News 07.07.2009
AmCham News article: "Private Equity for SMEs: Financing the Development of Russia’s Economy", by Richard Sobel Private Equity for SMEs: Financing the Development of Russia’s Economy
There is a sense of Déjà vu in Russia as the country again finds itself in the midst of an economic crisis. The Russian economy achieved impressive growth since the early 1990s, and especially since the 1998 crisis, exceeding many expectations; however, the country’s continued dependence on commodities and foreign capital contribute to heightened cyclicality and volatility, and result in a love-hate relationship with foreign investors. The challenge is clear. To reduce its vulnerability to external shocks, Russia needs to diversify away from commodities and build a “value-added” economy. To facilitate this, it needs to develop long-term domestic sources of private sector debt and equity capital that also reduce its dependence on short-term international capital flows.
President Medvedev and Prime Minister Putin have outlined the country’s economic goals, which include diversification away from a dependence on resources, increased employment in value-added sectors, the improvement of Russia’s longterm industrial competitiveness and an increase in the average standard of living. These worthy and ambitious goals are not new to post-Soviet Russia, and while they have been widely and rightfully lauded, they require time, resources, and commitment. Unfortunately, the path to achieving these goals is not clear, and the necessary programs and resources are not yet in place. The growth of small- and medium-sized enterprises (SMEs) offers the most effective means to achieve sustained GDP growth, job creation, and economic diversification. The current crisis affords Russia a wonderful opportunity, which it should not waste, to speed up SME development. As a veteran private equity investor active with SMEs in Russia since 1991, I encourage the Russian government to introduce financial programs to promote the development of SMEs and the domestic private equity industry, as well as to improve overall conditions for economic growth and diversification.
The Growth of Private Equity
Over the past fifty years, private equity has evolved and matured into an important asset class in developed and emerging markets. Private equity (PE) refers to a range of investment strategies from micro-finance, seed finance, venture capital, growth capital, buyouts, real estate, and infrastructure. Sophisticated investors appreciate that a portfolio of private equity funds can deliver above-average returns, with reduced volatility. Since the collapse of the Soviet Union, the young Russian PE industry has experienced waves of growth and contraction, emerging as a respected, value-added source of equity funding for small- and medium-sized businesses. Beyond the long term equity capital, private equity managers typically support portfolio companies and their owners and managers in a variety of ways, including management recruiting, improved transparency, governance and accountability, strategic planning, M&A, budgeting, and arranging additional debt and equity.
International capital plays an important role in an emerging market’s development. Foreign investors act as catalysts, demanding transparency, accountability and attractive riskadjusted returns. In both portfolio and private equity investing, foreign investors bring valuable experience, know-how and credibility. Over time, the role of these investors in an emerging market is taken over by local investors, who learn, come to understand the opportunity, and ultimately dominate the market. Indeed, in Russia during the recent period of economic expansion, local financial groups came to play the largest role in private equity deals, albeit often by using borrowed foreign capital. As a result of the economic crisis and tightening credit marks, however, most Russian financial groups suddenly find themselves once again with sharply reduced resources for new private investment.
Around the world, government sponsored initiatives in support of the private equity industry have had a powerful development impact. These initiatives are important for the capital and economic incentives they provide, and for the commitment that they demonstrate, which bolsters investor confidence. Small business investment company initiatives (SBIC) in the U.S., as well as micro-finance programs and other private equity fund initiatives in emerging markets by the European Bank for Reconstruction and Development (EBRD), the International Finance Corporation (IFC, part of World Bank) and the U.S. Overseas Private Investment Corporation (OPIC) represent a few of the successful programs. These programs have demonstrated a powerful ability to scale up and mobilize institutional capital, with a large multiplier effect. For example, every dollar of direct, government-related financing or financial guarantees can attract from three-to-ten dollars of additional private capital into fund-investment vehicles. Some OPIC fund programs provided debt financing to PE funds, which bolster investor confidence and enhance returns to the equity investors, while protecting and ultimately repaying OPIC’s capital with interest and a small profit share if the fund is successful. Additionally, fund performance has generally been positive, due to the fact that the capital is awarded through a transparent, commercial process, with risk sharing, profit sharing, transparency, and accountability. Equally, the money that pours in to private equity quickly trickles down to the local economy in ways that other government initiatives fail to do. It turns job seekers into job creators. Employment growth, training and creation of successful businesses encourage a virtuous cycle of entrepreneurship and new business formation.
Since 1994, many Russian private equity funds have been formed with some of the capital from the EBRD, IFC, and OPIC. International investors rely on these institutions to screen and carry out due diligence regarding the fund manager, to provide seed or anchor capital, to participate in governance, and to generally give a good housekeeping stamp of approval. Alfa Capital Partners, an affiliate of Russia’s Alfa Group, manages or co-manages $701 million in three private equity funds, targeting growth capital and buyouts, real estate, and infrastructure. We receive valuable support from OPIC, EBRD, and IFC in forming and managing these funds. EBRD, and IFC both remain active in Russia. The Russian government has also supported various private equity related efforts, including the EBRDsponsored Regional Venture Funds, Russian (government) Venture Funds (RVFs), and RusNano, demonstrating its recognition of the importance the PE industry plays in national and regional economic development.
As the chart below shows, from 2005-2008 roughly $6 billion was raised for Russian private equity funds. While this amount represents a large increase over previous years, when compared to developed markets, and especially when compared to China and India, funds raised for Russian PE partnerships lag far behind in both absolute terms and as a share of GDP. This low amount can be attributed to a combination of misperceptions and concerns on the part of many international investors about Russia and the relatively small role of Russian investors to date.
In 2008, Private Equity Fundraising and Investment continued to grow for Russia, while other BRICs saw investment activity slow.
Private Equity Penetration in Russia vs. Other Emerging Markets, 2008
Rewarding Investors
The current demand for private equity capital in Russia is large and pressing. In recent years, excess liquidity, inexpensive bank debt and the ruble bond market reduced the attractiveness of private equity financing for SMEs. With the sharp reversal in economic conditions, and a sharp decrease in domestic liquidity, debt is either not available or too expensive and short-term. Many Russian SMEs are now under severe pressure to refinance short-term debt at a time of declining earnings and reduced availability of equity capital. Private equity is needed to fill the funding gap, and the resulting dynamics for investors are much more favorable.
EBRD tracks the performance of PE funds in Russia and Eastern Europe. According to EBRD data, many of the best performing PE deals and the best performing funds since 1992 were those which were formed and invested in during the years following a major crisis. With private company valuations now off sharply and the cost of doing business moderating, investments made in the next two years are likely to find better value and lower risk, rewarding investors for their courage and market timing.
The case for investment in Russia remains sound and is based on strong long-term fundamentals, as well as the fact that Russia is again one of the cheapest emerging markets in the world. An abundance of natural resources, a large consumer market, and a talented human resource base contribute to the country’s potential.
Analysts expect Russia to return to moderate GDP growth in 2010, and the recent rebound in oil prices has led to growing signs of stabilization, namely the strengthening of the ruble and a rebound in the stock market. Russian private equity has certain advantages over public-market investment, including broader access to the domestic economy, generally lower valuations, better transparency and governance, and the ability for PE managers to add value and manage risks through board participation. Most PE funds in Russia are focused on consumer-related industries, targeting the surge in disposable income and spending. Our experience indicates that private company valuation multiples are down from 8-11 times EBITDA at peak to 4-6 times at present, although relatively few PE investments have taken place recently. While many of the best companies remain reluctant to sell control, it is becoming easier to secure favorable governance rights.
The best time to invest is often the hardest time to raise capital. The next one or two years are expected to be extremely challenging to raise PE capital for Russia, amidst growing capital flight and an overall slowdown in fund formation globally. Unfortunately international investors are scaling back commitments to alternative investments, including PE, and are increasingly comparing investments in Russian private equity, real estate, and infrastructure funds with comparable, lower risk partnerships in developed markets in which valuations are also sharply reduced and risks are lower. Investors typically demand a premium in expected annualized returns of 5-10 percent for investing in Russian PE relative to similar investments in developed markets. In the current crisis, many investors are so severely capital-constrained that they will not invest in emerging markets PE under any circumstances. A recent survey of leading international investors by the Emerging Markets Private Equity Association (EMPEA) and Coller Capital ranked Russia the lowest among the four BRIC countries for new LP commitments to PE in the next 1-2 years. Some international investors will come, but greater attention must be paid to raising PE capital from local investors. Over the long term, the real potential for Russian PE lies in developing the domestic funding base. The Russian government’s support for PE fund formation will be particularly essential for success in the near term. Fortunately, Russian PE is attracting growing interest from local high net-worth individuals, pension funds, insurance companies, and corporations. A number of Russian investors became disillusioned with Russian public equity, following the 80 percent decline in 2008, however, as a result, Russian institutional and private investors are once more starting to explore Russian PE, in search of better returns with reduced volatility.
The relatively small amount raised for Russian PE is also due to the significant challenges involved in raising Russian PE funds, and the volatility many first time funds have experienced over the past fifteen years. Many PE funds raised in the 1990s fared poorly due to the crisis of 1998, with losses forcing some to exit, while deterring others. While two of the oldest Russia-dedicated PE firms recently succeeded in raising their third and fourth funds, most PE firms in Russia are still on their first or second fund. During the recent economic boom, Russian private company valuations surged. It became challenging to acquire stakes in good companies at reasonable valuations, and many investments made in the last two years now appear over-priced. EMPEA tracks investment levels in emerging markets and reported that PE investment in Russia surged from $0.6 billion in 2006 and $0.8 billion in 2007, to $2.7 billion in 2008. Many funds invested most or all of their capital; some Russian PE partnerships are even undergoing restructuring, due to a combination of bad deals, staff turnover, and failure of LPs to fund their capital commitments. Those Russian PE groups that have capital to invest are reviewing deals and seeking to acquire good companies with stable cash flows, at reduced valuation multiples.
Broadening Focus
The focus of private equity in Russia continues to broaden, mirroring the development of the economy, with increased demand for equity to finance businesses in a wide range of consumer and industrial industries, both manufacturing and services, including food and beverage, technology, transport, media, and in recent years real estate and infrastructure. Real estate and infrastructure represent large segments of the economy which require enormous investment for modernization and expansion, although both segments have raised relatively limited partnership capital to date, and are more dependent on cost-effective debt to achieve target returns, so are likely to experience more moderate growth in the near term. Successful private equity backed companies are involved in many other industries, including specialty retail, movie theaters, auto and home security, agribusiness, software, and business process outsourcing. Other private equity backed companies target new, relatively underserved sectors in the economy, including elder care, health care, waste management, supply chain services, and document storage. Others include fitness, food processing, casual dining, auto retail, consumer finance, oil field services, multi-modal transport, logistics services, and real estate.
Many leading Russian economists continue to lobby for further liberalization of the economy and for structural reforms as a means to aid new business formation, job creation, economic growth and diversification. Empirical studies in the U.S. and Russia show that industries in which the government played an active role and where greater regulation existed lagged in growth, profitability and overall competitiveness.
Structural reforms have advanced slowly in Russia in recent years and the Russian government must determine the timing and pace of any further reforms. Investors and entrepreneurs watch closely for substantive policy initiatives that demonstrate Russia’s commitment to reform and to developing its economy to its full potential, and for the degree to which property rights are protected. Meanwhile, the delay of Russia’s WTO accession sends a mixed signal to domestic and international businesses and trading partners regarding its commitment in promoting free trade, open markets, and long-term competitive development.
Russia’s Image Problem
Regrettably, Russia also has an image problem with global investors. While misperceptions cloud the picture, real challenges exist that impede raising both international and local capital for Russian PE and SMEs. Legitimate concerns include a weak judicial system, corruption, and the large role which the government continues to play in the economy. Investors, owners and entrepreneurs would welcome the introduction of stronger legal measures to protect against aggressive raider activities, which hinder the development of successful businesses, harm the country’s reputation, raise the risks and cost of capital and impede the flow of funds to SMEs. Taken together, economic liberalization, structural reforms, and stronger measures to protect property rights would bolster investor confidence, increase entrepreneurship and competition and stimulate economic development.
A key event in the development of Russian SMEs and the Russian private equity industry was the Vimpelcom IPO in November 1996. Originally backed by a group of private investors and PE funds, Vimpelcom was the leading mobile phone operator in Moscow at the time. The Vimpelcom IPO demonstrated to local owners, managers and investors the powerful wealth creation which can be derived from the market capitalization of a successful, transparent business, which is many times the wealth which can be made by owners and managers who seek to maximize short-term cash flow and stealing. Another example of the successful fusion of entrepreneurship, SME and PE in Russia is World Class (now also referred to as Russian Fitness Group). In 1993, Olga Sloutsker founded World Class, Russia’s first modern fitness company. In 2006, Alfa Capital Partners made an investment in World Class and her chain of ten clubs. Over the last three years, it has expanded to thirty clubs, with roughly 100,000 members and nearly 3,000 employees. For fifteen years World Class has promoted fitness and in so doing, pioneered a new industry to develop. Unfortunately these entrepreneurial successes rarely get the same amount of publicity as the problems in Russia. Meanwhile, my own personal involvement with successful Russian SMEs has exposed me to the tremendous skill, passion, and determination of Russian entrepreneurs and informs my own confidence in the great potential for SMEs and PE in Russia.
Russia must decide for itself its economic priorities and its model for economic development, including the role of SMEs, free trade, and private equity funds. While many informed observers remain skeptical as to whether Russia can achieve sustained high growth through entrepreneurship and SMEs as has occurred in many countries around the world, I believe the potential is great and depends mostly on creating favorable conditions and providing some catalytic support. There is significant international experience that the Russian government can tap into to develop its own strategy for how best to promote development of SMEs. Government support for the private equity industry and development of a domestic funding base play an important role. The United States is indisputably the most advanced market for private equity in the world, and venture capital, private equity, and SMEs have been an engine of U.S. innovation, growth, wealth creation, and national competitiveness. The United States has unmatched experience to share regarding entrepreneurship, management training, and the cross fertilization of academia, research, capital markets, and investment institutions. July’s presidential summit in Moscow and its parallel business summit afford both Presidents, their advisors, and invited guests an opportunity to share experiences and explore the many opportunities for closer economic cooperation. If President Medvedev signals interest, President Obama can even encourage experienced U.S. VCs and PE managers to explore partnerships and investments in Russia, bringing valuable capital, know-how, contacts, and credibility. Closer cooperation offers benefits to all participants. Strengthening business and commercial ties between the U.S. and Russia could improve relations, broaden and deepen mutual interests, and serve as a shock absorber to soften the bumps from periodic political differences. Most importantly, it can be a big boost to advancing Russia’s economic priorities. ■
This article reflects the personal views of the author and not necessarily those of his company.
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