07 July, 2009
By Philip Alexander
By the onset of the global credit squeeze in 2007, Russian companies had racked up at least $300bn in foreign debt and more than 100 were considering equity listings abroad. The world has since been transformed as companies battle for scarce capital and funding. This round table on financing for Russian companies, held in April, gave senior bankers the opportunity to discuss the challenges with investors, corporate advisers and company executives. It was sponsored by VTB Capital but independently edited by The Banker.
Philip Alexander - Finance editor of The Banker
Yuri Soloviev - President and global CEO, VTB Capital
Ilya Yakubson - CEO, Dixy Group
Herbert Moos - CEO, VTB Capital Plc
Liam Halligan - Chief economist, Prosperity Capital Management
Jon Edwards - CEE and CIS senior manager, London Stock Exchange
Karl Johansson - Moscow managing partner, Ernst & Young
Dominique Fache - Russia and CIS general manager, Enel
Alexey Yakovitsky - CEO, VTB Capital in Moscow
Philip Alexander - Finance editor of The Banker, Chaired the round table
- The search for new funding
- An oversold market
- New pools of liquidity
- cultivating local finance
- ending 'legal nihilism'
- cleaning up Russia's act
- crisis management
- a time of opportunity
The Key Issue
The search for new funding
For Russia, the credit crisis has been intensified by large Western investment banks scaling back on lending and capital markets activity in the country and shutting down channels of intermediation. To plug the financing gap, Russian companies will need to raise their game and consider new sources of funding. Russia's banks will also have to step up and play a greater role in intermediating between issuers and investors. Philip Alexander, finance editor of The Banker chaired the round table.
Banks, metals companies, real estate developers and some parts of the retail industry have all taken on significant leverage that now needs refinancing, said Yuri Soloviev, president and global CEO of VTB Capital. Those companies would still like to access international markets if they can, because the cost of funding through this route has historically compared favourably to domestic sources.
"The price of debt capital in Russia is about 18% to 20% in roubles. Last year, we had a syndicate of foreign banks where the price is Libor plus 3.3%. You can't get the money as cheap in Russia," said Ilya Yakubson, CEO of supermarket chain Dixy Group.
As a result, the appetite for foreign financing has not declined significantly. But the rules of engagement for obtaining funding are now very different, said Herbert Moos, CEO of VTB Capital Plc. "Price discovery and information flows have significantly changed. It is important to have a very strong research team that is able to provide investors with very close insight into which companies are going through the crisis in relatively good shape," he said.
An oversold market
Investors who dig deep enough to find this information see opportunities in a market where overall leverage is low. "Russia is generally a place where companies have, until now, financed themselves from their retained earnings," said Liam Halligan, chief economist at Prosperity Capital Management, Russia's largest foreign portfolio investor.
"If you add up total household, corporate and state debt in Russia, it is equivalent to less than 40% of gross domestic product (GDP). Even in India and Brazil that number is nearer 80% to 90% of GDP. In China it is about 120% of GDP and in the US it is well over 250% of GDP," he added.
There are low-debt companies with defensive business models in the consumer sector, which should be resilient to a decline in consumer demand, said Alexey Yakovitsky, CEO of VTB Capital's securities arm in Moscow.
"Top of the list in the liquid universe of stocks would be wireless telecoms. People do not stop using their mobile in a downturn. These companies do not need massive capital to keep growing or to sustain their operation. They are free cash-flow positive," he added.
New pools of liquidity
At a time when the capital of many Western banks has been slashed and investment funds face a wave of redemptions, the challenge is to convert cheap valuations in Russian markets into investor appetite. To achieve this, Russian companies must increasingly think beyond their traditional funding sources.
Most recently, VTB Capital opened in Dubai to tap the Gulf markets as a whole. "It is surprising how little interaction there is between Russia and the Gulf region. In many cases, we have very similar problems. For example, we need a lot of electricity production because of the cold; the Gulf region has to produce a lot of electricity because of the heat," said Mr Soloviev.
Gulf investors will be interested in Russia for diversification - for example, by entering a consumer market that is far larger than the Gulf state populations, he added. "We are also hoping to be the first Russian bank to provide our clients with sharia-compliant products, both for the investor side in the Gulf region and the borrower side in Russia, and we are working on a number of sukuk transactions."
Mr Yakovitsky said that large Asian energy consumers, such as China and India, have already invested significantly in the African resources sector and may increase their attention on Russian assets such as coal producers.
While deal managers in the investment banks will need to engage specifically with these new investors, they may be able to do so through traditional channels. The London Stock Exchange (LSE) has been a destination of choice for Russian equity listings, and CIS and CEE senior manager Jon Edwards said this is unlikely to change imminently.
"We are also talking to investors in the Middle East and China, and we want them to understand that you can buy Russia in London. We recognise that there are very significant pools of capital in both of these places, and we are going to focus on those pools," said Mr Edwards.
Cultivating local finance
There is one untapped pool of liquidity closer to home. Despite the size of its economy - possibly among the 10 largest in the world - Russia has not been able to mobilise domestic savings effectively. In particular, its banking sector of more than 1000 licensed entities is mostly too fragmented to provide concentrated long-term funding.
"It is clear that we cannot have a thousand banks in Russia, we really need about 150 or 200 banks, and getting from where we are now to a Russian banking sector that is consolidated is going to be a painful process," said Mr Halligan.
The process is already beginning, with the Central Bank of Russia tightening charter capital requirements to force merger activity. Meanwhile, a flight to quality has caused the largest state-owned banks, VTB and Sberbank, to increase market share among depositors, boosting their financing capabilities.
"The government needs to create a sophisticated financial intermediation system that was, in the previous era, simply imported from Western investment banks. For VTB, that is a fantastic opportunity to turn itself from a commercial lender to a fully fledged universal bank, including, most importantly, an investment bank," said Mr Yakovitsky.
This is only half of the equation. Building on undeveloped insurance and pension industries is the other half. Pension assets in Russia are equivalent to just 2% of GDP according to Mr Halligan, compared with more than 100% in many developed economies, and they account for only 15% of stock market capitalisation.
Karl Johansson, Moscow managing partner at accountancy firm Ernst & Young, and a veteran of Asian markets where savings rates are far higher, said much needs to be done, especially in the realm of creating a regulatory framework and supporting financial infrastructure. He believes the government understands this challenge and has started to create suitable institutions.
Ending 'legal nihilism'
In addition to market infrastructure, the legal framework has also deterred investment in the past. Russian president Dmitry Medvedev recognised this after his inauguration last year, speaking of his intention to end 'legal nihilism' that had impeded economic development and discouraged private enterprise.
There are at least two aspects to the problem - the court system and the internal corporate governance of Russian companies. Mr Halligan said that generational change in the Russian legal profession is helping to bring through judges with a sounder grasp of commercial law, and the transition since the Soviet era has been relatively swift. "We spend a lot of time in the courts in Russia, pressing claims for minority shareholders. In our experience, in the Moscow courts if you are right, eventually you will win, although it does take time.
"Having said that, outside of Moscow, it is much more difficult to get redress in the courts. Now we have a Russian president who is a trained lawyer, what we are looking for and what our investor base is looking for once the emergency situation is over is a real push forward in bolstering the legal system," he added.
This is especially important for long-term strategic investors such as private equity or infrastructure funds, which rely on effective contractual rights to make their decisions. Mr Soloviev said the government's handling of key infrastructure legislation, such as the framework for public-private partnerships (PPPs), has sent out the right signals. "The first PPP project we looked at several years ago had about 240 inconsistencies between the regional laws and the federal laws. Since then, there has been some change, we have seen a number of initiatives," he said.
He added that the crisis has helped to focus minds further, as bankers and policy-makers actively compare Russia's record on attracting investment with the performance of other major emerging markets such as Turkey or Brazil. "There are big debates in government on how Russia will move forward. Some would like to retrench, some would like to proceed with opening up the Russian economy. And we certainly try to advocate the latter," said Mr Soloviev.
Cleaning up Russia's act
The debate within the Russian government is mirrored inside companies themselves as tough financial conditions provoke diverging responses from executives. "We've seen a burgeoning of international standard accounts in Russia, we've seen the emergence of peer pressure where Russian entrepreneurs know that if their colleagues misbehave it ruins access to capital for everyone," said Mr Halligan. "But as the market fell since last summer, as conditions got tighter, as the currency began to depreciate and credit got tighter as a result, we saw some significant deteriorations in corporate governance."
Mr Johansson, a member of the Foreign Investor Advisory Council that liaises with the Russian government, agreed with this analysis. Those companies "that have focused on upping their game will win", he said. "The country is at a crossroads and to the extent we can have a more consistent rule of law, more focus on corporate governance, it will allow more capital to come in."
Mr Yakovitsky said that Russia faces not so much a window of opportunity, but rather a necessity. "Now we are in an era of money not being available so freely, very heavy competition for international capital and the need to build trust among domestic savers, there is a good reason to expect that you would see an improvement in corporate governance, because otherwise you just do not get capital," he said.
For many Russian companies, the process of listing equity overseas has already helped them to rethink their approach to corporate governance. "Most of our issues from Russia are global depositary receipts, where the companies are not technically required to follow the combined corporate governance code," said LSE's Mr Edwards.
"However, what you are seeing is - call it peer pressure or call it best practice - a lot of companies are instituting these policies, not only on governance, but also the smaller things like the open-door policies," he added.
Foreign strategic investors can also drive those improvements. Dominique Fache, the Russia and CIS general manager for Italian energy company Enel, instituted an open-door policy at the power plants of Russian generator OGK-5 when Enel assumed majority control in 2007. Mr Fache became chairman of OGK-5. He said another priority was to improve on the poor health and safety record of the previously state-owned monopoly power company RAO UES, where there had been an alarming number of workplace fatalities.
For those companies that find themselves unable to access fresh funding, the relationship with investors will be a matter of survival as debt restructuring becomes more widespread. At the height of the crisis in late 2008, the Russian government spent a significant part of its foreign exchange reserves to provide last-resort refinancing for strategically important companies. However, Mr Moos said the worst affected companies will ultimately need to clean up their balance sheets, which will present a distinct challenge for investment banking in Russia.
"You will need to understand the Western creditor proxy system; and you will need to understand the specifics of Russia. There are not that many players in the market right now who can provide that expertise. We are certainly working with VTB clients to provide for those restructurings. Traditional restructuring techniques will apply, but it will be in the Russian context," he said.
Mr Johansson said the legal framework for balance sheet restructuring in Russia will also be tested on a new scale. "We have a set of rules that we have not had to deal with in Russia before, impairment rules and going concern rules. The process puts a premium on cash flows, on full disclosure, on being more transparent about what you are trying to do, in terms of understanding either covenants or debt," he said. He is looking for financial institutions to be flexible with troubled clients because reaching amicable solutions is in everybody's best interests. But the companies will also have to deliver improvements from their side. "It clearly sharpens the focus of the efficiency, productivity and how a company operates, as well as the importance of international accounting standards," he said.
A time of opportunity
For those companies with healthier balance sheets, the general financial dislocation should provide opportunities for consolidation at cheap valuations. Mr Halligan alludes to the retail sector, where the top five supermarket chains have a combined market share of only 8%.
However, Mr Yakubson is more sceptical about whether there are assets worth buying for retail companies such as Dixy. "There will not be consolidation, but concentration, through bankruptcies for the smaller chains and organic growth for the larger chains. Because when we look at different retail chains in Russia, especially local chains, very often their equity value is much lower than their debt," he said. As a result, even buying 100% of such a business does not make sense if the purchaser also assumes the debt burden.
Mr Yakovitsky suggested that the Russian steel industry, which has six large producers, may be suitable for consolidation. And once this process has been completed, he expects more deals similar to Severstal's purchase of US steel mills Sparrows Point for $810m in 2008. "People say Severstal has overpaid for its US assets. But [when] the next bull market comes, it is going to be the global player," he said.
Mr Johansson has been impressed by the speed of execution and degree of strategic thinking demonstrated by Russian companies when expanding abroad. "There will be a level of caution because getting value out of acquisitions is challenging right now. But the learning curve is very short and the process has given them experience, interchange and cultural understanding," he said.
Power sector sets tone
When, in July 2008, former state-owned power monopoly RAO UES was transformed into a federal grid and a large group of electricity generators and distributors, the move was hailed as an example of Russia's ability to build the right environment for large-scale investment.
However, less than one year later, shareholder disputes at two regional generators, TGK-2 and TGK-4, have raised questions about the enforcement of commercial legislation. And investors are still waiting for the government to outline a long-term strategy for boosting output.
"The government is a little bit late in establishing the rules of the game, especially for the capacity market," said Dominique Fache, country manager for Italian energy company Enel, and chairman of wholesale generator OGK-5, in which Enel bought a majority stake in 2007.
He is confident that the government will complete reforms as investment is needed to avoid a supply crunch. "We keep investing because we think at the end of next year our equipment will be retained because it will be competitive," said Mr Fache.
Liam Halligan, chief economist at Prosperity Capital Management, which has significant investments in the regional generator (TGK) market, said: "The deal was that if people like us put money in, we would be required to make increases in the capacity of these generating companies, and in return, tariffs would gradually be liberalised. To date, the Russian government has liberalised tariffs, pretty much on track."
He said that, generally, board seats in Russia are distributed on a proportional representation basis according to share ownership. However, with TGK-2 and TGK-4, the government has not yet enforced the rule requiring majority owners to make a buy-out offer to minority shareholders. Strategic and investment decision-making at the companies is paralysed until the ownership disputes are resolved.
"If the right steps are taken now, particularly in the flagship power sector, Moscow really can stake its claim as being one of the world's financial capitals," said Mr Halligan.
Head of Press