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EAST-WEST-RESEARCH  November 2002

EAST-WEST-RESEARCH November 2002

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Subject:

New Stage in Russia's Economic Development: M&A

From:

Andrew Jameson <[log in to unmask]>

Reply-To:

Andrew Jameson <[log in to unmask]>

Date:

Wed, 27 Nov 2002 12:10:44 -0000

Content-Type:

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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."

*******

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