Graham Stack in Moscow -

Project finance, once the preserve of international players, is starting to go local in Russia - despite and because of the credit squeeze.

Don't get confused - there is a big difference between the "financing of projects" and "project finance." The first is simply raising money for some business line a company may want to develop; the second is a highly technical kind of financing that involves some very complicated legal structures, designed to reduce risks to investors and slash the cost of borrowing. It is a distinction that is lost on most people and was incomprehensible to Russian business leaders until recently.

"People now know what you are talking about," says White & Case partner Mark Polonsky. Polonsky acted as common counsel for export credit agencies, multilateral lenders and commercial bank lenders involved in the massive $20bn Sakhalin-2 oil and gas project.

Sakhalin-2 was at least originally a foreigners-only project, but Polonsky says that it's increasingly large Russian companies such as RusAl, Severstal and OGK-1 who are looking for project finance. "There has been filtering down of know-how from foreign banks to Russian banks to Russian corporates," Polonsky explains. "Individuals who have learnt how to do project financing with international banks then go in-house to the finance departments of big Russian companies. Generally, it is still foreign banks advising on these things with Russian companies, but the big Russian banks are pretty involved - Gazprombank, VTB, VEB all know what they're doing."

Along with increased expertise, the legal framework has improved. The key to creating a project-finance deal is to set up a special purposes vehicle (SPV), which owns all the assets and money of the project. Imagine it this way: you are a controversial Russian company with good ties to the Kremlin, but seen by investors as vulnerable to political attack. However, you own the license to a massive oilfield. You need investors, but they are going to charge you for the perceived political risk, even though no one doubts the oilfield is worth hundreds of billions of dollars. The point of the SPV is to hold the oilfield license and separate your Russian company and its political risk from the oilfield development project. Once you have removed your Russian company and its political risks from the equation, the cost of borrowing will depend only on the normal operational risks of production and so should be much, much cheaper.

SPVs lie at the heart of securitisation deals - banks separate themselves from something like mortgage loans that they sold and the resulting asset-backed securities can get a much higher rating than the bank itself - indeed the whole point of the exercise is to get as close to a 'AAA' rating as possible. But all this legal jiggery-pokery requires a sophisticated legal infrastructure and until recently SPVs were hard to create in Russia, as things like property rights, which are central to SPVs, were poorly defined. That has started to change. "It is becoming clearer how the Russian legal system works in terms of what security is feasible," says Polonsky, "so that banks are able to make a better assessment of what security they need. They don't need to be so heavy handed and ask for everything; now they can ask for a more limited security package."

From a currency control perspective, one of the positive developments is currency convertibility and the abolition of central bank approval of offshore bank accounts and debt service reserve accounts, which makes project finance easier to implement. Polonsky also views recent legislation restricting foreign involvement in strategic sectors and strategic deposits as having helped create more certainty about "the rules of the game." This legislation cordons off areas from foreign investment that have great potential for project finance, such as large-scale mining or port projects. However, says Polonsky, "the trend is favourable to investors to the extent they want certainty."

On the bright side, the 2005 Law on Concessions, in combination with a coming flood of state infrastructure spending, means that public-private partnerships (PPP) promise to be a massive booster for project finance in Russia. The government has been promising astronomical sums for funding. On May 21, Prime Minister Vladimir Putin announced that his government would spend $570bn in 2010-2015 on roads, railroads, airports and ports. Of that amount, $215bn is to come from federal and regional coffers, with the remaining $355bn to come from the Investment Fund and private investors.

Polonsky remarks that the Law of Concession is not yet perfect. "Practice has shown that the law could benefit from amendments. It is very prescriptive and rigid, so that projects take longer than expected to finalise. There probably isn't enough scope for competitive dialogue, ie. negotiating with several bidders at same time, and procedures for amending agreements are time-consuming. There are also limits on the security that can be provided on the object."

White & Case was involved in putting together a pioneering PPP in St Petersburg to construct a wastewater treatment plant. The St Petersburg authorities remain in the avant-garde of PPP, to the extent of having passed a regional concession law that improves on the federal one. St Petersburg's political importance also benefits investors, and in December 2007, Russia's richest man Oleg Deripaska and partners including Hochtief agreed to invest $20bn in PPP transport infrastructure projects in St Petersburg through 2015.

Another driver of project finance is likely to be phase II of the Kyoto Protocol launched earlier this year in Russia. Around 40 joint implementation projects between Russian energy companies and investors from developed countries looking to earn carbon credits have already applied for approval from Russia's economy ministry.

Credit crunch

The global credit crunch, although making it significantly harder to access finance in general, will logically lead to an expansion in local project financing in Russia, as easier channels close off to companies. This is already apparent in real estate. "I feel there's a hierarchy of financing," Brady Martin, real estate analyst at Alpha Bank, told bne. "The first choice is top-level equity. Following that, companies would rather get financing in the form of construction loans. The third level, which I believe is now coming, is project financing."

Aleksandr Roika, vice-president of Russia's Nomos Bank, one of the most active private Russian participants on the market, sees "the lion's share" of project finance in Russia coming in residential and commercial real estate. Nomos Bank provided $76m worth of project finance in the first two months of the year.

According to Polonsky, as commercial banks retrench, borrowers will also turn to the multilateral development banks such as European Bank of Reconstruction and Development, who are expert in project finance and infrastructure and stick their necks out "where commercial banks fear to tread."

"Project finance is on a roll in Russia, both despite and because of the credit crunch," concludes Polonsky.

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