russia's judiciary and other institutions may not yet be capable of providing a mechanism to balance these interests.

International reactions to the Khodorkovsky affair have been mixed. While some observers question whether Khodorkovsky's arrest marks a step backwards for the rule of law in Russia, many international private equity investors are more circumspect.

“In the short term, Khodorkovsky's arrest will have a negative impact on asset prices, as capital flight increases once again,” says Michael Calvey at Baring Vostok. “If Russian acquirers step back from the market, exits may become more difficult. The flip side is that entry valuations should fall, which will benefit investors.”

Another short-term impact may be a delay in an upgrade of Russian bonds by other rating agencies, such as Standard & Poor's, which has expressed concern that Khodorkovsky's arrest signifies weakness in Russia's political and legal institutions. Although Moody's has reaffirmed its investment-grade rating, JP Morgan reportedly described Moody's upgrade of Russia as premature.

In the long term, however, investors believe that Russia's progress in creating an environment supportive of private enterprise will speak for itself. “We are concerned, but we sense a long-term opportunity if things settle down,” says Jonathan Colby, a managing director with The Carlyle Group.

“Smart money looks for what is happening on the ground, not what is being said,” commented Clay Pew, a managing director with Draper Fisher Jurvetson, which manages a Silicon Valley fund that invests in disruptive Russian technologies.

If Russia is to be judged by its actions, it is important to recall that a little over a decade ago the country did not have a convertible currency, officially allow private enterprise, or provide mechanisms for foreign ownership of property.

Although Russia's transition has not been smooth for its citizens or for international investors, the country has taken critical steps to demonstrate its commitment to private enterprise and integration with the world's economy. Today, Russia boasts improving macroeconomic fundamentals, rapid growth throughout almost every sector of the economy, and substantial investment activity by Russian investment groups and companies.

Despite the likelihood of additional political surprises, there is little doubt Russia possesses many characteristics of an attractive private equity market.

As international private equity managers reflect on Ambassador Strauss' 1991 wisdom that investors place just $10,000 of their $10m in Russia, they may be well advised to consider raising their commitment.

What Russian private equity investors look for
In the years preceding 1998, many domestic investors, if they had capital, were focused on moving it offshore or consolidating existing holdings. Today, Russian investors are aggressively pursuing opportunities at home, both in Moscow, the traditional centre of political and commercial power, and throughout Russia's regions.

With a few notable exceptions, Russia's leading asset management groups and corporates share a number of general characteristics and objectives when investing in businesses:

Excellent knowledge of, and access to, investment opportunities. As in any private equity market, industry insiders often have deep relationships through which they can access, evaluate, and secure investment opportunities. (Recognising this, international investment funds active in Russia rely heavily on local partners.)

Control situations. Russian investors usually seek control, installing their own management and financial directors. As a result, international investors may have more success than their Russian counterparts in pursuing opportunities where owners are interested in a minority equity partner that can provide growth capital.

Sophisticated deal analysis and execution. Russia's leading investment groups are increasingly sophisticated in their analysis and approach to transactions at home and abroad. Many groups employ investment professionals with prior experience at leading international investment banks and financial institutions.

Importance of listed securities. From time to time, Russian investors target listed securities, accumulating sizeable minority positions with the goal of a later sale to another party with a strategic interest in the asset. This trend has led to a shrinking supply of listed equity securities, which in turn has contributed to the Russian stock market's rise this year.

Limited investment experience. In general, Russian investors have had an extraordinarily intense, but short investment experience. This could prove challenging when working with troubled portfolio companies or attempting to create value by enhancing operational or financial efficiencies. In addition, because many Russian investors have strategic interests in their assets, they have limited experience managing private equity portfolio risks through asset allocation.

Willing to employ outside advisors. Russian investors have recognised the advantages of employing outside technical advisors, including accounting, legal, and finance professionals. Outside assistance may become increasingly important as financial markets mature and investors look to financial engineering to drive returns.