Seeing red

William Browder had cause to feel smug. His Hermitage Fund had racked up a 228 percent return, making it the best-performing fund of any type anywhere in the world in 1997.

William Browder had cause to feel smug. His Hermitage Fund had racked up a 228 percent return, making it the best-performing fund of any type anywhere in the world in 1997. His Moscow-based firm, Hermitage Capital Management, had amassed $1 billion in assets from a standing start 20 months before. And Browder was now regularly rubbing shoulders with Russia’s elite: the great and the good -- and the not-so-good.

Running money in Russia seemed both uncomplicated and awesomely profitable. But fate -- sudba -- the ineluctable force at the heart of the Russian novel, was about to intervene. Browder had been invited to a party to celebrate the Russian New Year by the brother of Boris Jordan, the former star deal maker for Credit Suisse First Boston in Moscow and the founder of Renaissance Capital, Russia’s premier investment bank.

Although no bon vivant, the workaholic Browder readily accepted because he was anxious to have a little chat with Boris Jordan. He had heard rumors that Renaissance was about to issue a convertible bond on behalf of oil company Sidanco, but only to management insiders, threatening serious dilution of minority shareholders’ stake. Hermitage happened to own 2 percent of Sidanco, which was controlled by Vladimir Potanin, one of the Russian “oligarchs” who had acquired enormous economic and political power in the early 1990s.

As white-jacketed waiters doled out caviar, Browder pressed Jordan for an explanation, but the banker responded blandly that talking business at a festive occasion just wasn’t done in Russia. He told the fund manager that there had been a simple misunderstanding and to drop by his office the following week, where he would explain everything.

At the allotted time, Browder was shown to a Renaissance conference room, where he waited and waited. Jordan never showed up. Instead, after an hour had elapsed, Browder was greeted by the firm’s head of investment banking, Leonid Rozhetskin, who favors the slicked-back hair, crisply tailored suits, brightly colored braces and aggressive attitude of a 1980s-style U.S. investment banker. Rozhetskin informed Browder that Sidanco was indeed planning a convertible bond. It would be priced at a 96 percent discount to the current share price and would increase Sidanco’s share capital by 173.3 percent. And yes, minority shareholders would be excluded.

Aghast, Browder did a back-of-the-envelope calculation and concluded that, in effect, $65 million was about to be stolen from his fund because of the extreme dilution. He angrily told Rozhetskin that there was no way Renaissance and Sidanco could get away with such flagrant disregard for minority shareholders. In reply, recalls Browder, Rozhetskin calmly but firmly told the fund manager that the deal was going ahead anyway and that “a little guy like Bill Browder” couldn’t stop it.

Browder was no innocent abroad. The then 34-year-old Chicago native had been involved in investing in Eastern European businesses for eight years, following Stanford Business School and a stint as a proprietary trader of Russian securities for Salomon Brothers. He had done everything from establish Yellow Pages directories in Poland to privatize the Murmansk trawler fleet. Although Browder had already had plenty of exposure to sharp business practices in Russia, even he was taken aback by Sidanco’s seeming audacity.

So Browder called his chief financial backer and confidant, Edmond Safra, the legendary banker to the wealthy, who died in 1999. Safra’s counsel: “If we want to fight this, we do it properly. We go to war.” First, Browder hired bodyguards. Next, he talked to everyone he knew who had leverage with either Renaissance or Sidanco, including Safra’s friend, hedge fund manager George Soros, a significant investor in Russia, and Sir John Browne, CEO of BP, which owned 10 percent of Sidanco.

Days later Jordan was on the phone to Browder telling him that he wasn’t “playing by the rules,” according to the fund manager. Nevertheless, Browder persisted, instructing his lawyers to draft a complaint to Russia’s Federal Commission for the Securities Market, which had to approve the convertible issue. On February 19, 1998, the commission annulled it. “It was a landmark,” says Dmitry Vasiliev, then head of the commission and now of the Institute for Corporate Law and Governance in Russia. “It showed that minority shareholders had rights if they were prepared to stand up for them.”

The Sidanco skirmish was to be the first of many such battles for Browder. In others he would go up against Russian powerhouses like Gazprom, Sberbank and Unified Energy Systems. He has become famous -- or notorious, depending on one’s perspective -- as a scourge of the oligarchs, a crusader for corporate governance reform and, in the process, an important catalyst for economic reform in Russia.

“Bill has shone a light into the darkest corners of Russia, and in my view that has done great service to both investors and the country as a whole,” says Dominic Gualtieri, head of equities at Alfa Bank, part of Russia’s powerful oil, industry and financial services conglomerate, the Alfa Group. Adds emerging-markets doyen Mark Mobius of Franklin Templeton Investments, who sits on the board of two Russian companies: “I applaud anyone who is prepared to stand up and be activist.”

Browder too decries the “timidity and amorality of many fund managers.” He says that “many are more concerned about keeping their names out of the paper or what their investment banking group will think than with standing up for the investors in their fund.”

But to his many enemies -- and not just those among the Russian oligarchs he challenges -- Browder is a vainglorious publicity junkie eager to take credit that he doesn’t deserve for corporate reforms. “You can’t knock the guy’s record,” says one London fund manager. “But some of his recent antics do strike me as publicity stunts.”

Ironically, Browder’s highly visible activism has in some respects overshadowed his exemplary track record as a fund manager. For the five years ended December 2001, Hermitage Fund ranks as the world’s best-performing emerging-markets fund, with an annualized return of 30.9 percent. This is in spite of -- there’s that sudba again -- a peak-to-trough decline of 88 percent in 1998, the year that Russia defaulted on its domestic debt. This year through July 31 the fund is up 25.5 percent, compared with 7.2 percent for the CSFB Russian ordinary share index, and from its April 1996 launch through this year’s first half, Hermitage has risen 465 percent, compared with the index’s 184 percent.

Browder approaches investing like a detective -- an especially appropriate technique for Russia. He refuses to rely on published accounts or brokerage reports because other investors read them and he likes to have an information edge. Led by research chief Vadim Kleiner, Hermitage analysts interview company officials, suppliers and bankers. The resulting scraps of information are assembled into minutely researched analyses. Hermitage Capital, which currently manages $600 million in the Hermitage Fund and a further $200 million in separate accounts, typically has no more than a dozen, invariably low price-earnings investments.

BROWDER DIDN’T GO TO RUSSIA EXPECTING TO become an agitator for good corporate governance. After graduating from business school in 1990, he was drawn to Eastern Europe by the fall of the Berlin Wall and by a curious family connection: His grandfather, Earl Browder, had been the leader of the U.S. Communist Party between 1932 and 1945 and had met his Russian wife while taking part in the fractious Communist International debates in Moscow in the 1920s. He died in 1974.

His son, Felix, Bill’s father, became a mathematics professor at the University of Chicago. After graduate school, Bill worked briefly for the Boston Consulting Group, then for Robert Maxwell’s Central and Eastern European Partnership before joining Salomon in 1994. There he once parlayed a $25 million investment in Russian privatization vouchers into $100 million in six months.

But he left to start Hermitage in 1996 -- and became embroiled in no fewer than 11 public rows with Russian oligarchs in less than five years.

It was a turbulent time. Russia’s default on its domestic debt in 1998 had created a climate of political and economic chaos that gave rise to a stunning display of outright corporate theft. The government had devalued the ruble, the stock market had crashed, and Russia had become a virtual pariah on international markets. The oligarchs saw that they had virtual carte blanche to do whatever they pleased.

“The default and devaluation sent the message from the state that it was okay to cheat,” says James Fenker, chief strategist at Troika Dialog, a Moscow-based brokerage. “The message was enthusiastically seized upon by the corporate sector. It was a crude and rude time -- the nadir of corporate governance in Russia.”

Browder, meanwhile, had a mess of his own to deal with. Hermitage was devastated by the crash of ’98. Its funds under management plummeted during a ten-month free fall from $1.38 billion to $165 million. Of the 42 funds then investing in Russia that had managed more than $10 million, only ten survived. “The party was over,” recalls Browder.

But he reasoned that Hermitage mostly owned companies that exported oil and were paid in dollars, while the bulk of their staff and capital expenditures were in devalued rubles, boosting their competitiveness. One catch: “I knew my investments were fundamentally sound, but I had to make sure they were not about to be stolen from me,” says Browder.

He had determined early on that the best assets in Russia were the large holding companies, not their so-called “daughter” assets: partially owned, separately listed subsidiaries that were often more widely traded than the illiquid holding companies themselves.

Browder’s emphasis on holding companies would pay off splendidly. Oligarchs like Mikhail Khodorkovsky, CEO of Yukos Oil, began a concerted campaign to gain full control of their company subsidiaries, with many riding roughshod over investors in these daughter assets. Today just 15 companies control more than 50 percent of Russian output.

“Avoiding getting ripped off was the key to making money,” confides Browder. “The best investment policy was to try to align the fund’s interests with the oligarchs’.” The Hermitage Fund soared 196 percent in 1999 because of big gains on such holding companies as Lukoil and Yukos.

Postconsolidation, the Russian investment landscape has changed dramatically but not necessarily to Hermitage’s disadvantage. Consolidation was nasty, brutish and short. Most of the oligarchs behaved deplorably toward minority shareholders whose holdings they sought, through such unethical if not necessarily illegal stratagems as threats of massive share dilutions and implicit blackmail.

Now the oligarchs proclaim that they’ve undergone a conversion and become good corporate citizens. “Once you own 51 percent of something, you start behaving like an owner,” says Stephen Jennings, CEO of Renaissance Capital. “What’s the point of stealing money and risking going to prison if you can grow the market cap of your company and become seriously rich another way? Yesterday’s robber barons inevitably become today’s respected businesspeople.”

Browder’s scrappiness also played its part in inducing the oligarchs to go straight. For instance, in October 2000 Browder launched his biggest corporate battle -- with Gazprom. Hermitage held a small stake but was wary of the oil and gas giant because of scuttlebutt that it was engaged in massive asset-stripping, with the enthusiastic participation of its chairman, former Russian prime minister Victor Chernomyrdin, and its CEO, Rem Vyakhirev.

On the other hand, this was Russia, and Gazprom was cheap. At the end of 2000 its market capitalization worked out to 5 cents per barrel of hydrocarbon reserves; by contrast, Exxon Mobil Corp.'s reserves had a stock market value of $13.68 per barrel.

Browder figured he could put a reasonable valuation on Gazprom, provided he could find out how much of the company had in effect been stolen through asset-stripping. The bureaucratic instinct of Russians provided Browder with the evidence he needed. Hermitage research chief Kleiner discovered records of transferred assets at the Federal Securities Commission and other agencies. A picture of corporate theft at Gazprom soon emerged. By October 2000 Kleiner was able to report that 9.65 percent of Gazprom’s assets had been looted -- an amount equivalent to more than $5 billion.

Gazprom had salted away assets and cash flows into companies run by executives’ wives, sons, daughters, uncles and sometimes by the executives themselves. One company, Itera Group, has been a conspicuous beneficiary of Gazprom, rising to become the world’s third-largest oil and gas company. In 1999 Gazprom sold Itera 32 percent of a joint venture company called Purgas for $1,200; the value of the stake has since been estimated at $566 million. Between 1996 and 2001 Gazprom incrementally signed over its gas distribution business in the Commonwealth of Independent States to Itera, forgoing an estimated $1 billion in annual profits. Itera has reincorporated in the Netherlands Antilles.

The corruption, as bad as it was, wasn’t as awful as the market had imagined. Hermitage took a large position in Gazprom. But Browder decided that he couldn’t let Kleiner’s findings molder in a file cabinet. “What we discovered was so shocking,” he says, “that we started to selectively leak it to the press.”

Browder’s tactics attracted the attention of Alexander Dyke, a corporate governance specialist at the Harvard Business School. “It’s his use of the media I find interesting,” says Dyke. “It works in Russia, and what interests me is whether his approach could also work in the U.S. and other markets.”

Browder’s media campaign had an impact. In November 2000 he was able to arrange a meeting with Boris Fedorov, a former minister of Finance and part-owner of Russian brokerage United Financial Group, who served on Gazprom’s board as a representative of minority shareholders. Together Fedorov and Browder rounded up the legally required 10 percent of shareholders to call for an audit of Gazprom’s accounts.

At a December board meeting, CEO Vyakhirev refused point-blank to allow the audit. This infuriated Russian Economic Planning Minister German Gref, one of five Gazprom board members who represent the interests of the government, which owns 38 percent of the company. Gref told Vyakhirev that he had no choice but to consent to an audit. The CEO acceded, but on the condition that the board could choose its own auditor. Its choice: Gazprom’s existing auditor, PricewaterhouseCoopers, which would effectively audit itself.

But before PWC could report, Russia’s president, Vladimir Putin, sacked Vyakhirev, starting a purge of Gazprom’s old guard (Putin appointees now control the board).

PWC presented the results of its audit in June 2001, concluding that there was nothing untoward about the relationship between Itera and Gazprom. Browder dismisses the audit as “false and misleading,” and on April 16 this year, he sued PWC in Moscow. The suit was thrown out of court on the grounds that the only business relationship at issue was between Gazprom and PWC. Hermitage is preparing an appeal. PricewaterhouseCoopers spokesman Dave Nestor says: “Mr. Browder is looking for publicity. There is no basis for a lawsuit against PricewaterhouseCoopers.”

Meanwhile, the process of recovering assets has begun, boosting Gazprom’s share price. Between October 2000, when Hermitage purchased its stake, and the end of July this year, the holding has returned 168 percent.

Gazprom might have been forced to reform even without Browder’s media barrage; the government has an interest in protecting its stake in the company. But observers praise Browder and Fedorov for promoting reform. Says Alfa Bank’s Gualtieri: “The revelations were so bad the government had to act. Using the Western media was a smart political tactic.”

Fedorov and Browder fell out, however, when UFG subsequently backed a dilutive share issue seemingly intended to benefit insiders at Sberbank, Russia’s dominant retail bank, in which Hermitage holds a 5 percent stake. Fedorov now expresses contempt for Browder. “He thinks he is a mover and shaker,” he says. “It’s pathetic. He thinks he single-handedly changed laws in Russia. No one in the government has ever heard of him.” Tensions between the two reached a peak this June when Browder ran against Fedorov for the minority shareholder seat on the board of Gazprom. Fedorov won easily.

Browder detects a change in Fedorov since Moscow took control of the Gazprom board. “Boris was a politician,” says the fund manager. “He put up a great fight for minority shareholders against the previous management. I don’t sense the same appetite now.”

The Russian government is the shareholder that Browder increasingly will be pitted against. He has large positions in Gazprom, Sberbank and monopoly electric utility Unified Energy Systems -- in all of which the government is the biggest shareholder. The rewards of owning such companies are potentially huge: UES, for instance, trades at only about 10 percent of its book value. But the political risks are daunting.

“If I had an infinite time horizon, UES would be a great buy,” says Douglas Helfer, the London-based manager of F&C Management’s Russian fund. “It needs to be restructured, but it’s impossible to say whether that will be good for outside investors or bad.”

Today the interests of the government and of minority shareholders at both Gazprom and UES coincide in the fundamental sense that Putin is eager to further economic growth, and the gas and electricity industries account for more than 10 percent of GDP. The government and minority shareholders together got rid of the board of Gazprom and began asset recovery; at UES they threw out a suspect restructuring plan.

Will the interests of Moscow and minority shareholders be aligned in the future? Gazprom and UES provide heat and light to almost every Russian home, school and hospital -- at massively subsidized prices. A gradual move to global rates -- as foreign investors would surely propose -- would cause massive social dislocation. In sum, arguing the rights and wrongs of energy pricing is more complex than just pointing out the excesses of the oligarchs.

Browder sees much more to do. “Things have gone from terrible to bad,” he says. “We have to be constantly vigilant. I’m slightly concerned that Russia is suddenly on the radar of fund managers in London and New York again. Easy money has led to problems in the past.” As Browder’s experience attests, in Russia there are fortunes to be made, but there is no such thing as easy money.