Russia Tries to Court Foreign Investment

A summons to meet Vladimir Putin can be an unnerving thing for a business executive to receive. Mikhail Khodorkovsky, the former Yukos Oil CEO serving a 14-year prison sentence for fraud and tax evasion, is said to have aroused then-President Putin's wrath in part by turning up for a Kremlin conclave without a tie. Igor Zyuzin, the controlling oligarch of coal and steel producer Mechel, ducked a meeting with now-Prime Minister Putin in 2008 on grounds of illness and paid a steep price. Putin quipped that "maybe we should send a doctor" for Zyuzin, then asked prosecutors to investigate pricing policies that seemed to minimize Mechel's tax burden. The company's share price plunged 37 percent in one day.

For foreign investors, however, Putin is showing a more welcoming face these days. In May he convened 16 of the world's leading investors to Moscow. The group that met in a grandiose conference room at the government's Vozdvizhenka guesthouse, a converted prerevolutionary mansion steps from the Kremlin, included such Western buyout legends as Blackstone Group chairman and CEO Stephen Schwarzman and TPG Capital founding partner David Bonderman, as well as sovereign wealth fund titans like Lou Jiwei, chairman and CEO of China Investment Corp., and Bader al-Saad, managing director of the Kuwait Investment Authority. Altogether the invitees controlled a cool $2 trillion in investable assets.

In a 40-minute pitch, after which he took questions for more than an hour, Putin offered his high-powered visitors a deal: The Kremlin stood ready to coinvest with them if they would put money into Russia's nonresource economy by building toll roads, producing medicines and modernizing ports and warehouses, among other things. Russia would contribute $10 billion over the next five years to a new entity, the Russian Direct Investment Fund, which would hunt for undervalued companies, broker deals with foreign investors and share up to half the financial risk.

Putin's sovereign visitors responded enthusiastically. "CIC is willing to invest in Russia," Lou told a Chinese news service a few days later. The country, he said, had "big development potential given its vast market and rich resources." (CIC backed up Lou‚s words earlier this week by striking the first deal with the Direct Investment Fund. Under the arrangement, CIC and the Direct Investment Fund will each contribute $1 billion to a new vehicle, the Russia-China Investment Fund, that will make equity investments in Russia. The new fund also aims to raise up to $2 billion from other investors.)

The emissaries of private capital were intrigued but more cautious. "There is no doubt that having the government as a co-investor ought to be attractive," Bonderman tells Institutional Investor. TPG has some experience in Russia, having spent $110 million to obtain a 31 percent stake in supermarket chain Lenta in 2008.

Today the Direct Investment Fund is fast taking shape under the direction of Kirill Dmitriev, a U.S.-educated financier who until recently worked for a leading Russian private equity firm. Last month Dmitriev announced the hires of six investment professionals from prominent Russian and foreign firms, the first members of a team of fund managers he expects will grow to two dozen by the end of this year. He also aims to sign his first few deals by December. The Direct Investment Fund will invest on a 50-50 basis with foreign partners in its early projects, then take smaller equity stakes as outsiders grow more comfortable with the process, he says.

“We could move to 5-to-1 or 4-to-1 in favor of the outside investor,” he tells II in an interview at a roomy corner table in Café Pushkin, an elegantly restored prerevolutionary eatery on Moscow’s Boulevard Ring that serves as an office of sorts while the fund’s headquarters at the Moscow City financial towers are being finished.

Such a new stream of funding could play a critical role in helping Russia diversify its economy away from oil, gas and other raw materials — a key government goal. The country has had little of the type of investment Dmitriev aims to attract. He hopes to sell sovereign funds on big infrastructure projects, the need for which is abundant across Russia’s enormous land mass. The fund wants to generate a steady 15 percent annual return on such investments over a period of decades. For Western private equity players, Dmitriev will scout underperforming manufacturing or service companies that could yield returns of 25 to 30 percent through restructuring and eventual public share sales.

Russia lags other big emerging markets in foreign direct investment. It received about $14 billion in FDI in 2010, according to the Finance Ministry, well below India’s $26 billion and China’s $106 billion. Nearly all the foreign investment in Russia has come from corporations like IKEA, which operates 13 of its furniture outlets in the country, or PepsiCo, which spent $3.8 billion last year to buy 66 percent of dairy and juice maker Wimm-Bill-Dann Foods.

A small, intrepid band of venture capitalists has worked profitably in Russia since the 1990s. Baring Vostok Capital Partners, a Moscow-based private equity outfit run by American Michael Calvey, bought 36 percent of Internet search engine provider Yandex for a reported $5 million in 2002. It cashed in handsomely when the company made a $1.3 billion initial public offering in May, a week after Putin’s investor conclave, selling a 10 percent stake for about $800 million. But these funds’ average bet is in the $50 million range. Private equity on the scale Dmitriev is aiming at — $500 million to $600 million per target — is virtually unheard-of in Russia.

There are good reasons for that. Foreign businesses have been beset by a seemingly endless array of difficulties. A prospective partnership between BP and state oil company Rosneft was torpedoed earlier this year by litigation from the Russian partners in existing joint venture TNK-BP even though the Rosneft deal had Putin’s apparent blessing. For smaller-scale investors, sticky-fingered officials and local rivals or partners can bend a pliant legal system to undermine presumed property rights. IKEA, whose success in Russia Dmitriev boasts about (sales per square meter are more than double the company’s worldwide average, according to a recent study by real estate consulting firm Jones Lang Lasalle), halted new store openings in Russia in 2009, blaming the “unpredictable character of administrative procedures.” IKEA’s octogenarian founder, Ingvar Kamprad, said the company had been “cheated” out of $190 million by power suppliers who reneged on contracts and other unreliable partners. IKEA finally opened a complex in the oil-refining center of Ufa this summer, its first new Russian outlet in two years.

TPG has had headaches of its own with Lenta. The CEO it installed, Jan Dunning, was deposed in a boardroom coup last year by a fellow investor, U.S.-born businessman August Meyer, who had teamed up with one of Lenta’s founders. When Dunning tried to reclaim his office, armed with a Russian court judgment, fisticuffs broke out and 20 people were arrested. TPG managed to overcome that setback. In August it agreed to buy Meyer’s 44 percent stake for $1.1 billion, taking control of Lenta in partnership with Russian state-owned VTB Bank and the European Bank for Reconstruction and Development.

Political risk exists at a higher level too. Putin’s announcement late last month that he would run for president next year — effectively swapping jobs with Medvedev, who will become prime minister — prompted the resignation of Finance Minister Alexei Kudrin, a man regarded by most foreign investors as the best guarantor of financial stability in Russia.

Given that background, critics say the Direct Investment Fund will have little impact without systemic improvements to reduce corruption and firmly establish the rule of law in Russia. “They need to do the hard work of real reform, not launch another fund,” says Florian Fenner, managing partner at UFG Asset Management, a Moscow-based firm active in both direct and portfolio investment for more than a decade.

Dmitriev says his fund will not do what many foreign investors would like it to do: ride herd on the bureaucracy so that projects can proceed more smoothly. For that purpose, foreign investors already have an ombudsman’s office run by influential First Deputy Prime Minister Igor Shuvalov, he insists. He is backed up by Stanislav Voskresensky, a deputy minister of Economic Development and Trade, who helped get the Direct Investment Fund established. “The fund’s job is not to get construction permits,” he says curtly.

Instead, Dmitriev says, the fund will help multinational investors access an opportunity that is too complex for most to explore on their own: modernizing Russia’s domestic economy to meet surging demand from consumers who are rapidly growing richer and more sophisticated. “How does Korea Investment Corp. get deal flow in Russia?” he asks hypothetically, naming another sovereign wealth fund he hopes to partner with.

For statistical illustration, Dmitriev reaches for the iPad resting next to his espresso cup and whips through a few screens: At $15,900 a year on a purchasing power basis, Russia’s per capita income is by far the highest among the big emerging markets, almost 50 percent greater than Brazil’s and more than two times China’s, according to the Central Intelligence Agency’s World Factbook. The number of families with annual incomes of more than $10,000 has tripled in the past three years, according to official statistics

The Russian economy is crying out for improvements to match that rise in purchasing power, says Vyacheslav Pivovarov, a former adviser to the Economic Ministry who also helped lay the groundwork for the Direct Investment Fund. Like Dmitriev, Pivovarov is a “repat,” as Western-trained professionals who return to Russia are called. He earned an MBA at the Stanford Graduate School of Business, worked as a portfolio manager at New York hedge fund firm Third Point Capital, then became a partner at Vikram Pandit’s Old Lane Partners, which Citigroup acquired in 2007.

The potential for investors in Russia is enormous considering that average productivity is just one fourth of U.S. levels, Pivovarov explains. The country’s wealthy oligarchs have focused on where the easiest money is, in commodities and in heavy manufacturing like steel. A less-well-known group of entrepreneurs has overhauled retailing and is spreading smart new supermarkets across Russia. But a vast array of sectors, ranging from light manufacturing to business services to infrastructure, remains badly underdeveloped. “There are a lot of companies that oligarchs are just sitting on” because they are too busy milking their cash cows, Pivovarov contends.

The key to raising efficiency in these lagging sectors is better management, not heavy capital spending, he says, citing a 2009 McKinsey & Co. study that attributed 80 percent of Russia’s productivity lag to inefficient processes rather than outdated equipment.

Dmitriev identifies a number of early target sectors for his new fund. Health care, port and railroad logistics, and services related to municipal housing, such as building management and electricity distribution, will be among the fund’s early priorities, he says. Further down the road, he expects the fund to invest in pharmaceuticals, energy efficiency, agribusiness and forestry.

Pivovarov left the ministry to start his own firm, Altera Capital, in partnership with former deputy Economic minister Kirill Androsov. He has raised a $350 million private equity fund that is focused on opportunities in logistics, food processing and housing.

Dmitriev says he is heartened by the apparently solid backing his fund has received from both sides of Russia’s dual power structure: the ministerial network overseen by Putin and the Kremlin apparat that answers to Medvedev. The seed of the Direct Investment Fund was planted by the Economic ministry, the driving force behind market-oriented reforms since Putin first took power in 2000. In March 2009, in the depths of a recession that saw Russia’s economy contract by almost 8 percent, the ministry asked Pivovarov to come home from New York and advise it on “new sources of growth after the crisis,” as he puts it.

Medvedev unveiled the concept for the new fund in June 2010 at the St. Petersburg International Economic Forum, which has become Russia’s key annual business event. The final push came from Putin at his May meeting. The fund had to buck opposition from Kudrin, the former Finance minister, who was skeptical about adding such a large government expenditure, but he ultimately agreed to support it, Dmitriev says.

Perhaps more important, after years of building up state holding companies to control so-called strategic industries and maintain jobs, Russia’s leaders seem more inclined to promote private investment and the profit motive as the best engines of long-term growth. “At the May meeting Putin clearly said that the goal of the fund is return, and employment will be generated as a by-product,” Dmitriev says.

The Kremlin is preparing an ambitious new privatization campaign. According to the Economic Ministry, the program aims to raise $40 billion over the next three years. A key test will come next year with the planned sale of a 15 percent stake in oil giant Rosneft, which would be worth more than $10 billion at the current market price. For now, though, the government has delayed planned sales of shares in Sberbank, the country’s leading lender, and Sovcomflot, the No. 1 shipping company, because of poor market conditions. The Russian Trading System share index has dropped 35 percent from its high in early April.

The appointment of Dmitriev to head the Direct Investment Fund is a positive sign in itself, Russia watchers say. It marks a rare instance when the state has reached beyond its own bureaucratic ranks to pick a financial professional with actual experience in private equity.

Dmitriev is very much a product of post-Soviet Russia. In 1989, a year when the Berlin Wall crumbled and Mikhail Gorbachev’s perestroika policies gave Russians hope of a freer future, Dmitriev got his first taste of the wider world when an exchange program brought a California couple to visit his parents, both molecular biologists in Kiev. The visitors gave 14-year-old Kirill a Stanford University T-shirt, sparking his ambition. A few years later he went to Palo Alto on a full scholarship and earned a bachelor’s degree in economics from Stanford, then proceeded to obtain an MBA from Harvard Business School. Equipped with his degrees, Dmitriev put in stints at Mc­Kinsey, where he consulted for clients ranging from theme park operators to insurance companies, and at Goldman, Sachs & Co., where he worked on technology IPOs at the height of the tech boom.

He returned to Moscow in 2000 to work for a computer systems company, then settled two years later at Delta Private Equity Partners, an outgrowth of one of the funds the U.S. Congress started in the early 1990s to seed capitalism in Eastern Europe.

Despite Dmitriev’s impressive résumé, mingling with the world financial elite and managing billions of dollars in state money represents a big career leap, and some Moscow financial hands question his readiness for the task.

His American boss at Delta, Patricia Cloherty, says Dmitriev was the star of the firm’s seven investment professionals. He focused, among other things, on the successful disposals of two financial institutions: Delta Bank, which the firm sold to GE Capital, and DeltaCredit Bank, which was bought by Société Générale. Cloherty says she was grooming Dmitriev to succeed her as chief executive in 2007 but his outsize ego caused her to change plans. “I was asking him to be a CEO, not a king,” she says. “His attitude made it difficult for other people to perform their jobs.”

Dmitriev faces a dual challenge at the Direct Investment Fund. Working with sovereign wealth funds looks promising, judging by the initial reaction of fund managers as well as the interests of their governments. China, for instance, is eager to secure energy supplies and has a strategic interest in developing closer ties with Russia as the country develops oil and gas exploration in eastern Siberia and off Sakhalin Island. Russia’s Gazprom and China National Petroleum Corp. signed a framework agreement two years ago to build two pipelines to ship massive quantities of Russian natural gas to China, but the two sides haven’t been able to agree on price terms that will allow the deal to go ahead. By the standards of that proposed deal, which would involve billions of dollars’ worth of gas a year, a few billion from CIC to improve Russian roads would be a pittance.

South Korea and other Asian countries are also warming to Russia for its energy riches and as a potential counterweight to China’s economic might. The Middle East’s oil-rich Gulf states may be willing to invest in all the friends they can find given the turmoil sweeping the Arab world and an equivocal U.S. policy toward the anciens régimes.

Luring billions of dollars from the likes of TPG and Blackstone could be a much tougher sell. As Russia rebounds from the 2008–’09 crisis with a solid growth rate of about 4 percent a year, Western capitalists are increasingly convinced of the investment potential of the country’s nonresource economy. “Growth is coming from almost everywhere” in Russia, Blackstone’s Schwarzman told reporters at this year’s St. Petersburg economic forum. “One doesn’t have to be in resources and minerals to do well.”

But whether he himself will dive into Russia, and if so, via the Direct Investment Fund, is another question. “I think we have an open mind in terms of looking at that vehicle,” Schwarzman added. With growth markets like China and Brazil beckoning, private investors are likely to exercise caution in Russia until Putin can demonstrate that the country’s investment climate has changed.

Still, Dmitriev insists that private equity will play an equal role alongside sovereign wealth funds in investing with the Direct Investment Fund. He points out that it will take only a modest amount of those funds’ vast resources to make the new Russian venture a success. “There’s a total of $27 trillion in long-term capital available through sovereign funds, private equity and family offices, and just $20 billion of it is available for Russia right now,” he says.

The future seems promising. But starting from scratch under the watchful eye of Vladimir Putin means Dmitriev needs to succeed quickly. “Now comes the time for execution, where there is very little room for error,” he concludes. “We are like someone who clears mines on a battlefield. You can only make a mistake once.” • •