Patrick Gill in Moscow -

Richard Sobel from Alfa Capital Partners will be speaking at the Adam Smith conference on Russian alternative investment in London on February 21-22

It was only a matter of time before Russia would feel the full force of the global boom in private equity. An estimated $1.5bn was raised in 2006 by funds using mainly foreign institutional money. And though the amount of Russian private equity transactions still makes up only around 5% of all the M&A activity in the country, with many deals carried out informally, experts believe the actual volume of deals could be significantly higher.

One of the latest investors was the development bank the EBRD, which said December 5 it has put $35m into Troika Capital Partners' new Russian private equity fund, the Russia New Growth Fund, which is focusing on opportunities in Russia's consumer sector.

The fund, which was set up last year, will be closed at about $300m in the first quarter of 2007, according to a statement from Troika Capital Partners.

The move by the EBRD is a clear vote of confidence in the fund, as well as private equity in Russia as a whole. "The EBRD is the granddaddy of investors in Eastern Europe and Russia from the time of the fall of the Soviet Union and at the leading edge of investment trends," says Stephen Cohen, managing director of Troika Dialog, Troika Capital Partners's parent firm.

Troika's Russia New Growth Fund is just one of many private equity funds that have appeared over the past few years. The well-established Baring Vostok Capital Partners (BVCP) estimates that foreign funds make up around $2bn of the private equity capital in Russia, while domestic groups control around US$40bn.

And more activity is expected this year as financing mechanisms such as leveraged buyouts (LBOs) become more readily available, and M&A and IPO activity picks up, raising the prospects for successful exits.

Greater choice of targets

Private equity investors say the range of target companies is broadening rapidly, although valuations are rising.

"There are lots of companies looking for capital, particularly as local debt markets are not well organised for small ones, and international markets are inaccessible," says Richard Sobel, CEO of Alfa Capital Partners, who still sees private equity as the best way to invest in the Russian economy.

Private equity funds are limited by the number of potential targets with a combination of high levels of transparency, good management teams and high growth prospects, however. The consumer sector in particular offers an ever-expanding set of niches, such as media, logistics and fitness, Sobel says.

The established players say returns have been exceptionally good in recent years, with firms making several times their money. Portfolio company growth rates stand at around 25%-30%, according to industry sources. The director of one firm says the main constraint on private equity is the limited length of the funds, as some portfolio companies are growing so well that he is disinclined to sell them.

The private equity firms themselves are also turning to debt as a tool for acquisition finance. Both BVCP and Delta Private Equity Partners say they are planning LBOs. Whereas LBOs have so far been limited on the Russian market, investors say Russian banks are showing increasing interest in making acquisition finance available. BVCP co-managing partner Michael Calvey says he expects the development of LBOs to be the biggest change in the market in the next five years.

So why then, if the climate in which private equity needs to flourish continues to improve in Russia and the number and size of funds grows, do many observers remain so cautious about the prospects for growth in the industry?

First growth is easy growth

BVCP's Calvey warns that the best investing years may already be over. "The last six years will come to be seen as the best investment period of our lifetimes," he says. "It's easier to go from (sales of) $50m to $100m than from $500m to $2.5bn."

"One reason for the growth was consolidation in many industries, but you can only do this up to 100%, and then have to grow organically," he says.

Another reason for the explosive growth of recent years was the effect from displacement of Soviet distribution channels. "Retailers have grown at exponential rates due to modern channels, but now they won't be able to grow so fast. Therefore, profit margins will begin to fall as growth slows and competition for market share intensifies," he says.

Slower growth may be offset by improving exit opportunities, however. The recent uptick in M&A activity means private equity firms are seeing more options for exiting their portfolio companies, either through IPOs or trade sales.

"Four or five years ago exits were a bit of a puzzle," says Dmitry Bosky, managing partner of Berkeley Capital Partners. "But now it's clear there's a market. Exit is no longer unknown – if the company is profitable, there will be a market."

However, improved M&A options may sometimes create problems for private equity firms, as their target companies also have more choices for attracting investment than simply selling to buyout firms. Calvey of BVCP says company owners are becoming more reluctant to sell with these expanding alternatives: bank financing is cheaper than before, and debt capital will be more accessible than in the past, meaning private equity will be seen as an increasingly expensive alternative.

Another issue is the reluctance of owners of rapidly growing businesses to sell out while they still see several years of potential upside, a factor that in turn is pushing up valuations. "Strong Russian managers are not quick to sell their businesses," says Alfa Capital's Sobel. "They want a financial partner but don't want to give up control."

Target companies are increasingly looking for a partner who can take the company through a development process from issuing bonds to credit linked notes and eventually a sale to a trade buyer or an IPO, according to David Wack, a partner with Squires Sanders & Dempsey in Moscow.

Despite the healthy returns reported by the existing firms, international groups have also been reluctant to enter Russia, with investments in Europe and other markets perceived as less risky than Russia. Carlyle, the Washington, DC-based giant, opened a Moscow office in 2004, but shut up shop abruptly last year having only made one modest investment.

Yet there are signs that these fears of a slowdown in growth might be overdone.

The Americans are coming!

Paul Murphy, a partner with Ernst & Young in Moscow, says that despite the lack of activity from global funds to date, the chances of their arrival on the market will increase as acquisition targets become larger and cross their minimum investment threshold.

"The private equity opportunity in Russia and CIS is very different from Western Europe, where private equity players are competing with strategic players for some positions," he says. "We haven't seen a lot of international private equity firms coming to Russia."

Recent visits by Western private equity players to Moscow indicate that their interest is on the rise.

Texas Pacific Group (TPG), the US-based firm, "may well" invest in Russia from its newest fund, according to Stephen Peel, a partner at the firm. TPG raised $15bn for the fund.

"We are looking at situations in Russia, as are a couple of competitors," he said. The acquisition "needs to be one of scale that warrants the work. We have the ability to do that with the latest fund."

Peel said "several billion dollars" from the fund would go into non-US/Europe countries such as Russia. "With growth in the US hard to find, Russia may well be part of the portfolio of our new fund," he says.

Gartmore, a UK-based firm, is "at the early stages" of analysing Russia, according to Nick Shaw, a director. Speaking on a recent visit to Moscow, Shaw said the firm would be interested in investing in Russia, "where prices are attractive."

He said Russia looks attractive in terms of the economy and valuations. "Investors haven't been particularly interested in investing in [Russia's] private markets due to caution over perceived risks," he said. "The core issue to face is why we should move to riskier markets when there are attractive rates of return in the core markets."

Russia is still a way from seeing the kind of "club" deals that have been increasingly prevalent in Europe and the US, and situations where private equity firms compete with strategic players for large, listed companies, E&Y's Paul Murphy notes. Instead, deal sizes are still mainly in the $5m-30m range and focus on medium-sized entrepreneurial companies.

Whether that will change depends, it seems, on the appetite of foreign private equity houses to escape the rapidly rising prices of assets in the US and Western Europe, and venture east in larger numbers.

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