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On the Challenges and Opportunities we see in Russia

By : Ziad K. Abdelnour| 7 May 2010
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Although Russia is today the world’s largest producer of oil and gas, which is the primary source of its power, we at Blackhawk believe that multiple challenges in the Russian context presently impede the development of the private equity industry and will continue to do so until effective changes take place. The most important of these challenges are summarized below.

Narrow Deal Pipeline

Private equity begins with a deal pipeline from which investors at large can pick and choose situations in which they would like to invest. In Russia, it is difficult to find deals that simultaneously include solid management; transparent and credible financials; clean provenance; large and growing markets; a solid business plan; binding contracts with vendors, suppliers, and distributors; and clear potential exit strategies. When these deals do occasionally appear, we find ourselves in frustrating situations where our money is not wanted. The companies in question may not be interested in growth beyond a certain size or they end up being the subject of deeply discounted acquisitions conducted in relative secrecy. Many deals are also too small in size ($500,000-$1,000,000) and, given the intensity and costs of hands-on, private equity investing, deals this size simply do not make economic sense for us yet.

Due Diligence

Private equity involves intensive due diligence on technology, management, markets, contracts, current and future financials, ownership structure, and other matters. In Russia, market culture and infrastructure have sufficiently matured in the past decade to allow us to carry out a significant amount of due diligence. There are challenges, of course, but the most vexing problems tend not to be those fact-finding problems, but judgment on risk taking at the end of a long and intensive due-diligence process. What risks are we willing to take? If we uncover facts related to nonpayment of taxes, should we assume that this was a one-time lapse that is unlikely to recur? Can we ascertain that certain payments made were legitimate, or were they illegal bribes? Can we accept mistakes in a deed, records of transfer payments between companies, and other risks common in the Russian deal marketplace?

Difficult and Unreliable Legal Environment

In the United States, the most common form of private equity securities is preferred stock, which grant certain privileges and protections unavailable to holders of common stock. In Russia, private equity deals largely entail the purchase of common stock, giving minority shareholders inadequate protection. In fact, most laws that have been developed to protect minority shareholders have to do with large enterprises, instead of small and medium-size enterprises that are the domain of private equity. There are also no legally binding shareholders’ agreements, which are the norm in developed markets private equity. Other problems on the legal front have to do with the difficulty of rights enforcement in local courts, corrupt judges, opaque bankruptcy laws, poor corporate governance, and cumbersome regulations. One example of the last of these problems is the requirement that the Anti-Monopoly Ministry register and approve every security issuance, including those by small private companies. This imposes an unnecessary burden on us or any other private equity investor out there and increases transaction costs.

Limited Entrepreneurial Culture and Inadequate Financing Options

Russia’s entrepreneurial culture has improved in the last decade. However, the concepts and practice of innovation and growth remain inadequately developed, thus hampering the advancement of private equity. Many investors we know thought that Russia might have a comparative advantage in high technology but discovered that it was extremely difficult to convince Russian technical and creative talent to change traditional approaches in order to meet the needs of a potentially larger Western market. There is also, in some corners, a meager desire for growth. For example, one private equity fund was interested in putting growth equity into a cooking oil and margarine company that had over $200 million in sales in 2009, but the company in question was not interested in further growth. On the financing front, the problems of Russian banking need not be elaborated here. Suffice it to say that the absence or, at least, grave scarcity of debt financing, equipment financing, lines of credit or other types of short-term and medium-term financing make the burden of nurturing and growing companies too huge for alone.

Few Exit Opportunities

Finally, a critical challenge for Russian private equity is the limited availability of exits. The small size of the Russian public stock market and its illiquid nature make it highly unlikely that IPOs will soon become a common exit for private equity investments. Exits to date have been carried out primarily through strategic sales. Strategic sales are good, but represent only one exit option. Other potential exits (e.g. IPO market, management buyouts) have to emerge for private equity to gain further traction in Russia.

Conclusion and Recommendations

Private equity in Russia can be an exciting and lucrative investment discipline. However, we believe the space for making Russian private equity deals remains narrow and fraught with risk. Some of those who invested early made spectacular returns, but the advantage of cheap assets and deals in the early days of Russian marketization has been largely exhausted. Going forward, we are proceeding with great caution and working hard to cultivate an attitude that will allow us to ride the relative unpredictability, illiquidity, and occasional turbulence of the Russian market.
Two policy recommendations for the U.S. government develop from the preceding analysis:

One is that it may be advisable for the U.S. government to limit its direct role in Russian private equity. It is clear that Russia needs huge capital infusions, but government money is not the best source of such infusions. Instead, private capital (especially Russian) that is more accountable to its sources is what needs to be harnessed for the Russian private equity market at this stage of its evolution. U.S. governmental and quasi-governmental moneys that poured into Russian private equity in the early 1990s may have been useful in starting the industry and creating the initial legal, accounting, and other infrastructure and culture around it, but is not going to be its main driver going forward. If the experience of developed markets is any guide, it is the participation of pensions, endowments, and other institutional funds that truly unleashed the potential of private equity.

Second, the U.S. government would do well to focus more of its political and financial capital into facilitating and expediting banking reform in Russia. Some of this is already being done, but the results are still meager to date. Without a functioning banking system, there can be no sustained sources of funding for the small and medium enterprises that are needed for sustained Russian economic prosperity and growth. Private equity can propel some small and medium businesses forward, but it is woefully inadequate as the basis for a dynamic and diversified Russian economic base.

Looking forward to doing business with you and to continue being your resource for deals, capital, relationships and advice.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.


By :� Ziad K Abdelnour

Ziad is also the author of the best selling book� Economic Warfare: Secrets of Wealth Creation in the Age of Welfare Politics (Wiley, 2011),

Mr. Ziad Abdelnour continues to be featured in hundreds of media channels and publications every year and is widely seen as one of the top business leaders by millions around the world.

He was also featured as one of the� 500 Most Influential CEOs in the World.