One step back, two steps forward

More than half a decade after Russia's financial crash, which sent domestic income levels plummeting, cut the country's GDP in half, caused the central bank to default on its debt, and sent investors fleeing to greener pastures, private equity firms are nudging the great sleeping bear from its economic slumber. The Yukos affair of last year, viewed by many as a Kremlin attempt to consolidate its hold over business leaders, failed to frazzle investors.

Good news came in September, when Standard & Poor's and Moody's credit-rating services announced they wouldn't change Russia's “investment-grade” status, which the country achieved in October 2003 to the tune of greater confidence to foreign direct investors and fresh capital inflows. Many analysts had been concerned about the potential market impact caused by the recent terrorist attack on a school in the southern Russian town of Beslan, in which more than 330 hostages, mostly children, died in explosions.

“What has happened in Russia in the past year has not had a significant impact on the business environment”, says Alistair Stobie, a partner at Moscow-based high technology venture investor DFJ Nexus. “There is a perception purveyed by the media, but that doesn't mean anything's really changed at the underlying level. Whatever has happened since Yukos hasn't changed the underlying business risk, or the ability of people to get things done. In fact, some things, like tax issues, have become easier to resolve”.

Russia today remains as paradoxical as ever. On one hand, the country is an attractive destination for Western private equity dollars. Western firms see great potential for adding value to existing Russian companies in the form of managerial talent and Western-style financial practices that encourage transparency.

Russia's emerging economy is blessed with a wealth of natural resources, undeveloped primary markets and a consumer base of nearly 145 million people. According to Russia's Economic Development and Trade Ministry, the country's GDP increased 6.9 percent year-on-year in January to September, with officials predicting year-end GDP at that same number.

However, economic growth in the third quarter slowed by approximately 60 percent, which the ministry attributes to a “significant slowdown in the rate of investment growth”. Furthermore, a Central Bank official reportedly said that Russia may overshoot its 10 percent inflation target by half a percentage point; analysts see inflation on average going up 10.9 percent this year.

Private equity exits are still tough and the legal system often impedes the business process, especially involving intellectual rights cases. Developing solid company infrastructures and improving corporate governance are pressing issues, and the power of local oligarch groups hampers deal flow. Russian companies take much longer to develop than their Western counterparts; private equity investors also encounter complicated logistical problems when deal-sourcing.

“It is difficult to find good companies here because there are not that many of them yet and because Russia is just so big”, says Andrei Terekhov, a managing director in The Carlyle Group's Moscow office, which opened earlier this year. “Unlike in Central and Eastern Europe, you cannot leave our Vienna office to visit a company in Hungary and be back home for dinner. Flying to the Russian Far East from Moscow takes as much time as flying to the US”.

But Russia is slowly becoming a breeding ground for private equity opportunities. More and more Russians of the younger generation are returning from abroad with Western educations and training. And in 2002 the US Russia Center for Entrepreneurship was set up to help entrepreneurs with networks to provide capital backing for their companies. DFJ Nexus's Stobie says that since Russia was shut out from Western innovation for much of the 20th century, Russian technology companies may even have different ways of approaching s imi lar universal technical challenges.

FUNDRAISING: ROUND TWO
However, despite these trials and tribulations, private equity operators and institutional investors say that things are improving. Though the total size of funds operating in Russia amounts to between $1 billion and $2 billion (€799 million and €1.6 billion), a few firms have achieved considerable success over the last ten years, creating a small community of managers who possess an acute eye for what makes the market tick and what cogs still need greasing.

Moscow-based Delta Private Equity Partners, formerly Delta Capital Management, is one of these veterans. Established in 1994 with financial backing from the US government, the firm's US Russia Investment Fund has distributed approximately $300 million (€240 million) to 44 Russian companies. The firm is currently fundraising for its first standalone vehicle and held a first close early this summer on $60 million (€48 million). A source close to the fundraising says the firm expects to cap the fund around $100 million (€80 million).

Patricia Cloherty, Delta's chief executive officer and chairman, says her firm has completed eight successful exits in the past 13 months, including selling two supermarket chains to local buyers; floating a beer company on the public market in Belgium and selling leasing company DeltaLeasing to rival Moscow-based private equity firm Baring Vostok Capital Partners.

Most recently in August, Delta sold off Visa credit card issuer DeltaBank to GE Consumer Finance, the global consumer lending unit of the General Electric Company, for $100 million (€80 million), making it one of the largest private equity exits in Russia thus far. Sales like this one, Cloherty points out, are making Russian private equity more visible, given the high capitalisation of the purchase to a large, public entity.

“All of the opportunities for private equity right now are the result of an emerging middle class for basic goods and services – they have experienced extraordinary growth, whether in cosmetics, flavourings or fragrances”, Cloherty says. “It's all about food, shelter and clothing. But because you don't have the technology risk in these companies, you take on the overriding market and political risk”.

Moscow-based Mint Capital, which invests in the Russian high technology sector, is also in the process of raising two new funds: one will focus purely on the growing Russian economy and the consumer markets; and the other one is being raised in conjunction with Silicon Valley venture firm Draper Fisher Jurvetson and will also focus on technology investments. The two funds are expected to close at the end of this year or early next year, according to a source close to the fundraising. “The firm has been working on gathering capital for a while, but raising money for a Russian fund is still not easy – it's no walk in the park”, the source said. Furthermore, much of the private equity capital coming into the country is still from foreign institutions.

LEVERAGE OR LACK THEREOF
Capital markets in Russia are much less developed than are those in Europe and the US. The absence of a fully-fledged banking industry has left Russia's corporate sector almost entirely unleveraged. As a result, private equity remains one of the only sources of long-term capital for a business, even in primary sectors such as consumer products, media and telecommunications. As a result, it is the primary markets where a majority of private equity firms active in Russia invest their money, as opposed to the niche industries that funds in Western Europe and the US often target. Private equity firms are able to find opportunities to buy or invest in companies with hard assets and significant cash flow, which in more developed countries would be able to raise much cheaper long-term debt financing in the credit markets.

“Even for attractive companies in Russia, long-term debt financing is still not an option”, says Mike Calvey, co-managing partner of Baring Vostok. “For these companies, if they're looking at growth plans, acquisitions opportunities or other financing needs of a long-term nature, private equity remains really one of the only sources of financing”.

Though Russian companies are having to contend with a significantly greater cost of capital, it also means their balance sheets are typically in good health. At the time of the currency devaluation in 1998, the fact that companies had few loans to repay helped them escape the potentially disastrous effects of the crisis more or less unscathed.

“[The crash] did not destroy the ability to repay debt because companies were not leveraged or underleveraged”, says Drew Guff, managing director and founding principal of New York-based private equity shop Siguler Guff, which has made forays into Russia. “As opposed to Asian companies who were wiped out with billions outstanding on their balance sheets, Russian companies were better able to weather the downturn”.

IN FOR THE LONG HAUL
Russia is all about long-term growth capital: those familiar with the territory say success comes to investors who have patience. “I think people who come in, come out and try to pick the best time to invest in Russia have all failed”, says Baring Vostok's Calvey. “Those that have maintained long-term commitments to the market and have laid down deep local roots have mostly succeeded”.

But long-term holdings need looking after by established, professional managers. Maria Kozloski, a principal investment officer at the World Bank's private sector arm International Finance Corporation (IFC), says that when her team decides on capital placements in Russia, it looks for managers that have a track record in the country as well as some experience with investee companies in the target market. IFC was one of the earliest investors in Baring Vostok's First NIS Regional Fund back in 1994, and backed the firm again in 2000 with $15 million.

Whereas in Western private equity markets investors have grow accustomed to quicker exits, Russia still has to deal with investors who come in with unrealistic short-term expectations. Russian private equity managers do see progress, but making sure foreign investors understand the market takes time.

Investors also need to be aware that exits are still hard to achieve. Given the scarcity of debt in Russia, companies have to focus on growth and can't rely on financial engineering.

“At the moment, you can exit via a strategic sale, a sale to a domestic group, or, more rarely, via dividends and international or local IPOs”, says Terekhov. “A virtual non-existence of the domestic IPO market is the main exit problem right now, although the successful closing of the Irkut IPO in March is an indication that this market has substantial potential”.

GOVERNANCE ISSUES
Other key concerns of private equity firms operating in Russia are transparency and corporate governance. Private equity firms in Russia are busy addressing governance issues by taking steps to protect their investments, such as installing new managers and independent boards to ensure that financial reporting is accurate.

“You need your own financial controllers to make sure people don't steal money ”, says Rustam Aksenenko, chief executive officer of Finartis, a Geneva-based investment bank with operations in Moscow. “If you have a transparent structure and financial reporting, it becomes very difficult to steal”.

Transparency not only helps when choosing what companies to invest in, but also when selling off portfolio holdings, especially when general partners hope to be able to sell companies to foreign strategic buyers. Delta, for example, gets audits for its problem companies and puts its financial director in to solve any issues. A more transparent company, naturally, is more attractive to foreign buyers.

MANAGING, NOT MONITORING
Baring Vostok's Calvey calls Russians “great innovators – though not necessarily great workers” when it comes to business operations. Ambitious and talented entrepreneurs often lack the business knowhow of their Western peers. “What a lot of these private companies need more than money is operational expertise or marketing expertise”, says IFC's Kozloski. “[Managers] are very hard to find in emerging markets anywhere. There are very few in Russia”.

Carlyle's Terekhov says that the local market of top managers is still pretty shallow, and the management dearth will be the biggest problem for both the economy and private equity in particular. “Only those private equity firms will succeed capable of creating pools of good managers will succeed”.

As a result, general partners need to stay close to their investments. “This is one of the specifics of the Russian private equity market, that to be successful you have to manage, not monitor, the investment”, says Vladimir Andrienko, managing director at Russia Partners, a subsidiary of Siguler & Guff. “It's not like in other countries, where you can just invest and monitor the growth of the company. In Russia you really are managing day-to-day operations for all major investments”.

DFJ Nexus's Stobie says that the tech companies he works with tend to be mature technologically and less developed in a corporate sense. “On the technology side, these are companies that are less operationally mature than you would expect to see at peer businesses in the West at the same stage”, he says.

Stobie adds that the business owners he encounters also need lessons in strategic planning to enable them to grow their companies. Often these business owners may not be familiar with private equity as a financing tool when coming into contact with GPs for the first time.

It's not difficult to understand why some small- and medium-sized Russian companies are wary of dealing with “big investors”. Redistribution of the country's oil and gas assets since the collapse of the Soviet Union has created a small vanguard of extremely well-capitalised Russian oligarchs looking to further expand their asset base in Russia. According to Kozloski, often times their objectives are strategic, and they are far from shy about booting managers to meet those goals.

Entrepreneurs often fear that private equity investors might approach a transaction equally aggressively. “The problem is that nobody wants to lose control of their company, but [business owners] want money”, says Finartis' Aksenenko. “They look at private equity firms as predators, when really they are coinvestors who want to grow the company, who want to make money as well”.

Oligarchs can also make dealmaking difficult for private equity firms, and not just by paying higher prices in an auction. Calvey says that when Baring Vostok was negotiating the exit of Syktyvkar, a large Russian industrial group surfaced and tried to buy the company without any competition. Only after weathering a series of legal attacks designed to discourage other potential buyers did Baring Vostok prevail. As Calvey says, private equity firms who want to invest in Russia require experience as well as “tenacity” to deal with these headaches.

NOT FOR AMATEURS
Russia to many remains a “two steps forward, one step back” environment. Nevertheless, incumbent players that have taken the time to build out their local networks see attractive opportunities going forward, though the risks involved – as in any emerging market – may not be for the faint of heart.

“Of course an investor can just invest his money in Treasury bills and sleep soundly – that's easy to do for a stable rate of return”, says Delta's Cloherty. “The people that are getting into Russian private equity, however, are extremely seasoned private equity investors in any geography they care to go into”.

Cloherty says that the government administration is committed to growth and enabling private equity investments – from corporate and individual tax-rate reductions, efforts to improve the court system and banking reforms -and keen not to destabilise the situation.

“The bureaucratic headache factor here is higher than it is in the developed world and the result is it's a tougher environment often for small enterprises to grow to become medium-sized enterprises”, says Baring Vostok's Calvey. “But those that do [succeed] tend to have a less competitive playing field than in other markets. As a result, they tend to grow faster and generate higher profit margins in Russia than almost anywhere else in the world”.