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Central & eastern EuropeSeptember 2 2007

CZARs chew over coming clean

While some eastern European mega companies are improving corporate governance and listing abroad, others are moving back closer to the state. Ben Aris explains.
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“In the past, Ukraine was famous for making rockets, but the advantages of implementing good corporate governance is not rocket science,” says Roman Vodolazskyy, the chief financial officer of System Capital Management (SCM), the biggest industrial conglomerate in Ukraine.

Eastern Europe is a famously dangerous place to invest, but the explosive growth of all the economies in the region is pushing the leading companies towards improving corporate governance and reducing those risks fast.

SCM is the property of the richest man in Ukraine, Rinat Akhmetov, who is worth about four times his nearest peer, ex-president Leonid Kuchma’s son-in-law, Viktor Pinchuk. Both men owe their fortunes as much to government connections as to business awareness and neither are famous for the transparency of their firms or their respect for minority investors.

However, SCM has been systematically making over its business in the past two years to improve transparency and clarify the ownership structure. The company has been reorganised from top to bottom and broken up, putting like with like. Now the company is divided into four sub-holdings – Metinvest (metals), DTEK (power), SCM Finance (banks and insurance) and HoldCo (media and telecoms) – of which the metal and energy companies may float sometime next year.

White hot economic growth has convinced oligarchs that there is more money to be made from cleaning up their acts so they can borrow abroad, rather than relying on their government connections to make money.

“Millionaires are making money, and billionaires are making history,” Viktor Pinchuk boasted to a group of journalists, while standing with his back to the Livadia Palace where Stalin, Churchill and Roosevelt held their historic conference in the closing phases of the Second World War. “I am a businessman. I am not oligarch,” says Mr Pinchuk. “I am not connected either to politics nor to power. I am a big Ukrainian businessman, who wants to take an active part in the country’s social life.”

Ukraine is maybe the most dramatic example of the ongoing disconnect between politics and business. This year has been stormy politically but businessmen have blithely ignored the resulting constitutional crisis and the economy continues to roar ahead, growing a whopping 8.3% in the first quarter of this year.

Since the Orange Revolution in 2004 there has been no stable government, yet the country remains the fastest growing economy in eastern Europe for the past three years as businessmen continue their investment and expansion plans oblivious to the crowds gathering on Independence Square.

Flotation driver

The need for capital to continue this rapid growth has been the main driver for companies cleaning up their act. Ukraine has seen its first round of initial public offerings (IPOs) and Russian companies raised more money last year with flotations than in all the previous years since the fall of the Soviet Union in 1991.

Russia is furthest advanced in this respect and saw an explosion of IPOs in 2006 after 15 companies floated on domestic and international stock markets to raise $17.7bn. This was an excellent result, even if the $10.6bn that state-owned oil company Rosneft raised with its historic IPO in July is excluded from the tally.

With some 90 Russian companies hoping to raise an estimated $30bn this year alone, the impetus for cleaning up their corporate act is only growing stronger.

“The owners of most companies have realised that increasing transparency and improving corporate governance means a lower cost of borrowing, so a lot of them are getting on with it,” says Chris Weafer, chief strategist at Alfa Bank.

However, bankers say that not all the IPOs on the block are just about raising money.

“About half of the IPOs in the pipeline now are also there for political reasons,” says one senior banker in Russia. “It is a lot harder to renationalise a company or force it into a merger with a state company if part of its shareholder capital is owned by foreign investors.”

Following Viktor Yushchenko’s triumph in the 2004 Orange Revolution, the first thing the new president did was promise a limited re-nationalisation of companies privatised under Mr Kuchma on contentious terms.

Within a few months, SCM launched a very slick advertising campaign, dropping some $20m on media outlets such as Newsweek and CNN to raise the company’s profile. It also accelerated plans to prepare his various companies for an IPO that could happen as soon as 2008.

“It came out of the blue,” says John Canning, head of European sales at Newsweek. “It’s a lot of money and no one had ever heard of this company before. Everyone scrambled to find out who Mr Akhmetov was.”

Transparency drive

In Russia, oligarch Vladimir Potanin has gone furthest in making his companies transparent. One of the original seven oligarchs that earned their first fortunes in the Yeltsin-era, Mr Potanin is credited with coming up with the idea of the now notorious loans-for-shares deal that saw most of Russia’s industrial crown jewels sold off to the top oligarchs on highly attractive terms.

However, Mr Potanin has managed to hang on to his assets and promised to “IPO at least one company every year going forward”.

The first was Open Investments, a property and development company, one of the few Russian IPOs that has outperformed the market since its debut.

INCREASING TRANSPARENCY - OLD OWNERSHIP STRUCTURE

Analysts say that the demand for companies in sectors other than oil and gas has meant many of the IPOs last year were expensive and three quarters of these new listed companies are performing less well than the RTS index. Open Investments saw its share price rising 64% in the 12 months to March against a 27% gain by the RTS index and now has a market capitalisation of $2.4bn.

Mr Potanin followed up by spinning off the gold mining operations of his cash-cow Norilsk Nickel into Polyus Gold and then listed the company on the London Stock Exchange in December 2006 as American depository receipts.

Mr Potanin was planning to organise Russia’s first ever bank IPO with the float of a 20% stake in Rosbank, also part of his Interros financial-industrial holding, and spruced the bank up ahead of the float by hiring two independent directors and overhauling the bank’s corporate governance. But in the end, France’s Société Générale (SG) took a stake in the bank and the IPO plans were shelved because of poor market conditions. SG is now on course to own 50% plus one share in the bank.

“Russian owners were moving towards opening up to get better valuations already, but the surge in foreign interest last year has only catalysed the process as it is teaching the Russian owners the standard practice and they can see the value of the deals rise if they are willing to jump through all the hoops the foreigners hold out,” says Peter Westin, chief economist at MDM Bank.

Mr Potanin’s motives for floating his companies may be partly political, but it also makes good business sense and the improvements he has made in corporate governance are real. Most companies with an intention to either sell their stock or raise debt have already made most of the corporate governance improvements they are going to.

In its most recent report on corporate governance, Standard & Poor’s found that in 2006 Russian companies made only modest improvements to their corporate governance: S&P’s transparency index rose from 50% in 2005 to 53% last year, which measures the performance of 50 big Russian companies.

Once Russian companies wanting to IPO can clear the corporate governance hurdles imposed by international stock exchanges, they stop making any more improvements. Still, this is a significant improvement on the opacity of Russian companies in the 1990s. It means that most of the leading Russian blue chips can already boast western standards of corporate transparency.

For the most part, the improvements in corporate governance are where you would expect to find them – in the most modern industries with high capital needs and low margins, such as telecoms, retail and fast-moving consumer goods.

“In addition to the increased confidence that the Yukos affair was a one-off case, the drive of Russian companies to meet the informational needs of international investors appears to be the main motive for improvements in ownership disclosure,” S&P said in its Transparency And Disclosure report in November, 2006. “In many cases, this comes in connection with completed or planned IPOs. While the regulatory requirements associated with listings on international exchanges continue to set standards for disclosure, market-based disclosure incentives play an increasing role. This role is demonstrated by progress among companies that are not exposed to stringent regulatory requirements.”

The improvements in corporate governance have been dramatic, but for every Russian company that is cleaning up its act there are nine that remain resolutely private, according to S&P.

A large number of Russian and Ukrainian oligarchs have no intention of cleaning up their companies as they do not want independent shareholders analysing their business practices.

Until about two years ago, SCM’s corporate structure was a classic example of what could be called ‘spaghetti’ governance. The idea is to build a company structure that is so complicated that neither the tax authorities nor acquisitive rivals stood a chance of ever knowing where the businesses’ cash or shares were really held. The resulting organisational chart looks like someone dropped a plate of spaghetti on it.

SCM'S BUSINESS STRUCTURE

Pryvat Groups is the most obvious example in Ukraine. The country’s second biggest industrial group remains opaque and closed. The owners say they have no interested in going public and continue to play aggressively in the marketplace.

“[Pryvatbank] is open and transparent, but as a bank it has to be, but not the rest of the group,” says one banker that has worked with the group.

The situation in Russia is more complicated given that the Kremlin is now the biggest single shareholder in the country after the government increased its ownership in companies such as Gazprom and the state-owned oil major Rosneft took over the main production assets of embattled private oil company Yukos. Between January 2000, when president Boris Yeltsin stepped down and December 2006, the state share of voting stock in Russia’s 20 leading companies has increased from 18.1% to 38.9%, according to Aton Capital.

The government’s new financial-industrial-military group has been dubbed ZAO Kremlin, a ‘closed joint stock company’ where shares can only be bought by invitation of the other owners.

President Vladimir Putin has built up ZAO Kremlin into not only the biggest company in Russia, but with just the listed parts worth $360bn at the start of this year, ZAO Kremlin is now one of the biggest companies in the world. The dividing line between business and politics, axiomatic in the West, has been removed completely in Russia. Mr Putin’s plan seems to be to recreate the Soviet Union, with the caveat that it is no longer evil to make money.

Strategic targeting

The Kremlin has targeted key companies in sectors deemed ‘strategic’ and ZAO Kremlin consists of a series of ‘national champions’, with the state-owned arms export agency Rosoboronexport acting as the holding company for many of the assets.

Rosoboronexport has been extremely active and holds key stakes in automotive, aviation, shipping, media and metallurgy companies to name a few.

Some of the oligarchs are being pulled into this state activity. The Alfa Group owned by the Yeltsin-era oligarch Mikhail Fridman has gone into a joint venture with Rosoboronexport called Patriot Capital, which is supposed to give the state’s defence holdings a financial once over.

Likewise, Ruben Vardanian, the owner of investment bank Troika Dialog, is on the board of Russpetsstal, a producer of specialist steels, along with Sergei Nosov, who was the former partner of Alexander Abramov that founded private steel company Evraz Steel. Russia’s richest oligarch, Roman Abramovich, also bought a 41% in Evraz Steel last year and is probably the closest of all the oligarchs to the Kremlin.

Evraz Steel is nominally private, but as one of Mr Putin’s closest confidants, Mr Abramovich’s stake means the Kremlin has managed to gain control of a large part of the steel sector without having to go through the damaging process of bankrupting someone.

State direction of business in Russia is now common. Viktor Vekselberg had been trying to sell his aluminium company SUAL for about four years, but was rebuffed by all the obvious candidates. Last summer he finally gave up and announced the company would float on the London Stock Exchange. Then he had a one-on-one meetings with Mr Putin, now a regular feature of the Russian big businessman’s life, and was told to merge with Oleg Deripaska’s Russian Aluminium company instead to create a Russian national metals champion.

“Mr Vekselberg had almost given up and announced that SUAL would float on the London Stock Exchange. But when he met with the president, Mr Putin vetoed the IPO until the merger with RusAl was completed,” says a senior executive involved in the talks who asked not to be named.

Most oligarchs have accepted a partnership with the Kremlin willingly. Oligarchs with strong ties to the Kremlin can expect the state’s backing for their expansion plans.

“After Yukos, it is clear to everyone what will happen to you if you do not play along. And most of the oligarchs are happy to co-operate, as what the Kremlin is offering is to help them open new markets and make investments that are beneficial to their business. The line between business and government has not just been blurred; it has gone altogether,” says one well connected banker.

But being close to the Kremlin is no guarantee of success. None of Russia’s big businesses are closer to the state than Surgutneftegaz. However, William Browder, the manager of Hermitage Capital, one of the biggest investors into Russia, says that Surgut has recently restructured in a move that looks like an attempt to head off a state sponsored take-over bid.

The company structure was never simple, and then in January analysts became alarmed when it was radically changed again.

Mr Browder’s team began investigating and after several month’s research worked out the new company structure. The question is, why are some owners bucking the trend towards more transparency?

While almost all of Russia’s leading companies are cleaning up their corporate governance and restructuring their company structures to improve transparency ahead of a possible IPO, why is Surgut’s management deliberately muddying the water?

“The answer is very simple,” says Mr Browder. “Imagine how hard it would be to consolidate Surgutneftegaz with this complicated structure. I believe this is a Russian poison pill and the fact they have done it means there is more of a risk of the company being taken over than ever before.”

PUTIN'S NINE COMMANDMENTS After taking office in 2000, one of the first things president Vladimir Putin did was hold the first of the so-called ‘oligarch meetings’, where the president spelled out the new rules of his administration: no more stealing and pay your taxes.

That was before the so-called Yukos affair. The Kremlin arrested the deputy chairman of the oil major in the summer of 2003 and then later the company’s owner, Mikhail Khodorkovsky, provoking fears that the Kremlin was going to start a programme against the oligarchs and a wide ranging re-nationalisation of Russia’s most valuable (and mostly publicly traded) companies.

Over the next two years, Mr Putin met with the oligarchs several more times and expanded the rules of the game to what Chris Weafer, Alfabank’s chief strategist, calls “the nine commandments of Russian business”:

  1. Stay out of politics.
  2. Pay your taxes.
  3. Operate within the law.
  4. Wealthy individuals should use their wealth to help improve Russia and in support of state objectives.
  5. Businesses in strategic sectors should work to further the state’s plan for industrial and economic development.
  6. Companies operating in the natural resource sectors should plan to shift from exporting unprocessed material and invest in downstream processing so as to increase the value-added segment of natural resource exports.
  7. Foreign strategic investors are allowed invest in strategically important companies or projects but only up to a maximum of 49%.
  8. For more ‘sensitive’ companies and projects, that limit is reduced to a maximum of 25%.
  9. International companies that offer reciprocal investment opportunities outside of Russia will increasingly be favoured as strategic partners for the Russian state-controlled companies.

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