Ben Aris in Berlin -

Mattias Westman, co-founder of Prosperity Capital will be speaking at the Adam Smith conference on Russian alternative investment in London on February 21-22

In November, Prosperity Capital ousted Hermitage Capital to become the biggest fund invested in Russia. The fund has drawn in about $400m since the start of 2005, but what pushed it out in front was the $250m that Prosperity raised with its new Voskhod fund, which was floated in London in October.

The Voskhod fund takes investing into Russia's rapid growth in a new direction. For most of the last decade foreign investors have made a fortune by doing nothing more than buying blue chips and sitting on them. But Voskhod focuses on Russia's restructuring and hunts down companies tucked away in the regions that are prospering thanks to the rebuilding of the country's economy.

The debate is still on as to whether it's time to abandon the traditional strategy of buying blue chips and holding them on the assumption that even Russia's best companies are trading at a big discount to their international peers. And Prosperity has returned an annualised 33% per year since its inception over a decade ago.

However, the Voskhod fund assumes the Russian economy has gone through a fundamental change. By seeking out companies that are growing thanks to reform and restructuring, the fund assumes that investing into Russia is no longer a "plain vanilla" deal. It matters which company you choose to buy.

"What is driving the Russian economy is not just consumer demand but investment demand," says Igor Danilenko. "In the previous cycle, brown-field projects didn't need much investment, as most of the money had been invested in Soviet times; the oil company just had to try and run their companies properly. Now the best companies have reached their capacity constraints and they need to invest into green-field projects if they are going to keep growing."

Caught up

Russia's economy has been growing at over 6% for nine years in a row and is already worth more than $1 trillion if the gray economy is included. Estimates for next year say the growth will accelerate again to top 7.5%. This rapid growth has fed through into company valuations and the capitalisation of all Russian companies (including those that trade on foreign bourses) topped $1 trillion on November 30.

However, Russia can't keep this pace up. Part of the reason the economy has been growing so fast is that it was simply playing catch-up with the rest of the world from the low base that was the Soviet economy. Last year saw the first round of big investments into increasing capacity.

"You don't need lots of people to run an oil field, but you do need lots of people to build roads, lay tracks and repair infrastructure. This means more and better-paid jobs, which leads to the growth of a middle class that fuels consumption – a virtuous circle," says Danilenko. "We have now started on this cycle after 15 years of no investment to speak of."

The oligarchs have been a basic feature of the Russian economy, but they represent the few that understood the seismic changes Russia went through in 1991. The money this realisation put in their pockets empowered them to grab control of some of the most attractive assets in the country. The first round of "smash-and-grab" privatisation is coming to an end, argues Danilenko, and in the second round, successful businessmen – the so-called "minigarchs" – are consolidating enterprises, a process being driven by growing competition as much as anything else.

"Lots of industry was sitting idle when there was no demand and remained very fragmented. Now there is some investment and demand is picking up, so some sectors are consolidating," says Danilenko. "It is same basic story as we have already seen in the oil sector: there were 60 oil fields in 1991 that were privatised one-by-one and now there are 6 companies."

The oligarchs grew rich by taking control of the state's industrial crown jewels, but in the second phase, just starting now, the winners will be those that have set up or own companies that cater to the needs of business, rather than simply digging metal and hydrocarbons out of the ground.

"Even under the Soviets there were lots of service companies in each of the regions where the workers were sitting around waiting for something to break in the power station," says Danilenko. "Now we see some consolidation beginning as bigger, more efficient companies emerge."

"It is a derivative of growth. You don't invest into oil companies, but the companies that service them. You don't invest into steel companies, but the companies that provide and fix their equipment," says Danilenko.

The state is taking a bigger role in what it regards as "strategic industries" – largely extractive ones – but it has left the rest of the economy wide open to foreign competition. With commodity prices expected to sink this year on the back of a slowdown in the US economy, there was a dramatic trade out of the traditional oil, gas and metal companies that dominate the leading RTS index in the autumn and a rush to buy into Russian companies that cater directly to the consumer and should be immune to a fall in commodity prices. However, Danilenko says this is also a risky strategy.

"The consumer growth story is very obvious and obviously these companies are going to do well," says Danilenko. "However, the Russian economy is very open and there is lots of foreign competition that is very good at what they do and have very deep pockets. We want to know that we are betting on a company that is going to be a winner in its sector and I am not sure that all the Russian companies are good enough to be able to withstand this foreign competition."

Danilenko cites the example of Swedish furniture marker IKEA, which opened its first superstore in Russia in 2001. The success of the store surprised even IKEA, which found the volume of sales-per-square-meter was higher even than at its flagship store in Sweden.

The company has been throwing money at its Russian operation, opening a string of superstores with IKEA as the anchor and teaming up with France's Auchan food retailer and Germany's Obi DIY stores as co-anchors. The result is a shopping colossus that IKEA's would-be competitors can't even begin to challenge. And it earns the company excellent rental yields.

Russia's a big country

The restructuring story means going to the regions. While most of Russia's wealth is concentrated in the twin capitals of St Petersburg and Moscow, the most dynamic growth moved into the regions a few years ago.

The Kremlin is slated on almost a daily basis for the "creeping authoritarianism" and the growing role of the state in the economy. However, Danilenko argues that in reality the opposite is happening.

"The state's actions only matter in a few sectors," says Danilenko. "In the 1990s the government aggressively privatised much of the economy and created lots of private players – even today the Russian oil sector still contains more private companies than in most other oil rich countries. And thanks to the strong economic growth every year the economy is becoming more private, not less, as the private companies are growing so much faster than the state-owned companies."

Despite some well publicised backsliding, such as the strong-arm tactics used by the state to take control of Shell's Sakhalin-2 oil project in Russia's Far East at the end of last year, this trend will continue this year. The privatisation of the utilities company United Energy Systems (UES) began in November with the first IPO of one of the newly created generating companies, and Svyazinvest, the state-owned fixed-line operator, is due to be sold sometime this year.

Prosperity Capital estimates that, in all, Russia's private companies generate about $200bn a year in revenues, about 20% of GDP, much of which is reinvested into their companies. Add to this the $90bn that UES is planning to spend on upgrading power facilities over the six years and the billions of dollars that the government has earmarked for updating Russia's creaking infrastructure and the country should experience many years of continued growth.

"The companies that will benefit are the ones that will do this work, not the people that are spending the money – the road builders, power engineers, computer scientists and the like," says Danilenko.

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