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A well-kept secret

Private Equity International
May 2011

It took a decade for Russia to wake up to the potential of private equity, but then the financial crisis hit Russia's fragile economy hard. Will government reforms and a new, transparent approach to business see Russian private equity deliver on its potential? Lyndon Driver reports

The Russian private equity market has experienced a roller coaster ride over the past decade. The first signs of life can be traced back to the early 2000s when the government, seeing the positive economic growth achieved by private enterprise in many western nations, began to relax its hitherto prohibitive attitude towards entrepreneurialism. This leeway allowed universities to establish the first spin-out enterprises, principally technology-orientated companies.

Alexandra Johnson, managing director of DFJ VTB Aurora, says, "For close to 60 years entrepreneurialism had been virtually banned in Russia, but from 2000 the landscape began to change. The first university to embrace this new mood was the Tomsk Polytechnic University, but soon other institutions across Russia began to recognize the opportunity to commercialize their academic work. Today, university spin-outs form one of the most important sources of deal flow for venture capital houses."

The market continued to grow apace throughout the mid-2000s and a handful of local venture capital firms emerged in response to the new-found investment opportunities. At this time, as the market was still relatively nascent, competition for deals was strong, and some VCs began to broaden their horizons beyond Russia.

Alexandra Johnson explains. "As Russian VCs began to turn their attention to technology areas such as Silicon Valley, so too Russian limited partners began to invest in US VC funds. This new dynamic opened the eyes of the west to the Russian VC marketplace, and before long the large international buyout houses started to take a keen interest in Russia's new-found growth."

International funds had good reason to take note of developments. There were a number of factors driving the market. Ulf Persson, managing partner of Scandinavian private equity firm Mint Capital, says: "At the beginning of the decade, the newly-established technology and software companies relied solely on the export market, which deterred many VCs from investing, but as Russia's economy grew, there developed a healthy domestic market, which took a lot of the risk out of the investment."

Persson continues, "The VC market expanded beyond technology as other sectors including health & beauty, retail, food and other consumer-related industries began to flourish. Growth in these areas was driven by the increasing affluence of Russia's middle class society."

But just as the country was enjoying an unprecedented period of growth - according to the IMF Russia's GDP topped $1.4 billion in 2008, a rise of 87 percent over the 2005 figure of $750 million - the economic crisis took hold. As a relatively new, fragile economy, the downturn hit Russia much harder than in Western Europe. Those investors that had recently raised their first funds were burnt badly and left the market completely, and the returns achieved by the more experienced fund managers were greatly reduced.

But some economic indicators suggest that even without the crisis, Russia was facing a problem anyway. Persson says, ''Increased competition for deals, rising salaries, inflation, a failure to make cost efficiencies and a Government crackdown on tax evasion all combined to reduce margins. The warning signs were there even before the crisis, as investors were executing bridge loans to help their portfolios that were running out of cash."

Irrespective of the dynamics, the crisis had a dramatic impact on the Russian private equity market. According to data provider Mergermarket, there were 53 deals with a total value of just over £6 billion in 2007, whereas the following year there were just 33 deals registering £2 billion. And in 2009, at the nadir of the crisis, just eight deals totalled less than £230 million.

In spite of these striking statistics, some industry practitioners remain upbeat.

Andreas Boesenberg, deputy global head of Private Equity and Special Situations at investment adviser VTB Capital, says: "The crisis has helped cool what was a rapidly overinflating market. Today it is a more rational environment for doing deals. Russia is now in the second year of recovery, and those companies that have ridden the storm are beginning to grow once more and that will encourage the return of the private equity market."

Ulf Persson agrees. "The quality of the opportunities today is constantly improving and this is a direct result of the crisis. Businesses have had to improve their reporting standards, their management teams and their balance sheets in order to attract the investment they need."

There are other factors influencing the recovery. Hans Christian Dall Nygaard, head of growth capital provider CapMan Russia, says, "The widespread reforms that the Russian government is overseeing can only improve corporate governance. These reforms signify a clear commitment to make Russian companies more investable.

"In addition, the lack of availability of debt for SMEs will also mean that these firms will turn to VC firms and PE houses for funding. In Russia, it is only the larger businesses that can access debt," he adds.

But in spite of these glimmers of positivity, there remain some doubts over Russia as a near-term proposition. Countless press reports of corruption over the years have done little to endear Russia to outsiders, and this naturally makes investors wary. Ulf Persson says, "Whereas corruption is still a big problem in Russia, it is confined to a small number of highly-lucrative industries that have a high-degree of government involvement, such as the natural resources sector."

However, Alexandra Johnson believes there has been some improvement. "Dealing with the bureaucracy can be challenging, especially if you are unfamiliar with the market, but it is definitely moving in the right direction," she says.

Another question mark hangs over an investor's ability to dispose of assets within a reasonable time frame. Hans Christian Nygaard says, "Currently there are not many exit opportunities in Russia. Whereas we have seen some trade sales to the larger conglomerates, the IPO market is not attractive. Although it is true that the Russian stock exchange in near an historic peak, easily exceeding those of other emerging markets by some margin, it nonetheless remains a volatile market with long lock-up periods."

Andreas Boesenberg also identifies other issues. "Whereas the challenge before the crisis was in identifying companies that were not over-leveraged, now the real challenge is to find businesses that are well-managed, correctly-structured and have real growth potential," he says.

There is also Russia's notorious infrastructure and track record of unpredictability to consider. Francis Skrobiszewski is senior vice president at Hungarian-American Enterprise Fund, who has spent several years working in Central & Eastern Europe, with a keen eye on Russia. He says, "The Anglo-Saxon legal system offers a much more flexible and creative approach to structuring and closing deals than Russia's.”

He continues, "Then there is the 'predictability' factor. The Russian Ruble crisis in late 1990s took many by surprise, as did the subsequent dismantling of YUKOS. These and other events shake foreign investor confidence."

In addition, according to a recent report published the Emerging Markets Private Equity Association in association with Coller Capital (based on a survey of 156 private equity Investors globally), 63 percent of respondents cited political risk as a major deterrent to fund managers new to investing in Russian private equity - the highest for any region in the survey.

However, Erwin Roex, partner at Coller Capital, clarified, "It's tied with how Russia is perceived in the outside world. Investors that are already in the Russian market have a quite different perception from those that are not in."

This goes some way to explain why LP appetite for Russia remains low when compared with other emerging markets.

Hans Christian Nygaard says, "When it comes to institutional appetite for emerging markets private equity funds Russia is bottom of the league table. But this is an anomaly, since when it comes to realised returns from Russian investments it is firmly in the top three in terms of fund performance."

And in the world of alternative assets, the main objective is to generate attractive returns.

Alexandra Johnson says, “Given the amount of support the Russian government is beginning to provide to the industry it is surprising that relatively few international firms have tested the water. For now at least, Russia is a well-kept secret."

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