Patrick Gill in Moscow -

The outlook for foreign investment into Russia's energy sector may appear gloomy, particularly in the light of the recent negative headlines relating to Shell and TNK-BP's prospects, but other parts of the economy offer foreign investors lots of opportunities. At the same time, the value of cross-border mergers and acquisitions is being boosted by Russian firms expanding abroad.

Sectors such as consumer finance and retail are churning out more and more attractive targets for foreign firms, and M&A in Russia is increasingly focusing on these "non-strategic" areas.

"In 2006 we are seeing positive changes in M&A, specifically the growth of mid-sized deals in a number of sectors outside oil and gas," KPMG says in a recent report.

M&A activity rose 57% on year to total $24.2bn in the first half of 2006, according to the report. The absence of large energy deals and only modest growth in the total number of transactions was compensated for by the higher average size of deals.

"The growth was due to increasing valuations of Russian businesses, lowering of risks and Russian companies' efforts to raise corporate value," KPMG notes. Russia accounted for 6.25% of the total value of European M&A, up from 4.5% in the same period of 2005. KPMG expects the value of deals to total around $50bn for the entire year.

Sprucing up the banks

One area where M&A has really taken off is in banking.

It's not only banks that are looking to capture a share of the lucrative lending and retail market; foreign carmakers' finance houses are said to be among those scanning the market for opportunities to buy up retail lenders and form their own local banking vehicles.

The savvier Russian banks are learning how to "package" themselves to increase their valuations for eventual sale to strategic investors. One way to do this is to attract an international finance institutions (IFI) as minority shareholder, as the presence of one is seen as a stamp of quality for which buyers will pay a premium. Banks with IFIs as shareholders include Sibacadembank and Absolut, which are seen as being among the most attractive acquisition targets by strategic buyers.

One foreign banker who is in the process of identifying targets says some of the most attractive banks are local institutions in smaller cities, such as Veliky Novgorod and Kaluga. Many smaller players have their own niche in cities of under 500,000, and these banks are now appearing on the radar of foreign players.

Selecting a specific region with promising growth is more important than having a countrywide presence, says another European banker.

Despite the lack of "political" risk in retail banking – at least outside the oligarch-owned banks – commercial risks can make acquisitions particularly hazardous. The two main issues are finding an appropriate target and knowing what exactly you are buying.

Obstacles to a successful acquisition fall into several main categories, according to bankers familiar with the process.

The first is not being fast enough: sometimes a bank finds a suitable target, but is then beaten to the acquisition by a rapidly expanding domestic (often state-owned) bank. Next is the problem of "reputational" risk, when a bank is financially attractive but turns out to have been involved in questionable practices that could damage a potential buyer's image. Integration problems, when the target's structure makes fitting it into a global entity's portfolio difficult, is another common issue. Another major deal killer is that existing owners want to retain at least a blocking stake, or 25% plus one share, something few international banks will agree to.

Agreeing the deal with numerous minority shareholders can be another troublesome task. Russia may not be a market known for its protection of minority shareholders, but when you have to track down 50 shareholders who own just 1.5%, they have too much protection, some would-be acquirers say.

Going west

Another area where cross-border M&A is set to pick up is outbound activity by Russian companies competing for a larger slice of global business. Bolstered by rising ambitions and access to financing, Russian firms are already buying up assets far beyond their domestic market. "Leading Russian companies and financial investors are showing serious intentions toward acquisitions of new foreign assets," KPMG's report noted.

It remains unclear how welcome large Russian outbound strategic investments will be. Reports earlier this month said the US authorities intend to examine Roman Abramovich's links with the Kremlin before deciding whether to approve the sale of Oregon Steel to steelmaker Yevraz Group, which the billionaire co-owns.

Martin Schwedler, a member of the managing board at Raiffeisen Investment, says the M&A landscape needs a "big hit" deal, such as Sistema's rumoured plan to acquire a stake in Deutsche Telekom, to pave the way for large strategic transactions by Russian firms.

Russia is already becoming one of the leading emerging market foreign investors, Schwedler notes. Specific synergies that Russian companies bring to targets include flexible decision making, low-cost resources and experience of difficult business environments, he adds. "If Russian companies manage to improve their reputation internationally, they'll become the new global players," Schwedler reckons.

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