Russian resistance

In the year to July 2008, Russian private equity exploded. The aggregate value of the 32 deals done in the period was $2.7 billion: almost seven times larger than the previous 12 months. International private equity firms piled into a market, which like many of the other Commonwealth of Independent States (CIS) nations and their neighbours in Central and Eastern Europe, presented a newly stabilising economy, domestic growth and a wealth of untouched growth investment opportunities.

UK-based private equity firm Lion Capital teamed up with Goldman Sachs to pay $600 million for Russian Alcohol Group in May, just nine months after setting the record for Russia's largest-ever leveraged buyout – the $700 million acquisition of juice manufacturer Nidan Soki.

TPG trumped this when it bought 50 percent of pharmaceut ical company SIA International for $800 million in April, while Finnish alternatives investor CapMan established its foothold in the Russian market by buying domestic private equity firm Norum.

A new faith had blossomed within the Western investment community regarding Russia's economic and political stability and newfound transparency.

But that was more than six months ago. Since then, the apparent battle for control of energy joint venture TNKBP between the Russian and British shareholders has been feasted on with relish by theWestern media, conjuring up images of Soviet bureaucracy, corruption and intimidation.

In August, tension with neighbouring Georgia escalated into fully fledged conflict. The US said Russia's actions put it on a “one-way path to isolation and irrelevance”. President Medvedev replied that his nation is being forced back behind a “new iron curtain” by theWest.

A July report from the Emerging Markets Private Equity Association (EMPEA) had suggested that “perceptions of investment risk in CEE and CIS have improved,” but conceded that “enforcement of legal protections and treatment of investors still varies from country to country”.

In this year's EMPEA limited partner survey – also conducted in July – Russia ranked just eighth out of ten emerging markets in terms of which ones limited partners view as offering the most attractive investment opportunities.

Does this mean LPs are getting spooked by what they read in the news? “Of course investors get scared,” says chairman and chief executive of Moscow-based Delta Private Equity Partners, Patricia Cloherty. “Sovietologists who made their careers during the Cold War will swing into action when something like [the Georgian conflict] flares up.” Delta is currently seeking $500 million for its third fund.

Aurora Russia is a Russia-focused fund listed on London's Alternative Investment Market, and its share price provides a useful window on investor sentiment. In the last year its shares have lost 80 percent of their value, despite a robust performance from its portfolio, with 77 percent of that loss being recorded in September and October. Trading at a discount of 86 percent to net asset value, Aurora's shares have had a hard time even by the low standards of other listed private equity vehicles.

But not all investors are easily deterred. Via its 2009 emerging markets fund of funds, US-based Adams Street Partners is mandated to invest as much or as little as it sees fit in Russian funds. As such, it can be seen as a good measure of whether LPs are easily scared off by news reports. “There is an opportunity in Russia, and recent events have not impacted us,” says London-based partner Lucy Nicholls, who does not rule out increasing the firm's Russian exposure in the near future.

Those joining Delta on the fundraising trail at the moment include Troika Capital Partners, the private equity arm of Russian investment bank Troika Dialog, which is looking to garner $850 million, and Russian asset management group UFG, which is targeting $500 million for its second fund.

Vladimir Kozlov, a director at Troika, suggests that once LPs are comfortable with Russia, they continue investing. “It seems that there are two radical perceptions of Russia and Russian risk. Some investors understand it and continue investing in the country and others just want to stay away from it,” he says.

Gert Tiivas, managing director of Stockholm-listed private equity fund East Capital Explorer, believes that investors have always had a distorted view of Russia. “Now that the political risks have come to the fore, people tend to forget the strong points of the market. We have seen a 180-degree turn in the way investors view the Russian market. People were over-positive, now it is the opposite – both extremes are wrong.”

Exuberant private equity investment in Russia during the first half of 2008 perhaps made the market look more developed than it really is. “It is new and fragile and finding its way, like the banking system, the stock market and the government,” says Cloherty, who points out that there is less private equity money under management in Russia than in some individual funds in mature markets.

Russia is not a market into which international firms can just walk without a local guide. “The business culture is still in formation – the rules of the road are not yet clear – and the language barrier is significant,” says Cloherty. The market's opacity is exactly what makes it appealing to those on the ground. “International players find it harder to crack, and the opportunities are better for this reason,” says Aurora director John McRoberts.

The suggestion among local GPs is that while internationally Russia is perceived as an increasingly risky environment, nothing has changed when it comes to doing business there.

“Russia has been misunderstood,” says McRoberts, adding: “The Georgian conflict, it seems, was misrepresented and misunderstood by the Western media. BP TNK appears to have been blown out of proportion. The business environment is fine. If you know your way around the market, know how to invest and how to structure deals, it works.”

“Having been in the region for a certain amount of time, you know who to deal with and what to stay away from,” says Tiivas.

When it comes to mitigating political risk, GPs in Russia unanimously stay away from “strategic assets” – namely those in the oil and gas sector and other natural resources – and concentrate on fragmented markets which will benefit from growing domestic demand, such as retail and financial services.

Cloherty points out that in terms of investment infrastructure, the progress that Russia has made in the last 10 to 15 years has been miraculous. When she began investing in the country, there was no such thing as wire transfer. Transactions could involve suitcases full of hard currency and many of the Russian entrepreneurs she dealt with learned how to do business by watching 1980s Hollywood film Wall Street.

Listening to Michael Katsnelson, head of Quadriga Capital's Moscow office, it is clear that Russian GPs have the same immediate concerns as their counterparts around the globe, i.e. taking care of portfolio companies. “Six months ago it was all about increasing market share. Now we are all thinking about cash flow,” he says.

It is widely accepted that the Russian economy has not been decoupled from slowing Western economies, but GPs are hopeful that adequate foreign currency reserves and low levels of borrowing – Cloherty describes it as a “money-inthe-mattress economy” – will stand it in relatively good stead to brave the storm. With the World Bank forecasting economic growth of 6 percent this year and 3 percent in 2009, the optimism could be justified.

“The risks on the ground are nothing like how they are perceived from outside of the country. The legal system is not perfect, but it is a different world from how it was. Today you have full service accounting, legal and wire transfer capabilities.”

Patricia Cloherty, chairman and chief executive officer, Delta Private Equity Partners

“In thesemarkets you have to be long termand you have to be well diversified. We tend to stay away from certain sectors which are of ‘strategic importance’ to the Russians and therefore tend to be more politically vulnerable. Having been in the region for a certain amount of time, you know who to deal with and what to stay away from.”

Gert Tiivas, managing director, East Capital Explorer

“It's generally accepted now that you cannot separate the emerging markets from the developed world. That said, Russia has strong reserves and has been lucky with the oil price. Ironically because Russia was less able to borrow than other countries it is now in better shape to weather the storm. Mortgage borrowing constitutes around 3 percent of GDP compared to about 40 percent in the UK.”

JohnMcRoberts, director, Aurora Russia

“As we described in ourApril letter, the problem of corporate “raiding” is now so endemic in Russia that President Medvedev speaks about it as one of the biggest problems faced by Russian businesses. In this case, raiders have taken this problem to a new and absurd extreme by “raiding” the Russian state and so far getting away with it. It is hard to predict what will happen next in this unfolding and unbelievable saga, but as always we will keep you updated on any further developments as they arise.”

Extract froma July letter to investors froma Russia-focused fundmanagement company that claimed to have been the victim of corporate identity theft