Don’t waste a good crisis

Doing business in Russia’s private equity market can be likened to one of the country’s fairy tales. The hero searches the inside of a warm house full of hidden treasures as strong winds rage around the eaves on a dark and stormy night.

Dmitry Schuetzle, Moscow-based managing director of VIYM, a $400 million private equity house specialising in Russia, puts it succinctly: “Now is not such a good time to exit. But it’s also true that it’s a very good time to enter.”

Russia is certainly subject to the strong winds of economic turbulence.

“Russia is in a serious economic crisis, which is probably three-quarters about the oil price and one-quarter about the political fallout from the Ukraine conflict,” says Michael Calvey, senior partner at Baring Vostok Capital Partners, the Moscow-based investment adviser to the Baring Vostok private equity fund, which invests in Russia and other former Soviet Union countries.

Brent crude oil futures were trading at only $48 a barrel in early September, down from $116 in June 2014. This drop has plunged Russia, a large net oil exporter, into recession, exacerbated by economic sanctions from western nations over the country’s role in the civil war in Ukraine.

The recession presents a paradox, however. On the one hand, it has undoubtedly slowed deal flow. In the year to late August Preqin, the data provider, had recorded only five transactions worth $200 million – a fraction of the $4.2 billion, in 22 deals, recorded in 2013. Fundraising has totalled $929 million this year – a small amount compared with many other emerging markets, though this reflects the historically small size of Russia’s private equity industry as much as the cyclical downturn in investment.

On the other hand, GPs and their advisers are enthusiastic about the current buying opportunities.

This paradox can be understood partly in terms of the highly selective approach taken by general partners. 

“The overall Russian economy is not doing so well, but particular sectors and niches are not so bad,” says Schuetzle. He recommends avoiding sectors exposed to the economic cycle, such as cars.

For VIYM, a promising non-cyclical sector is food, the ultimate consumer staple. The firm is looking for further opportunities in this sector, following the April sale of its minority shareholding in Agro Alliance, a packaged cereals producer. The sale to one of the company’s existing, unnamed, shareholders ends a five-year investment.

Calvey argues that growth in some sectors may even have been accelerated because of Russia’s economic problems. He cites ecommerce, which offers cost savings for cash-strapped businesses, and private healthcare, which is gaining from the Russian government’s cuts in public services to meet its new fiscal challenges.

In 2012, Baring Vostok invested in Avito, Russia’s largest online classified advertising platform.

Another investment strategy is to profit from the sanctions imposed on Russia by buying businesses engaged in “import
substitution” – producing agricultural commodities that must be sourced internally because they can no longer be imported from the West.

Yuri Soloviev, first deputy president and chairman of the management board of Moscow-based VTB Bank, which is majority-owned by the Russian government, says businesses in this field can be bought at multiples of only two or three times EBITDA.

He acknowledges that buying into companies benefiting from import substitution is a risky strategy: “Some of these companies will definitely perish or be in a difficult situation if sanctions end.”

However, “other companies will be able to renew themselves and survive in the long-term by investing in technology”. 

Analysing the overall situation, Soloviev says: “In a period of economic volatility and a shortage of alternative sources of capital for companies, private equity investing can generate premium returns.”

Another explanation for the paradox between GPs optimism and the trickle of recent deals is that the best opportunities are yet to come.

“Usually the sweet spot for investing is about a year or two after the big event of a major crisis – not in the months afterwards,” says Calvey. “Owners’ expectations of pricing in the immediate aftermaths of a crisis are still anchored to pre-crisis assumptions – it takes a while for them to adjust.”

From the opposite perspective, “investors also want visibility about potential target companies, and this visibility deteriorates a lot at times of volatility”.

Most observers date Russia’s economic crisis to September 2014, when the rouble started plunging in response to the sharp drop in oil prices – falling from 37 to the dollar to 69 within a few months. According to Calvey’s rough timetable, this suggests that Russia should soon be entering the “sweet spot” for general partners.

Investors willing to do private equity deals in Russia in the coming months and years have a further reason to press ahead: the Russian government has been quietly doing the spadework to make the legal backdrop more attractive.

In the past, “Russian laws didn’t reco-gnise many of the typical private equity concepts like option agreements, warranty and indemnity”, says Mark Geday, partner in the Moscow office of Herbert Smith Freehills, the international law firm. However, “ironically, the law has become more favourable towards those sorts of things just at a time when investors have become more pessimistic about the market”. 

But regardless of how promising the environment may appear for transactions – for certain sectors, at least – it remains distinctly challenging for exits. Initial public offerings are much harder to do because of the crisis. Many multinationals do not currently want to buy into Russian companies through private equity trade sales and the depreciation of the rouble has greatly decreased the dollar value of exits.

However, satisfactory exits are not impossible. Schuetzle says his firm realised a return on Agro Alliance that was “slightly more than double our investment”. Baring Vostok sold its stake in Europlan, Russia’s largest auto-leasing company, to BinBank, a Russian bank, in September, at a price roughly three times its costs in dollar terms.

“We continue to pursue exits when attractive opportunities arise, but we’re not rushing to sell assets in today’s environment,” says Calvey. “For the most part it’s a buyers’ rather than a sellers’ market.”