The great Russian private-equity gamble
© 2005 Euromoney Institutional Investor plc.
In a city where overpriced service is usually either rude or unctuous — never anything in between — Prime stands out. The Moscow sandwich outlet is modelled on the UK’s Pret A Manger chain, most of its sandwiches cost less than R100 ($3.50), and the service is quick and cheerful. A sign says that it will make any sandwich on the menu within 10 minutes.
What makes Prime intriguing is that, in a city centre teeming with young professionals, it has no obvious close competitors. Restaurants down the road insist that the visitor sits down, and similar fare to Prime’s is nearly five times the price.
But it’s not just Russia’s hungry professionals who are impressed by Prime. The company is proving a hit with Delta Private Equity Partners, one of the country’s more innovative and impressive private-equity players. In March, Delta bought a blocking stake in Prime (anything between 25% and 50%), which means that it can veto some of the Prime management’s big decisions but can’t dictate overall strategy.
Prime fits Delta’s strategy of identifying and funding growth companies in Russia. The firm was established in 1998 primarily to manage the $440 million US-Russia Investment Fund. The fund, which was created under legislation passed by the US Congress, offers financing and management support to Russian enterprises, Russian-western joint ventures and western firms seeking to enter Russia.
Today, Delta has evolved to focus on the more upcoming sectors of Russia’s economy, mostly consumer outlets, financial services and telecommunications, media and technology. This strategy is paying off. The firm has a benchmark internal rate of return of between 35% and 40%. But its most recent exits have put those figures in the shade. Over the past two years, average IRR has been 400%, according to a Delta spokesman, largely on the back of two hugely profitable transactions.
The first, last year, was the sale of DeltaBank, Russia’s leading issuer of Visa credit cards, to GE Consumer Finance. That deal netted the private-equity firm $150 million. Then, at the beginning of this year, Delta exited from StoryFirst Communications by selling its stake to Fidelity Investments at four times its original investment. Delta has also just sold DeltaCredit, one of Russia’s leading mortgage providers, to Societe Generale. It’s said that the US firm will make as much as $100 million from the deal.
Delta will be hoping Prime proves as successful. The sandwich shop is well placed. Although it is the only outlet of its kind in Russia, analysts reckon the industry is set for strong growth. «There are areas absent in the Russian economy that are so basic that if they don’t exist yet, they will soon,» says Patricia Cloherty, chairman and chief executive at Delta Private Equity Partners.
Certainly retail appears to be the safest bet for investors (at least as safe as any bet in Russia can be). Retail, together with real estate, accounts for the bulk of the country’s private-equity deals, spurred by an emerging middle class that sometimes spends money faster than it can earn it.
«Consumption has taken up the slack [in investment in Russia] and has become the key driving economic force in the country,» wrote Vladimir Pantyushin, an economist at brokers Renaissance Capital, in a report published in June.
Despite Delta’s impressive returns, direct investment professionals are sharply divided over whether the benefits of investing in Russia outweigh the risks. Some say greater transparency and improving management skills have reduced the chances of a disaster. Others point to the shaky legal framework and poor contract enforcement, as well as the inability of many venture entrepreneurs to stick to their word.
Another concern is that there are few investment opportunities outside Moscow and St Petersburg. Low wages, poor infrastructure and predatory local authorities have conspired to confine most direct investment to Russia’s two biggest cities. This is changing, but slowly.
Cloherty: you don’t know if there is a demand for something until you do it.
The best private-equity players understand these limitations. The trick — for Delta and everyone else — is to take advantage of the seeming plethora of opportunities in a place where management talent is still rudimentary and sizeable businesses with potential are hard to find. «You don’t know if there is demand for something until you do it — and that is the risk,» says Delta’s Cloherty.
Although some people involved in Russian business say management skills have improved by leaps and bounds over the past decade, some elementary knowledge gaps remain. «You have got to explain many things here [to managers] — for example, the way to value a company [or] the structure of capital markets,» says Gleb Davidyuk, managing partner at Mint Capital, which has two funds, together worth $120 million.
«If you are [creating] a new type of business in Russia… you don’t have an experienced pool of people to build on,» says Cloherty. «We try to build a degree of experience into the board of directors, sometimes by bringing people in from other countries, where they have already built [a similar] business and can work with CEOs to reduce learning on the job.»
Delta is not the only one: overpriced restaurants and coffee shops all over central Moscow are crawling with expatriate advisers — although, for now, few of those are here to do private equity. As for those that are, they may have trouble spotting something big enough to be worth their while.
«In order for the mid-cap companies to develop enough to attract investors, they need to have been going for five or six years,» says Mark Jarvis, managing partner, client service and accounts, at Ernst & Young CIS. «The capitalist model in this country is really only 10 years old, so there is not a large amount of mid-cap companies of the size that would be attractive enough for big global funds.»
So it is left to smaller, more independent players, such as Delta, whose average investment is between $5 million and $10 million, to pick up what Cloherty calls «morsels».
For foreign funds that are not keyed into the network of local informal business relationships, the most important thing is clarity, says Cloherty. «Going into a joint investment with a partner should not be an invitation to go to war. There should be an agreement on the time frame within which you will sell your investment position.»
Baring Vostok Capital Partners, the largest Russia-dedicated fund, with $810 million of investors’ capital, makes sure its partners understand that it will exit a venture in five to seven years, says Stanislav Fetolov, the firm’s external affairs director.
Baring has nine other criteria. Among other things, the project must have the potential to triple in size within the five-year period, it should hold an exclusive licence or own a developed brand, it must be on good terms with local authorities and it should operate in a sector where high-cost equipment is essential, raising barriers to entry for competitors.
«There are not that many interesting projects that would yield 35% to 40% annual returns,» says Fetolov, whose group invests in oil and gas, telecoms, media, retail and financial services. The co-owners of those that do sometimes refuse to part with the business when it is time to launch it publicly, he says.
So vetting the potential partner is all-important — and could take months. «I’m doing a background on someone right now, and I have already talked to 12 people with whom the person has worked in the past,» says Delta’s Cloherty. The preferred candidate would be someone already tried and tested. «Most of the deals we have now came from the people we have dealt with in the past, and whom we know well,» she says.
And more often than not, these people have learnt the business on the job. Because the Soviet command economy used to encourage skills different from those desired in capitalist Russia, «almost every [entrepreneur] whom we work with in Russia used to either expect to be — or was — something else,» says Cloherty.
Vladimir Terziyev, the manager of Delta-invested apparel chain Vesch! (a pun on a word that variously means «a piece of clothing» and «quite something!») is a former biochemist. The chair of DeltaLeasing, which finances business acquisitions and from which Delta Private Equity Partners exited in November 2003, was previously an English instructor in Rostov on Don, a provincial Russian city. Andrei Korkunov, a famous Russian chocolate maker (with a company not affiliated with Delta) was a missile designer in Soviet times.
Cloherty says the expansion in direct investments is inevitable. «You are putting small amounts of capital at substantial risk in order to grow large capital value — and that is a new art in Russia, in the same way that credit cards are new and sandwich shops are new.»
Out of luck
Louis Gerstner, Carlyle Group
chairman: pulling out of Russia
It is three strikes and out for Carlyle Group, which in May effectively closed its Moscow office and cancelled a planned $300 million Russia investment fund.
The US private-equity group had first closed its Russia office in 2000, after making just one investment over a two-year period. Then, in 2003, it pulled out of a planned partnership with Alfa Group’s Alfa Capital Partners in the wake of the arrest of Mikhail Khodorkovsky, the CEO of oil group Yukos.
One market participant familiar with the situation says the group feared being tarnished if government prosecutors expanded investigations to include Alfa Group. Carlyle officially denies this. Now the firm is pulling out again.
«The current investment climate in Russia doesn’t justify a dedicated team in Moscow. At the moment, it doesn’t meet the risk profile that Carlyle looks for in all its investments on a global level,» says a Carlyle source, somewhat cryptically, without delving into specifics. The firm has said that it will continue to seek out opportunities in Russia via its Europe-dedicated fund.
The interesting thing is not so much the truth behind why the world’s largest private-equity fund manager failed again in Russia, but the speculation surrounding its demise. The theories betray fears affecting other investors contemplating the market.
The group sported a former manager from Baring Vostok Capital Partners, Russia’s largest private-equity manager. It had a trusted brand name. It also had extensive connections in Russia.
Khodorkovsky and Platon Lebedev, the former CEO of Yukos’s Gibraltar-based holding company Group Menatep, sat on the boards of Carlyle Energy and Carlyle Europe, respectively. Both men were convicted in Russia on several counts including tax avoidance, fraud and embezzlement on May 31 and sentenced to nine years’ imprisonment.
In 2003, an unidentified source close to Group Menatep told English-language newspaper the Moscow Times that Menatep had invested more than $300 million with Carlyle. Carlyle says it was just $50 million. Yet Carlyle had failed to make a single investment since establishing its most recent Moscow office in March 2004.
Carlyle is not the only private-equity player with little to show for its efforts. Although Russia is trumpeted as the next destination for private-equity capital, relatively little of this is actually trickling down. For example, Warburg Pincus made waves when it bought a controlling stake in three radio stations in Moscow and St Petersburg in September 2003, but it has not made a single investment since.
Other big funds are not even thinking of entering the market. Hamilton James, president of Blackstone Group, which manages more than $14 billion through its private-equity funds, told Reuters earlier this year that Russia was the second most attractive region after Asia for private-equity bidders. But a spokesman at the group’s New York headquarters told Euromoney that Blackstone had no immediate plans to invest in the country.
«Following the [financial] crisis in 1998, fundraising has been challenging for Russian private equity,» says Richard Sobel, chief executive of Alfa Capital Partners, the private-equity arm of Russian financial group Alfa, which is invested in biscuit maker United Bakers and real estate firm Noble Gibbons. «The past seven years have seen very little private-equity capital raised, particularly when compared with the size of the opportunity,» he says.
That was starting to change until the government arrested Khodorkovsky and expropriated the assets of Yukos via back-tax claims. In December 2004, the state auctioned off Yukos’s main production subsidiary in a sale that was allegedly fixed.
«The impact was profound,» says one local private-equity manager. «First of all, it made people very unsure about the new rules of the game; second, it appears to have changed the balance of government policies towards control and regulation and away from reforms.»
Foreign investors grew queasy. «There are rumours that Carlyle wants to go public. If they do that, they are not going to be rewarded for Russia,» says the manager. «It’s like a liability on their books. For [investors], Russia is very scary.»
Other investors agree. «There is really no pressure from our investors to go to Russia — in fact, we would have to persuade them to do that,» says Joanna James, managing director for central Europe at Advent International Corporation in Boston.
Advent’s charter allows it to invest in Russia, but it prefers to stick to central Europe’s new EU members. «The framework of the EU entry creates a situation of predictability for us as investors,» says James. «Whereas if you go into a country that doesn’t have that — such as Russia, Ukraine, some countries in the former Yugoslavia — you cannot be certain that the rules would not change overnight.»
In a country that has recently gone through a big upheaval, the waters teem with potential liabilities.
«Many companies have used aggressive tax avoidance schemes in the past,» says the private-equity manager. Contradictory tax legislation and an unstable legal framework meant that, in the early and mid-1990s, «it was very hard to operate successfully without cutting some corners».
Political and legal risks are a burden, but it is the marketplace that really tripped up Carlyle, say observers. The group manages $25 billion in funds worldwide and specializes in large projects as well as the defence sector. But large enterprises in Russia often seek funds from their parent holding companies, while much of the defence industry is off limits to foreign investment.
Although Carlyle set up an office staffed by two managing directors, two other investment strategists and half a dozen support staff, its bosses in Washington probably had little time or interest in pushing Russian projects to investors, says one source familiar with how multinational private-equity funds work.
«For those looking to invest in Russia, the best strategy is to work in this market with your own capital or with a reliable partner for a few years, get a sufficient track record, bear all related risks and then apply for institutional capital from abroad by raising a second or a third fund,» says Gleb Davidyuk, partner at Mint Capital, a private-equity fund manager with $120 million of foreigners’ money in sectors such as technology, media, consumer goods and finance in Russia and Ukraine.
«Just to come in like that and try to raise several hundred million dollars on the back of a big name is not an easy task — and Carlyle is a very good example. Today’s fundraising environment [in the] Russian market requires more than a brand,» says Davidyuk.
Some managers say that meaty projects that would interest big funds such as Carlyle are simply not there. Others point out that, all the same, the market has become too sophisticated for bargain hunting.
Prosperity Capital Management Ltd, which manages $750 million-worth of equities in former Soviet republics including Russia, has stayed away from pure private equity even though its charter allows it to strike deals.
«In private equity, those who sell you the shares are very well aware of the business, so objectively it is hard to make a good deal with them that would also be a good deal for you,» says Alexander «Today’s fundraising environment in the Russian market requires more than a brand» Branis, chief investment officer at Prosperity. «Financial investors, on the other hand, don’t always know the worth of certain shares in their portfolio very well, so it is much easier to find mispricings on the secondary market.»
Sobel of Alfa Capital Partners is convinced that the naysayers abroad will start banging on the door pretty soon. «If we develop our investment franchise now, we can become one of the leaders in the Russian private-equity market — like KKR or Warburg Pincus are in the west. But we have to do this now, or else in five years the market is likely to be more crowded,» he says.
Investors have to tread carefully, though. «The private-equity groups that have been successful are generally those that have steered away from politically sensitive industries and have focused on consumer industries,» says Sobel.
Carlyle Group would not return phone calls seeking a reply to the points raised in this article. Andrei Terekhov, the former managing director wooed from Baring Vostok two years ago, could not be reached for comments. Joshua Larson, the other managing director, who remains with Carlyle in Moscow, was said to be in the US and could not be reached.