Russia and CIS Loans Roundtable 2008: Part 3
Benjamin Binetter: In 2007, I think you are right in saying that. It was a very borrower-friendly market and we were gradually moving away from secured transactions. But that was only really reserved for a select few and for small amounts. We never actually really got to a market like in Western Europe of a pure plain vanilla market, because there is a still perceived risk tied to the country.
The fact that we are seeing banks manage their country limits and take a portfolio approach rather than a deal-based approach a lot more today is also linked to the fact that they have become more sophisticated in the application of the risk return models. The application of Basel II requirements also means that it is easier to find a balance on a secured transaction than it is on a cheaply priced most often not unsecured deal, and it is easier to allocate a new portfolio.
IFR: Is there any possibility of the secured structure being put on other non-commodity companies?
James Nisbet: Totally. We are looking at real estate and infrastructure deals in Russia. All these deals can be secured. We are seeing diversification into retail with X5 and others, into telecoms, into lots of other areas because obviously there is a lot of need there. So I think these deals probably will be structured with security attached to them, by and large.
Thankfully we do not have short memories, we do remember the Russian crisis, we do remember the Asian crisis, and it is important that we do remember that because that is in a way why the leveraged market became so over heated. People forgot the fact that cycles always happen. There will always be a credit cycle. You can elongate them, but unfortunately when you elongate them as we have seen now, the fall tends to be much sharper and the recovery slower.
So should we be saying to ourselves, well, actually, maybe we are better off having shorter cycles like we used to in countries like Turkey? There you would have a natural five-year cycle where pricing and structures would slightly erode, but then you would have a bit of a problem, and then pricing would go back up again, structures would tighten in again and then you are back on the train again in the typical cyclical fashion.
IFR: Is that fair on the borrower? The position in Russia now compared with 1997 or 1998, is miles away.
James Nisbet: There are still risks there. You still have a legal system that needs a lot of work doing to it. The LMA are going out to Moscow in June to talk about issues such as standardisation of documentation in Russia. The reason the rouble market in Russia has not really taken off yet is because there is a lack of faith in the legal system. There is a lot of work to be done there.
Everybody focuses on the macro economic situation and says fine, yes, the economy is booming, GDP is at 8 per cent, but there are a lot of risks there still. What is going to happen with the US recession? How is that going to impact Russia? Is it going to be dislocated? We are still reliant on the dollar in Russia and in the CIS countries. So there has to be an impact there, and as yet people do not know what this recessionary pressure is going to have. Our own economist gave us a presentation the other day and said Russia should fare fairly well. If you look back to when the dot-com boom hit and the bubble burst there in the States, the economies in emerging markets did not actually fare too badly. But we just don’t know. This is a global crisis here, so my view is that Russia will be inevitably be impacted and that is going to cause inherent credit risk. So while we are in a fairly benign credit environment at the moment in terms of default rates, everybody has to accept the fact that that could change in the next six months to a year, and we have to protect ourselves.
We didn’t protect ourselves with the leveraged market, and look what has happened. So people are using that, which is a very fresh experience, and saying, let us not replicate this here. We have a chance here to grow a market in a sensible fashion, with sensible pricing, sensible structures, but also making sure that we are protecting ourselves as much as possible from the inherent credit risk.
Benjamin Binetter: The borrowers have simply no choice, frankly, because the contagion effect from other markets is clearly there, and frankly their financing needs are substantial, whether it is in the form of refinancing of bridge loans, like we discussed, or M&A activity, or even just purely capex, I think there are limitations as well on the domestic banking market. Borrowers are simply not in a position to say no. The banks that have been leading the transactions in Russia are very consistent in their approaches, in their pricings, in their structures, without necessarily billing together.
Everyone knows today that there might be one or two outliers, but the broad consensus is generally there is a need to strengthen structures. And borrowers simply have to accept it, because there is not liquidity that you can rely on at a later stage.
Hasan Mustafa: The bottom line is that, whatever is happening, this is a banking crisis. For us to say this is an unfair situation on the Russian borrowers, they should find themselves to be lucky that they are able to go out, raise money when they want it for what they want it. Yes, it is costing them, but it is costing them for a reason that we are all, as bankers and lenders, suffering from our own individual issues, and our cost of funding has gone up as well. People used to borrow sub-Libor, now it is 70, 80, 100 basis points over Libor in some of the cases.
So to the extent that borrowers in Russia even from October until now, have been able to go out and borrow one, two, three or four billion, and do it successfully and build out their strategic objectives, I think that to me is a sign which is saying that we believe in the region. Pricing is just one element of it.
Benjamin Binetter: It is not a doomsday scenario. We can all sit here with our heads up high and say that the market in Russia and CIS has held up pretty well in comparison to other markets in the world. Banks as a whole have been very sensible and reacted very quickly to an emerging crisis in the summer last year, which immediately could have been perceived not to have an impact on Russia, but the fact was that the banks reacted quickly. The pricing moved up quicker in Russia than in other markets. Structures were tightened more quickly as well. So as a whole, very large transactions are still getting sold. It takes more time and there is a price to pay for it, but as a whole they are still getting sold.
James Nisbet: I think if you took a straw poll back in, say, November last year, even probably amongst us here, to say would US$28bn worth of loans get through the market in the first quarter in Russia and CIS? Most of us would put our hands up and say probably not, but it has happened, and it is continuing to happen.
The question now is how sustainable it is. It is up to all of us: the lenders; the borrowers, to ensure that that stability continues and that the market does not run out of steam and run out of capacity. It is going to be a challenge.
A lot of banks now are going to be realigning their strategies away from maybe Western Europe, away from high yielding leveraged loans, more into better structured, better priced loans in emerging markets. The loan market has always been flexible and it has always been able to adapt to whatever dire market conditions there are.
IFR: You have drawn a comparison between leveraged finance and Russia. Are we going to see the sort of pricing in Russia that will be comparable to leveraged market of last year?
Benjamin Binetter: In some cases, yes and I think it needs to move on the more aggressive structures; bridge loans in particular.
Hasan Mustafa: What will not happen is the leveraged finance model being applied in emerging markets. I think some people mid-2007 felt that they could cut and paste the ABC, secondary structures in Russia, but we never had faith in that structure, because they were born out of institutional demand. Our market generally relies on the bank market as an investor base.
To try to sell eight-year bullets and seven-year bullets to banks was never appealing. From the point of view of if there were to be leveraged finance deals done out of Russia and CIS, I think they would have to be tailored to appeal to the banking market.
They would have to be remodified. If you look at what has happened in Turkey where a lot of acquisition and privatisation deals were done, they were done on the basis that they were supposed to be distributed to the bank market, and were tailored in that respect, that there was only one senior tranche and that is the end of the story. If there is more equity needed, then it needs to be put in the pot.
IFR: Does that mean that Turkey would be more the model rather than Western Europe?
Hasan Mustafa: I would think that the Turkish acquisition leveraged finance model is possibly the one that needs to be replicated if there were to be deals done in Russia, rather than try to take something out of Germany or Spain or the UK.
Christian Eberl: So really not a western-style model where you had your traditional institutional investor base and, as we heard from James, the banks were just passing through, making loans without really caring about credit quality itself, because you were sure you would find someone taking on the risk and you can get rid of it.
Emerging markets have always been bank-driven markets and will remain so. The bank market was always the most flexible, one really to be tailored exactly to the need of your investor base. For example, if we have something in Russia or if we have something in Turkey, we will listen what for example the local market will require in order to get things done because in such an area a local market might be a very important source of liquidity, which might not be a traditional western-style pattern. But I think that is our big advantage; that we can be flexible and will be flexible to get things done. This should avoid the problems that have impacted the leveraged market.
Hasan Mustafa: The intensity of credit and risk analysis is far stronger than what you see in Western Europe. In Western Europe everything is weighted, things are easily available and disclosure is good. So it is all about originate and distribute. In our case, you need to dig and dig and dig until you get your info memo ready. I think the whole ethos of focus on credit and risk has held us in good steam in the sense that we never originated deals that we thought we would never hold ourselves. So that already brings in a certain amount of discipline. By virtue of that, we never had an institutional appetite for the assets that we were originating. So the troubles never arrived, partially because of the fact that our deals were always lender friendly, to the extent that we were doing a lot more due diligence and risk analysis than what is being done in the Western European context.
James Nisbet: I have been out to see a lot of the investment banks recently, and what I am sensing on the institutional side is that you will get institutional money coming into the Russian market, and it is already coming in, but it will be very much driven by specific sectors. You will get funds being set up that want to invest in things like infrastructure. Our economists have worked out there is a trillion dollars’ worth of funding in Russian infrastructure over the next ten years. So the demand is huge if you think about it; airports, roads, hospitals, all of this infrastructure in Russia and in the other CIS countries needs over time to be developed.
There is no way that the loan market is going to have the capacity to take that. But what we will start to see now is funds being set up, and they are already being set up, that will invest in certain strategic areas like infrastructure, you would be getting real estate funds as well being set up. And they will not be necessarily an integral part of the loan structure as we saw with the leveraged market where institutional funds take a tranche or a couple of tranches of a leveraged loan; it will be a separate part of the package. So you might get a syndicated loan, a structured loan put in place to provide part of the financing, and the fund money maybe through a mezzanine tranche or something will come into that, but it will be a separate part from the senior debt structure. So the traditional LBO structure model will have to be revised. We will not see it replicated. I do not think we can say that the institutional fund market is dead and it is not going to be investing. I think there is a lot of interest, there is a lot of private equity interest already in Russia and CIS and I think this market will develop, but along different lines. Hopefully they will learn from what has happened in the US market and in Europe, but it will be more specialised.
William Sharpe: You can point to the level of maturity of Russian equity markets as well as the legal system, which has been mentioned, from the point of view of transparency and also sophistication. These are two major constraints in terms of allowing Russian potential LBO market to evolve along the lines as it did in Europe and in the United States. At the end of the day there is only so much you can do with a domestic Russian entity that does not export products, and therefore does not have income in foreign currency outside of roubles.
Now, especially the constraints just mentioned, the legal system in particular, that is just a different play, both for a lender and for an equity investor today, in my view.
IFR: But there are several popular borrowers that don’t have foreign currency revenues.
William Sharpe: Absolutely, but it is just a different type of marketing approach, a different type of presentation. If you had to distinguish between the two, I think one would expect to see pricing continue to rise, in particular for those non-exporting domestic companies, as opposed to borrowers that have recourse to the pre-export financing structure.
Christian Eberl: I think in this respect, one fair comment might be, even if you have borrowers which do not have export receivables or hard currency revenues, I think there are still quite top names out which are operating in a basic industry where I think overall you could assume that there should be appetite from a lender’s perspective, for example telecom in Russia. All these telecom companies were able to secure funds more or less on an unsecured basis. Even telecom is a traditional local currency generating business, but it is a fundamental service everyone knows and, with a growing population, there are certain exceptions where you might be able to take a different view, despite generating local funds.
IFR: One sector that does not export but has been extremely important in the loan market is the financial institution sector. This area has a huge refinancing requirement over the next year. What are their prospects?
James Nisbet: I think you have to differentiate. Obviously the FI markets have been quite a mainstay of Russia and CIS over the last two to three years before the emergence of the more corporate-led markets. So we have all probably experienced to some extent the good and bad points of the FI market. Kazakhstan was a classic case where that market pretty much collapsed last year because there was a big concern about refinancing of these huge deals. A lot of these FIs were launching deals, say, at US$500m, raising US$1bn and then increasing the deal size. Then of course, surprise, surprise, you come to look at their balance sheet again when they are looking to refi and they are suddenly more leveraged than you expected.
Hopefully people have learned from that and the classic model where these borrowers try and raise as much oversubscription as possible and increase the deal sizes should be a capped: banks should have the opportunity from the outset to say, “we have the right to scale ourselves back”. You know, we might commit US$30m to this deal upfront, but actually we only want to hold US$10m. So rather than you just having the option to raise the facility size to whatever we raise, we actually have the first right as lenders to scale ourselves back rather than having to sell in the secondary market. I think there will become a saturation point. As you say, there is a huge amount of refinancing. A lot of the Kazakh banks have already said we are just going to repay our debts this year.
We have already seen a lot of the Russian and Ukrainian banks coming back to the market. These deals are getting done, but they are not raising the amounts that they were before. Pricing is going up a lot. But you have to remember that there are a lot of investors out there who only want to do FI business, particularly the smaller retail banks. There is one area of the market where you are seeing retail activity happening because some investors are only comfortable by and large lending to financial institutions that they know. So the market will continue, but as we said before, if capacity, certainly individual borrower capacity starts to get clogged up and these borrowers try and come to the market too often, then there will be some indigestion in due course. I think we were seeing two years ago borrowers quite often coming to the market two or three times a year.
Those days really have to be over.
They have to say, right, what are our financing needs for this year? Let’s do one deal, get all our relationship banks into it, raise what we can, and then that is it. But doing a deal, closing it and then almost immediately coming out with another deal does not give confidence to the market.
Borrowers have to become more aware of what is happening. Some are and some aren’t. Some are still burying their heads in the sand and saying, yes, we can still do three-year deals at crazy pricing, but if you look at some of the bigger names they are more realistic. Sberbank came to the market back at the end of last year and very nearly had a disaster of a deal because they mispriced it. That was a warning signal. If you want to raise money, specifically big amounts of money, pricing has to be massively adjusted and you have to be aware that there is a finite amount of liquidity that is going to be put to play on these deals going forward.
We have much more corporate deals to look at now, the markets are opening up, lenders want to diversify their risk away from FIs, away from oil and gas, into new sectors, so there will be much more liquidity coming into the new areas like telecoms and retail and other areas, where people see opportunities to diversify away from their concentration of risk. I think the Kazakh issue highlighted that. Put all your eggs in one basket with FIs, then the whole market tends to go the same way. You do not tend to see one or two FIs going down, as with the Russian crisis, you see the whole lot. So I think there is a period when I think liquidity is going to move away from the FI market, certainly in Russia, and more into the corporate market.
William Sharpe: There is definitely more reluctance on the part of Russian banks to increase pricing in response to the crisis. It is interesting to note that last year Russian banks went massively to the bond markets, to the euro bond markets, compared to previous years. By my count, about US$20bn in euro bonds were placed in favour of Russian banks last year, which illustrates the fact that typically Russian banks have gone to the international capital markets more than their corporate counterparts, and a greater portion of their debt is in foreign currency.
If you combine this with the sort of general perceived weakness of the financial sector today they are a victim rather than being guilty. It is very rare are the Russian FIs to have invested in subprime in the United States. It is a combination of factors that makes the perception of Russian FIs less attractive compared to previously. Unless the perceived risk is correctly remunerated, then liquidity will still be drawn towards other asset classes.
Hasan Mustafa: It is not an issue that nobody wants to lend to the FIs, it is an issue that they do not want to pay for the liquidity that they need. So to the extent, if there is a large Russian bank or some of the Russian banks want to borrow, I think the market is still there, and that is the widest possible investor universe that one could think of in terms of the sector. Because even Asians will play it, Egyptians will play it, Middle Eastern will play it. So from a distribution risk point of view, it is probably the best sector to play in, but because the pricing had come down so low, I think some of the borderline retail investors had disappeared. But if they want to come back to and raise money, I think FI is probably the first sector that could reinvigorate the retail investor base, without the need to pay for that. I find that astonishing, that banks are still out there pitching new deals at FIs at returns which are lower than their own cost of funding.
Christian Eberl: There is a certain view among the arrangers where the pricing should be, but I think intensive discussions are ongoing, and I think what I hear for the time being is that everyone tries to find the lowest common denominator, which is obviously reducing the facility amount in the first instance and then trying to raise each available cent in the market. I think on the face of it, this might be a model to play, but not sure whether this is the appropriate model to play.
William Sharpe: There have been a couple of transactions that have been blow-out successes for this year for FIs, at the lower end of the tier. Now, blow-out success just in terms of percentage oversubscription, not in terms of total amount raised, but it shows that if the transactions are priced correctly, then they will generate appetite in the market.
Benjamin Binetter: I do find it astonishing that cheap deals are getting done, even if just barely; Sberbank really scraped through, and yet they can still find one or two banks that will completely undercut the market in the FI sector, in such a way that you are not seeing in other markets such in the energy and commodity sectors where the banks are pricing deals very closely to one another. And they are undercutting their own funds so there is no business logic in that.
Hasan Mustafa: There are some leading banks who do nothing but FIs. For them, that is their bread and butter business.
Benjamin Binetter: Yet those same banks, when they commit, or prior to committing to a deal which is priced a lot higher, with a security package on an energy deal, will not send in a commitment before they have actually confirmed with the treasury department whether they can actually raise whatever liquidity they need to commit to a deal. So there is a complete gap.
James Nisbet: I think there is still obviously a huge number of banks over the years that have become arrangers of FI deals. There is a lot of competition out there, and competition leads to one thing: price reduction and competition for pricing. The borrowers are not stupid. The FI borrowers are some of the most sophisticated borrowers in the market. They know how to play the banks because it is tested over time, the Turkish banks used to be the classic example.
So we need to be careful in that market, because we could very quickly find ourselves back at square one again where we have rock bottom pricing. This is where again the secondary market will be very key in terms of determining where pricing has gone. If you look at names like Sberbank and even VTB over the years, the pricing has just gone down and down and down, and the fall has got steeper and steeper and steeper, and as that has happened, the secondary price discount has got wider and wider. You look at the discounts now, if you want to sell a Kazakh bank name in the secondary market, you are having to give it away at maybe a four or five percent discount. That to me is the real cost of these financings. That is where they really should be priced, stripping the relationship and competition factor to arrange the deals.
But there are a number of banks in the market who will go into a deal irrespective of the return they are making, simply because they can be a mandated arranger, and internally it looks good, and they can go to their management and say, “haven’t we done well, we have been an MLA on this deal”. But I think those banks will start to suffer going forward, and the market will suffer if that continues. Ben is right, there is a much more sensible rationale with the corporate market; corporate lenders are a much smaller group of arrangers who do these deals and they are much more aware of the fact that now is not the time to be really trying to push pricing down. If anything, we should be doing the opposite.
William Sharpe: Even more than for corporate borrowers, Russian banks’ indications become top heavy in primary syndication. Even before the liquidity crisis, the strategy was to get as many MLA title banks in at the top level to generate as much liquidity as possible for the syndication. One of the results of that was that before where certain players only came in secondary, they were able to come in primary, so that even before the crisis, the secondary market was shrinking for Russian FIs, there was more appetite in primary and more appetite at the top level. In terms of corporates, you have seen the majority of the funds being comprised of the MLA group - you have seen that as a sort of defensive mechanism to the crisis, whereas Russia had already used that and exhausted that, and so that in terms of FIs, this explains why there is perhaps less liquidity for Russian FIs in primary today.
IFR: Does that have a knock-on effect for the rest of the economy? How keen is the Russian government to see the FIs supported.
William Sharpe: The advantage the Russian government has today is that they are much more liquid and they have much more resources thanks to foreign currency reserves. So we have seen them try to support Russian banks domestically in terms of interbank funding in roubles, so clearly they are committed to supporting the banks in terms of their liquidity position. They are able to do so and they want to avoid a crisis, but that does not really help the Russian banks in terms of tapping the international markets, loan markets and bond markets.