Russia’s evolution from its Soviet past and from the chaotic early days of democracy has been swift. Over the past 10 years, as Russia has transformed itself from a centrally controlled Soviet system to a modern market-driven economy, a completely new class of domestic entrepreneurs has emerged.
Briefly, it is rather remarkable that Russia’s economy has expanded an average 7% over the past five years, despite negative population growth and a per capita income of US$7,000 – a relatively high base compared with most other developing countries. That dynamic has made Russia an attractive destination for foreign direct investment, or FDI. This year about US$30bn in FDI is expected to flow into the country, with most of it headed toward the non-oil economy.
To be sure, the bull market in oil is not insignificant in fuelling the demand surge. However, the Russian economic renaissance story goes well beyond oil. What distinguishes Russia from many other oil-rich countries is the quality of its human capital, something that’s helping the country rapidly converge with the more developed nations in terms of a thriving business and consumer culture.
More importantly, the Russian small and medium enterprises sector (SME) contributes close to 12% to the GDP and provides about 15% of the total employment within the economy. According to the UNECE, the comparative figures for the SME contribution to the GDP, for emerging markets, remain close to 49% while half of the employment gets provided by it. Such seemingly large under-development of the Russian SME sector is the reason why the country has received a fraction of the total emerging market private equity flows. According to EMPEA statistics, the total emerging market PE funds raised were about 9% to total PE in 2006 or US$33bn in absolute terms. Out of which US$19.4bn were directed towards Asia while Central Europe/East Europe & Russia received just US$3.3bn. And this, despite very high IRRs being achieved in the Russian PE space. Examination of Table I shows that the IRR on the EBRD portfolio, one of the largest investors in the Russian private equity space, has been way above the average for other emerging markets. While most emerging markets offer opportunities with an IRR potential of 30% to 40%, EBRD’s Russian portfolio has seen returns closer to 50%. Therefore, despite such high growth prospects, the Russian private equity space has not been able to attract the same attention that India and China have.
Possible explanations for such an anomaly are two-fold. First, the state intervention to take control of strategic assets has raised questions about ownership rights. In the last five years, the weight of state-owned enterprises (SOEs) in the Russian economy has expanded dramatically, leading some observers to speak of a reversal of market reforms. According to researchers at Alfa-bank, in the middle of 2003, Russian state-owned stock was worth about 20% of the capitalisation of Russia’s stock market. By early 2007 the state’s share had risen to 35%. Much of the growth represented a buying spree by SOEs, especially oil company Rosneft and the natural gas monopolist Gazprom. Among the largest acquisitions were major assets confiscated from the private oil company Yukos in lieu of tax debts, purchased by Rosneft, which thus became the country’s largest producer of crude oil.
Second, Russian SMEs/Corporates using accounting norms consistent with GAAP/IAS are far from few and thus present a major hurdle for PE funds searching for potential investments. There have been plenty of ownership disputes and corporate governance horror stories over the years in Russia. Company law and securities regulation are now comparatively well-developed and progressive in their protection of minority shareholders. In April 2002, the Russian Securities Commission and the Government adopted and published a corporate governance code, which was supposed to provide another stimulus for increased transparency and better management. However, bureaucratic corruption, the mentality of secrecy and a less than independent judicial system remain. Hence, most foreign PE firms prefer to take the PE structure off-shore.
Russian laws related to investment funds are not yet developed sufficiently in their substance or in practice to make domestic funds attractive to foreign sponsors and investors. Russian private equity funds have all been established in jurisdictions other than Russia. The most popular jurisdictions have been Guernsey and Jersey for European sponsors and Bermuda or Cayman Islands for US sponsors. A few funds (or parallel funds) have been formed under Delaware law for marketing to US institutional investors. Other LPs, which are not deeply committed to Russia, use vehicles such as Baring Vostok to invest within the country. LPs generally consider Russia to be riskier and more inaccessible than other major emerging markets, probably with good reason. It is fiercely competitive, both in terms of buying assets and in terms of keeping control of these assets.
The most typical structure is a partnership formed in a reputable, tax-advantaged jurisdiction; having a general partner and possibly a manager incorporated in the same jurisdiction; and a local investment advisor which is a Russian company or a foreign company with a branch office located in Moscow. Very often, investments will be made through investment companies established in countries such as Cyprus or Germany, which have favourable tax treaties with Russia minimising the withholding tax on dividends, interest and capital gains. The average investment for a Russian fund ranges from US$5m to US$50m, and involves buying at least a blocking stake (25% plus one share) and often controlling interest. Experienced direct equity groups are able to manage the risk and increase the value of target companies through injection of new management, technologies and know-how. However, more recently exits are a lot easier than they were a few years ago. The exceptional performance of the Russian stock market has helped the IPO activity, which in turn has supported exits in an efficient manner.
Also compounding the problem of flows to this country is the overall structure of the private equity market. The CEE private equity markets still remain largely buyout markets, albeit with lower levels of debt with about 70% of the deals occurring in the LBO space. Only recently, the Russian private equity space witnessed its largest ever LBO transaction when Lion Capital completed the buyout of the juice drinks company Nidan Soki for over US$500m.
In addition to this, there are about 15 institutional players in the Russian Private Equity space and some of them manage their own money. Of the US$40bn that is available for investment, US$12bn is managed by funds that are open to LPs, while US$28bn is under the management of oligarchic groups. This implies that close to 90% of Russia’s private equity fund flow is completely domestic, suggesting rising wealth effect within the economy. However, on a positive note, Barings, Goldman Sachs and Merrill Lynch all have a strong presence in Russia, which will help to deepen the market.
Despite constraints, the potential opportunities in Russia remain attractive and are gaining in popularity. As an example of Russia’s growing favour among investors is the recent raising of US$1bn by Baring Vostok Partners – the country’s largest buyout fund. Fundamentally, some of the sectors look extremely attractive. As illustrated in Table I, Telecom/IT/Media remain one of the most widely sought-after sectors, with Services coming in a close second. However, the figures above mask the underlying potential of the retail space in Russia. Consider the following. Retail sales reached US$318bn in 2006 vs US$245bn in 2005, ranking Russia the second most lucrative and twelfth largest retail market in the world. Disposable income has almost doubled over the last four years and is currently estimated at US$4,900 per capita per annum.
The fastest growing segment is non-food retail, which grew over 13% in 2005 to roughly US$125bn. Retail growth is increasingly driven by major chains, which saw their top lines grow 70% to 80% over the last few years. Retail chains, large and small, are projected to increase market share from 50% in 2006 to 70% by 2010. Over the next several years, non-food retail is expected to grow much faster than food retail, which is in line with the maturation of the retail sector. Moscow retail space penetration is just 30% that of Prague.
As a drawout from a vibrant retail sector is Moscow’s casual dining market size – estimated at US$1.0bn to US$1.3bn in 2006 and expected to grow at more than 40% CAGR in the medium term. The Russian auto market is another opportunity to look at. After growing rapidly from 2003 to 2006 at a CAGR 34%, a market still far from saturation due to the wealth effect and enhanced access to consumer borrowing opportunities driving market growth. Low car density and comparatively old age of cars (more than 50% are over 10 years old) are additional catalysts driving such purchases.
The cable TV/Media industry is another sector venture capital and private equity fund managers are looking at very seriously. The dynamics are seemingly straightforward. The number of households receiving pay-TV is likely to increase from 8m to 12m in Russia and CIS. And the penetration rate is likely to grow from 3% to 10%. The number of local cable and satellite channels is expected to double from 22 to more than 50. Total subscriber fees collected by the local channels will increase from US$236m to US$634m. At least 1% of the audience exposed to teleshopping (or 0.5% of the US$200bn retail market) will adopt this concept. Similar parallels can be drawn for the TV & Cable advertising industry. This is one of the rationales as to why Delta Equity Partners, a manager of private equity funds in Russia, invested in CTC Media and successfully exited earlier this year. Another private equity deal in this sector was executed by Warburg Pincus in 2003 when it bought a controlling stake in three radio stations in Moscow and St Petersburg in September 2003.
The Russian Gaming industry is also an idea coming onto the boil. In the past, PE firms have made a number of investments in Russian gaming companies, including Intel Capital and Quadriga Capital Partners in Akella, EnerGroup Inc.’s investment in Nival Interactive, Norum’s investment in Buka, and i-Hatch Ventures’ investment in Reaxion. These early stage firms have been able to quickly increase their subscriber base and become leaders in this rapidly evolving space. With the gaming industry expected to grow at 40% to 80% over the next few years, the prospects look promising.
But what about the oil sector? Is it too tightly controlled by the Government for the PE funds to be interested in? Not really. Take for instance a recent deal executed by Barings Vostok in an oil firm called Burren Energy. The fund invested US$27m in this oil business in 2000. The business was floated on the London Stock Exchange in 2003. After several partial sales of its stake, Baring Vostok now owns 8% of the company’s shares. Logistics, financial services (particularly mortgage lending) and climate control manufacturing firms are some of the other sectors PE funds are quite keen on.
Finally, a thought for the next few months. An area requiring careful monitoring over the next three months would be introduction of Basel II’s Pillar 2 requirements (beginning in 2008), which will affect GPs not just in Russia but globally. Any corporate governance model will need to have formal controls for managing and monitoring the investment portfolio. This might include systems for formulaic management reporting from portfolio companies. Most GPs will escape having to comply with this directly – although it will apply to the few marketing retail investment vehicles.
The Russian private equity space, while risky, presents a rewarding opportunity in an environment where value is becoming increasingly difficult to unearth.
Rohit Chawdhry is Portfolio Manager at BBK (Bank of Bahrain and Kuwait).
Disclaimer: The views expressed are the author’s own and do not reflect those of his employer. The author bears no liability that may arise from investments made based on the article.