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Russia: the best is yet to come

Patrick McCurry
Emerging Private Equity
May/June 2008

Multiples are lower than in the EU and the exit market is improving as strategic buyers enter the country. But while the macro picture is positive, there are significant problems facing investors at the micro level; notably a lack of law enforcement, a culture of tax evasion and a lack of high quality managers.

It is now nearly a decade since the Russian default and financial crisis and in the past five years GDP growth has been more than 7% a year, thanks partly to the soaring commodities market worldwide. In consumer-related industries growth is often much higher. According to KPMG research, food retail, automobiles and media are expected to grow by more than 20% a year compound annual growth rate between 2007 and 2011.

Also, per capita income is forecast to reach European levels in the next five years, says KPMG, growing from an estimated $519 in 2007 to nearly $900 in 2010 and around $1,500 in 2014. This compares with per capita GDP of $1,450 for Portugal in 2006, around $ 1,100 for the Czech Republic and $800 for Poland.

This burgeoning consumer market is an obvious attraction for private equity houses, all the more so given that politically sensitive sectors such as oil and gas and other strategic sectors are generally regarded as off limits to Western investors. Oil and gas is believed to make up around 20% of GDP and generate about 60% of export revenues.

Peter O'Driscoll, a partner at law firm Orrick, says that in the last 12 months Russia has gone from an obscure market with a few specialist firms to one that the leading PE houses are all looking at. Orrick advised the private equity fund of the US's Capital Group on its $175m acquisition of Unimilk, Russia's second-biggest dairy company in March 2008. The firm is thought to be planning for am IP-0 in 2009.

Among the main players are domestic firm Troika Capital Partners, international house Baring Vostok Capital Partners, Delta Private Equity Partners, Renaissance Group, Quadriga Capital and Russia Partners, which has a partnership with US firm Siguler Guff. Of the global firms TPG set up a representative office in early 2007 and last September said it wanted to buy Russian grocery chain Seventh Continent, in a deal valued at $1.1 bn to $1.2bn, although in February 2008 there were reports that the owners did not want to sell. Carlyle is also thought to be considering returning, after having twice already set up and closed offices in Moscow.

Significant fundraising has also been occurring, such as Moscow-based Renaissance Group, which announced in March 2008 that it had raised $660m for its first PE fund. The group said the fund was oversubscribed and that the initial target had been $500m. Scandinavian firm Mint Capital has said it intends to raise $250m-$300m in the autumn for its third fund investing in Russia and the CIS. East Capital, another Scandinavian firm, has also raised significant sums.

Thomas Dix, a KPMG partner in Russia, says there are different models of investment fund in Russia. These include funds set up by oligarchs to invest in start-ups or growing businesses outside their core area of activity Although there are a number of foreign players in the market now, it is still a relatively small number and that's partly because of a lack of sizable targets and the effort required to identify and execute deals.

Few LBOs

As a result, LBOs have not really developed yet. Dix says: "Private equity deals so far have been more about financing growth businesses and earning a corporate governance premium from making companies more transparent, rather than improving operational efficiencies. Buyouts have been limited as transactions have usually no or just a very limited leverage and not too many management teams have had the quality to proceed with an MBO."

The low level of leverage is partly due to the under-developed local debt market and the risks associated with many transactions. A lot of the companies don't have audited accounts and a clearly understood balance sheet, which makes banks less comfortable in financing the leveraged transaction, says Alexey Costyashkin, chief operating officer and partner at Baring Vostok Capital Partners. There is also the fact that many deals involve companies growing at 30% to 40% a year. "Excessive leverage at the very beginning might limit the company's ability to finance further growth," says Costyashkin.

PE houses and advisers active in Russia stress the importance of having a team on the ground. This is not just because of the importance of understanding the local culture but also factors such as the huge input required in assisting and monitoring the running of Russian portfolio companies. Thomas Dix says: "The involvement is much more intense and you need local people on the ground to provide guidance to the management team. You also need significant manpower to source deals in the first place and be able to look beyond the lack of transparency and assess targets."


There is also the issue of legal enforcement, or lack thereof. Unfortunately, the Russian legal system tends to be unclear and inconsistent and rule of law is not always applied. "It's important to try and structure transactions so that there's as little exposure to Russian law as possible. For example, by using offshore vehicles and having agreements that are governed by non-Russian law," says Peter O'Driscoll.

On the corporate governance and accounting side things are changing, however, says Thomas Dix; "There is a gradual move towards transparency and there is also consolidation in some sectors, which means bigger targets, and spin-offs of non-core assets by large groups." Dix argues that the best future route for Western PE firms is in partnering with local firms. This unites the local know-how and networks of the Russian firm with the sophistication and experience of Western firms.

Late last year the government put pressure on food distribution companies to keep the cost of basic foods, such as bread, down. This action came in the run-up to March's presidential elections. Thomas Dix says he does not believe this signals a return to state interference in the market economy He says; "I don't think there's much to fear about unwelcome state interference in the consumer market; the government measures last year were due to social concerns and the elections."

Baring Vostok Capital Partners raised Russia's first US$ 1 bn fund last spring for investment in Russia, Ukraine and Kazakhstan. The fund was much bigger than its previous fund in 2005, which raised $413m.

Andrey Costyashkin says Russia has a growing market for private equity investment and an increasing number of opportunities, as well as only limited competition for assets. But the challenge is actually doing business on the ground, with high levels of bureaucracy, the need to protect one's interests and problems in finding high level management. "In a fast-growing economy it's often hard to recruit high quality management, but there are a lot of well-educated Russians with good business experience now returning from the West."

It is not just finding good CEOs that is a challenge, but also CEOs, human resource directors, upper management and even middle management. Costyashkin says; "These guys, who are returning from London or New York, are usually fine about working in Moscow or St Petersburg, but if you want them to go to Novobirsk, Omsk or Tomsk you need to sweeten the deal a lot and that can become expensive. It's become one of the main challenges facing our portfolio companies."

Deal opportunities

Baring Vostok is able to look at companies that are a bit rough round the edges in terms of their accounts and internal processes, he says, because of the firm's long experience in Russia and its knowledge of legal, administrative and government relations issues. He says; "That's part of the value that we bring and it means we can consider businesses that other houses might be reluctant to approach. We introduce best practices and turn a family-run company into a well-managed transparent corporation."

Costyashkin' points out that the Russian M&A market is domestically driven, not by oligarchs but by regional groups that have large sums to invest because they have cash-generating businesses. "In the mid market they're the people we're bumping up against, not the other PE houses," he says. The global firms are usually looking to invest equity of $200m to $250m per transaction, which has not been easy in the past but may become more viable going forward as target companies are larger. "There were very few target companies in that range a few years ago, but with the economy growing at 20% a year in dollar terms there will be more opportunities." It will be hard for international firms to acquire companies that have not yet been "cleaned up" without a local partner, believes Costyashkin.

Fredrik Ekman, co-founder of Mint Capital, a Scandinavian fund investing in small to mid-cap Russian companies, argues that even though private equity is vastly outnumbered by domestic sources of funding it does have important advantages for Russian businesses that need capital.
The biggest difference between private equity and domestic oligarchs is its independence, he says; "If a company just wants money, it can find it from a Russian individual but there's always something a little ominous in that. We offer an independent source of finance and support to get that company to the next level." He says that often the entrepreneur has made all the decisions himself but, as the market gets more competitive, realises he needs outside help Private equity investment can also help a business in recruiting the best people, believes Ekman; "For a Russian company having external investors like us makes them more credible in attracting talent and that's important because Russia has an overheated labour market. We're involved in the recruitment of senior people and that sends out a positive signal to candidates and shows that we're taking a firm interest in the company's development."

AVC dawn

While private equity is still an emerging activity in Russia, venture capital is virtually non-existent. The government last year announced an allocation of up to $600m to encourage venture, with a government-sponsored fund willing to match fundraising by private funds. By late 2007 around 10 funds had received funding.

"It's a good idea to encourage start-ups because of the country's long history of technology and science but there are very few examples of people turning a good idea into a viable business in Russia," says Jan Dewijngaert, investment director at Belgian PE firm GIMV, which has been active in the country through its Eagle Russia Fund.

He adds that it is still very early days and points out that a similar programme in the EU in the 1980s had mixed results. "What will be important is that those monitoring the Russian programme are able to independently select the best projects and that they're not pressured to choose projects from particular regions." Another question, he says, is to what extent those funds that have received backing from the government will be able to access follow-on funding.

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