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Johnson's Russia List #6573 26 November 2002 [log in to unmask] A CDI Project www.cdi.org #12 St. Petersburg Times November 26, 2002 Picking Up and Passing On the Pieces of Russia's Privatization As the economy evolves into a more sophisticated beast, mergers and acquisitions have begun to replace the naked asset-grabbing that was the hallmark of the Yeltsin era. Ben Aris reports on the country's third, and so far quietest, redistribution of property. Neither a candy nor a rapper, M&A is all the rage in corporate circles, as savvy tycoons and entrepreneurs are increasingly snapping up and expanding their corporate castles out of the industrial Legos left scattered about after the the first wave of privatizations a decade ago. M&A, or mergers and acquisitions, have quickly become the driving force of the country's third, and so far least controversial, redistribution of property. The process began two years after the 1998 default and devaluation, when Oleg Deripaska's Siberian Aluminum - now known as Base Element, or BasEl - bought the PAZ bus factory, and it reached maturity earlier this month with Mobile TeleSystem's purchase of Ukraine Mobile Communications, or UMC, for just under $200 million. UMC is the second-largest cellular operator in a country of 50 million people, and the deal was Russia's biggest cross-border telecoms acquisition. PICKING UP THE PIECES The privatization process of the early 1990s was a crude affair, but it created myriad investment opportunities that only recently became worth pursuing. The problem the government faced was that, with the absence of a working free market, there was no one to buy the newly independent companies. Instead, every single factory, bakery and kiosk was made into an independent legal entity, and most were given to employees and managers via privatization vouchers. In the years that followed, powerful business people grabbed the few assets that were actually making money - mostly raw-material producers - and the rest were left to wallow in economic misery. The devaluation of the ruble completely changed the playing field for investors. Assuming that the country is finally settled on the road to recovery, thanks to rising consumer spending and corporate profits, whole new classes of assets have become attractive. It wasn't just the rich and powerful who saw and capitalized on the possibilities. While the likes of the International Monetary Fund and investment bankers were predicting doom and depression for Russia - the IMF said that the economy would contract by 8 percent in 1999, when it actually grew 5 percent - oligarchs and entrepreneurs went on a shopping spree, unable to resist the bargains. "[In 1998], good companies could be bought at rock-bottom prices. They were cheap, not because their equipment was obsolete - although it is old - but because most of these companies were in a difficult financial condition and it took little money to buy them," said Dmitry Sokolsky, the head of Zenit's investment-banking group. Factories that are worth millions today were snapped up for as little as $60,000, Sokolsky said. Now, according to M&A specialists, nine out of 10 deals are relatively small, involving only a few million dollars and no banks. CLOSING THE DEAL "Most of these deals are made between the two principles sitting in a room with a bottle of vodka and thrashing out the details," said Lucas Wilson, head of corporate finance at UBS Warburg. "They had no need of a bank, which would probably just get in the way." With more businesses chasing fewer choice acquisition targets, prices are rising to the point where those that simply bought businesses at the end of the 1990s because they were cheap are now thinking about selling them. For example, MTS and the other mobile-phone companies have been snapping up regional operators over the past year. MTS paid $350 per subscriber to take over Kuban-GSM at the start of the year, but $705 per subscriber for its most recent acquisition, Dontelecom. "Real M&A started over the last 18 months," said Vladimir Rashevsky, chairperson of MDM-Bank. "Russia's business people have seen the example of a few companies like [No. 2 oil producer] Yukos and [leading dairy producer] Wimm-Bill-Dann increase their value by several times and want to do the same." Now, businesses are concentrating more on their long-term strategies, and a round of selling is under way as major groups begin focusing on specific areas of interest. "No one was interested in the agricultural sector a year ago, but then Agros began buying dairy and milk plants, as did Millhouse Capital," said Alexei Panferov, head of MDM's investment banking operation. "They went into this business thinking about how they could get out again, and the business plans are thought right through to eventual IPOs." Agros is the recently spun off agricultural arm of Vladimir Potanin's conglomerate Interros, which controls, among other companies, metals giant Norilsk Nickel. And the new company wasted no time embarking on an acquisition binge. Millhouse Capital, Roman Abramovich's holding that includes Sibneft, the country's fifth-largest oil company, has done the same, setting up an agriculture and food-processing subsidiary called Planeta Management. Typically, the parent company gives the subsidiary a big dollop of seed capital and then leaves it to fend for itself. Planeta and MDM recently cut the first leveraged takeover deal - where a bank both organizes an acquisition and lends the money to complete it - for a large meat-processing plant in Irkutsk. According to bankers, Planeta didn't have enough money to do the deal on its own but couldn't tap Sibneft directly for the balance. "Millhouse gave Planeta some money to get it going, but management is not going to use all its resources on a noncore business. Planeta's management have to run their business on their own," Panferov said. COMPARTMENTALIZATION This compartmentalization of different businesses in a group is new. In the past, a big business would deliberately confuse the structure of its businesses to make it easier to disguise cash flows and move cash offshore. Now, however, the trend is for subsidiaries to prove that they are profitable in their own right; there is little cross-subsidization within groups once the initial capital has been committed. "Interros is looking much more focused than it did a few years ago," said Steve Jennings, president of Renaissance Capital. "It is being realistic. These companies can only manage a few things well. The small and relatively inexperienced teams can only cope with so much. They still have core assets that need a lot of restructuring." There are other processes pushing this tendency forward. Banks used to be at the heart of major financial-industrial groups, but are no longer the cash cows they were in the 1990s. Industrial groups' banks are increasingly doing real banking business, while the separate industrial parts are receiving investments to make them more profitable. And the owners of the real cash cow in the group - Sibneft in Planeta's case, Norilsk Nickel for Interros - are trying to boost the company's share price; portfolio investors prefer to see noncore businesses kept separate. "The industrial groups are now buying assets in different sectors - chemical, pulp, timber or agriculture - and pulling together something that can reach critical mass or take advantage of the economies of scale," said Alfa Bank chief executive Alexander Knaster. "It remains to be proved if these groups will add value or not, but they are doing the basic things - putting in decent management and imposing some financial discipline." What differentiates these deals from the asset-grabbing fest of the Yeltsin era is that, for the most part, companies have to buy shares in their acquisition targets on the open market at market prices. None of these acquisitions will make money from day one, as an oil company or a metal producer can be expected to do. They all need investment and restructuring. This difference has brought about a revolution in thinking: Managers are no longer concerned with how much cash a company generates, but with the return that can be earned on the money invested - the return on capital. SHIFTING EMPHASIS Return on capital has been an alien concept in Russia for most of the past 10 years, but there is nothing like spending your own money to make people learn. "The novelty of running a business is beginning to wear off," Jennings said. "The owner/managers are more aware of being a shareholder and the value that brings. There is an ongoing trend of bringing in professional managers as the majority shareholders begin to step back from their businesses. The emphasis is shifting from merely controlling a company to adding value to it." Banks are still playing a relatively small role in the current round of M&A, as the bulk of the deals are small, while, at the other end of the scale, the really big deals are still more about politics and government connections than finding a fair price. Knaster estimated that the fees that banks earn from M&A are between $50 million and $100 million a year, a tiny amount compared to those in more developed countries. But banks are building up their M&A departments in anticipation of bigger cross-border deals. The big money will be earned when multinationals start buying local producers as a simple way of breaking into the Russian market. However, direct investment remains mired at about $4 billion per year, as most are still sitting on the sidelines and leaving the play to the Russians. Russian companies buying attractive assets in the "near abroad" are doing almost all of the cross-border M&A, and Russia has been a net exporter of capital for at least a year. MTS's purchase of UMC is typical of a Russian M&A deal, and the $250 per subscriber it paid for UMC makes these assets cheap even by domestic standards. "Foreigners see Ukraine as a politically unstable and risky place to work - much worse than Russia," said Viktor Frumkin, chairperson of Bridgetown, a Russian food-processing company that is about to open a factory in Ukraine. "But for the Russians, Ukraine is like another Russian region, except this one has over 50 million people - a third of Russia's population." Another oddity of the Russian M&A business is that there is very little 'M' at all. The first attempt at a big merger quickly fell to pieces and underscores the problems. In 1997, oil companies Yukos and Sibneft tried to join forces and create Yuksi, but the deal quickly disintegrated, as neither of the two owners could agree who would step aside. "Mergers are not part of the Russian corporate culture. In Europe, the company's general manager can step down but, in Russia, it is almost impossible for one of the owners to step aside," Sokolsky said. "When only a few hands control big companies, then you can't say the company is public, even though it has publicly traded shares. There are very few truly public companies in Russia." SMOOTH EXCEPTION The most obvious exception has been the merger of 70-plus regional fixed-line telecoms companies into seven super-regional holdings as part of the ongoing overhaul of the industry. The process is due to finish by the start of next year, and it has gone very smoothly. "The [telecoms mergers] were made easier as there was a clear champion in Svyazinvest, which helped in persuading the daughters [the regional telecoms companies that make up Svyazinvest] and a few rogue shareholders, as well as doing a lot of the analytical work," said Alexander Tolchinsky, Alfa Bank's board member in charge of corporate finance. "It went very smoothly, but everyone will benefit as these mergers have made the sector vital again." The emphasis on return on capital is a key change and will drive the current redistribution of property toward more efficient market and better corporate governance, since there is no point buying an attractive business that can't be sold off. The main danger is that too much economic power will be concentrated in the hands of too few companies. But, at the moment, companies are simply chasing profits, which is what they are supposed to do. "In 10 years, the structure of the economy will be as if communism and central planning never happened," Jennings said. "The changing shape of Russian industry is the same as has happened in every other country, just here it is changing five times faster." *******