Russian corporates in the global capital markets

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With zero interest rate policies in the US and eurozone, but uncertain views on economic prospects in either region, there have been substantial flows into emerging markets fixed income over the past year or more. The picture is particularly favourable for Russia, with oil prices pushing $120 per barrel and government debt at less than 10% of gross domestic product.

Issuers have taken full advantage of these favourable conditions. Alexey Zabotkin, head of investment strategy at VTB Capital in Moscow, estimated that total issuance in Russian roubles reached about Rbs500bn ($17.84bn) in the first half of 2011, with another $9bn in Eurobonds – an increase of about 30% to 40% year on year.

“For prime borrowers the real interest rates are essentially negative at the moment and that signals very robust and favourable conditions in the debt markets,” said Mr Zabotkin.

Andrea Hosso, emerging market corporate credit portfolio manager at Investec Asset Management, said emerging market new issue pricing has been very tight for much of 2011, with little quarter given to investors. This could prompt profit-taking at some stage, but she added that Russia benefits from its high profile.

“Russia is a big market that enjoys the advantage of being relatively liquid, with well-known issuers that are familiar in the markets, so investors are more ready to buy into a Russian big corporate issue than in some other markets,” said Ms Hosso.

Rouble attraction

Local currency issuance is also attracting more attention from investors. Investec already holds about $2.2bn equivalent of sovereign exposure in local currencies, out of about $7.5bn invested overall in emerging market debt. Its corporate emerging market debt fund was launched in April 2011, and is focusing on hard currency paper to begin with, but Ms Hosso said the fund plans to begin taking local currency positions in the future.

Mr Zabotkin said the increased currency volatility during the financial crisis was a wake-up call for those who had begun to assume that the appreciation of emerging market currencies against the dollar would be linear. But the long-term trend toward a stronger rouble remains intact, and companies want to be able to choose currency not only to secure the best pricing, but also for the best asset and liability management profile.

“People understand that currencies move both ways and on the top of that, domestic liquidity in Russia has been very vibrant, partly because of the relatively muted borrowing activity and partly because of the very favourable current account situation. This year it means that it was cheaper to fund in the domestic market than the global market,” he said.

Christopher Parks, the chief financial officer of a leading Russian electronics retail chain M-Video, said working capital optimisation was a key consideration for leveraged companies. His company issued a rouble bond in 2006, redeemed a year later. But he said companies that want longer-term fixed-rate financing may still prefer the Eurobond format instead of a series of short-term loans at fluctuating interest rates.

Buyer beware

“As a corporate I would say that it is better to go for the bond market for long-term because then you can fit that into your cash-flow forecasting. One of the reasons that people did the Eurobond was not just because of the lower interest rates but because the rates were stabilised for the whole period of the bond,” said Mr Parks.

The bond market also remains attractive because there are fewer collateral requirements than for bank debt, especially for a company that is already well leveraged. And there appears to be growing appetite for corporate debt further down the credit curve.

“If they do the credit analysis work on the ground and know their terrain, then actually investors can find excellent companies and get the pick-up that goes with the lower credit rating,” said Ms Hosso.

But investors must pay attention to documentation risks. Jochen Wermuth, founding partner and chief investment officer at Wermuth Asset Management, said one of the firm’s private equity investee companies, lingerie retailer Wild Orchid, had little difficulty raising Rbs40m, even with a capital structure that left assets quite remote from the bondholders. This became important because the company had agreed to a put option on the bond, which has now forced it to restructure its debts.

“There was a rush for yield, and some investors became sloppy. We felt you have to behave yourself, so we have sought to take care of the Wild Orchid creditors, but it is a two-way street; you need responsible investors to encourage responsible borrowers. I think it is positive that, after the 1998 crisis and now the 2008 crisis, investors can distinguish between how issuers behave – for example, in 1998 the Russian government defaulted, but Moscow City kept on paying,” said Mr Wermuth.

Equity markets

While the fixed income markets have favoured issuers, conditions for equity listings have been less clear-cut in 2011. A number of high-profile companies such as VTB or internet provider Yandex enjoyed highly successful secondary share placements or initial public offerings (IPOs). But at least five planned Russian IPOs were postponed in the first half of 2011, and the panel’s participants felt that global volatility was not the only cause of IPO delays.

Jon Edwards, senior manager, Russia and CIS, LSE,; Alexey Zabotkin, head of investment strategy, VTB Capital, Chris Parks, CFO, M-Video

“The pulling back of a number of deals year-to-date is actually a very healthy sign, it means that the buy-side is getting more rational looking at trades, and is not prepared to jump on Russian risk just for the sake of being on every deal in the market. That disciplines the issuers as well, so the issuers which came to the market in April and May were more open-minded and reasonable in assessing their options than those [which came to market] in January,” said Mr Zabotkin of VTB Capital.

Mr Parks of M-Video, which listed for about $365m in Moscow in 2007, said he believed investment banks still tend to promise owners excessive valuations in order to win the IPO mandate, then cut the pricing to get the deal away in the market. He also said companies were tempted to compromise on corporate governance in a way that could deter investors. M-Video had had to create a single holding company prior to listing in Moscow in 2007, where previously each store had been separately incorporated so that it could sign its own local servicing contracts.

“Some companies say we will set up the board once we have done the IPO, but if we are not going to do the IPO in the end, then we do not want that cost. We as a company said we need to have an advisory board and get the corporate governance in place regardless of whether we do an IPO, so in the end the IPO was just a natural extension of what we wanted to do,” said Mr Parks.

And Mr Wermuth added that investors are frequently alienated if a company’s original owners are seeking to cash out entirely through the stock market, rather than simply raising some capital for development while retaining their economic interest in the company.

First-mover advantage

There was debate among the panel regarding whether it was better to be first to market, or to benefit from suitable comparators. Jon Edwards, senior manager for Russian business development at the London Stock Exchange, cited the successful $575m IPO of real estate developer Etalon in April 2011 as an example of a company being able to draw on the experience of previous issuers in a sector to assess its own valuation.

“There are a lot of prospectuses for companies to look at if they want to see how another company has handled an IPO and what has been disclosed. There are so many companies out there to benchmark yourself against, in agri-business, energy, metals, utilities and so on – Russian companies are learning very quickly in terms of how to play the market,” said Mr Edwards.

But Mr Parks felt that M-Video held an advantage from being the first Russian consumer electronics retailer to come to the market. Investors could compare the company with international peers, factoring in the under-penetrated nature of the Russian market. Owners of subsequent companies to list in any given sector may be reluctant to accept a discount to existing stocks in their sector, even if listed companies have a longer track record and better disclosure.

Choosing where to list

Historically, Russian equity issuance has been split between the two Moscow exchanges – Micex and RTS – and the London Stock Exchange, but several factors may now be changing that picture. 

First, RTS and Micex announced a framework agreement for a merger in June 2011, with Micex president Ruben Aganbegyan to become chief executive of the joint exchange. Mr Parks said the central complaint of investors in his company’s shares was the poor liquidity on the Moscow exchanges, because there is still a high proportion of over-the-counter trading. Mr Wermuth said the merger would not of itself boost Moscow’s status as a financial centre, but could lay the groundwork for improvements.

“Hopefully one unit will have more power to put into place a central depositary system, to improve liquidity, and to introduce insider trading rules – the energy of the new team will bring us the reforms that we need,” said Mr Wermuth.

Other significant developments include signs that Russian companies are looking towards Asia as a new source of liquidity, following Rusal’s decision to list in Hong Kong in early 2010. Since then, Rusal has launched a 'Russian Depositary Receipt' programme designed to allow Russian domestic investors to buy into its Hong Kong listing. But Mr Edwards maintained that the LSE would still be the market of choice for overseas or dual listings by Russian companies.

“In the case of Rusal, the issue did not get access to Chinese retail investors, and the geographic spread of investors was far more limited. So Russian companies still see London as a perfect compliment to their own domestic market, we have shown that we can work well with the Russian domestic market, [whereas] Hong Kong has not yet demonstrated that there is a good two-way flow,” he said.

Dual listing debate

Mr Edwards also said that ongoing consolidation among the largest global exchanges – the LSE recently failed in a bid to buy the Toronto Stock Exchange – should not cause Russian companies fears about their profile on a larger stock exchange. He said the LSE would continue to emphasise the importance of the AIM small and mid-cap market as a selling-point to help Russian companies find the right investor pool.

Mr Zabotkin agreed that dual listing was a favourable choice for Russian companies, as two-thirds of the investor base in Russian equities was foreign. The underdeveloped nature of the domestic institutional investor base is an important factor here.

“It is still in the adolescent phase of its development, the regulation of both the insurance industry and the pension system is quite restrictive as far as equity investing is concerned. But already this year we estimate that the pension fund flows contributed something like $500m to $600m of inflows into the market in the spring which is a non-trivial amount,” said Mr Zabotkin.

However, Mr Parks argued that dual listing was not an attractive option for a smaller Russian company, as it would simply split trading of the stock without providing a large enough free float for UK institutional investors to participate. There was general agreement on the panel that liquidity in dual- or foreign-listed stocks could be greatly helped by the Russian government lifting the 25% limit on how much of their equity Russian companies are allowed to list overseas. President Dmitry Medvedev signed a decree to this effect in July 2011.

Private equity

Return on equity is sufficiently high at successful Russian companies that there has been little need or appetite for a leveraged buyout market. In addition, corporate governance and ownership challenges have tended to undermine strategic investor sentiment. Mr Zabotkin said that the share of mid-cap companies in the Russian economy is still well below peers, at about 4%, with corruption and bureaucracy both factors that stymie entrepreneurship. As a result, companies have tended to opt for gradual growth funded by retained earnings and bank loans, rather than venture capital.

However, the Russian government has shown increasing determination to build a more dynamic mid-cap backbone to the economy and to attract the management expertise that can accompany strategic investment. In April 2011, a $10bn Russian Direct Investment Fund (RDIF) was created under the auspices of state development bank Vnesheconombank, to be managed by Kirill Dmitriev, the highly regarded founder of Icon Private Equity fund.

A private equity specialist himself, Mr Wermuth was one of the foreign investors who had long urged the Russian government to create some form of co-investment fund to provide private investors with the confidence that they would have official support in their efforts to enhance the performance of investee companies. It remains to be seen at present how the RDIF will operate in practice.

“In principle it is a great breakthrough. In practice, the fund will need to demonstrate how it is going to be arms-length from the government. To attract others into this pool, this big investment club, it will have to demonstrate independence, a track record, a team that works together from scratch,” said Mr Wermuth.

Given the limited pool of existing private equity funds currently operating in Russia, there was general concern on the panel that the new RDIF should avoid weakening the sector by building a large team of its own composed of staff recruited from privately owned funds. And Mr Edwards said the success of the merged Russian stock exchange would also be important, to provide a clear exit route for investments in smaller and mid-cap companies.

Mr Parks warned that pre-IPO investors need to avoid being too aggressive in their plans for the Russian market. Most of Russia’s newer, more dynamic companies are still owned by the entrepreneurs who founded them, and who are therefore cautious about decisions that could provide big short-term gains at the expense of long-term stability. And making rapid efforts to consolidate the market can backfire.

“We had pre-IPO funds coming to us saying we can help you do things and really leverage up your business to make sure that the IPO is successful because you have not shown a lot of growth. I think that is too aggressive for most of the small businesses in Russia, what is needed for an IPO is to get professional management in that helps companies devise a proper strategy – whether that is consolidation or not – to do the basics, not to take short cuts,” said Mr Parks.

Mergers and acquisitions

Taking a more gradual, organic approach to growth is also a reflection of the difficulties of merger and acquisition (M&A) activity. Several sectors of the Russian economy remain highly fragmented, especially retail and consumer goods, and the banking sector.

“In the case of retail stores, we have two leaders which have developed by taking completely different routes: Magnit is the company which is growing organically and X5 is the acquisitive business. Only time will tell which strategy will work out better, but so far the market is according a higher multiple to Magnit,” said Mr Zabotkin.

Mr Parks said M-Video had remained sceptical of M&A activity, thinking more about broadening its geographic presence in Russia than in buying market share via an acquisition. He said Russian staff and managers alike tended to fear that mergers would lead to winners and losers: “There is not a spirit of co-operation in terms of doing mergers because everybody is worried about what is going to happen afterwards. In Russia as worldwide, the whole idea of mergers of equals just does not happen.”

At the top end of the banking sector, consolidation is now well under way following VTB’s purchase of TransCreditBank and a stake in Bank of Moscow, and the decision by several foreign banks including Santander, HSBC and Barclays to sell or close retail banking operations in Russia. But there are more than 1000 banks in Russia, many with a tiny and highly localised client base.

“The Russian banking industry is in the process of rather rapid consolidation, the significant decline in net interest margins forces a lot of the smaller banks into the hands of the leaders, and within three to five years we probably will have less than 100 banks. For the regulator clearly it is much easier to have a compact banking system and it looks like that is the strategy that is being pursued quite consistently,” said Mr Zabotkin.