The changing Federation

The Russian landscape is set to alter beyond recognition and only the strongest will survive. Toby Mitchenall reports from Moscow

Asked how the financial crisis is affecting the man on the street, a Moscow taxi driver says things are not so bad. It turns out to be an interesting definition of “not so bad”: “Only about half of my friends have lost their jobs,” he says. Russian consumers are hurting. The rate of unemployment averaged 9.5 percent in the first quarter of this year, and reports of further business closures and job losses continue to make the headlines.

Dented consumer demand should give many Russian private equity players cause for concern. Ask a local GP about which sectors offer the best hunting ground and the response will certainly include consumer-related industries. The rapidly expanding middle class and increasing purchasing power over the last ten years has provided the thesis behind much of the local private equity industry's activity.

The nation's largest ever leveraged buyout by a consortium led by UK-based Lion Capital in 2008 – a notable transaction because it was so “un-Russian” in its size and structure – was for a consumer business, Russian Alcohol Group. At the smaller and more typical end of the market, it is still the hypothesis of growing demand fuelled by rising incomes and increasing consumer credit that drives the majority of investment decisions. The consumer-driven sectors of retail financial services, telecoms and consumer goods accounted for 83 percent of all private equity investments during 2008, according to data compiled by financial services firm KPMG.

Does waning consumerism mean private equity firms will look to other sectors? Given Russia's wealth of natural resources it would be logical to assume that energy and mining could provide a viable alternative. Depressed commodities prices mean that private equity firms willing to play in this space may be able to pick up some bargains. A survey conducted at the beginning of the year among private equity investors showed that 73 percent rated the energy and mining sectors as offering attractive returns for the coming year, while a slightly smaller number – 71 percent – selected consumer goods. But natural resources is a tough arena to play in given the government's unwillingness to hand the industry a free rein.

For example, once an oil and gas concern reaches a certain revenue threshold, it automatically becomes a “strategic asset” and can no longer be sold to a foreign buyer. That said, if you are starting with relatively small operations, the threshold is rarely met. Even if it is, there are normally plenty of domestic buyers, be they oligarchs or conglomerates such as Gazprom, the world's largest oil and gas company.

Perhaps the biggest challenge is to understand the rules of the game – if the rules even exist. There are numerous historical examples where the law has been circumvented or simply steamrollered, leaving once privately-owned assets in government hands. “If you want to work natural resources in any serious way, you need a $10 billion fund and Putin on your board,” says one experienced Russian GP.

High-profile disputes between the state and oil companies, such as Yukos in 2004 and, more recently, the bitter wrangling between the UK and Russian shareholders of TNK BP, cast a long shadow over anyone eying the sector. “When a business like BP – a company that by its nature makes its money in some of the toughest markets in the world – gets hauled over the coals, it makes an impression,” says Chris Allen, a Moscow-based partner at international law firm Latham & Watkins.

Perhaps it is the spectre of these incidents that means private equity has accounted for very little acquisition activity in the sector to date.

Leaving natural resources aside, it is very possible to navigate the Russian corporate environment safely, say local players – as long as you know who to deal with and who to avoid. In terms of corporate governance, Russian business managers and owners have come a long way in the last decade.

Hanna Loikkanen, a Moscow-based senior adviser at fund manager East Capital, contrasts the corporate reaction to current troubles with that experienced during the Russian crisis of 1998. “The rate of deterioration of corporate governance standards [in 1998] was rapid; everyone was busy preserving their own assets, putting them somewhere offshore,” she says. “Now there is a clear change. Even though there were some alarming signs of eroding corporate governance, it has not really developed into the huge issue it could have.”

This progression towards more robust corporate governance is part of a wider trend says James Cook, a Moscow-based director at Aurora Russia, a private equity fund listed on London's Alternative Investment Market. “Prior to '98 it was more of an asset land grab. Since then there has been an increased focus on building value,” he says.

But while strides have been made in terms of governance, Russian company law still remains bureaucratic and unwieldy to the extent that 90 percent of M&A deals are executed offshore, normally under the Anglo-Saxon legal framework of Cyprus. Latham & Watkins's Allen points to a proposed amendment to Russian limited company law that will require documents transferring interests in Russian limited liability companies to be reviewed and not arised by one of a very limited number of Russian notaries. “The implications are frightening,” says Allen. “It puts into the hands of notaries – who are not corporate lawyers – a degree of judgement over deal documents.” There is no clear benefit to the amendment for investors. It just provides another reason for deals to be taken offshore, says Allen.

A complicated business environment – due to a combination of excessive red tape, state intervention and patchy corporate governance – is one reason why international players which have tried to crack the market have frequently withdrawn. The Carlyle Group – the third-largest private equity firm in the world according to the PEI 300 – is the highest-profile example. In 2005 the firm effectively closed its Russian office, which had opened the previous year, and cancelled plans for a $300 million Russia-focused fund.

For this reason, international private equity firms tend only to operate in the country with a local partner as a guide, as was the case with Lion Capital's acquisition of Russian Alcohol Group. US-based Indigo Partners, an aviation-focused private equity firm, is at an advanced stage in establishing a joint venture with A1, part of Russian conglomerate Alfa Group, to launch a low-cost airline in Russia. While modest in terms of economics, such an investment by a US firm – particularly in a heavily regulated industry – would be almost unthinkable without the support of a local player.

Nowadays, international GPs have mostly withdrawn to focus on more pressing concerns and opportunities in their home markets. Russian firms, meanwhile, are spending time trying to ensure their portfolios survive the recession.

“We are doing a lot more portfolio management than in ‘peacetime’,” says one lower mid-market player, who, like most managers, is dedicating time to renegotiating bank facilities, putting in place cost-cutting programmes and helping rework budgets to account for an unsteady ruble.

Russians are probably more used to crises than anyone else but the boom of the last ten years has spoilt us

Giedrius Pukas

Elena Ivashentseva, a partner at private equity firm Baring Vostok, says that, while the firm is actively looking at new deals, the portfolio is the primary focus at the moment. She adds that while all of the firm's 20 portfolio companies are being affected to a degree by the crisis, only three are leveraged in any meaningful way, which is indicative of what could be a saving grace in the Russian market. Local players never had the mixed blessing of bountiful leverage – minority growth investments have always been the norm, with leveraged buyouts such as Lion's being the exception to the rule. This could prove a vital factor in portfolio company survival.

Another potential saving grace comes in the form of battle-scarred management teams. Unlike most developed nations, Russia has experienced a relatively recent financial crisis. It follows, therefore, that management teams and entrepreneurs – who tend to be relatively young in Russia – gained valuable experience during the 1998 financial crisis. “Russians are probably more used to crises than anyone else,” says Giedrius Pukas, founder of private equity firm Quadro Capital Partners, “but the boom of the last ten years has spoilt us.”

Tim Demchenko, who heads up private equity and special situations at Russian bank VTB, qualifies this point: “'98 was predominantly a financial crisis, now it's economic. This time we are seeing a lot more micro difficulties for businesses – falling demand from consumers and businesses, etc.”

But while portfolio company managers may be of the hardened variety, private equity fund managers are in many cases a little greener. A few firms have been operating since the early- and mid-1990s – Baring Vostok and Russia Partners are prominent examples – but the bulk of the local market has been formed since the turn of the century. Significant names in the market – Marshall Capital Partners, UFG Private Equity and Troika Capital Partners to name a few – have grown up amid benign conditions.

Couple this with the fact that the core skills needed in Russian private equity activity to date have been solid deal sourcing and structuring, and there may be a shortage of managers with the operational experience to steer portfolios through the current economic turbulence. Some teams do benefit from genuine industrial experience, such as Troika spinout Quadro and Baring Vostok, but in the words of one local GP there are “simply too many distressed assets and too little talent”.

The current economic downturn will undoubtedly change the shape of the nascent private equity industry in Russia. The changes have already begun. In April, Delta Private Equity Partners, a long-established member of the local investment landscape, moved into rival UFG's offices in what is widely thought to be a precursor to an official merger. Both firms had been in the market attempting to raise new funds when the financial crisis escalated in September last year. In May, Troika Capital Partners, the captive arm of investment bank Troika Dialog, parted company with five senior professionals – the bulk of its team – including former chief investment officer Giedrius Pukas. Four of them have since founded Quadro Capital Partners. Troika also had its fundraising plans scuppered by the downturn.

These changes are probably just the beginning. Vladimir Zaluzhsky, a spokesman for private equity firm Mint Capital, believes some funds will die out because their LPs will not allow an extension to the investment period – as they have with Mint's latest vehicle – while some investors are looking to change the way they commit to the asset class altogether. “LPs are now keener to invest on a case-by-case principle rather than make commitments to funds,” he says.

While some funds and firms will be blown away, others will be left to take advantage. For those with dry powder, prices are starting to look more attractive and many vendors are in need of liquidity. “The number of approaches from potential investee companies has shot up,” says Alexander Vlasov, investment director at Norum, a Russian private equity manager owned by Finnish investment firm CapMan. “We are not distressed players, but some good businesses are labouring under unsuitable capital structures and there is less competition from other players,” he says.

Rest assured that the earthquake that has shaken the Russian market will produce both winners and losers. For the survivors, the landscape will look very different.