ZAO Kremlin

By bne IntelliNews August 16, 2007

Ben Aris in Berlin -

This is the first in a series of pieces over the coming months where bne will look at the structure of ZAO Kremlin.

Got a couple of billion to invest and want some geopolitical clout to go with stellar returns? Buy into ZAO Kremlin - now Russia's biggest industrial holding.

Russian President Vladimir Putin has taken a leaf out of the oligarchs' book and, instead of hounding them into exile, he has joined forces with the richest to create the world's largest corporate structure. ZAO Kremlin is like the financial-industrial groups that the oligarchs have created, but on a much bigger scale. And as a government, it adds a military component to the mix that Putin hopes will make Russia one of the most powerful countries on earth.

ZAO Kremlin controls assets in oil, gas, power, shipping, rail, media, utilities and automotive assets to name a few. Just the publicly listed part of this holding was worth $360bn at the end of last year, or equivalent to 40% of GDP. At their peak, Russia's top-20 oligarchs between them never controlled more than 22% of the economy, according to a World Bank study.

The only trouble is that not just anyone can invest in this corporate powerhouse. That's what ZAO means: "closed joint stock company." Shares can only be sold with the consent of the owners, so you have to be invited into the company.

The divide between politics and business is axiomatic in the West. In Soviet Russia there was no distinction at all. What Putin is trying to do is to build a hybrid system where the state retains control but businessmen – both domestic and foreign – are invited in and given enough autonomy to make sure that ZAO Kremlin is profitable.

All the national champions that make up ZAO Kremlin's subsidiaries are going to be floated on stock markets to raise investment capital, but more importantly IPOs will bring in people with the commercial nous and management skills to make the companies profitable.

If there is a choice, the Kremlin prefers to work with Russian investors – the oligarchs – but if the sector is technologically demanding, or the market global, then foreign investors will do. Just as long as control of the company is not given away in the process.

Corporate restructuring and guns

The creation of ZAO Kremlin is a work in progress. Ironically, the Kremlin is going through exactly the same process as the oligarchs went through over the last five years, making liberal use of complicated holding structures, buying assets through empty offshore shell companies and offering investors the most opaque of accounts. Investors hope the Kremlin will continue to follow the oligarchs' example and after the redistribution of assets going on at the moment is completed, the holdings will become more transparent. But the jury is still out on that.

The structure is certainly still very messy. The subdivisions of ZAO Kremlin can be split into three main parts. First are the classic state-owned companies like Gazprom and Sberbank, which are formally controlled by the Kremlin. Then there are the new national champions like United Aviation Company, holding companies that group diverse assets in a single sector, convert them into joint stock companies and provide a vehicle that can be floated on stock markets later to raise investment capital. Finally, there is Rosoboronexport, the state-owned arms export company, headed by Sergei Chemezov. In addition to its arms sale duties, Rosoboronexport has become a corporate holding for Kremlin-backed investments and takeovers.

Chemezov is part of a team of ZAO Kremlin executives who are remaking the economy. Also on the board of directors are Alexei Miller (Gazprom), Igor Sechin (Rosneft), Anatoly Chubais (electricity), Vladimir Yakunin (railways) and Sergei Kirienko (nuclear).

Their approaches to restructuring might be very different and some are more liberal than others, but they share Putin's stated goal of restoring "Russia's place in the sun" by corporatising their sectors, establishing the state's control and raising investment capital.

If there is an ideology shared by this assortment of foreign intelligence officers and liberal economists, it is this: Russia's current economic growth is dangerously dependent on high oil prices. Diversification from commodity extraction into industries and services where added value is generated in Russia is thus not only an economic, but also a national security, imperative.

And like the oligarchs, ZAO Kremlin's control over companies is backed by guns. With an entire army at its disposal, rather than ordinary business' legion of hit men, any fight between an oligarch and the Kremlin is one-sided, but the choice of Rosoboronexport as ZAO Kremlin's holding company of choice is pertinent.

The Kremlin has been using its control over the military-industrial complex as a seed crystal for the growth of the industrial sectors. This is the main difference between ZAO Kremlin and the oligarch empires of the 1990s - Putin has added "military" to the end of the traditional financial-industrial structure.

It is no accident that while many of ZAO Kremlin's national champions are nominally producing products for civilian use, a point that is usually missed is that almost all of these enterprises has a military wing.

While the government plans to invest $118bn into desperately needed power stations over the next five years, it will spend almost twice as much on equipping the Russian army in the same period. At the sovereign level, business is almost as rough as that between competing oligarchs and the Kremlin believes it can't compete on the international stage without a strong conventional army. The US' decision to put missiles in Poland has only reinforced this belief.

Putin has already tied arms sales together with economic development. Since becoming president, Putin has become Russia's best arms salesman. Rosoboronexport's sales have doubled during his tenure to about $6bn a year.

When cutting deals with the likes of Kazakhstan, Venezuela and Algeria, Putin has expanded the idea of energy security in recent oil and gas deals with these countries into overall "security;" arms deals now go hand in hand with the building gas pipelines or developing oil fields.

The Silo-garchs

The first thing Putin did after taking office in 2000 was to build up the presidential apparat into the real seat of political power in Russia, despite it only being mentioned in passing in the constitution. Over the last two years, Putin has been busy with his trowel again, this time building up a corporate apparat that is increasingly becoming the seat of economic power.

This is where the blurring of the line between business and politics comes in. Rather than recreate the monopolistic state-owned companies that were the death of the Soviet Union, Putin hopes to avoid the pitfalls of central planning by bringing in Kremlin-friendly businessmen to manage big chunks of ZAO Kremlin. Putin's Russia is the Soviet Union, except it is no longer evil to make money.

Russia is almost unique in that senior government officers now sit on the boards of the majority of Russia's biggest companies, giving the state formal control over the state-owned enterprises. However, a new class of oligarch has emerged that is close to the Kremlin and under the control of the Siloviki - a Kremlin clique with its roots in the security services. These "Silo-garchs" meet regularly with Putin in one-on-one meetings like managers meeting with a CEO, giving the Kremlin informal, but effective, control over their companies.

With the example of Yukos' bankruptcy still fresh in everyone's mind (and the state's recent takeover of Russneft even fresher), none of the oligarchs are going to resist the Kremlin's advances.

Primus inter pares is Oleg Deripaska, the new "Minister of Acquisitions," who created an aluminium national champion following the merger between his Russian Aluminium and Viktor Vekselberg's SUAL earlier this year. He sat shoulder-to-shoulder with Putin during Russia's successful bid for the 2014 Winter Olympics in July, promising to put $2bn of his own money into the development pot. And his decisions to invest in things like power and infrastructure in recent years are moving in lock step with the Kremlin's own plans to develop the economy.

The Silo-garchs support of the state's goals is not charity; nor have they necessarily been coerced into support. It can be very good business. Deripaska's plans to invest a couple of billion dollars into a new hydroelectric power station next to his Boguchansky smelter was backed earlier this year by over $1bn from the new State Investment Fund – the first big allocation the fund has taken on.

Likewise, Putin pressured the Turkish government to allow Alfa Group to acquire a stake in the country's largest mobile phone company Turkcell in 2005, publicly endorsing the deal when it went through. Later, Putin again opened discussions with the Vietnamese government on the possibility of Alfa acquiring a mobile phone company there.

Alfa has also gone into a joint venture with Rosoboronexport called Patriot Capital, where Alfa Bank's staff work their financial and restructuring magic on Rosoboronexport's defence assets.

Some unlikely business leaders have also become Silo-garchs. The owner of investment bank Troika Dialog, Ruben Vardanian, has been working closely with Rosoboronexport Chairman Chemezov. Vardanian now sits on the board of several Rosoboronexport-controlled enterprises such as Sukhoi Civil Aviation, which is spearheading the Kremlin-backed project to create a new passenger plane, and Russpetsstal, a specialist steel producer with military applications which is being set up by the Siloviki .

Other oligarchs have found themselves on the outside. When Renova boss Viktor Vekselberg tried to float his aluminium company SUAL on the London stock exchange last year he was called into the Kremlin and told by Putin "no."

"Vekselberg had almost given up and announced that SUAL would IPO on the London Stock Exchange. But when he met with the president, Putin vetoed the IPO until the merger with RusAl was completed," says a senior executive involved in the talks who didn't wish to be named.

Will it work?

"Putin's Russia is like a dinosaur. It has a tiny brain and it takes an enormously long time for messages to run down the neck to the legs and back again. Once you start it moving it will be very difficult to make it change direction," says Dmitri Trenin from the Carnegie Endowment for International Peace.

The reason why business and politics are divided in the West is because mixing the two is, at best, inefficient and, at worst, an invitation for corruption. But Putin is hoping the disadvantages of state involvement will be outweighed by the advantages that Russia's leading companies will have from the full weight of the Kremlin's backing in their international dealings. At the same time, the plan to privatise nearly all the national champions is supposed to ensure these companies stay commercially minded.

Certainly, as the Russian state is now the biggest shareholder in the country, it can no long afford to scare portfolio investors with politically motivated attacks on publicly traded companies – or at least it can't afford to do this too often.

Macroeconomic stability, based on lashings of oil and gas money, and coupled with Finance Minister Alexei Kudrin’s canny policies, has changed the equation for state holdings: large companies now enjoy direct access to international capital markets and stock exchanges. Capital constraints have been lifted.

Gigantic and secretive entities like the Ministry of Rail and the Ministry of Atomic Energy have transformed themselves into equally gigantic, but potentially less opaque and more efficient, joint-stock companies – 100% state-owned, of course.

At the other end of the scale, the ongoing overhaul of the defence industry will see scores of federal unitary enterprises (FGUPs), currently languishing in the orphanage of the federal property fund, corporatised for adoption by national defence concerns. The Federal Agency for State Property has declared its goal to be the liquidation of FGUPs as a class.

And then there's the questions of what role the retiring Putin will have in all this. It doesn't matter if Putin leaves to become the CEO of Gazprom or takes charge of a beefed-up Security Council, in reality he will join some kind of ZAO Kremlin supervisory board and steer the ship from behind the scenes as chairman while a new CEO takes on the day-to-day work. The structure he has created is flexible and he can carve out a position to suit him.

The risks are obvious: will the Kremlin respect inconvenient property rights when setting up national champions? Or will it happily undermine the rule of law, which has, far more than Kremlin policy, been behind the surge in investment rates?

Oleg Deripaska did little to reassure private owners when he declared himself ready to surrender RusAl "if the Kremlin says it is necessary" in July. But showing his loyalty and willingness to give up his businesses if he is told to is probably the best way to ensure that he will get to hang onto them.

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