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Competition drives M&A

Competition is the main reason for Russian companies to buy others and realising value is the main reason to sell.Ben Aris reports from Moscow.
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Russian takeovers used to involve men with guns trying to pry managers out of locked offices but these days, rising valuations and red-hot competition are fuelling a boom in more civilised mergers and acquisitions (M&As).

Some owners are cashing out to fix profits after an astronomical rise in valuations. Others want to raise money for expansion or new projects. Another common reason to sell is fear of a possible political crisis during 2008’s presidential elections, when president Vladimir Putin has promised to step down. Others are buying because they believe Russia will continue its strong, fast growth. And all the activity is driving improved corporate governance and increased transparency.

“The presidential elections are a factor and some people are worried so they are selling. But the point is for each seller there is someone who is not worried who is buying. Russia has become a normal market place with both optimists and pessimists, which is new,” says Charles Ryan, chairman of UFG.

Consolidation

True mergers are still thin on the ground. Russia’s privatisation turned every single factory, shop and warehouse into an individual company like so many pieces of Lego. After six years of strong growth, sectors are beginning to consolidate as the strongest companies buy out their less ambitious peers. Sectors such as meatpacking are still at the beginning of this process; others, such as steel, are already almost completely in the hands of half a dozen rival conglomerates.

Acquisitions are being undertaken at several levels. At the top of the pile are the natural resource producers, which are awash in money thanks to extraordinarily high global commodity prices. These companies, typically hydrocarbon and mineral producers, have nothing left to buy at home and are rapidly expanding overseas. Flush with cash, they have already snapped up most of the attractive assets in the surrounding countries of the Commonwealth of Independent States (CIS) and are targeting assets as far away as Africa, Australia and the Americas.

In the stolid middle-weight industries, such as cement and machine building, a few dynamic companies have emerged from the otherwise unreformed morass of Soviet-era industry and are shopping for similar companies in other regions that have similar businesses.

And at the bottom of the economy in the fast-moving consumer-related sectors, such as supermarkets and gaming concerns, competition has become so fierce that companies have been forced to seek partners in an effort to maintain their market share.

The government is adding to the supply of acquisition targets as privatisation moves into its final phase. On the block in the next 18 months is telephone fixed-line operator Svyazinvest, which holds majority stakes in nearly all Russia’s phone companies, and utilities monopoly United Energy Systems – probably Russia’s last major privatisations.

Vodka and sausages

Until recently, the Russian acquisition process consisted of two businessmen thrashing out a price for a factory over sausages and a bottle of vodka. They paid little attention to things like tax liabilities because most of these problems could be solved “the Russian way”. That has changed.

“There are fewer ‘quickies’ as companies can have huge hidden liabilities. There is a new system of checks and balances and businessmen are looking for professional advice because they want to be sure that they know what they are getting into,” says Guerman Aliev, Rosbank’s deputy chairman.

Another change, warn lawyers, is the need to get the local authorities to sign off on a deal, even if the regional administration has no business with the assets involved.

“There are a million and one ways to block a deal that the local government doesn’t like. If you can’t get them on board, don’t even think about buying,” says one lawyer, who did not want to be named.

Despite the government’s attack on and destruction of Yukos, property rights have improved and ongoing judicial reforms have made prospective buyers more confident that they can keep the company they bought. A virtuous circle has formed: more transparency means higher prices and investors buying companies want to be able to sell them later.

Deals volume rises

The figures are vague, but Rosbank estimates that the volumes of M&A deals has doubled every year from the $7bn-worth of acquisitions in 2002 to $24bn last year. Some of that is made up of huge strategic investments in the oil and gas sector but, nevertheless,no-one doubts that buying and selling activity in the order of $40m-$60m is frenetic.

Deals are usually financed with loans from Russian banks, although in the big deals the Russian companies have access to cheaper long-term financing from abroad. Typically, companies will go to one of Russia’s leading commercial banks for a short-term bridging loan that is then re-financed by one of the large state-owned banks.

“It is a question of culture. The state banks are still not comfortable with taking equity as collateral. They want buildings and machines and only take over with their cheaper resources once the initial risks have gone,” says Nikita Riauzov, deputy head of investment banking at MDM Bank.

Russian bank loans to a single customer are capped at 20% of the bank’s capital, putting a de facto credit limit of $100m on deals, while the two state-owned giants, Sberbank and Vneshtorgbank, can lend a maximum of $200m. Beyond that, deals typically go overseas and are financed with syndicated loans among international banks.

Prices rise

Prices are going up quickly. By the start of April, the Russian Trading System index had risen by more than 30% from December’s lows (see table below) and profit/earnings ratios for most companies are on a par with international emerging market peers or at a premium in the fast-growth sectors such as food processing and banking.

“There is a huge raft of companies with sales that have grown to $500m or $1bn a year but remain more or less anonymous. Many of them are quietly preparing an initial public offering (IPO) or are looking for strategic investors,” says Mr Riauzov.

For example, mobile phone operator MoscowTele Systems (MTS) paid $315 per subscriber in its acquisition of Kuban GSM in 2002, regional operators now cost more than $500 per subscriber and MTS forked out $835 per subscriber for Uzbekistan’s leading operator in 2004. Likewise, GE Capital paid four times book value for Russian retailer Delta Bank last year, when the CIS average for banks was not more than two times book value.

Reasons to buy

Several factors have gone into fuelling Russia’s booming M&A market but competition is the most important reason for buying; and realising some of the astronomical gains in value is the motive for selling.

“Sophisticated Russians are buying out their competitors – be they in Russia or Ukraine – and sticking to their business lines. At the same time, there is a lot of senior management cashing out because they are happy with the money they have made but have no ambition to be the market leader,” says Eric Michailov, a partner at law firm White & Case in Moscow.

In one of the most recent deals, Elena Baturina, the first Russian woman to make Forbes’ annual billionaires list this year and wife of Moscow mayor Yuri Luzhkov, added to her fortune by selling her Inteco cement holding in April to Russian market leader Eurocement for $800m.

The combined company becomes Russia’s biggest construction material producer. Inteco is the second biggest company in the sector and owns five cement plants in Russia and one in Ukraine. Ms Baturina started last year with an ambitious plan to catch up with Eurocement, which owns seven plants across the country, but she clearly conceded defeat and nearly doubled her net worth to an estimated $2bn in the process.

Ms Baturina’s decision to sell is typical. Most sectors are still dominated by one company but a few have already finished the process of consolidation. The oil sector is an obvious example but politics has twice scuppered Yukos and Sibneft’s attempts to merge. Analysts say that the steel sector – which six groups have carved up between them – is ripe for mergers but because all the companies are still growing fast and fat from high international prices, there is little incentive to merge at present.

However, a supermarket ‘war’ in the retail sector looks as though it will force Russia’s first true merger. Half a dozen leading chains have staked out their turf and are battling over progressively smaller pieces of the pie. One, Seventh Continent, announced in March that it was in talks with rival Perekrestok for a possible merger. Analysts estimate that the companies are worth about $700m each and neither has borrowing power enough to buy the other. If the deal goes ahead, it would be a rare example of a true merger.

Cross-border moves

With money in their pockets, Russians are not shy about buying companies abroad and the number of deals is increasing fast. The first was LUKoil’s groundbreaking purchase of US petrol station chain Getty Oil in 2000. Overseas acquisitions only began to gather pace in 2003, though, after Norilsk Nickel’s multimillion dollar purchase of Montana-based Stillwater, which was arguably Russia’s first modern investment into a production facility overseas, and steel-maker Severstal’s deal to acquire Rouge in North America.

Russian industrial groups, mostly raw materials producers, have been on a shopping spree in both the CIS and central Europe. In the past year, they have begun to buy assets across the globe and are starting to look like multinationals.

Another deal, in early April, was leading aluminium producer Russian Aluminium’s (RusAl) addition of another foreign asset to its rapidly expanding stable. RusAl paid $401m for a 20% stake in Australia’s Queensland plant, the world’s largest alumina production unit. The deal will allow RusAl, formerly part of the bankrupt Kaiser Aluminium, to expand its operations in Russia, where it has more smelting capacity than alumina and hopes to boost Queensland orders from 770,000 tons of alumina to one million tons.

Also in April Kalina, Russia’s leading domestic soap producer, brought 59.3% of Germany’s Dr Scheller, the first time a Russian consumer goods company has bought a western peer.

Foreign companies have been more shy about buying Russian companies and prefer to start from scratch with greenfield projects: foreign direct investment is booming, reaching $11.7bn last year and $5.4bn in the first quarter of this year, according to the Central Bank of Russia.

The number of deals is increasing – White & Case says it is carrying out due diligence on half a dozen big deals – but many plans have been put on the back burner following the Yukos fracas.

“Foreigners are worried about politics and it has taken the wind out of the sales of some plans. They are pulling back while they wait and see what happens,” says Mr Michailov.

Still, deals are being done as the booming consumer market proves tempting. US soft drinks giant Coca Cola bought out Russia’s third largest juice maker Multon, valued at $650m, at the end of March in a landmark deal. Both Coke and Pepsi have built extensive production and distribution facilities in Russia but, with number one and two juice-makers Lebendansky and Wimm Bill Dann expanding aggressively, Coke’s acquisition is partly a defensive move to protect its share of a market that has grown by 30% a year between 1999 and 2004.

While strategic investors are taking their time, Russian bankers report a sudden increase in the foreign private equity purchase of Russian assets. Rosbank’s Mr Aliev says that plane-loads of investors are arriving in Moscow from London and New York and making for the regions, where they are bingeing on companies from across the spectrum, “buying into any sector that made them money elsewhere”.

Private equity

White & Case estimates that between a fifth and a third of all acquisitions (in terms of number of deals) in the past six months has been made by private equity firms. “They structure the deal around the shortcomings of Russian law and are investing all over – retail, oil and gas, telecoms – cherry-picking among the firms in each sector,” says Mr Michailov.

Ironically, Yukos’ death knell was the trigger, as fund managers argued that Russia had hit bottom and companies were not going to get any cheaper. The biggest deals are in the range of $40m to $60m and most are done with the help of a Russian investment bank as funds take everything from a minority stake to super-majority in their target companies.

“It is like the rush into the regions to buy up privatisation vouchers,” says Mr Michailov, referring to the early 1990s when investment banks bought these scraps of paper from rural residents and turned them into major stakes in Russia’s leading enterprises, earning a fortune in the process. “The private equity and venture fund investors are taking a leap of faith that Russia’s upward progress will continue.”

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