Russia is a PE desert

The global crisis has depressed private equity investment everywhere, but in Russia the business has yet to get going, despite offering some of the most attractive returns in the world.
Money. It’s the air that entrepreneurs and fast growing companies breathe. It is also hard to come by for those in Russia and the current crisis has just made it a lot harder. The Kremlin has started a big push to modernise the Russian economy, but while in the west, anyone with a really good idea and a bit of development under the belt can usually find cash to continue; in Russia the nascent private equity (PE) business has been given a messy nose and will take years to recover.

Richard Sobel, the head of Alfa Capital Partners, is the old man of Moscow’s nascent private equity business. He has been working and investing into Russian business since the Iron Curtain fell in 1991 but after almost 20 years in the game, he still refers to Russia’s PE sector as a “young market”.

Russia’s PE industry was just getting going in the boom years, but was still very lopsided. Prior to the crisis, Russia boasted about $40 bn of private equity funds, according to Michael Calvey of Barings Vostok Capital Management, another doyen of the market. Of this money, only about $5 bn was institutional money managed by professional (almost all western) fund managers. The rest was the oligarch’s money that they were investing into anything other than the sector that made them rich in the first place. By 2007, this oligarch money was becoming more sophisticated and several of Russia leading businessmen had hired professional fund managers to invest their billions.

But the crisis hurt Russia’s super-rich more than anyone else and almost all the oligarch money has evapourated. Sobel’s fund has $611mn of assets under management, of which it has invested about $300 mn. But most of what is left of the PE assets under management now belongs to the international financial institutions like the IFC and the EBRD.

“The Russian PE market is young but in each cycle, it gets stronger,” says Sobel, speaking at the C5 Private equity conference in Moscow in March. “The current downturn is to be expected. Private equity is an inherently cyclical business and the extremity of Russia’s cycles exacerbate these flows [of money].”

For most funds, 2009 was a year of simply surviving as the game went from expanding into the regions as fast as you could, to consolidating assets and improving operational efficiencies.

“You could find yourself in the position where your company was still profitable but managing the debt and credit repayments became really hard,” says Sobel. “Still, most banks were willing to sit down and discuss restructuring, so there have been relatively few distressed sales.”

Most Russian companies put in flat sales growth in 2009, but thanks to inflation and the ruble’s appreciation that translates into a 20 pc real fall in sales in ruble terms and 30 pc fall in dollar terms, says Sobel. On the flip side, the cost of business has come down considerably and it has become much easier to find experienced managers.

As the main source of investment capital remains a company’s own funds, most had a stock of cash at the start of the crisis. Some fund managers thought that they would be able to pick up some real bargains as the crisis hit. They were wrong. Valuations held up really well at first as owners were reluctant to let their babies go. But as the cash ran out some owners changed their tune.

“In 2009, we saw the valuations come down slowly at first, but then they started to fall fast,” says Sobel. However, other fund managers say that the valuations of the best companies – the ones that they were most interested in – didn’t move and cheap companies were often not worth buying.

Now, the economy seems to have passed as bottom investors are getting interested in growth again. KPMG predicted in a recent report that the volume of mergers and acquisitions would go up by half this year over 2009 to around $70 bn. However, the same report went on to say it could take more than five years until the peak levels of deals seen in 2007 are reached again, when the volume of funds invested reached $125 bn, or about 10 pc of GDP.

Russia has never been an attractive destination for international PE funds because of the perceived risks. Fund raising surged between 2005 and 2007 to reach a total of about $5 bn almost all of which was invested. However, Russia will struggle to raise money now and was already lagging behind its BRIC peers: Russia’s PE ranking in terms of assets under management has fallen from sixth to ninth place amongst the emerging markets, while China, Brazil and India have retained their slots of first, second and third respectively.

“Making a list of the risks you will face in Russia is easy,” says Sobel. “They are all there – every risk you can think of. ”

Enough to put anyone off? It would be, except that Sobel goes on to point out that investors are amply rewarded for taking these risks. Russian PE investments have returned 7.2 pc, 24.1 pc and 15.6 pc over the last three, five and ten years respectively, making it by far the best performing of any PE market in the world, let alone its BRIC peers.

And even with this stellar growth Russian companies remain very cheap. The average company valuations are 8-10 times EBIDTA against the other BRIC valuation multiples in the high teens or close to 20.

Russia’s economy has now clearly passed bottom and owners are getting more confident again. If they got this far, then they will probably see the course through to the end. Sobel says that the time is now to get into the game for private equity funds.

“The opportunities now are much better than they have been for years,” says Sobel. “The valuations are lower and there is almost no competition.”

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