The Russian government is pushing hard for more financing to the small and medium-sized enterprise sector, but opaque accounts and a shortage of management skills can deter banks and private equity funds alike.

Many of Russia's fastest growing companies, from supermarkets to rail freight operators, have been set up in the past decade. But despite this, finding the capital to grow remains a challenge. Russia's initial public offering (IPO) pipeline has run dry and credit is far harder to come by than it was before the 2008 financial crisis. This creates a challenge for Russia's entrepreneurs to raise finance to fund the expansion of the private sector and wean the Russian economy off its unhealthy dependence on oil, gas and other commodities.

From private equity funds with hundreds of millions of dollars to spend to microfinance organisations, funding Russians entrepreneurs in the country's vibrant consumer sector is an increasingly big business, and is becoming far more profitable for banks and private equity organisations than dealing with the behemoths of Russia's state sector.

RDIF thinks big

At the top end of the spectrum is the Russia Direct Investment Fund (RDIF), a $10bn government-funded vehicle launched in 2011, which does deals of more than $100m. The fund was set up as a subsidiary of Vnesheconombank, Russia's development bank, to act as a cornerstone investor to help attract foreign capital into the Russian economy.

Kirill Dmitriev, RDIF's CEO, says that out of $1bn already invested, the fund directly contributed $200m, while $800m came from its partners. Among the partners sitting on the fund's advisory board are the heads of the sovereign wealth funds of China, South Korea and Kuwait as well as luminaries of the investment business, such as Leon Black, David Bonderman and Apax's CEO, Martin Halusa.

Mr Dmitriev says that there is a yawning gap between the actual risk of doing business in Russia and the perception of the risk. The presence of Russian government money and expertise on a deal can go a long way to reassuring foreign investors.

"We work with one private equity shop that looked at 14 deals in Russia but did not do one. We can bring them to the table and give them the confidence to put pen to paper," says Mr Dmitriev. "People who make decisions are often based in New York or London, and it takes much longer to get approval for the first investment in a new market than for deal number 20 in Germany. That has dramatically reduced the number of deals in Russia," he adds.

Many investors have questions and concerns about investing in Russia but if government money is aligned with their investment it lowers the risk profile

Kirill Dmitriev

So far, RDIF has made two deals with a third in the pipeline. The first investment was made in Micex-RTS, the integrated Russian stock exchange, as an indication that investors have faith in the Russian financial market and to attract an important co-investor, the European Bank for Reconstruction and Development (EBRD), before the stock exchange’s IPO.

The second deal was one of the biggest in the power sector: $625m invested in Russian power producer OGK-5, of which RDIF contributed $140m. The fund's third deal is a tentative agreement with the world’s biggest investor in healthcare that wants to invest in private healthcare in Russia. The entire investment will be spent on developing clinics and upgrading medical services.

"Many investors have questions and concerns about investing in Russia but if government money is aligned with their investment it lowers the risk profile," says Mr Dmitriev.

The fund not only helps businesses raise cash to finance growth, it can also bring in foreign sector-specific expertise, so many entrepreneurs are knocking on RDIF’s door. Mr Dmitriev expects that in the coming years as much as 80% of the fund's financing will go to Russian entrepreneurs, although such deals will take longer to put together because of the demands of due diligence. RDIF sees significant opportunities ahead in financial services, healthcare, logistics, telecoms and agriculture.

VTB Capital looks to future

Another large vehicle is VTB Capital, the investment banking arm of Russia’s second largest bank, VTB. This bank has built the biggest private equity operation in Russia during the past three years. VTB Capital funds the next tier of Russian entrepreneurs, with equity deals of between $20m and $100m and more, funding companies who are seeking a second or third round of financing and already have experience of dealing with outside investors.

The company, which now has a 20-strong private equity team, steers clear of oil and gas, looking instead to the traditional sectors of interest to private equity such as media, retail, modern transportation and technology. These sectors benefit from Russia's fast economic growth and uptick in consumer spending.

"The topline growth of young companies is very positive and has shown astonishing resilience to the macroeconomic climate, and has not been impacted so much by the 2009 downturn," says Andreas Boesenberg, deputy head of private equity and special situations at VTB Capital.

Mr Boesenberg says that because VTB is not an initial investor, the company does not suffer from the accounting headaches that many private equity investors complain of, because most of the companies they invest in already have International Financial Reporting Standards accounts.

The topline growth of young companies is very positive and has shown astonishing resilience to the macroeconomic climate, and has not been impacted so much by the 2009 downturn

Andreas Boesenberg

"The biggest obstacle is more a psychological one, getting Russian entrepreneurs to think of us as a partner to develop their business further, and we usually can overcome this hurdle by using examples from our portfolio," he says.

There are huge opportunities in Russia for businesses and services that did not exist in the Soviet Union or that have been developed in the past 20 years. VTB Capital sees its investment in Brunswick Rail as one of the best examples of new areas for business growth in Russia. Brunswick is a rail wagon leasing company which offers wagons to the main commodity companies, and has been even more successful than similar companies in more developed economies.

Accounting challenge

Large funds and investors are increasingly turning their gaze towards Russia's vibrant consumer sector, looking for new opportunities outside the West and other emerging markets. Larger operations are likely to dominate the private equity sector in Russia as time goes on, Mr Boesenberg predicts. However, there are still some hurdles that private equity investors with $10m investments and microfinance organisations offering $10,000 loans to growing Russian businesses both have to overcome. The main one is the confusing nature of Russian accounting systems.

Wermuth Asset Management, which has invested $150m into private equity ventures in $5m to $25m deals in Russia during the past five years, has found that across a variety of sectors, accounting problems are a real headache.

"Financial due diligence is a problem because companies can run three sets of accounts: one for the government, one for the owner and one for third parties. So, the process to understand the accounts and due diligence is a long one, with significant involvement on your part. It is time-consuming, takes effort and money and may even involve outsourcing accounting work to local service providers," says Roman Samsonov, the vice-president of private equity at Wermuth.

One of the biggest challenges is that none of the three sets of accounts that the business prepares does much to break down which parts of its business operations are running at a profit and which at a loss. "The extra accounting requirements from Russian officialdom often do not help you understand the business, so we usually help the company develop forms that are different from what they submit to the local government and the tax authorities," says Mr Samsonov.

Wermuth is very clear that the entrepreneurs themselves know how to run their businesses better than outside investors, but the fund still has to play a significant role in streamlining operations.

Russian market banks are not good at lending to innovative projects because they are too risky and typically take longer to show a return, needing a five- to seven-year loan rather than the typical three-year loans offered by the market

Olesya Teploukhova

"The value of private equity investors is [highest when] there is a lack of knowledge about the best Western industry practices – financing tactics, risk-management procedures, human resources polices, exit strategies and corporate governance – and no understanding of how to handle all of these things," says Mr Samsonov.

SME Bank thinks smaller

At the other end of the scale is Vnesheconombank's SME Bank, which is a government-funded microfinance organisation dedicated to serving small and medium-sized enterprises (SMEs) across Russia, from the city of Vladivostock on the Pacific coast to Dagestan in the restive Caucasus. SME Bank’s loans range from $300,000 to $1.5m and usually carry interest rates that are 2% to 3% lower than the going market rate for loans to SMEs.

"Russian market banks are not good at lending to innovative projects because they are too risky and typically take longer to show a return, needing a five- to seven-year loan rather than the typical three-year loans offered by the market," says Olesya Teploukhova, deputy chair of SME Bank's executive board.

However, she says obtaining reliable accounts is as much of a challenge much lower down the funding scale as it is for the private equity operators. "Small companies are even worse than larger ones. Their accounting procedures may not be quite legal due to a shortage of skilled accountants, so it is unsurprising that many banks are wary of giving them financing," she notes.

SME Bank, which has funding from the Russian government and the EBRD, has a remit to fund Russian innovation, and works with a network of 300 partners including banks, factoring companies and microfinance organisations. The bank also endeavours to fund companies in parts of Russia, such as the north Caucasus, which are economically underdeveloped. It now has 43,000 clients and boasts a $6bn credit portfolio.

Push from the top

The Russian government has talked extensively over the past couple of years about boosting Russia's SMEs, which generate about 22% of Russia's gross domestic product (GDP), compared with 70% to 80% in developed countries. Newly re-elected president Vladimir Putin says that by 2020, SMEs should generate 50% of the country's GDP. Ms Teploukhova sees this as a "highly ambitious task" despite increasing government support for the sector.

Vnesheconombank's efforts show how keen the government is to wean the Russian economy off its addiction to commodity production. But there is much room for improvement says Anatoly Khvostikov, head of the SME business division at Rosbank, which became a subsidiary of France's Société Générale in 2007. Despite all the promised government support, the pace of development of SMEs is quite modest, he says. Rosbank works closely with Russian think-tank Opora, which deals with SME growth. According to Opora research, the number of SMEs in the most developed regions is growing at about 10% per year, whereas in some regions the rate is static.

"One thing which is optimistic is that financing for SMEs has improved," says Mr Khvostikov. "In 2011, the pace of growth of Russian banks' SME credit portfolios was 22% to 25%, although this rate could be better given the ambitious plans for growth of the sector," he says, noting that statistics for the sector are notoriously hard to compile because different banks and organisations define SMEs differently.

Added benefits

In recent years, Russian banks have grown more interested in lending to the SME sector because it is more profitable than lending to large businesses. Large corporates demand lower interest rates or turn to international capital markets to raise finance. Lending to SMEs offers margins that are between 2.5 and 4 percentage points higher than those for large corporates.

Meanwhile, the risk of lending to SMEs has fallen as businesses have become more transparent, and many companies now own land, vehicles or equipment which can be used as collateral, making them a better credit risk, says Mr Khvostikov. Non-performing loans in the whole sector sit at a very low 1.5% to 3%. Moreover, SMEs are not only attractive borrowers, but have also become a growing business segment for other services such as current accounts, letters of credit and factoring. At Rosbank, SME deposits stand at 140% of the SME credit portfolio.

Banks are competing more and more for SME business, which is very good for the clients, as the range of services on offer to small businesses continues to grow. In 2011, Rosbank's SME portfolio stood at Rbs14bn ($450m), and the bank anticipates a 35% increase in 2012.

"We are instituting client relationship managers and moving from a product-orientated service to a more service-orientated approach to ensure that clients become long-term partners of the bank," says Mr Khvostikov.

Nimble Nomos

Another bank that has carved out a niche lending to small businesses is Nomos Bank, a private institution that has found its ability to make faster lending decisions than state-run competitors has served it well. Vadim Yuriev, vice-president of Nomos, who runs small-business lending for the bank, notes that after 14 years, Nomos bankers have become better at managing the risk of small business loans, which now make up 8% to 10% of the bank's credit portfolio.

Key to assessing risk is on-the-ground expertise, and an ability to get under company accounts and understand the cash flows in these businesses.

"We have the procedures in place to cross-check borrowers’ information, so if we talk to a factory or a rental business, we will do something such as mystery shopping to look at their prices and compare these with their accounts," says Mr Yuriev. "This makes us more comfortable about what cash flows companies are showing us and you only understand these kind of processes after you have worked in the segment a long time," he adds.

Russia’s largest state-owned banks such as Sberbank are increasingly keen to get in on the SME act, so that funding to the sector is set to grow. And with Russia's GDP growth far outstripping that in western Europe, for foreign investors, funding Russian entrepreneurs will also remain attractive.


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