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A New Era: Why Invest In Russian Private Equity Now?

Benjamin WIlkening
Russian Private Equity
November 2010

The Russian PE equity market, still far from being mature, is now entering its third stage. After a wild period of investment in post-privatization assets in the nineties and a period of rapid entrepreneurial growth in the first decade of this century, PE is now moving into a stage of consolidation, with entrepreneurs, companies and financial markets maturing.

First Stage: “Post-Privatization Grab”

The beginning of each stage was marked by a crisis that contributed to a paradigm shift in the industry. The first stage lasted from the beginning of the privatizations until the ruble crisis of 1998. This period was marked by very serious macro problems (hyperinflation, the “virtual economy”) and enormous political and corporate governance risks. In the beginning there were literally no self-made private businesses and – more important – no self-made entrepreneurs. The stage was dominated by “red directors” and budding oligarchs. It was all about assets, not businesses. The upside was that those assets were very cheap so that some PE investments yielded fantastic returns . Others went bust or were simply “diluted” away.

Second Stage: “Entrepreneurial Awakening”

The second stage was more similar to Western PE but with marked differences. In fact, it was more similar to venture capital but with very different risk and challenges. The creation of private businesses, which had started in the mid-nineties, was accelerated in the aftermath of the 1998 ruble crisis. This provided PE funds with an opportunity to make venture capital-like investments apparently without the traditional venture capital risks: No technology risk; in the virtual absence of any local quality products and services one could simply copy successful western business models. No start-up risk; the best opportunities were in growth capital for scaling up successful and profitable enterprises. Venture capital-like growth rates; in immature market segments companies could sustain 50-100% growth rates over many years, initially from internal cash  flows, later easily boosted by modest equity or debt financing. And, at least initially, low competitive risk. Add on top of this multiple expansion, partially driven by corporate improvements/transparency with the rest coming from the rapidly inflating bubble.

Of course, this sounds too good to be true. And indeed, this model has a downside that can be summed up in two words: people and execution. Both of these issues became more pronounced as the pre-Lehman bubble inflated. The single most important factor in this model is the entrepreneur. He (there are indeed very few women entrepreneurs in Russia) is the motor of the business. In the early stages, drive, energy and flexibility – and honesty – were the key factors of success. However, as competition increased in virtually all sectors during the ‘00s, the skill and know-how limitations of self-made entrepreneurs could turn into a liability. In this situation, PE funds should add value by assisting the company in transition from a one-man-show to a more institutionalized corporation with distinct separation of management and board levels. However, with increasingly inflated salary levels of managers in Russia this process has been extremely challenging. Attracting and retaining strong top and middle management into mid-sized firms has arguably been the single most important challenge to active PE investors.

There were other issues as well. With the inflation of the bubble, money, especially debt, became more easily accessible. This tempted many entrepreneurs to either circumvent PE completely or to turbo boost their growth through excessive leverage. Apart from balance sheet implications this has led to an erosion in the quality of investments. Many entrepreneurs focused too much on top-line growth and not enough on profitability and sustainability of their investments. Accordingly, the crisis hit those companies especially hard that were either over-leveraged or not focused on profitability and cash flow necessary to serve debt and keep growing once the easy money tap was turned off.

The opportunities and problems of the second stage of Russian PE investments can probably be best observed in the retail sector – an obvious industry for PE investments, fitting all of the splendid criteria listed above: low capital requirements; imitate a successful western format; grow fast and implement; get some PE money and leverage to boost growth. In some cases, this was very successful, both for entrepreneurs and for PE funds. But those who expanded too fast, not paying attention to managing profitability per square meter and financing growth with debt representing a huge multiple of operating cash, woke up to a new reality when the credit crisis hit. Retail is not so much about “location, location, location” – it’s about “operations, operations, operations”.

Third Stage: “Consolidation”

What will change in the Third Stage? There is bad news and good news. With maturation of product and service markets, natural growth rates and IRRs will be lower. Competition will continue its Darwinistic weeding out of the weak players. But there will also be more quality deals. Wiser entrepreneurs, better managers and more refined business models. An increased focus on profitability and cost control vs. unbridled growth will reduce risks. With the simultaneous maturation of the financial markets, there will also be more exit opportunities: simpler IPO procedures (inter alia with an emerging local platform) and secondary buyouts.

In fact, the most important long-term driver of change was increasingly exerting pressure already in the previous stage: competition, driven by accumulation of skills, know-how and experience. In the early stages of development energy, determination and flexibility were the most important entrepreneurial qualities. But by now these alone are not sufficient any longer. The successful development of any company requires deep industry know-how and operational experience. The “professionalization” of practically all product and service markets has accelerated dramatically over the past five years. Partially that is driven by know-how inflow from multinationals, but more important this is the experience accumulated by local executives and entrepreneurs.

The deflation of the credit bubble has led to a more sustainable approach to growth and financing. Entrepreneurs increasingly understand the value of a strong balance sheet with a reasonable debt/equity ratio. More and more entrepreneurs have also come to understand the role of PE investors as value-adding partners, rather than an annoying source of expensive capital.

With the maturation of companies, deal size will also increase naturally. If up to the middle of the last decade, a food manufacturer could start a new product line for less than USD 5 million in production equipment which was set up in an abandoned warehouse, he will now need to build a clean new facility of adequate size and capacity if he wants to create an asset that will be attractive for a potential strategic acquirer. Such an investment can easily run up to USD 20-50 million including working capital and marketing cost.

An increasingly more important factor will also be the structure of financing. For most entrepreneurs it was easy: finance everything with debt until the last piece of equipment and the shares are used up as collateral; then go to PE if that was still not enough to satisfy the thirst for growth. Now, both entrepreneurs and funds have matured to more sophisticated forms of financing such as sell and lease-back or mezzanine instruments. Together with that the attitude toward control is changing. During Stage Two the preferred investment mode was minority stakes. As in western venture capital this was extremely important to keep the entrepreneurs fully motivated and aligned to remain the drivers of capitalization. As the companies’ life cycle moves on and the entrepreneur is replaced in his managerial role by professionals, there is an increasing opportunity for funds to engage buyout teams and take control over them.

The consolidation process itself will offer interesting opportunities. Organic growth through capital expansion can often be financed with debt and without PE investors, but there will increasingly be merger and buyout opportunities that need to be financed with high-risk equity. Two interesting developments here are the “tired entrepreneur” and the “re-focusing oligarch”. Many entrepreneurs founded their companies in the mid- to late ‘90s. After surviving 10-15 years in an increasingly competitive arena, some have come to realize their own limitations in skill and energy to stay on as the driver of growth. They either want to cash out or simply hand over the helm to professional managers. This creates opportunities for buy-out/buy-in situations. The key here is the ability to attract and motivate managers with both the advanced skill set and entrepreneurial mind set to take on such challenges and risks. A similar opportunity is the spin-off of nonstrategic assets by oligarchs and minigarchs.

As to the question: why invest now? Similar to the post-1998 situation, the current debt crisis has helped PE investors in two respects: entry valuations have been brought down to a more reasonable level; and, more importantly, salary inflation has been halted for a moment. But both of these trends may again prove to be transitional. The RTS has already appreciated by 330% since the crisis trough and has already reached 67% of the pre-crisis debt level.

More important than these trends is the fact that the Russian PE market has matured. This means that the heydays of easy money and stellar growth are (almost) over. But as in any mid-cycle market the Consolidation Stage will offer attractive opportunities for those players that stay focused on the two most important aspects: people and execution. The same, by the way, will also be true for Russia’s PE industry itself.

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