The Private Equity Industry in Russia

by Justin Ashauer, Allegra Tosti and Celeste Vilde

Introduction

The transition from a Soviet state-controlled economy to a market-oriented system posed a huge challenge for the Russian government after 1990. The main priority was to create a functioning market, requiring fiscal and economic stabilization, thereby starting an enormous privatization program that marked the beginning of the oligarchs’ era. Since then, the Russian companies have been characterized by highly concentrated ownership, with the state and wealthy individuals as the main shareholders. This structure significantly slowed the development of the capital markets and the attraction of foreign investments. Moreover, the largely non-transparent business culture, one of the worst legacies of the Soviet times, still limits the disclosure of information.

Recent research has shown that Russia is one of the slowest countries in Central and Eastern Europe when it comes to shifting to a free market economy, and it seems that this pessimist sentiment has only increased over the years. Therefore, even though the country has made improvements in the last years, the Russian market shows significant differences from its Western counterparts. To better understand the development of the Private Equity industry, the present article takes a closer look at the market´s characteristics and the impacts of the war in Ukraine.

Russian PE Market: Overview

Certain peculiarities characterise the Russian PE Market:

Type of Investments and Transactions: In Russia, minority-stake investments tend to be the norm, with buyouts or public-to-private transactions being way less common. When control is in fact acquired, it is typically so through consortiums, as club deals provide investors with the chance to close larger deals. The increase in financial resources resulting from a club deal is especially significant in Russia where deals involve little to no debt financing.
Type of Financing: As mentioned above, the use of debt financing for highly levered PE transactions is not prevalent in Russia. It thus means that true LBO transactions are uncommon. Most deals are typically comprised entirely of equity and investors are restrained in their access to international financial markets, resulting from international sanctions put forward after the 2014-2015 geopolitical tensions. As such, the ability to “self-fund” is essential for funds. When state banks do provide debt financing for acquisitions, debt providers protect their investments through strict protections, such as lending covenants, or pledges over assets.
Types of Exits: Russia remains a challenging market to successfully exit from a PE investment. The most typical form of exit is through the sale of equity stakes to strategic or financial investors. Unlike in other countries, where IPOs have been on the rise, an IPO is not a typical exit strategy for PE in Russia. This implies that there is not an as close correlation between changing stock market valuations and PE activity. Moreover, the geopolitical climate, even prior to the Ukraine-Russian war, was not favorable for foreign investors entering the market. In fact, the only noteworthy IPO in 2019 was the listing of Headhunter, a leading Russian online recruitment platform, on the NASDAQ exchange. Unsuccessful investments are usually exited through a trade sale or, alternatively, a liquidation of the portfolio company.

In addition to the above characteristics, certain trends in the Russian PE market have emerged. Between 2018 and 2019, Russian PE activity increased, and this trend was expected to continue in 2020. Nevertheless, following the sharp contraction of the Russian economy due to the pandemic, the number of PE deals also declined. In 2020, the Russian economy was further challenged by the depreciation of the Russian rouble against other major currencies and the decrease in oil prices. Besides a volatile level of activity, the Russian market has been characterized by three additional trends: the diversification of investments across a wider range of sectors, the pivot to foreign investors, and the increasing importance of Russian state-backed players.

In the last couple of years, the Russian government sought to make Russia more attractive to foreign investors. However, a pivot towards the West was complicated by the imposed EU and US sanctions. Thus, we observed relatively high levels of investments from Asian and Middle Eastern sovereign funds in Russia. For example, a consortium of the Russian-Chinese Investment Fund (RCFI), several Middle Eastern funds, and the Russian Direct Investment Fund (RDIF) acquired 28% of Alium, a large Russian pharmaceutical company.

One of the Russian government’s policies priorities has been the diversification of the domestic economy and export base, which has traditionally been dominated by extractive industries. One may observe strong performance in the innovation, telecommunications, and technology sectors, as well as in healthcare and consumer markets. The performance in the digital sector was spurred by the digitization of the economy following the pandemic. A notable example of a PE deal in this sector has been the acquisition by DXC Technology of 100% of Luxoft, a Russia-based IT company, for 2 billion US dollars.

The recent emergence of state-backed sponsors and financial institutions, such as Sberbank and RDIF, has transformed the Russian PE market. These state-backed players have become increasingly active in the Russian PE market and have become more successful in fund formation than private investors. If state-backed vehicles play a complementary role by generating deals themselves and attracting private capital or taking on either lower-return or higher-risk deals than traditional PE pursues, this development may prove to be beneficial for the Russian market. However, if state vehicles end up crowding out traditional PE by bidding up prices or poaching on deals, we could see a negative impact on traditional PE players.

Impact of the Ukraine War on Funds and Investments

The Russian market as a possible investment region for Private Equity funds and other financial institutions has encountered growing barriers due to Russian incursions into Ukraine, dating back to the annexation of the Crimea peninsula in 2014. Currently, it is widely negatively perceived to invest in the Russian market, with many international companies bowing to public and government pressure and halting their Russian operations, as seen by BP’s divestment in Russian oil firm Rosneft, despite causing a $25bn write-off. The broad sanctions imposed by the international community in response to the Russian invasion affect investment funds by limiting potential investments as well as reducing access to wealthy and influential Russians as potential investors.

The Russian market is likely to see fewer investments by foreign private equity funds, with many independently choosing not to conduct business in the country. Index Ventures, a European venture capital fund, recently announced that they would not consider investing in Russia and have stated that they will avoid any business with entities tied to the Russian government. Foreign private investment funds aren’t the only ones under pressure, however, with Russian funds such as the Russian Direct Investment Fund being sanctioned by the U.S. Treasury for its ties to Putin and the Russian government, limiting their investment abilities, which were previously focused on Central and Eastern Europe. While the direct impact of divestments and sanctions are notable, the Russian private investment market was relatively small at 1.1% of the European market, and hence exposures were very low to begin with. For example, Blackstone withdrew from the Russian market in 2014 after the annexation of Crimea. Furthermore, the funds that are invested in Russia were typically invested in relatively unregulated and young industries, i.e. avoiding financial, energy, and commodities sectors, which are those most affected by sanctions. Nevertheless, despite the seemingly mitigated exposure, fund managers are increasingly worried about indirect consequences, namely the regional uncertainty spilling over into other geographical areas and affecting company valuations, especially with rising commodity and energy prices.

Evidence of the impact that the introduced sanctions on individuals are having on private investment funds is already widespread. In March 2022, Goldman Sachs announced that it would cease doing business with Pamplona Capital Management, a $9bn PE firm, with over 80% of its financing originating from LetterOne, the investment group of a sanctioned oligarch, Mikhail Fridman. The controversy and issues surrounding Pamplona Capital Management have led to the repayment of all money received from LetterOne, posing a substantial financing loss. Further highlighting the potential fallout for PE fund investors are increasing calls for the Securities and Exchange Commission (SEC) to strengthen disclosure rules, requiring private equity firms to conduct more rigorous due diligence, as some oligarchs such as Roman Abramovich have managed to circumvent restrictions using shell companies. Increased scrutiny on the funds’ investors could limit their access to the Russian capital in the foreseeable future, with many wealthy individuals facing sanctions, and funds facing potential reputational drawbacks if they are seen to conduct business with government-affiliated individuals or entities.

Conclusion

At current times, the long-term effects of the war in Ukraine on the Russian PE industry are hard to predict, but what is certain is that it is not only the Russian market that is affected. Even limited exposure to Russian assets may significantly affect company valuations. Indeed, the important role that Russia has as a major producer of commodities such as palladium, platinum, and wheat, subsequent higher energy prices, supply chain disruptions, and capital markets volatility are all elements that could severely impact investment portfolios, also of PE players. Even though the events could negatively affect the valuation of companies, which are targets of private equity funds, it has been demonstrated that private markets can be more resilient than public markets during periods of crisis and volatility. Higher flexibility, a broader range of investment techniques, and more appropriate pricing of liquidity are all private-specific measures for investment-management firms to attract investors.