1.5 Pension funds
In the US, pension funds and university endowments are the main investors into private equity. Generally, pension funds tend to change their asset allocations as they get scale, becoming more sophisticated and increasing allocations to equities, derivatives and private equity. Two graphs below reveal how the complexity of pension funds’ investments grows with size and where Russia is currently standing compared to the US.
Figure 3. Complexity of investments increases with size Source: Goldman Sachs
Figure 4. Pension fund AUM vs. investments in deposits and fixed income instruments by country
Source: Goldman Sachs
Having cleaned up the pension system in 2013-14, the Russian government now seems ready to allow resumption of contributions to private pension funds. The pension funds in Russia are growing, and the new trend has started. The % invested into Fixed income instruments and Equities is declining, from 96% of AUM in 2012, to 85% in 2015, with remaining 15% invested into alternative asset classes, including private equity. The share of pension funds’ capital invested in alternative asset classes is rising, and will someday reach the US levels. Ofcourse, the Russian government may impose restrictions on the investment strategies of pension funds, including directed purchases of certain instruments (eg. Private equity) which is not an uncommon practice. However, considering that the 2 largest private equity funds are run by the government, this scenario is very unlikely.
Pension funds are also key participants in deal flows, accumulating substantial stakes in companies at IPO. Thus their expansion will likely bring changes to the quiet Russian IPO market, making exits through IPO easier and thus increasing overall returns and reducing the uncertainty of the private equity industry.
2. Theory and framework
2.1 Theory and data collection
A general overview of the theoretical side of private equity is necessary in the beginning, because it sheds light on the processes and transformations, which are going in the private equity industry. Understanding of which is necessary to prepare correct and insightful questions and is absolutely crucial for the interpretation of the results. There are several trends in the western private equity industry and the difference between PE and VC funds is becoming more subtle in recent years. Some private equity firms have moved down-market: they invest in smaller, riskier projects. It became harder to private equities to generate returns using merely financial engineering because venture capital firms started to step on the private equity territory. Since, as discussed above, the line between PE and VC in Russia is negligible, as buyout firms are involved in venture deals and vice versa, I have used both PE&VC funds for my analysis. My goal is to establish the key differences between the Russia and the West according to the main industry players.
I have collected data from open sources, i.e. interviews, webinars and articles made by private equity executives in Russia, including the interview with Michael Calvey (managing partner of Barnig Vostok), conducted by Oleg Tinkoff who is a well-known Russian entrepreneur and a founder of the fastest growing digital bank in the worlds, Tinkoff bank. As well as that, I have conducted a face-to-face interview with a senior associate at Vostok Emerging Finance, Alexis Koumoudos, asking open-ended questions about the current situation and the future trends of the PE in Russia.
2.2 Limitations of data collection
Globally, the data available on the topic of private equity is very limited. PE funds are not legally required to disclose neither performance information nor the data about their positions. In emerging markets it is even less transparent and Russia is a perfect example of that. Academic focus on the topic of PE in Russia is extremely limited, compared to the extensive literature available on traditional financial activities.
Domestic sources can unreliable due to the Russian ”regulatory policies” of the public information in Russia. Sources that I have used in my research that I believe can be considered accurate are the Preqin.com, publications of the Private Equity associations, including European Venture Capital Association (EVCA), as well as of international institutions with interests and activities in Russia, such as the EBRD, the World Bank etc.
2.3 Key players used for the analysis
• Baring Vostok Capital Partners, Russia
is a pioneer and currently the biggest private equity fund on the Russian market, founded in 1994. The most famous deal of Barings is an acquisition of 35.7% of Yandex in 2000 for US$5m. Yandex currently has a market capitalization of US$9.4bn. Thus, Barings has generated more than 800x return. Through its funds, the company is now operating with almost $4 billion in assets under management (AUM).
• CapMan Russia Fund, Russia
is one of the leading alternative asset management companies in the Nordic region and Russia. It operates with more than $6 billion of AUM. The company was first formed in 1989 and is organised into several investment areas, including CapMan Russia, that invests in mid sized businesses in Russia, typically between $5m and $15m in companies with enterprise values up to $60M.
• VTB Capital, Russia
is the largest Russian investment bank, which has its own private equity division established in 2008. VTB PE group has invested nearly US$2 billion of capital that is comprised of Bank’s proprietary capital, as well as a significant amount of co-investments from a number of global institutional investors and sovereign wealth funds. PE Team invests in both minority and controlling stakes, and subsequently exits through public listings or trade sales, normally over a period of three to five years.
• Russia Direct Investment Fund, Russia
established by the Russian Government in 2011. Its strategy is to invest in mid-market businesses to stimulate the growth of foreign direct investment in the Russian economy. RDIF co-invests globally with large investors, looking to entice direct investment in Russia. It has collected around $4.5bn over the years.
• Vostok Emerging Finance, Sweden
Vostok Emerging Finance (VEF) invests in early and growth stage fintech companies across emerging and frontier markets, operating with more than $150m of AUM. VEF was involved in one of the most successful venture deals in the past decade in Russia, Tinkoff bank. Having acquired a 10% stake for $10m, they have sold the 7.5% during the IPO on the LSE and returned more than $200m and still remain one of the largest shareholders with 3.5% of what is now $2.2bn company.
3. Findings and analysis
3.1 Baring Vostok, interview with Michael Calvey
Michael Calvey, a senior partner of Baring Vostok, was assigned by American Barings bank to start private equity business in Russia in 1994. The roots of Barings bank trace back to 16 century. 1993-1995 were the years of mass privatization in Russia. Michael Calvey says in his interview that in 1994 many foreign investors were highly attracted by seemingly cheap and undervalued assets in Russia, however, things were much more complicated in reality then they seemed at first. Many investors were fooled by fake financial reports. As a result, they entered into risky speculative activity and lost everything in the financial crisis of 1998.
Baring has invested in the real sector only. Michael tells that 25% of their first projects in Russia were financially unsuccessful write-offs, which is an incredibly high number for a typical private equity fund in the west. These losses were compensated by several big successes and by the fact that Barings did not use debt financing, limiting the downside. Apart from Yandex, one of the largest successes was an investment in Vimpelkom, a major Russian telecommunication company, at the time they had just 2000 clients. Vimpelkom was also the first Russian IPO on NYSE.
According to Mr.Calvey, Russian entrepreneurs differ from the entrepreneurs in most other countries. People matter in Russia more than anywhere else. The market is very narrow and many things are based on relationship. The strongest sides of the Russian businessmen are creativity, adaptability to aggressive environment, the speed of decision-making and adjustment in real time. Back in the 1990s, the approach to doing business was very cynic, but it has started to change later. Baring is an independent private equity, with 30 out of 35 employees being born in Russia, knowing well the situation on the ground. For American investors wishing to invest in Russia, the fund acts as a provider of accurate business information. The problem with mass media is that it does not focus on business opportunities in Russia, and puts too much accent on the problems, which will (or may) be solved only in the long-run. Mr.Calvey acknowledges that there is a double standard in American mass media about Russia.
3.2 VTB Capital Private Equity, Interview with Tim Demchenko
Private Private equity division inside Russian investment bank VTB Capital has invested over $2bn. Mr Demchenko is the head of VTB Capital’s Private Equity business. According to Mr Demchenko, one of the effects of the 2014 turmoil is that debt financing has become more costly. It means that equity financing will be used more actively from this point. Aggressive leverage policy can be dangerous for small businesses and in Russia, some private equity managers often mistakenly pushed to increase leverage.
Smaller size can be an advantage, according to Mr Demchenko. For example, Carlyle group started in 1986 with $5m and by 2016, they had around US$140bn, 70 private equity, real estate and debt funds, 1000 employees in 29 offices about 400 of which are investment professionals. The funds are semi-autonomous. Every investment decision comes through the central office. The central office in Washington looks through all the deals in order to have a general understanding that these deals make sense. Thus, in western PE firms, they have to fight the bureaucracy to keep the entrepreneurial spirit. Consequently, in Russia, private equity firms have not yet reached that level and thus they do not face such challenges. Also, in the US, many funds, for example, KKR or Blackstone, have gone public, has grown to a few trillion dollars in AUM and has established a brand that can be valued high. Being public has a lot f downside, starting from the disclosure requirement. In Russia, funds are yet too small for IPOs, and very few have a goodwill that is significant enough to capitalise it.
Private equity investment in the developing economies tends to make less use of leverage. This accurately reflects the fact that financial leverage tends to be favoured in buyout deals, which focus on mature and older companies that are in need of operational and financial restructuring, and these are more commonly found in western, developed economies. Within the central Europe and the Baltic states (CEB) region, leverage plays a relatively more important role compared to Russia and south-eastern Europe (SEE), where LBOs are practically absent. Indeed, buyout funds that mainly depend on external financing are becoming common in the CEB region, explained by highly developed financial systems in the region. At the same time, operational improvements make a greater contribution to overall returns in Russia, reflecting the greater risks involved in investing in these regions.
In the West, private equity has passed through distinctive stages like any other industry. Stage 1 was through 1974 to 1984, the “Stone Age”. Stage 2 was from 1985 to 1990, the “Bronze Age”. It saw wider investment base, more firms, junk bonds, debt financing becoming more mainstream, public companies are taken private and outsized returns. One of the symbolic deals in that time was a US$25bn leveraged buyout of RJR Nabisco, which took place in 1988. Stage 3, the “Silver Age”, took place from 1991 to 2001. During this time, multi-billion funds were established, global investors and lenders appeared, many new funds appeared, overseas investments were made. Talent started to come from other financial companies. Investor base was dominated by public pension funds. The “Golden Age” lasted from 2002 to 2007. Many Fortune 500 companies went private, private equity accounted for 40% from a total M&A activity in 2007, private equity has become a global business. During 2002-2007, private equity went through a perfect storm. The returns were tremendous especially compared to stock market. There were large amounts of cash paid back primarily through recapitalizations. Interest rates were coming down and banks were lending more. Many new traditional investors were entering the market. They were attracted by the positive image of the industry, “star power”. The industry started to institutionalise. The growth of assets was also tremendous. Some private equity firms started to go public and found themselves under public and government scrutiny. Mr Demchenko believes that the Russian private equity is yet in the “Bronze Age” and will soon experience a significant growth.
3.3 Vostok Emerging Finance, Interview with Alexis Komondous
• Motivation for investing in Russia
The motivation for investing in Russia is primarily driven by higher returns. As opposed to the USA, there was no increase in government regulation of the Russian private equities industry; neither after the financial crisis of 2008 nor after the sanctions were imposed in 2014. A lot of Russian private equity funds are owned by ultra-high net worth families (DTS, Finstar are one of the most successful fin-tech VC funds, owned by Russian businessmen) and they are not institutionalized like in the USA or financed much by pension funds. The low regulation environment allows a greater scope for achieving above industry average returns. Furthermore, according to Alexis, Russia remains highly undervalued compared to western economies and even to other emerging market countries.
I have researched this further, and according to Bloomberg (Figure 1 in the appendix), Russia’s average multiple is 6.1, compared for example to MSCI India, which has P/E of 18.2. This means that now there a lot of good opportunities for entry, as in the future multiple will grow towards the average and thus it will be possible to exit at a higher valuation even without operational improvements and financial engineering.
As well as that Alexis prioritised the lack of professionalised private equity community i.e. unexploited opportunities that exist in the market. Due to a low number of participants, there is a large number of projects with great potential that are untouched. He has also briefly mentioned lower tax rate as another advantage.
These findings lead to a conclusion that main motivation for investment in Russia is not typically triggered by the factors that are present in the Russian market, but by ones that are absent or somewhat lacking in the developed countries. And also, now Russia is clearly undervalued and thus presents good opportunities for entry.
• Fundraising these days and how has it evolved over the years
According to Alexis, there are several enduring truths in the business. Money follows the performance. Excess capital reduces returns. Size may have an impact but only at some point. “Teams with good track-record have been always able to constantly increase assets under management and this has not changed in light of recent economic sanctions”.
• Main challenges that PE investors face in Russia
Alexis notices that the biggest difference of investing in the USA compared with the rest of the world is political stability in the USA. In emerging markets, there is greater government intervention and political risks that increase uncertainty about the future. After 2014, uncertainty associated with the consequences of Western sanctions is the main political concern.
Low industry transparency, unavailability of credit and immature banking systems follow suit as other negatively impacting factors. As well as that Alexis has mentioned the lack of skilled local managers as a significant challenge.
Looking at fund returns, we can conclude that it is worth taking a risk in order to invest in Russia. It seems that investors nowadays manage to successfully overcome the threats that are still prompt on the Russian market. Established presence in the market is seen as a competitive advantage on the global scale. Local competition in emerging markets will start to pick up, and funds with local presence are having tacit state support and are operating in local currency, which is advantageous.
• Transactions in Russia, leveraged vs. unleveraged
Alexis notices that the Russian PE market is currently largely unleveraged and has been unleveraged before the Western sanctions were introduced. “The scarce capital that has been the main characteristic of our market before and it has only worsen since the introduction of the sanctions.” The market is characterised by a nearly complete absence of LBOs. A total number of transactions has decreased since the start of the sanctions.
• Exit routes
According to Alexis, the most attractive exit route for the portfolio companies is a trade sale to a foreign or less commonly, Russian, strategic buyer. IPOs of Russian portfolio companies are less common. Yet, even on the quite IPO market, there have been a few successful IPO exits in the last years. For an IPO exit to be successful, investors need to assess in advance their respective objectives to the timing of their investment realisation. Given the current Russian market conditions, it is very difficult to consider a good timing for IPO exits.
• PE industry in the short and long term future
With regards to the PE sector, Alexis predicts that sector will experience expansion, and we will observe new players emerging (including well established foreign funds that will want to have a presence on the Russian market). Consequently, the number of transactions will rise throughout all industries. Small and unsuccessful firms have been disappearing very fast (past examples include, Troika Capital Partners, Aurora Russia Fund ) and this trend will continue. Investment strategy will likely be changing from today\'s growth capital and focus on buyouts, MBOs, LBOs and mezzanine. Finally, as capital markets improve, we are likely to observe increased amount of exits through IPOs.
There are not so many global private equities present on local Russian market because they do not possess enough expertise and experience with local culture and way of doing business, which is very important in this industry. There is no great competition from foreign firms because they lack the understanding and knowledge of local realities. Here leveraged buyouts and the use of debt are much less important than in the USA. Success in private equity depends on operational improvements and financial engineering, however, in Russia the impact of the second factor is limited due to low credit availability and higher and more volatile interest rate. The improvements in operations play the greatest role in private equity success in emerging markets. The value is added through multiple channels: stable positive cash flows, multiple expansions, margin improvement and revenue growth. Therefore, knowledge of operational side of business becomes even more important. The strategy that works in the USA can be completely irrelevant for Russia. Russian PE firms should pay attention to hiring talented CEOs who both know their industries and have strong entrepreneurial spirit. But finding good experts in Russia can be challenging. They are therefore actively searching the western market in order to find the best people as the local market lacks them.
Russian private equities are approximately at the point where the USA was 30 years ago. In particular, few founders and entrepreneurs are willing to sell their businesses to private equities. They are growing even without private equities therefore they are not ready to lose control over their business for the sake of a small increase in growth rates.
While having a 15-20% growth is considered good to have in the USA in private equity, in Russia growth can be as high as 50%, however, the situation is getting more difficult due to higher competition and uncertainty which followed 2014 ruble depreciation and political tensions with the west.
Advantage of emerging markets lies in their inefficiency. Since emerging markets lack transparency and financial information, higher returns can be sustained for a prolonged period of time. Some of the limitations of private equity on emerging markets are the following: market uncertainty may reduce demand for investment, strict capital regulation, domestic bias of US investors, lack of track record, absence of adequate measurement tools.
Sanctions have without a doubt hit Russia harder than others in the CEE region, but the PE sector was not affected by its consequences to the same extent as other sectors were. Ofcource, PE is a part of financial system and it does not operate in vacuum. What happens on financial market, influences private equity but private equity does not influence the financial market. In the US private equity accounts for around $3trln in holdings. For comparison, stock market is around $16trln. Thus private equity is relatively small compared to major banks and stock market and has lower systemic risk.
Russia continues to be a country in transition with considerable long-run potential. According to Andrey Aksenov, CIO of Elbrus Capital , one of the main problems with Russia is a lack of distinctive national brand. Branding is important for success in sales and for the private equity industry to grow it is important to create positive and working image of new projects.
Levels of private equity investment in the whole CEE region are very low as a percentage of economic activity. Figure 4 in the appendix shows that, while private equity investment totals more than 1 per cent of GDP in the United States, the United Kingdom and other developed economies, Russia and Turkey (the main destinations for private equity investment in the region) private equity capital totals less than 0.1 per cent of GDP.
In the short- to medium-term, Private Equity companies are going to hold on to the investments they already have and the buying activity should not be expected to pick up at a rapid pace. Although the crisis created more buying opportunities, it is unclear whether the real sector companies are going to accept the lower valuations and be available for sale. In long run, the market activity is expected to rise and the significant economic improvements are anticipated to take place. Stronger players will enter the market, putting pressure on small and less successful teams. In the future, Russia is going to see more buyouts, including MBOs and LBOs – which is not the case nowadays. The increasing contribution of pension funds is another key factor that will constitute to the growth of the Russian private equity industry. Globally, as their assets increase they tend to invest more in equities and alternative investments. It is expected that AUM of Russian PEs will triple up by 2020 and also percentage invested in alternative investment will continue to increase. Furthermore, as political tensions cool down, foreign pension funds will most likely enter the market as well, and contribute significantly to the expansion of the Russian private equity industry.
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