You would think the crash of the Russian stock market, plummeting oil prices, tightening credit, and the exodus of tens of billions of dollars in foreign investment since August would strike a sour note for Russia's private equity industry. But most Russia-focused funds are not ready to leave the dance floor just yet. In fact, some feel the outlook for private equity investment is rather upbeat. Says Dimitri Elkin of UFG Capital Partners: "Things are good for us, and seem to get better by the day."
Despite the optimism, private equity firms will proceed with caution. John Quinn of Alfa Capital Partners, notes: "The market is in severe flux, and a lot of buyers want to see where the dust settles prior to pulling the trigger." If the credit crisis continues and expands its reach in Russia, it may be increasingly difficult for portfolio companies to fund their working capital and/or expansion needs. Moreover, the deterioration in market conditions will likely affect exits for some time—particularly by way of initial public offerings.
Nevertheless, here are five reasons why Russian private equity funds may yet waltz through the global financial crisis:
1. Leveraged buyouts are still uncommon in Russia. In contrast with the U.S. and Europe, LBOs are a rarity in Russia. In fact, only two such transactions have been completed to date, both by London-based investment firm Lion Capital: the $500 million acquisition of juice maker Nidan Soki, in 2007, and the $700 million LBO of Russian Alcohol in 2008. Instead, private equity investors in Russia typically provide capital for expansion and generally take minority equity positions in their investments. As a result, the vast majority of Russian private equity deals are not dependent on the availability of bank financing.
2. For many businesses, private equity is now the only financing option available. Tighter credit markets mean that debt financing is no longer easily accessible. In addition, larger businesses that had expected to raise funds on the capital markets are now forced to consider other options. "In this market, companies are looking for quick disbursements or bridge loans," says Ulf Persson of Mint Capital. Challenging market conditions have enabled private equity firms to negotiate more aggressively and win better deals. For example, one fund recently repriced an investment to half the valuation demanded just a month earlier.
3. Valuations are becoming more realistic. Only a few months ago, fund managers were complaining that valuations were too high as competition for quality deals inflated prices. Now, valuations are being pressured downwards. "We are getting back to a more normal world," says UFG's Elkin. "Emerging markets are again being viewed as riskier, and therefore Russian companies are likely to be valued at a discount to Western peers." At the same time, investors' expectations are rising. Many funds now only consider opportunities where they can achieve returns that are at least five times invested capital. Still, many private equity firms are taking a wait-and-see approach, bypassing the distressed situations that are appearing on the market. Nikolay Sergeev of Troika Capital Partners, remarks: "Our shopping time should start in the first half of 2009 when valuations for healthier business will go down as well."
4. Foreign funds and strategic buyers are expected to remain on the sidelines. With a few notable exceptions, such as Lion Capital and global investment firm TPG, private equity in Russia is dominated by local funds. The most established players include Baring Vostok, Troika, Alfa, UFG, and Mint. Although earlier this year Russia began to attract the attention of major international private equity players and strategic buyers, they have dropped back to the sidelines. This is good news for large local funds because it means less competition for $100 million-plus deals—where many of the best investment opportunities currently lie. "Local teams that combine both Russian and international business expertise will be the most successful in the current environment," says Pavel Nazarov of NRG Private Equity Advisors
5. Private equity funds are sitting on dry powder. As many as 50 private equity funds are currently active in Russia and the CIS, with estimated total assets under management in the region of $10 billion. Several new funds were recently raised. For example, Baring Vostok launched a $1.5 billion fund in 2007 and Renaissance Equity raised $660 million for its first private equity fund earlier this year. Of course, capital commitments do not equal cash in the bank and a deepening financial crisis could result in defaults. And other firms seeking to raise money in the current environment could face a hard time. Still, even by conservative estimates, private equity funds have several billion dollars in capital ready to be deployed in Russia and other former Soviet countries.
To understand the current mood of the market, consider this example of an aborted deal: A local Russian fund recently walked away from an investment. But the reason is a little surprising. Rather than fearing the deal could result in losses, the fund manager decided that better investment opportunities had suddenly become available in the troubled marketplace. Comparing the deal to choosing a date for a dance, the fund manager explains that he "had settled for an average-looking partner because all the really attractive ones had dates already." But now "that there are so many pretty deals around," he adds, "who wants average?"
If the global financial pandemic worsens, fund managers may soon change their tunes and long for the days of "average" deals. For now, however, Russian private equity's last dance has yet to come.