Ben Aris in Moscow -

VTB Capital quickly came to dominate the investment banking business in Russia shortly after it was set up in 2009, and now it hopes to do the same in private equity.

For most of the last four years, private equity has been little more than a department within VTB Capital, but in 2011 the investment bank set up its first two formal funds - and more are on the way. "What we do now is more of a merchant banking operation," says Tim Demchenko, head of Private Equity and Special Situations at VTB Capital. "Until now, the principal investments have been done under the VTB franchise with the bank's own propriety capital. But for each dollar we invest, we have tried to raise another $3 to $4 of external capital. So far it has gone pretty much deal to deal."

Choosing to ramp up its commitment to private equity looks well timed. Private equity funds invested $4.2bn into Russia in 2011, double the $2.2bn invested in 2010, with the average deal size increasing to $80m against $50m over the same period, according to Ernst & Young. Most of the deals were done in the high-tech or internet sectors, which made up 42% of the total in 2011, with other popular sectors including, consumer (16%), real estate (16%) and the financial sector (9%), the consultant said in a recent report. And now is an ideal time to make private equity investments. "Periods of low growth and sluggish fundraising have historically produced rather strong private equity vintages - even in comparison to investments in public equity," says Thomas Meyer, an analyst with Deutsche Bank.

VTB's private equity business has grown steadily as the Russian economy starts to recover. Last year, one formal fund was capitalised with $500m of VTB money and another $1.5bn from third-party investors, all of which has been invested, much of it in the real estate sector, which has been recovering nicely over the last 12 months.

Heading for the exits

With only three years of operation under its belt, it is still early days for VTB's private equity business, but it already has had two outstanding exits. And Demchenko says two more exists will be announced over the next six to 12 months.

The most talked about was the IPO on the New York Stock Exchange of software developer EPAM Systems in February. "In this market, to list in New York being a good company is not good enough. There are billions, if not hundreds of billions, worth of IPOs delayed in the USA, so to offer a company it has to be a really exceptional story," says Demchenko.

On the face of it, EPAM was an impossible sell. Based in Belarus, dubbed the "last dictatorship in Europe" by the former US secretary of state Condoleezza Rice, this is not a familiar market for most American investors. But EPAM's explosive growth and high profitability meant the company sold 6m shares at $12 a pop, returning "well over 40%" for its investors, says Demchenko.

The soggy state of the equity markets, still labouring under the threat of the sovereign debt crisis in Western Europe, means IPOs are not high on Demchenko's priority list. The Russian equity market also has a long list of backed-up public offerings. In the meantime, Demchenko has focused on sales to strategic investors, as well as domestic mergers and acquisitions.

The fund's other big exit was more typical for Russia at the moment: the sale of the office center Lesnaya Plaza in central Moscow to real estate investor O1Properties for an undisclosed amount. Reports in the local press estimated the transaction value at $220m to $250m. O1Properties is 100% owned by Boris Mints, Otkritie's board chairman, who reportedly plans to IPO the company at the end of this year.

Demchenko will only admit to the deal meeting its target of "at least a 30% return," but the fund has not been shy in taking another big punts on the "White Gardens" development on the same street. The biggest real estate development in Russia's history, "White Gardens" has reportedly had $1bn of investment and China's sovereign wealth fund is also a partner in the project (Demchenko wouldn't comment, citing a confidentiality agreement).

Tough market

Russia has always been a tough market for private equity. The economy's super-strong growth means owners at the most attractive companies are reluctant to give up equity, while at the same time most companies rely on retained earnings for three-quarters of their investment capital needs; cash rich, there is little incentive to sell a stake to a private equity firm.

However, since the 2008 crisis, the environment for private equity in Russia has improved somewhat. Slower growth means valuations are growing more slowly and some good companies are looking for finance to acquire their weaker rivals. But the real attraction of partnering with VTB's private equity fund are the additional advantages that tying up with one of the most powerful institutions in the country can bring, says Demchenko. "If a retailer wants to expand fast in the regions, then thanks to the VTB network we can help on a variety of topics such as finding real estate and staff, as well as relations with the local government and suppliers or even new business partners. It is about building an eco-system around your partners," says Demchenko.

In Russia's rough-and-tumble business environment, having a good krysha, or roof, can help you simply plough through all the red tape in a local administration that you aren't familiar with. But Demchenko dismisses the common criticism that his bank's success is predicated entirely on its ownership. "It's helpful, but it's not the critical success factor. Sure, we see opportunities thanks to the state connection, but at the end of the day the success of a fund is based on its team and the best deals are always the ones that you originate yourself," he says.

Still, Russia's private equity business is still in its infancy and few institutional investors are yet present in Russia. The government has been trying to develop the business, partly by seeding the Russia Direct Investment Fund with $10bn and a similar IFC banking fund with $250m.

Demchenko says the small size of the business is a function of the development of the economy. "We are only two decades into Russia's development as a market economy; it is a question of supply and demand," he says. "There are only a handful of funds that are active in Russia, but then there are not that many attractive private companies either. In the West there are hundreds of funds, but there are thousands of companies, some with a couple of hundred years of history behind them."