Funding Russian private equity

For a country traditionally considered an unattractive investment destination, Russia has managed to accumulate a substantial amount of column inches in the financial and trade press over the last 12 months, helped by its position as one of the fastest growing economies in Europe, with a 7% GDP and a population of 140 million people.

Private equity, in particular, regards Russia in a much more positive light than it did even as recently as the beginning of 2005 (see EVCJ March 2005). Since then, the only negative private equity story was Carlyle’s failure, again, to secure a foothold in the country. In May last year the US giant shut its Moscow office and cancelled its US$300m Russia-specific fund, citing the unattractive risk profile of investing in the country. This is a common complaint about Russia, but it’s usually one heard from firms when they are dismissing the idea of investing there, not from one that has already failed once (Carlyle closed its first office in 1998), went out there again, and failed a second time. A strange move from a firm that should have been aware of the investment risk prior to setting up shop.

In March 2005 veteran Russian firm Baring Vostok Capital Partners closed its third fund, raising US$400m, US$50m over its target. The fund is to target companies operating in the oil & gas, consumer products, media, telecommunications, and financial services sectors. Its geographical focus, aside from Russia, also includes the Ukraine and other former Soviet Union countries, and it will typically take controlling stakes in medium-sized companies, mainly through MBOs or acquisitions together with outside co-investors.

Michael Calvey, co-managing partner of Baring Vostok, says of the oversubscription: “Our previous investors subscribed for a much larger amount than we had thought and this was because of the size of dividends from the previous fund. Most of our investors still consider Russia to be one of the riskier markets in the world but this is compensated by the high returns that can be generated. The loss ratio has not been much different to mid-market funds in US and Western Europe. We’ve had three write-offs out of 38 investments.”

Calvey admits there are still some risks and confirms the fund has no intention of investing in companies exposed to the political risks that have affected some of Russia’s larger companies, which could be renationalised under plans currently being reviewed by the Russian Government. Calvey said most of the companies the firm has invested in to date were formed after the Soviet Union fell and so were never privatised.

In May 2005, Delta Private Equity Partners closed its second fund, Delta Russia Fund, on US$120m. Similar to Baring’s offering, it will also consider Ukrainian investment opportunities. It will invest in fast growing technology companies operating in consumer goods, media, telecoms, technology and other rapidly growing sectors of the country’s economy. The investors in the fund consist of large international financial institutions, pension funds and individuals from the US, Western Europe and Japan.

Four investments have been made so far: National Cable Networks (NCN), a Russian cable operator; Prime, a chain of sandwich shops in Moscow; Compulink, a systems integrator, and One Globe, a provider of travel commerce solutions for the air transportation industry.

By November, there were two additions to the field. First up was the East Capital Explorer Financial Institutions Fund, a private equity fund with a focus on the banking sector in Russia and the CIS with a target size of between €300m and €350m. The fund is led by Kestutis Sasnauskas, founding partner of East Capital, who will be supported by Bengt Dennis, former head of the Central Bank of Sweden, and Jean-Marie Laporte, former Nordic director at Calyon and head of East Capital in France, as directors on the board, who will be responsible for evaluating investments and exits.

Peter Elam Håkansson, chairman of East Capital, says: “We believe that this new fund is an attractive and unique investment alternative for investors who can commit themselves in the long term. The outlook in the region looks promising. For example, the total banking assets to GDP are four to six times lower than in Western Europe, which, in combination with two to three times higher GDP growth, opens up more room for growth in the financial sector.”

The second fund launched in November was the Russia New Growth Fund, a joint venture between Troika Dialog, a Russian investment bank, and Temasek Holdings, an Asian investment company headquartered in Singapore. The fund, which has a target of between US$250m and US$300m, is to focus on mid-cap investments, and reached US$150m at first closing, with a final close predicted within the next 12 months. The management team will be based in Moscow and will be led by Richard Waryn, the former Centurion Capital CEO and Finartis Private Equity managing director.

The fund will target minority and majority equity investments in a wide range of sectors including retail, consumer goods, logistics, business services, specialised manufacturing, telecommunications, and select media. Investment sizes will be between US$5m and US$45m. Waryn says: “The strategy is to take control of blocking minority stakes in such companies, help them grow and expand, and then exit primarily via IPOs or strategic sales. We will place a lot of emphasis on finding or building the right management teams whose objectives are aligned with our vision. I believe there are synergies between the sponsors and the management team that we have assembled, which will be unique in the Russian private equity market. I am looking forward to creating a new standard of excellence here.”

Management quality still remains a problem for businesses in Russia. While there has been an increase in Russians attending Western universities, only a certain amount are returning to the country, with many either staying in the West, especially the US, or heading to Israel. Anecdotal evidence suggests the situation is improving, but the lack of quality is still a tremendous barrier to success, not to mention stories of bribery and corruption.

Corporate governance, depending on whom you speak to, is either “getting better” or “non-existent”. It is certainly a reason why SVG is reluctant to get involved. Guy Eastman, European investment director, says: “The issue we have with any emerging market is that the absence of rule of law, and Russia has severe corporate governance issues, and it’s pretty dangerous to take your investor into that sort of situation. The political situation too; Russia is not a democracy, and things are very unstable and capable of changing overnight.”

Eastman doesn’t rule out investing in Russia: SVG Capital has an option to invest 10% of its fund-of-funds outside the US and Western Europe, although it is paying most attention to Japan and South East Asia. “We would need to do a lot of due diligence, and there’s more than enough already going on in Europe, that isn’t as volatile as Russia.” He also makes a salient point about the nature of new investment destinations that applies not only to Russia, but to Asia as well. “When the Western markets start performing strongly, the interest in emerging markets takes off. When the home markets are performing badly, then everyone leaves the emerging markets.”

Another LP, Andre Jaeggi, managing director at Swiss fund-of-funds manager Adveq, is more upbeat: “Russia is clearly a place to look at for a private equity investor. The market has matured a lot. The proof is, since the past year or two, it is no longer a macro story, ie we find fund managers saying, ‘Hey, we have a great company with which we have this and that intent. Oh, and it happens to be in Russia.’ However, one has to be very careful when selecting managers. Not all of them have the combination of operational and strategic skills, mixed with the political relationships, to avoid assets that could suddenly be declared as being of strategic interest. As for the legal system, it looks ok, but is still somewhat untested. However, that’s a situation we unfortunately also encounter in some Western European countries.”

3i and Quadriga

Carlyle’s failure to establish itself in Russia hasn’t dissuaded some Western firms from venturing east. In February 3i invested US$20m in Quadriga Capital Russia Private Equity Fund II, making it the largest investor in the US$138m fund, which also received allocations from the European Bank for Reconstruction & Development (ERBD), the International Finance Corporation (IFC) and two well-known German families.

Quadriga Capital is a German firm, with its Russian arm based in St Petersburg. It has focused on private equity in Russia since 1995 making it one of the oldest firms in the country. Ere Kariola, 3i’s managing director in Finland will take a seat on both the advisory board and investment committee of the fund. Kariola says: “Russia is an interesting market for many of our portfolio companies within 3i at the moment and a relationship with Quadriga enables our portfolio to gain market access from local sources. We will also have a good opportunity to co-invest in fast growing Russian companies. There are a lot of opportunities, especially in consumer related markets, especially now that income levels are increasing. A lot of the companies in our Nordic portfolio, as well as across Europe, already had plans to expand and grow their business in Russia.”

The decision to invest via a fund rather than directly was based on two factors: one, it was less of a risk, and two, 3i lacks the local knowledge. “We made the decision to study Russia last year, at which time Quadriga was approaching the end of its fund raising and had already made four investments, so we were able to jump into a running train.”

Whether 3i’s investment is part of a longer-term strategy actually to acquire the fund is unclear at present, but it is certainly a possibility as the firm has not been adverse to acquiring smaller European rivals in the past, and one gets the impression from Kariola the investment in Quadriga is as much of a testing of the waters exercise as a chance to build and grow 3i’s portfolio companies. “There is a lot of interest in Russia right now,” he says, “Around four or five funds have been, or are being raised, and there are about 20 teams operating in Russia, some based there, some based in Western Europe and the US. The US in particular is looking at the market although many of them are just interested on the big deals, which is not our focus here.”

Nothing breeds success like success, and so far that is what the country has lacked, but the emergence of new funds has had the effect of pushing Russia onto the radar screen of more private equity managers. “The question still remains”, says Kariola, “‘when is the best time to invest in Russia?’ and it looks like the right time for us. Quadriga had made four investments and now the industry is already established and the rules in the market are more clear than they used to be.” He also points out that Quadriga Russia’s portfolio companies are experiencing growth of between 40% and 70% a year and all are profitable.

Also based in Finland is listed Scandinavian fund-of-funds Amanda Capital, with eight other Finnish institutional investors, which launched Amanda III Eastern Private Equity in May this year and immediately invested US$12m in Russia Partners II, a US$335m fund, which closed in 2004. The Amanda fund-of-funds has reached a first close on €44.5m and intends to target funds investing in Russia and Eastern Europe.

Domestic funds

In March this year former Russian finance minister Boris Fyodorov launched a US$250m private equity fund through UFG Asset Management, formerly part of Russian bank United Financial Group. The fund is aimed at SME’s in the country, specifically those unable to attract the interest of the big Western firms and the Russian oligarchs, a common competitor for Russian private equity funds. The vehicle will target companies with no government ties, so as to avoid the potential threat of being renationalised, worth between US$10m and US$100m. UFG Asset Management is expecting target companies to triple in value over the next five years, particularly in retail, where turnover is estimated to reach US$558bn in 2010. So far US$35m has been raised from 30 investors, including a handful of US citizens. Two investments have been made: a 46% stake in gold mining company Sigma, which cost the fund US$14m; and a 25% stake in, an online travel agent at a cost of US$13.6m. It is due to close in July.

During the same month Alfa Capital Partners reached a first closing of US$105m for its private equity fund, Alfa Private Equity Partners, which received commitments from institutional investors, family offices and parent Alfa Group. It is currently still searching for a final close of US$250m. The fund is targeting emerging and growing sectors and invests in management buyouts, expansion capital, roll-ups and co-investments alongside strategic partners. Priority sectors include consumer products and services, leisure, media, publishing, retail, healthcare, pharmaceuticals, construction materials and logistics. A team of nine experienced professionals led by Richard Sobel, ACP’s CEO, is managing the fund.

Aurora Russia Limited is hoping to exploit the Western public markets to finance its investment plans. The fund listed on the London Stock Exchange’s Alternative Investment Market (AIM) in March, raising £75m for investment in small and medium-sized private Russian companies. The management team is led by James Cook, former chairman and CEO of GE Consumer Finance, and John McRoberts, former head of the corporate finance advisory practice at Deloitte & Touche in Moscow, and has completed a number of transactions in Russia in the services sectors. Aurora Russia will invest in companies focused on the financial, business and consumer services sectors, where the directors believe there is potential for growth and lucrative exit opportunities within two to four years of making such investments. With regard to size, potential investee businesses will need to have an enterprise value of up to £100m, and will seek to secure controlling stakes and board representation taking equity stakes of more than 20% in each portfolio company. It is anticipated each equity investment will typically be between £5m and £25m. The directors anticipate investing in 10 to 12 such companies and intend to invest the funds within 18 months of admission to AIM.

Mint Capital is another domestic fund that raised money last year. It closed its second fund on US$130m, a significant increase from its first fund’s total of US$21m, which was fully invested in 2004. The firm launched during turbulent times, around 18 months after the October 1998 Russian financial crisis, and, unlike a number of other funds, decided it was worth sticking around, a decision it now believes is paying off.

Wanted: deals

Whether all this money being raised will translate into deal flow is a question that will remain open for at least the next year. So far the evidence would suggest a slight increase in deals, but whether that is because it is the case or whether Russian private equity funds are improving their PR is difficult to tell. Data on the country is difficult to come by and should generally be treated with caution. The fact money has been and is being raised leads to the logical conclusion that there are a number of opportunities out there, most of which tend to be concentrated around the consumer and financial services sectors and located in either Moscow or St Petersberg. But finding these deals is what makes the vast majority of GPs and LPs reluctant, if not hostile, to the idea of investing in Russia.

Exits, too, remain thin on the ground, with trade sales overwhelmingly the most popular exit route.

Optimism may abound when speaking to those on the ground in Russia, and well it should, as the number of funds and amounts raised is going to force the hand of the nascent Russian private equity community into investing. What gives Russian GPs hope is the rapid growth of the consumer class in Russia. Its economic success over the last five years has seen a dramatic rise in the proportion of the population with disposable income. A survey by AC-Nielsen published in January 2006 revealed only 5% of Russian respondents said they had no extra cash after covering essential expenses, compared with an average of 10% worldwide. Seventy per cent of Russians said they would spend their money on consumer goods. As a result, trade, including wholesale and retail trade, has become an important sector of the Russian economy, reaching 21.3% of total GDP in 2004. Retailing has become an increasingly significant proportion of economic growth, with real turnover increasing by 9.8% per year on average in 2000/04. Real disposable income growth is likely to continue at 6.5% to 7.5% a year in 2005/10, which has obvious implications for the retail sector, and pensions are set to rise (by 50% between 2005 and 2007), accompanied by a predicted 10% increase of wages per year in the 2005/07 budgets.

The banking sector is also set to benefit from Russia’s economic performance. Despite its underdeveloped nature compared to its counterparts in Eastern European countries, with banking assets of just 42.5% of GDP, economic and political stabilisation of the country has combined with the rise of banks as the main player in the business payments settlement process. And with the introduction of deposit insurance in 2004, the sector is becoming an increasingly attractive area for investment.

The construction sector is also improving, a corollary of the rise in disposable incomes. Residential construction is expected to continue to grow by more than 10% a year in the medium term, pushing the cumulative growth of construction to 8.5% in 2005/10. Moreover, Russia’s mortgage system is gradually developing, with a recent study by McKinsey finding the Russian mortgage market could reach US$25bn by 2010.

The potential is there, but deal flow remains limited. Despite being over halfway through the year, only a handful of deals have completed, such as Mint Capital’s investment of €8.3m in a company called Elecsnet, a provider of secure financial transactions services, and Warburg Pincus’ and Russia Partners sale of RBMH Broadcast Media, a Russian radio station owner, to Europa Media Group, in March. The sale was Warburg’s first Russian exit, meaning Warburg currently does not have any investments in Russia.

The lack of the bigger, well-known LPs in most of the funds raised indicates Russia is still regarded as a high risk environment, and arguably appears to be behind China and India in its attractiveness to private equity investors. While the old adage about high risk equals high returns is appropriate here, some LPs just don’t want that sort of risk attached to their investments when they can continue to make good money from safer commitments.

The challenge the Russian private equity market faces now centres around one thing: deals.

It is only with an improved deal flow, not to mention and an improved method of recording these deals, that GPs operating in the country can show Russia is a place really worth investing in. But while severe doubts remain over political instability, corporate governance and a questionable legal system, expect investors to remain suspicious for some time to come.