FUNDS: Russia's perception problem

By bne IntelliNews June 29, 2007

Ben Aris in Moscow -

There is a wall of suspicion that divides international investors looking in at the heady returns being made in Russia, from the investors on the ground who are actually making the money. It seems interest among international investors is rising, but few still dare to cross the divide.

David Fann is a relatively rare example of an US institutional investor who has not only crossed the wall, but earmarked a huge $400m for investments into Eastern Europe. He is the president Pacific Corporate Group (PCG), a US investment management firm with more than $15bn under management catering mainly to pension funds based in California, and he arrived in Moscow earlier this month to do some business.

The few intrepid investors who make it this far all seem to suffer from the same culture shock during their first drive through the capital. Fann was in town for less than 24 hours when he talked to bne, but says he was "floored" by the amount of change visible on the streets of Moscow.

"It was even a little disappointing as it was already so westernised. Every high-end store you can see in the States is here," says Fann, speaking on the sidelines of International Council of Institutional Investors conference in Moscow earlier this month. "But it is clear there is a great investment opportunity here because of the degree of modernization of Moscow. In the near term the consumer play is obvious."

However, like most international investors Fann is very concerned about the risks and is stepping very cautiously. Rather than seek out projects, PCG is going in through established funds already operating in the region. So far, the fund has signed off on one deal with Barings Vostok Capital Partners (BVCP), a doyen of private equity funds in Russia. Fann says he is struggling to find another partner of the same calibre.

"It is a nascent market and there are only a handful of funds operating competent private equity outfits in Russia," says Fann.

BVCP is an old hand in Russia having set up in the 1990s well before almost all of its competition. Since its inception, the fund has invested into a total of 48 projects with a book value of $650m, 31 of which have been completed. The fund has returned a handsome internal rate of return of 40% and paid out over $1.4bn in dividends to its shareholders. Today, BCVP has $460m worth of assets in its portfolio, which are valued at three quarters their cost, spread across telecommunications, media, technology, finance, oil and gas, and industrial sectors.

And the fund has shown itself to have an excellent nose for opportunity. Amongst its best deals was an early investment into Burren Energy in 1995, which was originally an oil tanker company until BCVP transformed it into one of the biggest independent oil and gas producers in Turkmenistan. The fund exited with an IPO on the London Stock Exchange in 2003, having made a mint in the process.

It is BVCP's westernised management, led by American Michael Calvey, and ability to navigate waters as treacherous as those in the dictatorship of Turkmenistan that have attracted funds like PCG, but Fann says more US money is on the way.

"We are in the leading wave of what is an explosion of private equity funds in the US in the last few years. Private equity is now becoming a major export product from the US," says Fann.

However, Russia's biggest problem is not the creeping authoritarianism or corrupt legal system - both real problems, nonetheless - but how the rest of the world sees Russia.

Peripheral views

Talking to Fann, it is clear he can see the opportunities that exist in Russia, but admits that all he knows about the country is what can be gleaned from the television and newspaper coverage at home, which is different from the reality on the ground.

"The visible political problems create a perception problem and in the investor world perception is reality. There is always a mismatch between perception and reality, but the perceived problems always win out in the mind of investors thinking about putting money in," says Fann.

Much of the interest in Russia is due to the rise of the so-called BRIC nations (Brazil, Russia, India and China). A Datamonitor survey in June polled more than 800 senior executives in companies from a range of sectors, with turnovers from $10m to over $1bn, on their attitudes toward doing business in the BRIC countries and found that Western executives are more uncomfortable about doing business in Russia than in any other major emerging-market economy.

The survey also highlighted that the perceived problems were so great that many business people have not made the effort to even begin looking at the country seriously to see if the problems are real. The survey found that some executives couldn't even name the national currency.

While 61% of international businesses believe it was "crucial" to have exposure to a BRIC country, a quarter said they were least comfortable with doing business in Russia.

Fann's attitude echoed the results of the survey. Like everyone else, China comes out as a clear favourite with India in the number two slot. Brazil and Russia are the also-rans, with Russia losing by a nose in the race for last place.

Fann's biggest concern is with the ropey state of the legal system. Reforms stalled after a short campaign several years ago spearheaded by presidential aide Dmitri Kozak. However, in the last year the Kremlin has started a low-key crackdown on corruption. Appointments for life for judges has been stopped, the Kremlin has started a series of sting operations to catch bent bureaucrats and only last week the government set up a hotline for citizens to report judicial abuses (+7 495 620 6557).

Businessmen report while rulings from courts, especially in Moscow, have become more reliable, progress is slow and the infrastructure that supports the court and implements its decisions is as corrupt as ever. Most importantly, the ant-corruption drive has had almost no play in the international press.

"As an investor, I worry about the judicial system, its ability to enforce decisions and its ability to reach a fair resolution of disputes," says Fann. "Investing in private equity only makes sense if you can have a contract between the investors and the owners that you can believe in. In Russia the legal system is the worst of the BRIC countries."

At least, that's the perception.

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