Post-Crisis Private Equity Investment in Russia
In this article I am trying to address the post-crisis environment for Private Equity investing in Russia. To gain a better understanding, a short history of Russian PE is needed. There are many aspects that I am not covering, including corruption and red tape. Also it is important for the reader to know that my vantage point is investing in small and medium-sized Russian companies that were created by post-Soviet entrepreneurs. Accordingly, the ideas and observations brought forward in this article may have less relevance for larger companies and for natural resource based companies.
Russian Private Equity 1999-2008
Russia bounced back quicker than most people had expected after the meltdown in 1998. This crisis, which was largely homegrown, was a much needed catalyst for change. A period of active reform and strong growth followed. Yet it was not until the middle of the following decade that we saw any significant increase of activity in the PE arena. The first five years of the “noughties” were good years for Russian PE investing. Valuations were reasonable and almost all companies saw massive growth while keeping profit margins high. The main challenges were related to corporate governance -lack of transparent legal and financial structures increased risks for PE investors but with good partners/co-shareholders restructuring was possible and indeed done.
In the second half of the 99-08 period, we saw new funds popping up at a speed that left some of us bewildered. International money started to flow more easily into Russian PE and Russian money entered the market (see Chart 1). New teams were formed to manage the new money. Since Russia is a very young PE market and has a very limited number of experienced former executives, it was natural that these teams were mostly from investment banking and consulting backgrounds. So, we saw a sharp increase in the supply of PE money starting from 2006.
At the same time, companies were getting carried away with >25% annual growth rates and bumper profits. Most people in the Russian market, including investors and analysts got carried away and assumed the same growth rates and high profit margins to stay. Reality was, however, beginning to catch up. By 2007 growth rates were falling, although still high, but what is more important, profitability was under pressure. This was driven by competition, wage inflation, improved tax compliance, and not least an almost complete lack of management focus on cost and efficiencies.
As a result, we had two main factors that in combination led to high valuations and in some cases bad investments: 1) Owners and Managers not acknowledging a new reality of slower growth and lower margins, thus using excessively optimistic assumptions in their forecasts; 2) A wave of money trying to get invested, in many cases by deal-driven new teams not questioning those assumptions vigorously enough (see Chart 2).
The conclusion here is that many PE investments made in the years leading up to the 2008 crisis were made on too optimistic assumptions at too high valuations and into companies whose management had little or no experience in cost-cutting and operational efficiencies. In addition, many PE fund managers were not driving the necessary changes pre-crisis as vigorously as we should have.
The 2008 Crisis
It took a while for the sub-prime crisis to become a Russian crisis, but when it happened in the fall of 2008, it did so with a vengeance. Once the crisis was fully understood, companies took decisive action and by the end of 2009, most companies in our universe had cut enough costs to be break-even on an operating basis. In those cases, where companies where leveraged, restructuring negotiations were very difficult and lengthy, but on the whole balance sheets were in order by the end of 2009 or early 2010.
2010 and Beyond - a New Era for Russian Private Equity Investments?
Perhaps the most significant development for PE investors in the first decade since the Russian crisis of 1998 was that owners, entrepreneurs and managers extended their investment horizon. For those of us who remember and participated in the quick trade mentality of the early 1990s, it is a different world altogether. This longer term view will prevail. In this respect, owners and entrepreneurs speak the same language as the PE investor.
What, then, has changed in the recent crisis and will it improve the ability to generate adequate and sustainable returns for PE investors? Let’s look at a few important factors below.
1. Growth will be strong, but uneven.
It is our, and most observers’, view that Russia will generate decent growth in the next decade or so. For the purposes of this discussion we can leave the absolute numbers aside and just assume that Russian growth will be stronger than most developed markets. From a macro-economic point of view, Russia is in good shape. From this we can derive that companies will grow too. What is new is that the era of all-encompassing above-par growth is dead and buried. This means some companies will be winners and others will do less well. In the heydays leading up to the crisis, even less well-managed companies did relatively well. The recent crisis has made it clearer which companies and managers are good enough and which ones aren’t. This means managers of PE funds will have to do better in picking winners but that should be viewed as an opportunity and another step towards normality of the Russian market. Conclusion: Growth will provide ample opportunities but picking the right companies will be a condition for successful investing.
2. Realistic Assumptions. Owners and managers have become more realistic in their growth and profitability assumptions. This should support a more even discussion between investors and owners/managers. Conclusion: A more sober approach to future growth should bring valuations down to more realistic levels.
3. Experience of Company Managers.
The most experienced lot went through the 1998 crisis but in most cases real growth and the creation of successful SMEs began after 1998. Therefore, the formative years for the new cadre of managers were in the fast-growing decade post 1998. Many were shocked to see that curve broken. Some are still expecting to see “a return to normal growth” once the crisis is over. Still, most managers and owners have taken on board the necessary lessons from the recent crisis. This means that Russian managers are now better equipped to forecast the future and to deal with difficulties in their businesses. One of the biggest challenges for PE investors in Russia has been to find and develop really good management teams. Admittedly, the development of a capable and experienced management cadre is by definition an evolutionary process but the 2008-2009 crisis and the ensuing slower growth 2010 have undoubtedly instilled both awareness and experience that were largely missing before. Conclusion: Company management is better than before the crisis.
4. Corporate Governance and Financial Transparency. These are much-debated areas when it comes to investing in Russia. Both of them are tightly connected with the investment horizon an owner has. As the horizon has extended and as the government has tightened control over tax evasion and some areas of corruption, corporate governance and financial transparency have improved considerably. Traditionally, these have been two areas were PE investors have been able to add much value by introducing better standards. With the crisis some market participants expected many companies to fall back to their old practices of aggressive tax evasion, but this doesn’t seem to be the case. On the contrary, banks are getting better at risk management and credit analysis, which forces companies to have their accounts in good order. In addition, managers and owners are getting used to improved standards. In other words, a return to the practices of the 1990s is hardly in the cards. This is good news for everybody. Conclusion: Corporate Governance and Financial Transparency continue to improve.
5. Private Equity Fund Managers. As mentioned above, the emergence of many new PE managers broadened the market considerably. The recent crisis will have culled the number of managers that is or will be raising new funds. Those managers that have managed to steer their portfolios through painful cost-cutting and restructuring will have gained invaluable experience. There are still only a handful PE fund managers that have managed more than one fund. Very few have what can be deemed long-term tack records. The Russian PE industry is still in its infancy and one of the effects of the recent crisis is to have brought its “sex appeal” back to normal again from the elevated levels of 2006-2008. Importantly, though, purely domestic PE fund managers have established themselves alongside the mainly foreign-owned managers that have been around for a decade or more. Conclusion: The crisis resulted in a consolidation of PE managers. Those that are or will be raising new funds are better off from experience gained in the crisis.
So, are we entering a new era for Private Equity investments in Russia? Our view is Yes. Having invested in Russian entrepreneurs since 2001, we firmly believe we are seeing a fresh start and we are in a good position to take advantage of it from our next fund. Increasingly, the basics for successful PE investing are falling into place. The market has been promising for many years but only a handful managers have generated good returns over the lifetime of the Russian PE market. In order for the Russian PE market to compete against China, India, Brazil and other markets, investors need to see good returns in a broader market and over a longer period. The Russian market has developed fast but from a low base. In 2010, the PE market is still immature but much more established than 10 years ago. The factors that I have mentioned are likely to improve the conditions for making good private equity investments in Russia. Given the better and broader market that is now in place, we think this is the start of a new era for Private Equity in Russia.