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Russian private equity: right time, right place?

Just a couple of years ago, few investors would have touched Russia. Now, largely untainted by the new economy boom that has affected Western economies and with economic reforms starting to take effect, Russia is looking increasingly attractive. And, as one of the few financing options available to fledgling companies in this huge market, private equity looks set to reap the benefits, says Nikoil's Steve Geiger.

What a difference a few years can make. In 1998 and 1999, Russia was a pariah in the international investment community. The country had defaulted on its government bonds and foreign debt obligations. Its banking system lay in ruin. The stock market dropped over 80 per cent and while the ruble-dollar exchange rate shot from six to 24. Meanwhile, Western economies were booming, both private equity and public markets were soaring to giddy new highs, and novel theories and valuation methods seemed warranted by a ‘new economy'.

Fast-forward a few years. Far removed from the current bloodbath in Western investment circles, Russia is bathing in good news. The years 2000 and 2001 have brought: GDP growth of 8.3 per cent and 5.5 per cent; a soaring trade balance; a tripling of hard-currency reserves, yes tripling, despite heavy debt repayments; stabilisation of the ruble; containment of inflation; and the first balanced budgets in its ten-year post-Soviet history. Not a bad performance.

Political achievements have been no less dramatic. A vigorous new president and a co-operative legislature have pushed through an impressive slate of reforms, including: extensive changes in the civil, labour and criminal codes; reduction of the corporate turnover tax from four per cent to one per cent; reduction of corporate income tax from 35 per cent to 24 per cent; reduction of personal income tax to 13 per cent (Europe's lowest); a new land code; a new law on judges; reduction of excise taxes; and streamlined import tariffs. And even more is expected to pass in 2002.

Not surprisingly, many Russian companies are flourishing under such improved economic and political conditions and require additional capital to develop. Yet external sources of capital remain scarce: 85 per cent of investments made by Russian companies is financed out of existing cashflow, compared to only seven per cent in the UK. Commercial credits, debt and public equity markets remain largely unavailable for most companies in Russia.

In this environment, private equity is uniquely positioned to drive company growth (and profit from it). The opportunity for exceptional upside is driven by a number of key factors.

First, asset prices remain very low as most Western equity investors have yet to fully appreciate Russia's dramatic turnaround. It is possible to earn healthy returns simply by exploiting the gap between perceived and real levels of Russian risk. Many investors might be suRprised to learn that Russia's 2003 Eurobond is currently yielding 6.6 per cent, down from 14.8 per cent at the start of the year; the 2007 Eurobond is yielding 10.2 per cent, down from 16.8 per cent in the same period.

Second, the lack of alternatives to private equity financing provides substantial buy-side strength in negotiations with target companies. The 1998 financial crisis was therapeutic in that many Russian businessmen now realise that investment capital is limited and investor demands such as transparency, accountability and proper governance must be met. Additionally, in many competitive sectors where access to expansion or acquisition capital is critical for survival, giving up equity early may be smarter than having to give it up later (being acquired).

Third, limited competition exists from the small handful of funds active in the market. Therefore, private equity investors in Russia rarely find themselves in auction situations or facing serious competitors. Contrast this to Central Europe, where 40 or more funds are bidding for assets in countries smaller in population than the city of Moscow alone.

Fourth, the most attractive Russian investment opportunities are usually available only via private equity. The majority of listed, liquid Russian companies are large energy or metal groups or natural monopolies whose substantial cashflows and access to capital minimise any need to share wealth or control with a private equity investor. Conversely, with a small or medium-size enterprise, an investor is likely to receive better economic terms as well as the control necessary for introducing difficult but necessary value-building changes.

Investor interest in Russia is largely driven by its two key assets: a huge natural resource base and a large technological and intellectual capital base. Russia is the world's second-largest oil producer (producing only four per cent less than Saudi Arabia), and produces 33 per cent of the world's natural gas, 20 per cent if its nickel, 23 per cent of precious-group metals, eight per cent of steel, and owns 22 per cent of the global timber reserves. These industries provide a vast universe of growth opportunities for local providers of goods and services, particularly those able to introduce significant cost reductions or efficiency gains.

Technology resources are equally impressive, with Russia's scientific infrastructure and personnel among the world's largest. Even more impressive is that despite a collapse in R&D and educational spending and the brain drain of the 1990s, Russia still produces more university graduates in engineering and natural sciences than Japan, India, China, or even the US.

This intellectual horsepower is increasingly sought after and offers broad opportunities for private equity investors, particularly in software and IT, industrial technologies, telecommunications, and biotech. It also highlights Russia's considerable potential for rapid development now that the framework for a modern economy is being put in place.

However improved the investment environment may be, Russia still remains a very tricky place to invest. But following a few basic rules can greatly enhance a private equity investor's probability of success:

1. Russia is unique. It is not just another emerging market. It poses unusual challenges that require specialised skills and knowledge.

2. Russia requires a hands-on approach. Each private equity investment requires much more time and effort to manage than elsewhere. This reduces the number of investments that a manager can successfully handle. The more passive approach common in the West is a clear recipe for disaster in Russia.

3. Control is king. Minority investments have a long record of failure in Russia. Shareholdings of less than a blocking 25 per cent+1 share should be avoided, while controlling stakes are desirable.

4. Have truly aligned interests. Most successful investors are able to view a deal through the eyes of their Russian partner and understand the various risks, threats, motivations, emotions and time frames from a Russian perspective. A hypothetical IPO in five years may not totally motivate your Russian partner, so you need to find out what does.

5. Build in structural impediments to bad behaviour. Russian legal and regulatory systems are still in their infancy and alone do not provide sufficient investor protection. However, with creative deal structuring, an investor can build in additional legal, financial, and technical mechanisms that compensate for these inadequacies and provide a healthy level of investment protection.
 
Despite the additional difficulties, Russia will undoubtedly become a prime destination for private equity over the next few years; its turnaround has been impressive and its asset base is simply too cheap and too large to ignore.

This process will be boosted by a fundamental re-think in East-West relations made possible by the post-11 September solidarity and co-operation shown by Russia with the West in the fight against terrorism. With the political and economic dividends that are likely to follow, Russia can accelerate its full integration into the Western community of nations by at least five years. So far, everything indicates that the Russian political elite intends to do just that.

Steve Geiger is director of private equity for Nikoil, a leading private bank in Russia. He has 11 years' experience in Russian direct investment and previously held senior investment positions with Marc Rich and Rosprom-Yukos, one of Russia's largest financial-industrial groups. He was educated at MIT, Harvard and the Wharton Graduate School of Business. Please contact sgeiger@nikoil.ru