Ben Aris in Moscow -

Oleg Jelezko just made a packet from the biggest private equity deal in Russia to date. Da Vinci Capital Management, of which Jelezko is managing partner, can partly cash out of its 20% stake in Russia's RTS after the exchange announced it would merge with its larger rival Micex on June 30.

The merger is a significant step in the Kremlin's much-vaunted plans to turn Moscow into an international financial centre (IFC) and build up the domestic capital market so it can better serve Russia's growing investment needs. The Russian pension system is also in desperate need of reform - a quarter of the current state deficit goes toward topping up the state's pension obligations - and a more efficient and better capitalised exchange is a first step in the pension reforms widely excepted next year.

Da Vinci was set up by a bunch of former Renaissance Capital employees in the wake of the 2008 crisis, and in a very ballsy move, as bne reported, launched as a crisis fund in October 2008 to capitalise on the rock bottom equity prices.

It was a big bet and it paid off handsomely. The fund has hit all its targets, initially raising $100m and then increasing this to the $300m of assets under management it has now three years later.

Where things went off at a bit of a tangent was after the fund bought 2% of the RTS at the start of 2008. Da Vinci ended up as one of the five major shareholders in the RTS - along with leading Russian investment banks Renaissance Capital, Aton Capital, Alfa Bank and Troika Dialog - which together control about 60% of the exchange's equity.

Under the terms of the merger, each of these banks can take a 35% of their stake out as cash and will get shares in the combined entity at a ratio of three RTS shares to one merged Micex/RTS share for the rest. (The other smaller shareholders will be bought out over the rest of this year.) "All of the investors are going to take out some cash as the merger is a validation of their investment, but we still see a lot of upside in the coming years and will remain investors and involved in the exchanges," says Jelezko, who cut his teeth at Renaissance Capital.

Jelezko draws a parallel with Brazil. "Brazil is comparable with Russia: it has the same level of technology, the same economic size and a similar economic profile. The Brazilian stock exchange is listed with a market capitalisation of between $15bn and $16bn. The combined Micex and RTS has a valuation of about $4.8bn, so we believe this will rise three-fold in the next five years or so."

The merger will be finalised in the autumn, as it still needs to be approved by the regulator and also the anti-monopolies service (FAS). But given there are about 50 licensed exchanges in Russia (of which about six are functioning), participants don't see any problems with completing the paperwork.

Getting down to business

The creation of a single stock exchange really only marks the beginnings of the IFC project. Despite the provocative moniker, the main point of the reforms is to create the financial infrastructure the market needs to integrate itself with the international capital markets, rather any attempt to somehow replace the likes of London and New York as the dominant global exchanges. "Really all we are doing it trying to make a giant plug that we can plug into the global markets," says Jelezko, who worked closely with the RTS a few years ago to create Russia's derivatives market.

From a business perspective, the merger actually makes a lot of sense. In the 1990s, the RTS was the favoured exchange for foreign investors that made most of the hay until the 1998 collapse, partly because all of the trades were settle and cleared offshore in places like Cyprus. However, as Russian investors got more involved in the stock market after 1998, Micex began to grow fast and really came into its own when it was given the exclusive right to trade Gazprom shares shortly before the so-called ring fence of protective regulators was nixed in 2006. Since then the volumes on Micex have soared. The RTS has put up a good fight and came back by developing a specialism in derivatives and these sophisticated products came into their own following the 2008 crisis, which Micex was lacking. "After 2008, the RTS standard platform [for derivatives] was much better able to manage the risks for and of brokers than the brokers were able to do themselves," says Jelezko.

And Jelezko and his team are the right people to be on the board of the exchange: the other shareholders see the RTS as a piece of infrastructure they use in their daily trading routing, for Da Vinci it is a business that needs to be nurtured. "The RTS was only fully dematerialised in 2007 and then became a commercial company," says Jelezko. "But it lacked the commercial company mentality. Things like sales and marketing were missing and we tried to develop them. Most of the other board members were brokers and saw the development of the RTS [as a business] as a secondary function."

Like many of owners of companies queuing up to list today, most of the RTS' own shareholders were not particularly interested in developing the business further and wanted to cash out with an IPO that was due to happen this year. But their plans were stymied when the government decided it would rather see a merger between Micex (which is majority controlled by the Central Bank of Russia) and the RTS - and so the exchanges were merged.

However, the IPO plans have resurfaced remarkably fast: the combined exchange plans to IPO by 2013 or earlier to raise at least $300m, Micex President Ruben Aganbegyan told journalists at a press conference on Wednesday.

Eggs in a basket

The next big challenge will be to create a central securities depository (CSD), something that has been under discussion for more than a decade. But that is likely to be as difficult as getting the two exchanges merged. Currently, there are two main depositories, DCC and NDC that worked with the RTS and Micex respectively. Neither of these depositories are keen to merge and the situation is made more complicated by the fact that much of Russian equity trading is cleared and settled through the company registrars, many of which are owned by oligarchs and used as a last line of defence to protect their companies from corporate raiders, who also don't want to see any more mergers.

However, the government is clearly committed to forcing through change in the sector. Jelezko is also a member of "Group #1" of a task force dealing with financial infrastructure, headed by Alexander Voloshin, former chief of Boris Yeltsin's presidential staff and widely regarded as the éminence grise in the Kremlin in the 1990s. "The lack of a CSD is a key bottled neck for many foreign investors who can't buy local shares without it [thanks to rule 17f7 in the US securities code] and so are forced to buy ADRs [American Depository Receipts] instead," says Jelezko. "The registrars will resist, but this has to be countered at a high level as everyone recognises the need for a CSD. There are lots of interests involved which all have to be balanced if we are to build a centralised streamlined infrastructure."

And the creation of the CSD is only the first of five key reforms that Jelezko says "Group #1" has identified as crucial to transforming Moscow into an IFC. Even more complicated will be integrating Russia's nascent electronic trading system with that of the rest of the world. "The RTS has been focused on e-trading for a year and now 13 international banks are connected to the Russian market, but it is not a seamless system and the traders still prefer to call to make trades," says Jelezko. "We still need to do a lot in terms of operations, IT, and legal changes to make it seamless."

It's worth making the effort, says Jelezko, because all of these initiatives will bring in more partners and open Russia further to new pools of liquidity that are currently barred.

The merger is a very positive sign that the political will is there to make the necessary changes and Jelezko can list several more (even more technical) improvements that have been put in place over the last two years - irrespective of the crisis winds blowing round the regulator's ears. Indeed, the meltdown of share prices on both the Micex and RTS during the crisis seems to have barely distracted the regulator from pushing ahead with the reform programme.

In the meantime Da Vinci is putting its money where its mouth is and hopes to follow through on the success of its first fund that invested in the RTS with a second one to launch this autumn targeting financial services in general.