How to stop a BRIC sneezing?

Private Equity International, 01.12.2011

The Kremlin hopes to ease the continued concerns of foreign investors with the launch of the $10 billion Russian Direct Investment Fund. Sam Sutton reports:<br/> 


“It’s always good to have friends when you are going to a place that you are not as familiar with.” This sentiment, voiced by The Blackstone Group founder Stephen Schwarzman to mark his appointment to the board of the $10 billion Russian Direct Investment Fund, rings true of any new frontier market. But it’s perhaps especially relevant in Russia, a country that has not always been friendly to international private equity players. Now Schwarzman – along with other leading lights of the industry – is in league with the best friend possible should he choose to start investing in Russia: the Russian government. <br/><br/>


The new RDIF is financed in its entirety by the Kremlin, which will provide it with $2 billion annually over the next five years, as well as financing up to 20 percent of the cost of its development projects. The fund, which was launched with the backing of Prime Minister Vladimir Putin and President Dmitry Medvedev earlier this year and will primarily target Russian businesses, is mandated to match each of its investments with that of an international investor. “The Russian government can provide leverage,” explains Martin Halusa, Apax Partners’ chief executive officer and another RDIF board member. “Should we do an investment in Russia in the future, we may invite RDIF in as a co-investor. This could very well be a partner … I like the fit between what we’re doing and what they’re doing.” It’s a bold move by the Russian government, as it looks to drum up investor interest in the country’s appealing macroeconomic trends – which include a rapidly expanding middle class and steady GDP growth. The fund has already received the implicit support of such luminaries as Schwarzman, Apollo Global Management’s Leon Black and TPG’s David Bonderman, all of whom hold seats on its advisory board. In October, the fund announced its debut partnership: the Russia-China Investment Fund, which will target Russian co-investments with the China Investment Corporation. “The structure of co-investing allows co-investors to pick deals they like; [it] gives them absolute control over the decision-making process, [and] how much due diligence and analysis they want to do,” RDIF chief executive officer Kiril Dmitriev told Private Equity International earlier this year. “I was talking to one of the leading private equity shops in the world, basically the founder, and he said, ‘Over the last three years, we’ve looked at 18 deals in Russia, and really would love to do something but we haven’t done one… With you it’s much easier, because our interests are aligned and there’s a second pair of eyes looking at this.” While a vote of confidence from several private equity giants, and the explicit backing of the Russian government, may be enough to pique the interest of foreign general partners, there are still several reasons why many remain wary of the Russian marketplace. In addition to well-documented concerns of corruption, a weak legal system and political instability, there is also widespread scepticism about what many perceive to be an unstable economy. <br/><br/>


“Russia’s a very volatile place. When the rest of the world clears its throat, it sneezes,” says Alpha Associates partner Henry Potter. “You can make a tremendous amount of money, but it has a set of risks that’s different from other parts of the world. So you need to know what you’re doing.” Prior to joining Alpha Associates, Potter worked on Russian investments at the European Bank for Reconstruction and Development; here, he got a first-hand view of the country’s unpredictability when the ruble was devalued during the Russian financial crisis of 1998 – an event that still rankles with many foreign investors. Russia’s economy recovered well in the nine-year period after the crisis, sustaining an average growth rate of around 7 percent, according to the US State Department. There was an inevitable (albeit massive) sneeze after the onset of the financial crisis of 2008 (GDP fell by 7.8 percent in 2009). But since then, it has rebounded strongly: the International Monetary Fund projects GDP to grow at around 4 percent over the next five years. Furthermore, the Russian market is remarkably underleveraged, with debt totaling only 9 percent of GDP as of 2010, according to the US Central Intelligence Agency. However, investors continue to keep their distance. Russian-dedicated vehicles raised only $60 million in the first half of 2011, only 3.3 percent of the $1.79 billion peak in 2007. Private equity investment has also remained sluggish, with only $383 million invested in the first half of 2011 – down from $2.65 billion in 2008, according to the Emerging Markets Private Equity Association. <br/><br/>


Until that outlook changes, the RDIF remains one of the only games in town – and may be the safest option for investors looking to gain exposure to a previously untapped market. “Russia has been criticised for government playing a big role in the economy, bureaucracy, corruption issues, enforcement of law issues, etcetera,” Dmitriev said. “Yes, there’s no question, there are issues to deal with, same as in other markets. But there’s no question in our mind that the returns can be significantly higher as well.”