Friday, December 08, 2006

Private equity Russian style

Stratfor has provided a bit of analysis behind the Litvinenko assassination (need a ticket to read), which John Mauldin has been able to put up on his site (click "next" bottom right of his page). Here's a bunch of it, but worth a whole read.

Russia's Interest in Litvinenko By George Friedman
Russian and Soviet tradition on this is clear: Turncoats like Litvinenko must be dealt with, for two reasons. First, they represent an ongoing embarrassment to the state. And second, if they are permitted to continue with their criticisms, they will encourage other dissidents -- making it appear that, having once worked for the FSB, you can settle safely in a city like London and hurl thunderbolts at the motherland with impunity. The state must demonstrate that this will not be permitted -- that turncoats will be dealt with no matter what the circumstances.


The death of Litvinenko, then, certainly makes sense from a political perspective. But it is the perspective of the old Soviet Union -- not of the new Russia that many believed was being born, slowly and painfully, with economic opening some 15 years ago. This does not mean, however, that the killing would not serve a purpose for the Russian administration, in the current geopolitical context.

For years, we have been forecasting and following the transformation of Russia under Vladimir Putin. Putin became president of Russia to reverse the catastrophe of the Yeltsin years. Under communism, Russia led an empire that was relatively poor but enormously powerful in the international system. After the fall of communism, Russia lost its empire, stopped being enormously powerful, and became even poorer than before. Though Westerners celebrated the fall of communism and the Soviet Union, these turned out to be, for most Russians, a catastrophe with few mitigating tradeoffs.

Obviously, the new Russia was of enormous benefit to a small class of entrepreneurs, led by what became known as the oligarchs. These men appeared to be the cutting edge of capitalism in Russia. They were nothing of the sort. They were simply people who knew how to game the chaos of the fall of communism, figuring out how to reverse Soviet expropriation with private expropriation. The ability to turn state property into their own property represented free enterprise only to the most superficial or cynical viewers.


The West was filled with both in the 1990s. Many academics and journalists saw the process going on in Russia as the painful birth of a new liberal democracy. Western financial interests saw it as a tremendous opportunity to tap into the enormous value of a collapsing empire. The critical thing is that the creation of value, the justification of capitalism, was not what was going on. Rather, the expropriation of existing value was the name of the game. Bankers loved it, analysts misunderstood it and the Russians were crushed by it.

It was this kind of chaos into which Putin stepped when he became president, and which he has slowly, inexorably, been bringing to heel for several years. This is the context in which Litvinenko's death -- which, admittedly, raises many questions -- must be understood.

For Putin, the only solution to Russian chaos was the reassertion of Russian value. The state was the center of Russian society, and the intelligence apparatus was the center of the Russian state. Thus, Putin embarked on a new, slowly implemented policy. First, bring the oligarchs under control; don't necessarily destroy them, but compel them to work in parallel with the state. Second, increase Moscow's control over the outlying regions. Third, re-create a Russian sphere of influence in the former Soviet Union. Fourth, use the intelligence services internally to achieve these ends and externally to reassert Russian global authority.

None of these goals could be accomplished if a former intelligence officer could betray the organs of the state and sit in London hurling insults at Putin, the FSB and Russia. For a KGB man trained by Andropov, this would show how far Russia had fallen. Something would have to be done about it. Litvinenko's death, seen from this standpoint, was a necessary and inevitable step if Putin's new strategy to save the Russian state is to have meaning.

That, at least, is the logic. It makes sense that Litvinenko would have been killed by the FSB. But there is an oddity: The KGB/FSB have tended to use poison mostly in cases where they wanted someone dead, but wanted to leave it unclear how he died and who killed him. Poison traditionally has been used when someone wants to leave a corpse in a way that would not incur an autopsy or, if a normal autopsy is conducted, the real cause of death would not be discovered (as the poisons used would rapidly degrade or leave the body). When the KGB/FSB wanted someone dead, and wanted the world to know why he had been killed -- or by whom -- they would use two bullets to the brain. A professional hit leaves no ambiguity.

The use of polonium-210 in this case, then, is very odd. First, it took a long time to kill Litvinenko -- giving him plenty of time to give interviews to the press and level charges against the Kremlin. Second, there was no way to rationalize his death as a heart attack or brain aneurysm. Radiation poisoning doesn't look like anything but what it is. Third, polonium-210 is not widely available. It is not something you pick up at your local pharmacy. The average homicidal maniac would not be able to get hold of it or use it.

So, we have a poisoning that was unmistakably deliberate. Litvinenko was killed slowly, leaving him plenty of time to confirm that he thought Putin did it. And the poison would be very difficult to obtain by anyone other than a state agency. Whether it was delivered from Russia -- something the Russians have denied -- or stolen and deployed in the United Kingdom, this is not something to be tried at home, kids. So, there was a killing, designed to look like what it was -- a sophisticated hit.

This certainly raises questions among conspiracy theorists and others. The linkage back to the Russian state appears so direct that some might argue it points to other actors or factions out to stir up trouble for Putin, rather than to Putin himself. Others might say that Litvinenko was killed slowly, yet with an obvious poisoning signature, so that he in effect could help broadcast the Kremlin's message -- and cause other dissidents to think seriously about their actions.

We know only what everyone else knows about this case, and we are working deductively. For all we know, Litvinenko had a very angry former girlfriend who worked in a nuclear lab. But while that's possible, one cannot dismiss the fact that his death -- in so public a manner -- fits in directly with the logic of today's Russia and the interests of Vladimir Putin and his group. It is not that we know or necessarily believe Putin personally ordered a killing, but we do know that, in the vast apparatus of the FSB, giving such an order would not have been contrary to the current inclinations of the leadership.

And whatever the public's impression of the case might be, the KGB/FSB has not suddenly returned to the scene. In fact, it never left. Putin has been getting the system back under control for years. The free-for-all over economic matters has ended, and Putin has been restructuring the Russian economy for several years to increase state control, without totally reversing openness. This process, however, requires the existence of a highly disciplined FSB -- and that is not compatible with someone like a Litvinenko publicly criticizing the Kremlin from London. Litvinenko's death would certainly make that point very clear.

Overcoming The Challenges Of Exploiting New Private Equity Opportunities In Eastern Europe And Russia
10th October 2006

In recent years the continued growth of the private equity industry has meant deal generation for many western European GPs has expanded into new and emerging markets. Whilst many of the larger GPs focus on movement in Asia, the majority of Mid-Market firms are now looking into moving away from domestic deals and trying a pan- European approach. Eastern Europe is already proving profitable for some, whilst others still see these EU accession countries as providing greater risk and unknown return opportunities.

Russia is often viewed by many as a potential private equity growth area. More deals are being done and returns are well established, but the political and economical unknown still causes concern for many considering investing in the region.

Capital Creation is Europe’s leading private equity investment conference focused on networking and enhancing relationships between GPs and LPs. Taking place in the glamorous setting of the French Riviera, the conference brings together an audience of senior professionals from the leading private equity funds, fund of funds and institutional investors. At no other event will you have access to so such a diverse audience of senior private equity professionals.

Achieving successful fund closures and maximizing returns Europe’s booming private equity industry through superior deal generation and enhanced understanding of investors, were the key themes of Capital Creation 2006. These cutting edge topics combined with unrivalled networking facilities ensured that our attendees were able to optimise their future investment opportunities all whilst in the stunning setting of Monte Carlo.


Private equity in Russia

Private equity, otherwise referred to as venture capital, is essentially long-term equity capital invested in new or rapidly developing enterprises. Traditional debt financing, which precludes issuing ownership, is not always a viable alternative for emerging enterprises because they generally lack the collateral, track record, or earnings to secure a loan. Accordingly, private equity is the lifeblood of entrepreneurs.

Over the past 10 years, as Russia has transformed itself from a centrally controlled Soviet system to a modern market-driven economy, a completely new class of domestic entrepreneurs has emerged. To wit, there are approximately 870,000 small businesses in Russia today, comprising almost 30% of the total number of enterprises and contributing 10-12% of Russia’s annual GNP.[28] In addition, entire Russian industries have undergone privatization and are now seeking opportunities for re-investment and consolidation.

In contrast to these appealing developments, Russia continues to be capital-starved. Operating loans, if granted, tend to be short -term in nature and usually demand oppressively high interest rates. As addressed in other sections of this paper, financing through corporate bonds or the public equity market are not realistic options for the vast majority of established companies. Retained earnings, therefore, provide the primary source of enterprise finance in Russia. Consequently, re-investment in existing firms has been highly limited in recent years and enterprises are forced to harvest existing assets.


Private Equity Environment in Russia
History of Private equity in Russia is relatively short (approximately a decade) and has yet to reach its full potential. In the beginning of the 1990s, the transfer of Russia from soviet command to a market economy set the stage for private equity. Inexpensive assets, available as a result of privatization, evoked a burst of private equity activity in Russia. During that time, Russian enterprises had extremely limited access to capital, mainly profit and scarce government budget financing, and were eager to obtain investment almost at any price. The nascent fast growing Russian stock market provided source of optimism regarding the exit opportunities for private equity funds (PEFs), because industries' consolidation processes were at early stage and strategic investors just started showing interest in the Russian markets. According to different estimates, from $2 to $3 billions were raised and more than half of these funds were actually invested by 1998.

The years between 1998 and 2000 promised to be very successful for a private equity development in Russia, as many PEFs targeted their exits for that period. However, 1998 financial crisis ended all these plans, eroding investment value and performance and postponing exits terms for uncertain period of time. Therefore, what promised to be a "golden time" turned out to be a "dark age" as most of the PEFs were caught by the crisis and still have not managed to fully recover.

In spite of the aforementioned crisis few people will argue that Russia did not come out of the crisis more economically viable than it was in 1998. During the five post-crisis years the country changed tremendously. During the president Yeltsin era political risk diminished substantially. President Putin put end to the ceaseless conflict between president and parliament, reducing the influence of Federation council and bringing stability to the country's political landscape.

Political stability allowed for the beginning of structural reform in the economy. Since the crisis, Russia has experienced tax improvement, launched pension reform, and has started reforming its banking sector. Several deregulations bills were put into effect, reducing administrative barriers and improving business climate in the country. Post-crisis Russian economy has also improved substantially. In 1999-2001 Russian GDP grew on average 6.4%, which is slightly below the 7.6% corresponding rate in China.

Russia's current economic outlook looks optimistic. Andrei Illarionov, economic adviser of President Putin, is quite sure that Russia's GDP will double in 8-10 year time. Other sources are more reserved, forecasting 4-5% annual average GDP growth in the medium term. The country's fiscal performance is strong and debt-to-GDP ratio is around 30%, which is very modest. Russia remains one of the few countries which boast both fiscal and current account surplus. The substantial improvement of situation regarding the country's indebtedness, robust economic growth, rising domestic demand are all positive factors, which determine the improving investment climate.

All these positive economic and political developments have again stirred up interest in private equity activity in Russia. There are currently about 20 PEFs initiatives focused on Russia and CIS countries with the announced plans to raise US$1.5-2.5 billion of capital in total. Only few of these funds have closed successfully, most are on the fundraising stage or just announced plans to launch the funds. Such a high number of non-closed funds is explained by slowness and complicacy of fundraising process, as investors seem to be very cautious about private equity in Russia. Lack of experienced professional teams in the emerging private equity industry makes the fundraising process even more difficult. Private equity remains of interest to sophisticated, global investors who have a positive medium to long term view on Russia and want to invest into dynamic domestic economy, which the liquid public equity market with its large resource and utility company concentration falls to provide. This skepticism is expected to change, as can be interred from the increasing number of announcements from Western Private Equity giants about their plans on Russia. More senior and experienced teams with traditional private equity approach and transparent structures are being developed.

In the face of a bunch of well-known risks, associated with Russia, the country is much better prepared for the inflow of private equity capital as compared to five years ago.

In the initial post crisis years, Russia's economy was helped by very favorable commodity price environment. However, the domestic demand has started to play a major role in the further recovery. Sectors such as construction, food manufacturing, financial services, transportation are booming increasing the country's GDP. Fuel and energy sector, which also grows at approximate 10% rate, has a couple of blue chip names, which account for the vast majority of the sector. In other industries targeted at the domestic consumer, there are opportunities abound for a private equity investor.

An entrepreneurial culture is also developing in Russia. More and more people with Western-style financial and economic backgrounds work in Russia. Infrastructural issues such as legal support and qualified due diligence are easier to obtain domestically.

With an improved political and economic environment, there is a higher likelihood of a successful and timely exit from the investment. In the last 2 years there were several domestic and international IPOs and the growing stock market provides good chances to exit investment at good valuation.


EQUITY PARTNER FOR RUSSIAN PRIVATE BUSINESS
NORUM is a private management company, which is responsible for operating the North West and West Russia Regional Venture Fund I and II on behalf of the European Bank for Reconstruction and Development (EBRD)

Norum's investment objective is to achieve substantial long-term capital appreciation through the purchase, holding and disposition of equity and equity-related interests in medium-sized, industrial or service companies operating primarily in Russia.

Norum is a long-term investor. The exit from an investee company will normally take place within three to five years after the entry.


REVIEW LITVINENKO CASE

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