Expanding horizons

IFR Russia 2008
9 min read
Emerging Markets

Russia is no longer seen simply as home to an assortment of companies ripe for picking by foreign firms. Russian companies are now themselves consolidating, and are even looking hungrily at targets to their east and west. Solomon Teague reports.

If M&A is the barometer by which the state of an economy can be measured then Russia is in good health. “M&A is becoming increasingly visible in Russia,” said Pavel Malyi, UBS’s head of investment banking for Russia, Ukraine and Kazakhstan. “In the past you expected Russia to be on the sellside and an international company to be on the buyside. You can’t say there has been a reversal exactly, but it has become much more of a two-way street. There have been some important transactions with Russian companies buying outside Russia.”

Russian companies are no longer exclusively targets but have become predators. Norilsk Nickel is one of the better known examples of this. Having purchased companies in Finland and Canada, it is now also one of the first Russian companies to acquire in the US, said Dmitry Snesar, co-head of global banking for Deutsche Bank in Russia.

Commodities get most press attention but other sectors have been almost as active. More interesting, according to Bob Foresman, deputy chairman of Renaissance Capital, is the Russian consumer sector, along with retail banking, telecoms, travel and healthcare, among others. “We are seeing phenomenal growth,” Foresman said, and foreign companies are eager to make investments in the country to cash in.

FIG was a very active sector in Russia in 2007, according to Chris Barter, co-chief executive of Goldman Sachs in Russia. This year infrastructure has replaced it as a hot sector.

In the last two years there have also been some very cash-rich Russian companies looking to break onto the world stage by acquiring international targets to make their business more globally competitive.

“We are seeing the emergence of global companies in Russia,” Foresman said. MTS and VimpelCom, two Russian mobile phone companies, have already started acquiring outside Russia – predominantly in the CIS but increasingly further afield.

“Russians don’t have the long tradition of capitalism the West does,” said Foresman. “It is only 20 years old. Acquiring in Australia, the US or Canada, for example, requires a certain level of management wherewithal that is still an impediment to this kind of business. But it is already starting to change.”

The easiest pickings are the companies close at hand and Russian companies are likely to pick up a lot of bargains in Kazakhstan, which has been disproportionately heavily affected by the global credit crunch.

But some expect to see an increasing number of deals from further away. A particular area of growth in M&A will be Africa, predicted Foresman, whose bank has made a particular push into that continent over the last year.

“Russia was no friend of apartheid,” he said. “Africans remember that, and there are close links between Africa and Russia. We are not competing with the Chinese in Africa – yet. But I think that will change.”

Again, this will be driven in large part by commodities, with Russia eager to expand its business interests into markets that are more welcoming to its investment, according to Foresman. African companies, in turn, are looking to diversify the source of the investment funding they attract.

“Russia has experienced the emerging markets environment,” Foresman added. “We have been through the same problems and perhaps have a better appreciation than some in the West about how to price the risk. I think it is lower than some perceive it to be.”

In terms of sector, there is likely to be a lot of business in financial services. “Russian state-owned banks are relatively insulated from the excesses of the global credit crunch due to the Central Bank of Russia providing billions of dollars of liquidity,” said Barter.

The domestic banking scene is ripe for a period of major consolidation amongst those institutions outside the top 10, according to Snesar, who predicted this will be a major theme as 2008 develops.

“The liquidity crunch will help force that trend,” he said. “Although Russia has strong fundamentals, foreign banks are very cautious about lending to Russian banks except for the largest players. This will force the smaller names to merge, in order to attract that competitive financing.”

That would be another sign of normalisation to international standards. There is an appetite amongst many of the small and mid cap banks in Russia for a sale to a larger competitor, bankers have indicated, but valuations do not look compelling.

About a year ago, companies were valued at around four times book. “Valuations were stretched already but now they are a joke,” said one banker. “Nobody rational would pay that. They should be trading at 1.5x or 2x book.” Goldman managed to extract better value than that for itself when it sold Absolut Bank to KBC for 3.8x one year ago.

VTB and Sberbank are said to be looking to swallow smaller and provincial rivals, but observers have reported this is being driven more by the smaller banks than the larger, potential acquirers, who are inclined to wait patiently for better value.

The bigger driver of the process is foreign banks looking to enter the Russian market. In March 2008, Barclays acquired Expobank for 4.7x book, which one banker described as “an insane multiple.”

Yet acquiring a Russian business is a very attractive option for those wanting quick exposure to the market.

“There are still barriers to entry in setting up a business in Russia,” said James Cook of Aurora Russia, an AIM-listed private equity firm. “Some companies want organic growth but that can be very difficult if you are not familiar with the Russian market. It takes three or four years to work out how to do business here, and some companies have historically wasted a lot of time trying to figure out how to operate here. Acquisitions are usually the preferred route because it is easier to grow the business when the distribution and client-base are already in place.”

GE bought Delta Bank using this logic, seeing a good platform already in place and sidestepping the potential problems and delays associated with applying for a banking licence. Considering the pace at which the market is growing, said Cook, companies can be forgiven for not wanting to wait to grow businesses from the ground up when an acquisition can give you the exposure you want much more quickly.

Although much has been made of the risk associated with acquiring business in Russia – with the perception that the government could arbitrarily nationalise it in the future – bankers in Russia dismiss this fear as unnecessary in most sectors outside natural resources. Increasing affluence among Russians is driving those other sectors, especially consumer goods, which are the most appealing to foreign businesses.

Lastly, there is internal consolidation amongst Russian businesses, a natural progression as companies combine strength to attract cheaper financing and other economies of scale. Although local Russian banks cannot compete with the likes of Deutsche Bank for cross-border M&A transactions, Snesar said, there is a role for them in local deals, although he said there has been a disappointing level of deal flow from domestic M&A recently.

On the Russian deals that have taken place, Deutsche has seen competition from a small number of Russian banks – predominantly Renaissance Capital, but also, to a lesser extent, from Troika, which is a medium-size investment bank, as well as Sberbank and VTB, the former of which is making a play to develop its investment banking capabilities.

“Sberbank could find a niche to occupy,” predicted Snesar, “though I doubt it could compete on a global level. It just doesn’t have enough deal flow within Russia to stimulate that kind of growth yet.”

There is an increasing use of debt for M&A deals and we have seen a rapid growth in the use of leverage in the last five years,” according to Sergey Komolov, partner at Hogan & Hartson in Moscow. “This has occurred as Russian corporates have gained increasing access to the capital markets. We are seeing more private loans and IPOs.” He admitted that the credit crunch had caused a dip in this general trend of growth but he predicted that this will prove to be merely a pause.