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CIS Private Equity Report14/11/2007. Source: Squire, Sanders & Dempsey L.L.P., C5.
 The use of leverage in Russian private equity deals appears to be on the rise, according to the results of a recent Squire, Sanders & Dempsey L.L.P. and C5survey of industry experts. However, widespread use of LBOs will likely remain unexplored territory for some time, particularly in light of recent volatility in global credit markets.
C5 and Squire, Sanders & Dempsey L.L.P. surveyed the more than 200 fund managers, investors lawyers and journalists who attended the 2007 C5 Private Equity and Venture Capital Forum in Moscow for their views on the rapidly evolving private equity market in Russia and the CIS.
The results provide a useful snapshot of the industry’s experiences and expectations in Russia and the CIS at a time when private equity has growing interest in new markets. Participants weighed in on a wide range of issues including investment sectors targeted, typical investment size, stage and investment period, exit opportunities and what factors prompt write-offs.
Private equity players have kept careful watch on Russia and the CIS for some time. In the past decade, the industry in Russia has grown substantially, with the number of general partners doubling and total assets under management rocketing from less than US$500 million to more than US$5 billion, according to recent research published by Troika Capital Partners. A survey by EMPEA indicates that Russia is running about 20 percent behind emerging Asia when it comes to limited partner (LP) commitments within the last five years, but well ahead of Latin America, the Middle East and Africa.
According to the survey results, most Russian private equity/venture capital deals tend to be early or expansion stage, with buyouts only starting to emerge. Lion Capital’s recent acquisition of NidanSoki, alternately billed as the first and/or the largest LBO in Russia, exemplifies the nascent state of leveraged buyouts. Public commentary on the Lion Capital deal focused on ways the deal is the exception to the Russian rule for private acquisitions. That said, increasing incidence of buyouts seems inevitable given the desire for diversified exit opportunities and an evolving and increasingly sophisticated management class.
Nevertheless, in order for buyouts to become a fixture of private equity in Russia, as they are in more mature markets in the West, the accessibility and use of leverage in transactions will need to increase dramatically. While difficult to draw any reliable conclusions from this data, it is noteworthy that approximately 50 percent of survey respondents stated they used leverage occasionally when doing deals. Approximately 30 percent responded that they or their clients use leverage frequently, 12 percent always use leverage and 8 percent never use leverage.
The survey demonstrates that Russian LPs are becoming an important source of capital for Russian private equity funds. Approximately 34 percent of those who responded stated they are raising capital in Russia/CIS. Compare this to the results of a survey conducted by the Russian Private Equity and Venture Capital Association (Yearbook 2006) which indicated that in 2005 the proportion of Russian capital was 22 percent. Despite increasing commitments from within Russia, European and North American LPs continue to be the primary source of funding for private equity in the region. Approximately 30 percent of respondents indicated Europe as a resource for capital and just under 25 percent tapped North America for capital. Investors based in Asia and the Middle East do not yet represent a major source of funds – both pegged in at approximately 5 percent.
Given Russia’s growing economy and burgeoning middle class, it is no surprise the consumer sector is booming, with nearly 25 percent of Russian private equity investment focused on retail and consumer businesses. (Russia closely trails top-ranked India in the 2007 Global Retail Development Index, published by A.T. Kearney.) The media and telecommunications sector is also a strong contender for Russian private equity investments, followed by financial services, real estate and technology. Predictably, given heightened awareness of political risk, private equity does not invest heavily in natural resources, according to survey results.
The snapshot provides some perspective on deal size, deal stage and investment period. Approximately 25 percent of respondents have done or are doing deals valued at more than US$20 million; just over half of the stated deal sizes are US$10 million to US$20 million. This is relatively small compared to private equity deals in other markets, but deal sizes are anticipated to grow, particularly as fund sizes and Russian businesses continue to grow.
The market’s enthusiasm for deals in Russia, however, is tempered by partnership challenges. Survey respondents indicated that untrustworthy partners, i.e., principals and shareholders in portfolio companies, create the primary reason for writing off deals. Other leading reasons for deal writeoffs are lack of added value or lack of financial control, followed by weak deal structure and macroeconomics. That said, control over the investment is not always a priority, according to survey respondents. Approximately half of those responding said having control as a prerequisite depends on the deal or company, while the remainder is split down the middle by those who require at least 50.1 percent of the company when making an investment and those who are comfortable being a minority.
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Those surveyed indicate they anticipate an average rate of return of 35 percent, with half of those responding anticipating a 25 to 35 percent rate of return and 26 percent of those anticipating a 45 percent or more rate of return.
The outlook for exits, a key private equity indicator, generally seems positive from the perspective of our industry experts. A wide majority of those surveyed – 73 percent of those responding to the question – expect an improving exit market over the next 12 months. Exit timelines seem to be largely consistent with global trends; approximately 38 percent of those investing in Russia/CIS exited the market after more than four years, and most deals exited within two to four years.
Clearly, much of Russia’s private equity landscape remains uncharted territory. Foreign investors intrigued by the country’s growth and potential are cautiously mapping their routes as Russia and the CIS continue their evolution. Opportunity abounds in a country that Forbes recently reported has more millionaires in proportion to its gross national product than any other key economy. But so do challenges, which range from lack of transparency to macroeconomic concerns to links between government and business. But Russia and CIS are on the world economic map for good, and private equity needs to keep a sharp eye on the horizon for safe passage into a still-maturing market that has potential to move into the top tier.
About C5: For over 10 years, C5 (formerly Euroforum) have provided cutting-edge conferences, summits and congresses across Europe, Russia and CIS for all major industry sectors, the law, and emerging markets. Producing over 100 events a year, attended by thousands of senior executives worldwide, C5 provide delegates with the chance to meet, network and share information with colleagues from across the globe.
Founded in 1890, Squire, Sanders & Dempsey L.L.P. has approximately 800 lawyers in 30 offices and 14 countries around the world. Our lawyers have extensive experience in private equity and venture capital transactions in Russia/CIS and Central and Eastern Europe. For additional information on Squire Sanders private equity services in CEE/Russia/CIS, please contact Christopher Rose at +44.20.7189.8000 in London or +7.495.258.5250 in Moscow, or visit the firm's website at www.ssd.com
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