The rise of Russia’s LBO market

It wasn’t exactly on the scale of the Bolshevik revolution, but one deal completed earlier this year in Russia caused a few heads to turn. When UK-based Lion Capital paid US$500m for Russia’s third-largest soft drinks company Nidan Soki in August, it marked the first ever ‘Western-style’ leveraged buyout (LBO) completed in the country.

For Lion, the move was part of a long-term strategy of acquiring headline brands from around Europe and the US. It already owns Weetabix, bought in 2003 for £640m, and Orangina (formerly the European beverages division of Cadbury Schweppes) in 2006, followed by crisp-maker Kettle Foods.

But for Russia, the move had far more symbolism, promising to push the nascent LBO sector into a new phase freeing up a fresh source of capital for the rapidly expanding economy.

Russia has an estimated US$100bn stabilisation fund. Its companies and citizens pay tax (most of the time) and its GDP is rising quickly, along with average incomes and stock market valuations.

“It’s the Russian story that has brought the buyout groups to the country,” says Tom Nastas at Innovative Ventures. “There is a huge set of billionaires who have taken companies public on the Russian stock exchange. That’s captured the attention of people.” Nastas is confident that from these currently small beginnings, the coming year will see a good deal more activity. “There are certainly other deals in the pipeline,” he says. “It’s partly a question of politics and economics, the ‘uncontrollables’, as well as the desire of the current owner to sell.”

Russia is not immune to the effects of the global credit crunch, but it has an enormous appetite for capital at the moment, says Nastas, along with a thirst for the know-how that international investment can bring.

What puzzles some financial experts is why the LBO market has taken so long to get off the ground, and why fewer private equity players are making their presence felt in the country. For all its booming economy, it is still less than a decade since the great default (which came following a time of similar optimism and racing valuations) and only a couple of years after Russia turned off the gas pipes which kept a quarter of Europe warm in winter. This action prompted many European political and business leaders to reconsider their relationship with Russia as a country and as trading partners.

For Russians themselves, this can mean concern over a political agenda entering business – as in the case of Yukos founder, oligarch Mikhail Kordorkovsky, jailed for aspiring to have political ambitions – and for investors, there is the worry that the sector in which they wish to invest may be deemed ‘strategically important’.

“Most equity investors are willing to get their feet wet, and maybe even their ankles, but they’re not quite ready to get their knees wet,” says Cliff Kupchan of Eurasia Group. “They know that Russia is potentially a very high reward market, but they’ve also heard about the pitfalls. For many of them it’s an incremental process of getting to know how Russia works, and that’s a slow process.”

Certain sectors are clearly out of bounds, including oil and gas, metals and minerals, as the Kremlin continues to hoard the greatest sources of the country’s current wealth. Private equity investors would probably do well to avoid armaments industry deals. But what of media and telecoms? Surely in an economy still gradually weaning itself off the one-party state with absolute control over propaganda and the media, these sectors, with their rapid convergence, would be ‘strategic’? “The telecoms sector is completely open to international investors,” says Andrei Tikhomirov, director of Russia Partners Management Group, currently raising its third (US$750m) investment fund.

He is underwhelmed by the idea of a new wave of LBOs in Russia. “There are no credit resources on the market at the moment,” says Tikhomirov. “The only banks that would consider LBOs are VTB and Sparbank, but they’re pretty conservative. And there’s no possibility to lend against the shares of a company, because share security can’t be considered collateral. Banks don’t want to lend to shell companies [companies set up solely to invest in other companies] and in any case they are barred from this kind of lending. They would have to create reserves equal to almost 100% of what they were lending.”

For banks outside Russia, whose lending criteria are not so restrictive, there could be deals in prospect, according to Tikhomirov. “In the food, beverage, steel, coal and manufacturing sectors there is room for consolidation,” he believes. And in telecoms, he has heard rumours of a potential US$3bn deal between Golden Telecom and Wintelcom.

It may just be the current credit conditions that are blocking the more rapid development of an LBO market in Russia, since Tikhomirov argues that the Russian banks are “finally getting real. They’ve started to finance businesses, which is healthy for the economy in general.”

The history of Russian private equity investment began a little more than a decade ago, with capital from international organisations such as the European Bank for Reconstruction and Development (EBRD), the United States Agency for International Development (USAID) and the German equivalent Kreditanstalt für Wiederaufbau (KfW).

Russian investment funds such as Russia Partners were able to form joint ventures with their groups on specific, often development-related projects. Then, as the oligarchs grew richer, in around 2001, they began setting up their own private equity houses, and began taking either minority or majority stakes in Russian companies. In 2003, there emerged ‘donor’ private equity funds raising capital from outside groups, such as pension funds, family offices and insurance funds.

Until recently, most private equity deals in Russia were completed in the range of US$5m to US$15m. In the past few months, this criterion appears to have changed, as groups such as Baring Vostok (the country’s largest private equity fund) and Renova Capital have shifted up to the US$50m range. In March, Baring Vostok announced the launch of the first Russian £1bn private equity fund and Delta Private Equity Partners has another US$1bn fund in development.

Nevertheless, Russia remains a long way from the kind of ‘club’ deals which have seen US and European private equity groups combine to acquire some of the largest multinational brands in the world. These big players, such as Carlyle Group, have taken a good hard look at Russia and decided to leave it for others to enjoy. Carlyle opened a Moscow office in 2004 but then shut it abruptly in 2006, citing the ‘unappealing risk profile’ of the country as it abandoned its plans for a US$300m Russian investment fund.

Taking Carlyle’s place at the beginning of 2007 was Texas Pacific Group (TPG), which set up an office in Moscow as part of a bid to invest its US$15bn global fund. It sent a senior London partner, Stephen Peel (married to a Russian), to oversee the office and negotiate his way through the maze of bureaucracy and opaque policy guidelines.

TPG’s first leveraged acquisition was Seventh Continent grocery chain, another non-controversial choice (alongside Lion Capital’s soft drinks target) and a natural fit for a private equity firm, according to a local expert. “Seventh Continent was undervalued, relative to other food retailers, trading at a 10% to 24% discount to the rest of the sector, thanks to lousy management, a hazy strategy and repeated disappointments,” says the figure, a Moscow banker. The chain has been mismanaged for many years, he argues; having had a virtual monopoly in the mid-1990s it blew its commercial advantage and now barely makes the country’s top ten.

For an efficient private equity investor, solving the company’s problems should be quite straightforward. It needs a better distribution channel, a more focused strategy, modern IT systems and uniform pricing, among other things. “This will take nothing more than people who know what they’re doing, and a bit of investment,” says the banker. He believes there are any number of willing international buyers in the market for a revamped Seventh Continent (Tesco, Wal-Mart and Carrefour to name just three), to say nothing of domestic rival such as X5 and Magnit. “So: cheap, mismanaged, relatively easy to fix, and with a natural buyer in the wings.” This is the Moscow banker’s assessment of Seventh Continent and why TPG was so wise to invest. But he has a number of other names in mind that would make similarly attractive targets, including giant conglomerate Sistema, with a market cap of US$1bn but the potential for its constituent parts to realise far more, if unbundled. Sugar and grain producer Razgulay is another hot property.

At Russian investment house Eagle Venture Partners, Jan Dewijngaert admits that the LBO activity so far has been surprisingly small, but has confidence in the eventual blossoming of the market. “It can only grow from here,” he says, arguing that Baring Vostok is likely to be among the first Russian private equity funds to enter the fray. His fund has so far taken part in a series of smaller equity investments – in the US$5m to uUS$15m range, but along with other players foresees his criteria rising to US$50m investments.

“High interest rates have been an obstacle to LBOs so far, but these are coming down,” says Dewijngaert. “It’s so far quite an unknown area for Russian banks; long-term finance hasn’t been easily available.” He admits that, while Russian banks have nothing to fear from the Government (since many of them are actually still state owned), “politics is certainly an issue for foreign banks.”

While the buyout market remains limited and nascent, there remains the prospect of some terrific bargains, with little competition from international rivals, especially at the highest end – upwards of US$100m deals. Yet for Dewijngaert, the best days are already behind us. “The period from 2000 to 2002 was best for investment,” he remembers. “Valuations were very low because of the lack of competition, and there were limited intermediaries. For every private equity deal, we were usually the only bidder. Now there are always several competitors and it is sometimes a tender situation. But the risks are lower, the economy is more stable and less dependent on oil and gas,” he says.

In particular, the SME sector is truly booming, as bankers become comfortable with the concept of entrepreneurialism and deal sizes are rising. It is at this end of the economy, at the level of the family business, or the university start-up, or the manager who has a great idea but cannot realise it within the large manufacturer that the Russian economy will start to transform, just as the economies of the Czech Republic and Hungary did in the mid-1990s. Once this has happened, LBOs will for Russians be just another tool in the box.