There is considerable investor interest in the debt collection business in Russia, but achieving growth is not straightforward, even though the industry is still young. Writer Philip Alexander

Foreign investors have acquired a taste for collecting non-performing loans (NPLs) in Russia. Goldman Sachs started the trend with an investment in Sequoia Credit Consolidation, the country's largest collections agency, in September 2006. A year later, German asset manager Wermuth bought a stake in Pristav, the number two agency. Another of the leading agencies, FASP, is itself investing to expand its operations into neighbouring markets, namely Kazakhstan and Ukraine. And one of the largest eastern Europe-focused funds, East Capital, made its second investment in the industry in early 2010 - a Russian joint venture with western Europe's leading collections agency, Intrum Justitia. East Capital has owned a 33% stake in Morgan & Stout collection agency since 2008.

Andreas Boesenberg, the deputy chief investment officer for unlisted investments at Wermuth Asset Management, says finding a company that can deliver efficiency improvements is of the utmost importance for a private equity investor.

"Many Russian companies tend to respond to any problem by just hiring more staff. Whoever can run a company efficiently can profit, and that is why we liked the combination of Western and local management at Pristav," he says.

For Kari Kyllonen, chairman of purchased debt at Intrum Justitia, a young industry that dates back less than a decade offers plenty of opportunities in the fresh Russian market. By contrast, Intrum celebrates its 100th anniversary this year in its home market of Finland.

"The market potential is huge, the biggest in Europe, in terms of the collections management and purchased debt businesses," says Mr Kyllonen.

Learning the trade

Intrum has moved cautiously, spending four years assessing the market. The firm ultimately chose to partner with East Capital because of the specific challenges of operating in Russia, where the fund manager has 13 years of experience since its foundation.

"The infrastructure does not exist compared to the Scandinavian countries, where we have data on almost the whole market, a register of all borrowers going back many years," says Mr Kyllonen.

By contrast, says Hanna Loikkanen, senior investment adviser at East Capital in Moscow, Russian credit bureaux are limited, they have information on bad payers, but not good, and the data often goes back as little as two years. This makes the valuation of loan portfolios for purchase more difficult.

The agencies have had to learn from experience in a short period of time - and with no trained collections staff in the first few years. Most quickly found that field collections by ex-police or bailiffs (Pristav literally means 'bailiff' in Russian) were costly and often ineffective.

Instead, the leading agencies now have call centres, mostly staffed by people with experience in sales or customer services. One agency has even found teachers make good hires as they have the patience and skill to explain the situation to distressed debtors.

Senior management often come from retail banking backgrounds: Elena Dokuchaeva, CEO of Sequoia, and Alexander Morozov, commercial director of FASP, both previously worked in the retail segment at Alfa Bank, while David Jones founded Pristav after working for ABN Amro, Citi and the start-up Russian consumer bank Delta. But there are exceptions - Dimitrios Somovidis, the co-founder and chairman of Morgan & Stout, retrained after having sold a fast-food chain he created.

Sequoia made its first NPL purchase in 2007 after developing a valuation model with Goldman Sachs, drawing on the investment bank's experience of the purchased debt business in other emerging markets.

"We did not earn much on that first deal but we bought useful experience. We learnt about some significant things, like guarantees that should be provided by the seller and the set of documents we should demand for future legal collection," says Ms Dokuchaeva.

The bankers themselves also needed training to understand the product. Mr Jones says his first step after setting up Pristav in 2005 was to educate banks and persuade them to benchmark their own collection rates against what the agency could offer. Bank CEOs tended to be more receptive to this than the middle-managers who were responsible for the collections process and felt themselves in the spotlight.

"We had to show them that benchmarking helped to evaluate staff and that outsourcing could ease their workload and improve delivery," says Mr Jones.

"The market did not take off initially. Bankers found the idea of outsourcing difficult, a kind of admission of their mistakes. They were not carrying out a cost-benefit analysis, they just wanted to keep control. So no one wanted to sell NPLs - or if they did, it was on very old loans that had been washed in house or by collectors many times so recoveries were poor," adds Mr Boesenberg.

According to Tony Thompson, head of financial advisory for the Commonwealth of Independent States (CIS) at KPMG: "Most Russian banks still regard the sale of NPLs as more of a trial, and we do not expect substantial distressed debt investments in 2010."

He says the original loan documentation often still falls short of international standards and that there are shortcomings on the IT side in terms of providing customer data. "This all makes valuations of distressed loans difficult - collection agencies do not have much transparency on what they are buying," says Mr Thompson.

Even now, banks are not always realistic on suitable commission fee percentages for collections management or pricing for sales of NPLs. Ms Dokuchaeva says Sequoia cut the average price it was willing to pay to about 2 cents on the dollar in 2009, from 8 cents before the financial crisis, as the visibility on loan performance was so limited. The price has now rebounded to about 5 cents, but some banks who are new to the business still expect to sell for upwards of 25 cents.

"Those customers who work with us for long periods understand that there is a point where, if the commission or internal rate of return goes any lower, it will affect the quality of collections. There are no miracles in this business. The more you invest, the more you collect, and you can invest more if you price collection services correctly. We encourage people to look at collection rates, not just commission rates," says Ms Dokuchaeva.

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Tony Thompson, head of financial advisory for the Commonwealth of Independent States (CIS) at KPMG

Uncertain legal context

The fees or purchase discounts of collection agencies also reflect an under-developed legal framework that tends to favour the debtor. As they are not banks, collection agencies are not allowed access to credit bureau data and client information to help track debtors or model expected recovery rates, and data protection was tightened recently under Law 152.

"Law 152 involves the gating of data that banks can pass on to their partners, and the market is still testing how this law can be used in practice," says Mr Somovidis.

More fundamentally, there is as yet no legal definition or regulation of collection agencies and the Russian Consumer Protection Society has even challenged the concept of banks selling debt to third parties.

Industry groups such as the National Association of Professional Collection Agencies and the World Organisation of Creditors (WOC) are lobbying the Duma, the lower house of the Russian parliament, to pass a bill that would formalise the business. They argue this is the best way to protect borrowers as it could eliminate the ex-police or bailiffs setting themselves up as one-man collection agencies and operating in an unregulated fashion.

"Debtors do not lose any rights when their debts are sold to collectors - or indeed to investment companies or other banks. To provide greater protection to consumers it is best not to prohibit but to develop laws if the current law does not cover the question of collection. Normally, if we have disputes with borrowers whose debts we have bought - for example, if the debtor has reason to dispute the debt - the court usually takes a decision favourable to the borrower, not the collector," says Ms Dokuchaeva.

In fact, Mr Somovidis says Morgan & Stout takes some 5% of its cases to court at most, usually larger commercial debts - of between Rbs2m ($70m) to Rbs3m - that are worth the higher cost of recovery. Retail debts of less than Rbs15,000 do not justify the lawyers' fees or the uncertain outcomes.

In addition, the banks sometimes trip themselves up with weak loan or security documentation. Sergei Shpeter, senior vice-president at Pristav, says many banks use car registration documents as security from borrowers for auto loans, to be able to take ownership of the car if the debtor defaults. But debtors can easily apply to the traffic police for a duplicate copy if they claim the document has been lost, allowing them to sell on the car even while the bank holds the original registration document.

And yet, the system works. Ekaterina Kapustina, head of international business for Russian Debt Corporation (RusDebt) and president of the WOC, says many creditors settle amicably in as little as two months once professional collectors begin to handle their case.

Wermuth's Mr Boesenberg adds: "The courts are unhelpful, with lengthy hearings, unpredictable verdicts and a lack of enforcement. And there is also no central credit bureau to provide data for valuing NPLs. Remarkably, despite all this, the collection business works. That is because most debtors are paying after soft collection methods alone."

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Elena Dokuchaeva, CEO of Sequoia

Competitive market

While recovery outcomes are more favourable than might be expected given the legal context, it would be a mistake to assume that the downturn in 2009 meant boom times for collectors. On the contrary, says Mr Jones, the fall in new loan origination means lower volumes of new business for collectors as well - and poorer quality among the collections being outsourced.

"When banks are aggressive with new lending, that is the best time for agencies. When people genuinely do not have the money, the collection business is much tougher and recoveries are lower," he says.

Ms Dokuchaeva says the cost of collections rose in 2009, although Sequoia offset this with administrative cost-cutting and lower staff turnover, so that operating profits were up four times compared with 2008. Ms Loikkanen of East Capital says the eventual upturn in retail lending will be a better opportunity for agencies to expand their business.

"Before the crisis, the bank's own collection departments were very small in Russia, so when NPLs rose they were forced to retrain sales staff to work on internal collections. When we see efforts by Russian banks to jump-start consumer lending, they will take people back from the internal collections departments to their sales teams again, and outsourcing collections to the agencies will become more worthwhile," she says.

But she also sounds a note of caution on the overall market potential, as the average length of the collection curve in Russia is only about 18 months. Indeed, Mr Somovidis says recovery rates on delinquencies of more than three years tend towards zero because creditors are not allowed to pursue cases through the courts after that time has elapsed. This is much shorter than the collection cycle in more mature markets and could encourage investors to be over-optimistic on long-term performance.

"The initial collection rates may look very good because the collection curve is so steep, which will encourage agencies to bid aggressively for NPL portfolios and attract investors, but the statistics only go back two or three years," says Ms Loikkanen. By contrast, Mr Kyllonen says Scandinavia's Intrum models cashflows on its purchased debt portfolios over a decade or more, making the internal rate of return more stable than that on a short-duration portfolio.

Buyer beware

Newer agencies are also moving quickly from collections management to purchased debt in an effort to win market share. This poses risks to the business if the agency has neither enough data on recovery rates to value purchased portfolios correctly nor the resources to handle the increased workload.

"When you work on a commission basis you have a predictable growth rate, but when you close a big purchase deal you may double your portfolio in one day, which is a stress for the company," says Ms Dokuchaeva.

Ms Kapustina says RusDebt is generating enough revenue to fund organic growth, so is treading carefully and not seeking foreign investment. But several of the leading agencies have been approached by smaller competitors seeking to sell or merge their companies, suggesting that some of the firms set up during the credit boom are struggling.

The leading agencies plan to diversify their revenue streams, taking on more work collecting from utilities or providing banks with outsourced call centres, data analysis or training. The general consensus is that the market probably only has capacity for about six national players - and foreign investors may already have found most of those winners.

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