TO MANY OBSERVERS, investment prospects in Russia have taken a turn for the worse. The stock market has declined by 9 percent over the past year, companies have postponed a raft of IPOs, oligarchs have been sending money out of the country at a prodigious rate, and antigovernment protests have drawn tens of thousands of people into the streets, an unprecedented sign of instability in the Vladimir Putin era.

To Todd Berman, though, Russia is the land of opportunity. Berman is the freshly minted chief of investment banking at Troika Dialog, a Moscow-based firm that was acquired in January by giant, state-owned lender Sberbank. Berman believes Troika’s market skills, combined with Sberbank’s deep pockets and corporate lending relationships, can create a national champion. Troika is hiring aggressively in a bid to fulfill that goal.

“The investment banking sector here can grow rapidly for the next ten or 20 years while New York and London are shrinking,” Berman tells Institutional Investor during an interview at Troika’s headquarters, one block from the Kremlin.

Berman and his colleagues have their sights set on crosstown rival VTB Capital, an arm of the country’s No. 2 lender, state-controlled VTB Bank. Operating with the implicit backing of the government, the bank built Russia’s leading investment banking franchise from scratch over the past four years by exploiting its corporate relationships and wielding a big checkbook to raid foreign houses for talent. Now Moscow bankers expect Sberbank to attempt a similar feat with Troika, which it bought in a deal valued at $1.2 billion.

Berman does not hide his ambition. “There is room in this market for two major banks, and we are happy for them to be No. 2,” he says, referring to VTB Capital. His counterparts express a similar degree of confidence. “Troika will definitely try to compete with us across all markets, but I’m not sure they will be effective in a short period of time,” says Andrey Solovyev, chief of debt capital markets at VTB.

Indeed, Troika has some ground to gain before it can make good on Berman’s boastful prediction. VTB Capital dominates the Russian investment banking league tables. The firm took first place in equity and debt capital markets and in overall investment banking revenues in 2010 and 2011, according to data provider Dealogic. VTB’s investment banking revenue rose 17 percent last year, to $122 million, equivalent to a 12.9 percent market share. That was well ahead of second-place Deutsche Bank’s $85 million. Troika Dialog trailed in ninth place with $31 million in revenue.

The new backing of Sberbank, however, promises to make Troika a potent competitor and establish a domestic duopoly at the top of the industry. Flush with cash after net income more than doubled in the first nine months of 2011, to 256 billion rubles ($8.6 billion), Sberbank appears determined to spend what it will take to raise Troika to greater prominence. In addition to recruiting Berman, who joined Troika last September from the London office of Bank of America Merrill Lynch, where he was co-head of the global telecommunications, media and technology practice, in January the firm lured Rob Leith, former global investment banking chief at South Africa’s Standard Bank Group, to serve as global head of investment banking and markets. Another key recruit is David Walker, whom the bank hired last autumn to bolster its M&A business. Walker previously headed emerging Europe, Middle East and Africa investment banking at Citigroup. According to media reports, Troika intends to hire some 40 new bankers. Berman says only that “we will expand the platform to meet the growth opportunity.”

Sberbank and VTB Bank together make more than half of all corporate loans in Russia, giving them a major advantage in winning investment banking business. The role of the two banks in the economy has grown significantly since the 2008 financial crash, when oligarchs overburdened with foreign debt had to come running to the Kremlin for refinancing.

As a result, Deutsche and other international banks are having to rethink their Russia strategy. Foreign banks haven’t made any notable cutbacks over the past year, but they also haven’t staffed up after the reductions that followed the 2008 market setback. “There are too many foreign investment banks in Russia,” says a top executive at one foreign house, who spoke on condition of anonymity. “There was a mistaken perception that this would be a huge wallet.”

Major foreign banks appear to be adapting themselves for co-existence with the two new elephants in the room. “We view VTB as our partner on many transactions,” says Andrei Chulak, co-head of corporate finance for Deutsche’s Moscow office.

The global banks’ somewhat more modest new ambitions fit with Russia’s economic recovery, which is solid but far short of its pre-2008 intensity. Steadily rising world oil prices helped the economy grow at an average annual rate of 6.9 percent from 1998 to 2008 and helped per capita incomes more than double over the period, to $16,040, according to the International Monetary Fund. When oil prices plunged in the wake of the financial crisis, Russia’s economy fell abruptly. Gross domestic product plummeted by 7.8 percent in 2009, far steeper than the 3.6 percent average decline among countries in Central and Eastern Europe.

The economy has bounced back, posting growth rates of about 4 percent in both 2010 and 2011, but the IMF predicts that the pace of expansion will slow this year to 3.3 percent. Such a rate compares favorably with the modest recession predicted for the euro area and a tepid growth forecast of 1.1 percent for CEE countries, but it lags far behind the pace of China and other fast-growing Asian economies.

Even when world capital markets thawed in the first half of 2011, Russia’s response was lackluster. Russian companies pulled six planned IPOs from the London Stock Exchange within a few months, mostly because investors balked at the prices demanded by the oligarch owners. As Deutsche’s Chulak puts it, “Expectations of value on the sellers’ side don’t go down as fast as values themselves.” Last year ended with new questions about Russia’s political stability — which had been a Putin regime strong suit — as huge crowds gathered to protest what they contended was a falsified parliamentary election in December. Protesters mounted four large rallies during the dead of winter, provoking a response from Putin that was part accommodation, part warning that disorder would not be tolerated.

Although Russia hasn’t produced the torrent of fees that bankers had hoped for, there is opportunity for foreigners. Russia’s underdeveloped financial markets are proving to be a saving grace for the outsiders. Domestic corporations look abroad — generally to London — to raise most of their equity and about half of their debt. When they do, they invariably want a global house such as Deutsche, JPMorgan Chase & Co. or Morgan Stanley to help manage the deal, even if the lead mandate goes to a Russian firm. As a result, some foreign bankers remain confident about the outlook. “The Sber-Troika combination is less of a competitor to us than to VTB,” contends Jeffrey Costello, president of JPMorgan Russia.

Speculation that the recent antigovernment demonstrations could turn into a full-blown Russian Spring also seems exaggerated. Putin has been clever enough to sympathize with the protesters’ cries for a more open society and economy. During his presidential campaign the prime minister has promised a long list of reforms, ranging from bringing back elections for regional governors — which he had abolished in 2004 — to lifting Russia from its embarrassing 120th place in the World Bank’s global ranking on ease of doing business. 

For investment bankers, the most relevant reform would be a new wave of privatization, long promised by Putin’s economic ministers, that could see $30 billion or more of state assets sold into private hands. Among the state companies at the head of the line for share sales are Sberbank and VTB themselves. Each has plans to reduce the government’s stake to a bare 50 percent-plus-one-share majority, compared with its current 57.6 percent of Sberbank and 75.5 percent of VTB; at today’s prices, those sales would be worth roughly $5 billion and $6 billion, respectively. The mandates from a privatization campaign might make Moscow look more attractive in a hurry.

At the same time, many big Russian companies have reached their credit limits with the state banks and will turn to the capital markets for further financing, says VTB Capital’s Solovyev. Other companies find themselves cash-rich again in a world of suppressed values, and they are hunting for foreign acquisitions, which could generate fees for M&A bankers. Cellular telephone operator Vimpel­Com bought Italian-Egyptian Wind Telecom for $6.6 billion last year, with Deutsche and UBS advising on the deal. Sberbank itself acquired Austria’s Volksbank International for €505 million ($678 million) last September and has said it is looking for further expansion in Central and Eastern Europe. CEO Herman Gref has described the deal as just the first step in Sberbank’s becoming “a global bank.”

That the giant lender could even pretend to have such ambitions is remarkable considering its history. Sberbank was founded in 1841 by czar Nicholas I, who sought a vehicle for “people of every rank to save in a reliable and profitable manner.” The Soviet Union could not do entirely without banks, much as its Communist leaders might have liked to, and Sberbank served as the ubiquitous savings institution where citizens deposited their nest eggs and stood patiently in line to draw pensions and pay phone bills. Vneshtorgbank, forerunner of today’s VTB group, was the foreign trade monopoly, an invisible elite bureaucracy whose functionaries exchanged petrodollars for rubles.

Neither bank was remotely prepared for a free market in the post-Communist era. Commercial lending and trade finance was pioneered in the 1990s by upstart houses controlled by rising young oligarchs like Vladimir Potanin (Uneximbank) and Mikhail Khodorkovsky (Bank Menatep). The new generation also introduced the profession of investment banking, through Troika, founded by chief executive Ruben Vardanian and two American partners in the early 1990s, and its chief privately owned domestic rival, Renaissance Capital. Other competitors included United Financial Group, which Deutsche bought in stages starting in 2002, and Brunswick Capital, which was acquired by UBS. Credit Suisse was the first global house to commit resources to Russia, ramping up in the mid-’90s. Goldman, Sachs & Co. and others followed when the Russian government began to borrow heavily during the administration of then-President Boris Yeltsin.

But the country defaulted on its debt in 1998, dealing a harsh blow to Russia’s young commercial banks — and many foreign houses — that held large positions in domestic bonds known as GKOs. The eclipse of these institutions paved the way for the slow restoration of state veterans Sberbank and VTB Bank. Bringing back state dominance in banking fit well with the ideology of Putin, who took over as president in 2000 and promptly moved to reassert government control over strategic industries. 

VTB started growing dramatically after a dynamic CEO, Andrey Kostin, took control in 2002. He dusted off old ties with big exporters to turn VTB into Russia’s No. 2 corporate lender (after Sberbank, of course), with a 20 percent market share. In 2005 he launched a retail subsidiary, called VTB24, which quickly became No. 2 in that category as well. With capital markets on fire in 2007, Kostin set his sights on investment banking. He poached accomplished financiers by the team-load, mostly from Deutsche Bank’s Moscow office. VTB Capital’s co-CEOs, Yuri Soloviev and Alexey Yakovitsky, were Deutsche’s Russia head of global markets and chief of research, respectively.

Kostin launched his VTB Capital hiring spree in the spring of 2008, not long before the collapse of Lehman Brothers Holdings caused a panic in global markets. By expanding with state backing just as his chief private rivals were slashing staff, Kostin positioned his bank to become the undisputed leader when the market recovered. “VTB Capital is a success,” Deutsche’s Chulak concedes. “Everybody knows it.”

Sberbank, meanwhile, drafted a transformational CEO of its own. Gref took the reins in late 2007 after serving for seven years as minister of Economic Development. He has stabilized the legacy bank’s share of Russian retail deposits at about 50 percent, and he used the private sector credit crunch after September 2008 to solidify Sberbank’s lead in corporate lending, with a share of 32 percent. Now he wants to emulate Kostin’s success in investment banking.

Although Sberbank and VTB are both state-owned, they belong to different bureaucracies — the Central Bank of Russia holds a majority of Sberbank’s shares, while the Finance Ministry controls VTB. Staff at both institutions are clearly eager to compete.

Troika boss Vardanian reportedly thought about selling his creation before the 2008 crash and turned down a multibillion-dollar offer from JPMorgan. Strapped for cash after the crisis, he sold 36 percent of Troika to South Africa’s Standard Bank in 2009 for the humbler sum of about $300 million. In January, Sberbank paid $372 million for that stake and bought the balance of Troika’s shares from Vardanian and other managers for an undisclosed sum. Vardanian will stay on at Troika through the end of next year.

Gref takes over an operation that has long been a leader in Russian brokerage and asset management. Troika is also strong in debt underwriting, particularly on the growing domestic market. It ran second to VTB Capital in 2010, according to Dealogic, and Troika and Sberbank’s combined debt capital markets deals ranked No. 2 again last year. But Troika has historically lagged in equities and M&A advisory.

Renaissance Capital found a deep-pocketed patron of its own after 2008, when metals billionaire (and now maverick presidential candidate) Mikhail Prokhorov bought 50 percent of the bank for $500 million. Even with that backing, RenCap appears to be squeezed between VTB and an ambitious Sber-Troika combination. It ranked seventh in investment banking revenue last year, with $49 million, according to Dealogic. The firm was in seventh place in equities and did not crack the top ten in debt capital markets.

Captained by New Zealand native and founder Stephen Jennings, who still owns half of the firm, RenCap is trying to refashion itself as a global emerging-markets bank with an emphasis on Africa. The firm still depends on Russia for 70 percent of its business, though, and it is fighting to carve out a niche as an independent local. The same state connections that give VTB and Sberbank their huge balance sheets may also deter clients who are loath to give the government full access to their books, says Alexander Merzlenko, RenCap’s head of Russian investment banking. “People don’t want to work with state banks if they can afford not to,” he contends.

Russia’s capital markets trajectory last year mirrored the rest of the world’s: a moderately busy first half followed by a moribund second half. Bankers are hoping that sentiment will improve if Putin is reelected, as is widely expected. Putin’s popularity may have declined in recent years, but he faces no viable opponent. Heading into election day, the real suspense was whether he would win an outright majority in the first round of voting or face a runoff, probably against perennial Communist candidate Gennady Zyuganov. Another big question was whether the ballot would be seen to be clean. The government installed webcams at polling stations in response to the protests over the December parliamentary election, but many Russians remained fearful that Putin loyalists across Russia’s 89 regions would try to tamper with the vote.

What comes next is less certain. Analysts read the winter’s protests as a cri de coeur from a rising middle class against the prospect of political stagnation. “The purpose of the marches was to prevent Putin from becoming dictator for life,” writes Boris Akunin, a popular writer who has emerged as a protest leader. The demonstrations could prompt Putin to abandon his plan of installing outgoing president Dmitry Medvedev as prime minister and maintaining the ruling tandem just as it has been since 2008. 

Investors would love to see Putin dump Medvedev for a more credible reformer, such as former Finance minister Alexei Kudrin or the current first deputy premier, Igor Shuvalov. A liberal-leaning cabinet shake-up plus a dramatic gesture or two — say, Putin fulfilling his campaign promise to appoint a cabinet-level official to protect entrepreneurs — could give underperforming Russian stocks a jolt. The RTS Index’s 9 percent drop over the past year is triple the decline of the MSCI Emerging Markets Index, which fell just 3 percent.

Rising RTS valuations plus more animal spirits on world markets could unclog Russia’s promising pipeline of IPOs, starting with some of the companies that canceled issues last year. Nordgold, a mining spin-off from steelmaker Severstal, postponed a $1.1 billion flotation at the last minute in February 2011. Chel­yabinsk Tube-Rolling Plant, known as ChelPipe, pulled an issue that aimed to raise more than $800 million.

A rising market could also spur the government to start unloading some of its assets. Near the top of the list is Sberbank: The state wants to sell a 7.6 percent stake to reduce its holding to 50 percent plus one share. CEO Gref is a strong proponent of more privatizations, and the bank said it was “technically ready” for this sale last September. But the Russian Treasury — hardly desperate for cash, with debt at less than 10 percent of GDP — decided to wait for a better global market. “Sber will be the litmus test for privatization,” JPMorgan’s Costello says. “The problem with getting it off is the price of international peers, not Sber.”

Of course, this being Russia, things could go off the rails after the presidential election. Officials could clumsily stuff ballot boxes again like they did in the December Duma contest. Crowds could reemerge on the streets. Putin could shelve his progressive face and crack down in the name of order. Even without such drama, inertia could take over and snuff out hopes of economic reform and a market revival.

One possibility that can be excluded is any retreat by Kostin and Gref from investment banking. These post-Communist managers clearly relish the chance to play the Wall Street game, and Kostin’s team has already proved its mettle. Foreign bankers will have to beware of the big Russian bears.  •  •