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Private equity in Russia

The opportunities for investors prepared to take a risk by allocating cash to a Russia-focused fund are boundless, argues Holly A Nielsen of Debevoise & Plimpton. Private equity firms are already increasing their presence in the area, and for the first time individual Russian investors are making significant contributions to private equity funds.

While in the United States vast amounts of capital overhang the private equity marketplace making it a challenging arena for investors looking for deals, the scene in Russia provides an interesting contrast. Not yet overcrowded, the site of increasing fundraising and full of challenges, the Russian marketplace represents a bold new frontier for private equity investing.

Russia's market economy is a nearly a decade young this year, and has matured from a shaky transitional economy to a growing emerging market. The federal budget posts a surplus; public debt has been reduced from 94 per cent of GDP in 1999 to 42.4 per cent in mid-2003; and the economy has enjoyed sustained growth of between 4.3 per cent and 9.0 per cent for each of the past three years. Since July 1994, more than 70 per cent of the country's economy has been in private ownership (today the figure is about 80 per cent), and the government continues each year to sell off its remaining stakes in major companies. Under the energetic leadership of President Putin, the legislature has adopted a favorable Tax Code, the government has approved a corporate governance code and is pursing judicial reform and difficult structural reform of the natural monopolies. Russia's accession to the WTO seems likely to occur during the next few years. 

On a micro-economic level, Russia has the most developed equity capital market among the countries of central and eastern Europe, and will be the region's financial center. The Russian equity market accounts for about 2.5 per cent of the Morgan Stanley Capital International index (MSCI), compared with a 1.4 per cent weighting for Poland, 0.8 per cent for Hungary and 0.3 per cent for the Czech Republic. The market capitalization of Russian equities has increased more than three-fold in the past two years to about $143.5bn in April 2003, and daily trading volumes of Russian equities in domestic and foreign markets fluctuate from $300m to $600m - almost six times the level of Poland's stock market. The RTS (Russian Trading System) index was up 91 per cent in dollar terms in 2001, 34 per cent in 2002 and is up a further 23 per cent for the first four months of 2003, making the Russian stock market one of the best performing markets in the world.
Because of these positive economic statistics and maturation of the Russian market, the level of interest in private equity and venture capital is up sharply this year. Baring Vostok Capital Partners, a subsidiary of Dutch ING Baring Group, closed a $205m private equity fund in January 2002 earmarked for investments primarily in Russia. The European Bank for Reconstruction and Development (EBRD) has plans to launch up to four additional private equity funds for Russia. For the first time, Russian individual and institutional investors are making significant contributions to private equity funds and there is growing interest among Russian financial institutions in sponsoring funds.

History
An early surge of investment fund activity followed the end of Russia's mass privatisation programme in 1994, which lasted until 1997 raising approximately $3bn, of which roughly $1bn remains uninvested. There are currently about forty Russian direct equity funds, with an average size of approximately $100m. Of these funds, about one-quarter were formed with public or quasi-public funds, such as the eleven regional funds created by the EBRD, and the $440m US-Russia Investment Fund established in 1995 with funds provided by the U.S. Congress. The remainder of these funds have private sponsors such as PaineWebber Mitchell Hutchins (now Russia Partners), SUN Group, AIG, ING Barings Group, Framlington and Daiwa. These funds target investments in a wide variety of sectors, including natural resources, wood and paper, communications, media, high-tech, consumer goods, pharmaceuticals, transport, distribution, real estate and services.

Not all of these funds have been equally successful, but some managers claim to get average annualised returns as high as 70 per cent on a significant number of their investments. An IRR in the range of 20 per cent-30 per cent may be realistic over the next decade for the best managed Russian direct equity funds.

Issues
The challenges for Russian private equity funds are significant. The first challenge is finding companies that meet investment standards. Although business opportunities in Russia seem unlimited, few companies have experienced managers, business plans, audited (or even unaudited) financials prepared in accordance with GAAP or IAS, transparent ownership structures, organised corporate records, or even properly documented title to their assets or contractual arrangements with suppliers, vendors and customers. The business environment of the early 1990s in Russia encouraged capital flight, tax evasion and 'grey-market' operations. Ten years of market experience and international market integration, consolidation of ownership, accounting reform and a new Tax Code have begun to make a difference, but identifying investment targets and completing due diligence is still a time-consuming exercise.

There have been plenty of ownership disputes and corporate governance horror stories over the years in Russia. Company law and securities regulation are now comparatively well-developed and progressive in their protection of minority shareholders. In April 2002, the Russian Securities Commission and the government adopted and published a Corporate Governance Code, which will provide another stimulus for increased transparency and better management. However, bureaucratic corruption, the mentality of secrecy and a less-than independent judicial system remain. Mentalities are evolving as businessmen learn the value of high stock prices, and the President has announced ambitious plans for reforming the judiciary and the civil service. These reforms will all take some time.  

Exits are also a challenge. Despite its relative importance vis-à-vis other central and eastern European financial markets, liquidity is still limited on the Russian capital markets. Out of about 250 companies listed on the RTS, only ten stocks are actively traded. IPOs are still rare - only five Russian companies have listed securities on the New York Stock Exchange, and one on the London Stock Exchange. Although IPOs and management buy-outs will provide some avenues for exit, the most realistic exit strategy in the short to medium-term is sale to a strategic investor.

Foreign private equity funds that enjoy little competition in central and eastern Europe face tough competition in Russia from domestic industrial groups which often play the role of venture capitalists. Russian private funds also face stiff competition for foreign institutional monies from hedge funds investing in portfolios of non-control positions in Russian public companies. More than twenty Russia-invested portfolio funds were created in the mid-1990s which now range in size from $5m to $432m under management. At least six of these are open funds listed on the New York Stock Exchange. During 2001, these funds had annual returns ranging from 47 per cent to 124 per cent.

Structure
Russian laws related to investment funds are not yet developed sufficiently in their substance or in practice to make domestic funds attractive to foreign sponsors and investors. Russian private equity funds have all been established in jurisdictions other than Russia. The most popular jurisdictions have been Guernsey and Jersey for European sponsors and Bermuda or Cayman Islands for U.S. sponsors. A few funds (or parallel funds) have been formed under Delaware law for marketing to U.S. institutional investors.

The most typical structure is a partnership formed in a reputable, tax-advantaged jurisdiction; having a general partner and possibly a manager incorporated in the same jurisdiction; and a local investment advisor which is a Russian company or a foreign company with a branch office located in Moscow. Very often, investments will be made through investment companies established in countries such as Cyprus or Germany, which have favorable tax treaties with Russia minimizing the withholding tax on dividends, interest and capital gains.
The average investment for a Russian fund ranges from $5m to $50m, and involves buying at least a “blocking stake” (25 per cent plus one share) and often controlling interest. Experienced direct equity groups are able to manage the risk and increase the value of target companies through injection of new management, technologies and know-how.

The range of fund products available to investors remains extremely limited. To date, unrelated funds have invested in common or preferred equity of Russian companies. Management buy-outs have not been common, although there is a generation of young managers who will want to buy-out privatized companies they run. Acquisition finance has not yet developed in Russia, although there are no financial assistance restrictions or other legal inhibitions that should impede its development. 

Prognosis   
The challenges of private equity investing in Russia also bring opportunities for adding value. By injecting new management and training existing management, adding new technologies and know-how and providing much needed capital, private equity funds can significantly impact the profitability of a Russian business. As direct foreign investment continues to grow, opportunities for exit will also multiply. A small group of direct investment fund sponsors have developed experienced Russia teams with track records, who are now investing a second generation of funds. This circle no doubt will widen over the next couple of years as new foreign and domestic sponsors enter the market.

Copyright 2003 Debevoise & Plimpton

Holly A Nielsen (hnielsen@debevoise.com) is International Counsel.  Her practice focuses on the areas of corporate law and finance.  She is based in the firm's Moscow office.

Debevoise & Plimpton, an international law firm, was founded in 1931. The firm, which now has more than 500 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, DC, London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.

Reprinted with permission from The Debevoise & Plimpton Private Equity Report.  © 2002 Debevoise & Plimpton.  All rights reserved.  No portion of this article may be reproduced without the express consent of the authors.