Russia's emerging private equity market is growing up. Leverage levels are rising as deals become more mainstream and international interest grows. But investing in Russia is still a challenge for non-locals. Nicholas Lockley reports.

There is another revolution starting in Russia. For years private equity in the country has been synonymous with growth capital, local firms and the oligarchs. Now the leveraged buyout, along with international investment firms, has arrived.

London-based buyout firm Lion Capital made its first foray into Russia with the acquisition of Nidan Soki, a branded juice maker, in the country's first-ever leveraged buyout in August this year.

Terms were not disclosed, but a year ago executive director Olga Yeremeyeva said Nidan Soki was considering a public offering that would value the business at between $600 million (€411 million) and $700 million. The company recorded increased sales of about $270 million last year.

Nidan Soki was, until recently, the exception to the rule that Russia was synonymous with growth capital deals. But as PEI went to press, reports were emerging in the Russian business daily Vedomosti that Alexander Zanadvorov, the co-owner of the Sedmoi Kontinent supermarket chain and managing partner of several ventures in the commercial real estate market, was taking over rival chain Seventh Continent in a leveraged deal with the backing of US buyout firm TPG Capital and Nordea, a Nordic bank.

According to Vedomosti , Zanadvorov had acquired 50 percent plus one share of 7K Invest Holding which owns 74.81 percent of Seventh Continent, Russia's largest supermarket, and 50 percent of Mkapital, which owns most of Seventh Continent's real estate.

The deal size was $995 million and was funded with two facilities, one from Deutsche Bank of $560 million and the balance coming from Nordea. TPG Capital and Goldman were negotiating with Zanadvorov to acquire 60 percent of Seventh Continent.

These deals aside, anecdotal evidence also suggests that the use of leverage in Russian private equity deals appears to be on the rise. In law firm Squire, Sanders & Dempsey's survey of more than 200 fund managers, investors and lawyers at a conference in Moscow earlier this year, approximately 50 percent of respondents said they used leverage occasionally when doing deals. Approximately 30 percent responded that they or their clients use leverage frequently and 12 percent always use leverage. Only 8 percent said they never use leverage.

But leveraged buyouts happening regularly in Russia will remain unlikely for some time, particularly in light of recent volatility in global credit markets.

International private equity players have kept careful watch on Russia and the CIS for some time. In the past decade, the Russian market has grown substantially, with the number of general partners doubling and total assets under management soaring from less than $500 million to more than $5 billion, according to recent research published by Troika Capital Partners.

Alexander Pankow, investor relations manager at local buyout group Troika, says: “Russia has opened up. International buyout shops have arrived. TPG Capital is close to its first deal. Permira has been talking to people and the rumour is they will open next year.”

He says it is the beginning of a bigger story. Ten years ago, he says, the landscape was relatively sparsely populated with private equity firms – now it is looking relatively crowded.

Michael Calvey is co-managing partner at Moscow-based Baring Vostok Capital Partners, which has invested in Russia and the CIS since 1994. He says 95 percent of the private equity capital invested in Russia is owned by Russians, meaning the predominance of local investors has not changed in recent years. However, he also says: “What has changed is that the market has become more fragmented: we used to have ten large competitors – the oligarchs; now we still have the oligarchs plus about 100 much smaller investors. We see this as mostly positive, since more competition is good for the market in the long run.”

Drew Guff, managing partner of New York-based emerging markets specialist Siguler Guff, says the trend among managers as the market matures is for increased specialisation among the more experienced players. He says: “We will continue to see the phenomenon of the large getting larger and the strong getting stronger. It not surprising, for example, that the list of top VC firms in Silicon Valley is largely the same list as 10 years ago. What's changed is that those firms today are more specialised and more knowledgeable than their predecessors.”

Chris Rose, an attorney at Squire Sanders specialising in venture capital and private equity transactions in Russia, adds: “As managers get more sophisticated, more will want to do a buyout.”

He says deal types are also changing and average deal size is going up. In the past, Russian entrepreneurs were just looking for a quick profit, but now they are taking a more long-term view.

“Private equity has become like a doctor of Russian corporates. Governance and transparency tend to be a disaster. Private equity comes in and cleans up.” In the end, portfolio businesses look like very different.

Rose says this dovetails neatly with the latest Russian trend of companies going public. Stock market listings of Russian companies are now regularly taking place both at home and abroad. Guff says this is essential for the recirculation of capital back into an economy.

He adds: “I think the next five years will show that the stock markets and debt markets in the large developing economies – Brazil, Russia, India, China – will continue to expand. Some of this growth will be in home markets and some will come from companies seeking a listing outside their home markets, such as in London or New York.”

But for some Western firms, Russia is still too much of an emerging market to be part of an investment thesis. Thierry Baudon, managing partner of Central and Eastern European investment firm Mid Europa Partners (see Privately Speaking, page 50), says: “Russia is complicated. It's impossible to operate in Russia without being there. We did a deal there with Pilkington in 2002. We wouldn't be able to do that deal now. You need to know which sectors are open for business for Western investors as opposed to oligarchs only. And you find that things are very different from one region of the country to another. It was possible to invest ten years ago in regions where today it is impossible to invest. I would say that many sectors are off limits. It is a true emerging market, unlike some countries in the CEE region which are beginning to shake off the emerging tag.”

The market's enthusiasm for deals in Russia is tempered by partnership challenges. Respondents to Squire Sanders' survey indicated that untrustworthy partners, principals and shareholders in portfolio companies create the primary reason for writing off deals.

In addition, Russia still has some way to go as far as international fund investors are concerned too.

A survey by the Emerging Markets Private Equity Association (EMPEA) shows Russia is running about 20 percent behind emerging Asia when it comes to limited partner commitments within the last five years, but well ahead of Latin America, the Middle East and Africa.

For those investors and managers who are bold enough, Russia's growing economy and burgeoning middle class has created a booming consumer sector. Nearly 25 percent of Russian private equity investment focuses on retail and consumer businesses.

The media and telecommunications sector is also a strong magnet for private equity investment, followed by financial services, real estate and technology.

Predictably, given heightened awareness of political risk, private equity has so far not invested heavily in natural resources, according to the survey's results.

But even this sector is far from forbidden fruit. First Reserve, the US oil and gas-focussed buyout firm, is hunting for its first Russian deal, albeit in partnership with a local operator. Its approach underlines that the opportunity in Russia is not all about capital. Expertise combined with an international perspective is attractive in a land where money is cheap.

Neil Huntley, a partner at the firm, says: “We bring relationships or specific knowledge of how the investment case works. We minimise the risks of deal execution by partnering.”

It is a model that surely more buyout firms will pursue as the Russian market becomes ever more attractive.