Newsblock
February 14, 2012
UFG AM Family of Funds performance recognition awards
Published in the World Finance Review, March 2012
Comparing returns across emerging markets
According to EMPEA, which tracks 10-year returns for various regions, CEE and Russian region combined looks quite favourable if compared with other regions: 18.33% ten-year return versus 11.96% for emerging markets PE&VC, albeit slightly behind Western European PE index. Interestingly, if CEE countries are excluded, Russia & CIS return stand-alone increases notably to 23.83%. For full disclosure, it should be noted that Russia & CIS stats above are based on perhaps the only source of complete objective data for PE funds in the Russian region – the EBRD sponsored GPs which have a follow-on fund (not a one-off fund, i.e. a descriptive sample frame for the industry). Generally, Private Equity performance data in Russia, where the number of active PE funds is small and they rarely disclose returns, still has years ahead to go to be fully credible for international comparisons. Still, existing performance data is more than enough to clearly point out a notable gap in perception between attractive Russian region PE returns and Russia’s place vis-a-vis other emerging economies private equity investments being the most “unloved” market. One of the best illustrations of this point is fundraising dynamics over the last few years. The assumption here is that institutional investors, other things being equal, should continue funding the country that has the most attractive PE performance. However, based on the latest EMPEA report on Private Equity developments, the volume of fundraising in other BRIC countries demonstrated better dynamic than that in Russia, as is seen in the table below. Reasons for this may be the following:
• Long-term nature of Private Equity business. Significant amount of capital was raised in Russia in 2005- 2007 – over $3bn versus $0.5bn in three prior years and was deployed at rather high valuations. Investees then stumbled at problems during the 2008-2009 financial crisis and needed time to recover. Potential LPs now need to see actual success stories in existing pre-crisis portfolios, and are reluctant to make an allocation only based on projected returns of post-crisis investments. • General perception of Russia, especially among large international PE groups. At the moment only few known international houses are present in Russia - and those mostly nominally. Sour stories from the 1990s are still vividly remembered, though some market players, for example TPG, after all re-launched activity in Russia despite bumpy prior experience. In this respect the initiative of the Russian Government to launch Russian Direct Investment Fund (“RDIF”) looks very logical and should help Russia regain credibility in the eyes of top international PE fi rms. Indeed, one of primary purposes of RDIF is to become a transparent co-investment platform for international private equity investors. But this will require time. • Importance of prior track record for raising new funds. New teams face a tougher chance to succeed in fundraising, especially amidst ongoing financial turbulence in Europe and the USA, aggravated by cautious view on Russia. • Lack of long-term capital sources inside Russia allocated to private equity funds, mostly due to restricted existing regulation for domestic pension funds. However, recognising highly attractive investment opportunities in Russia, several local teams launched fundraising process in 2011 with a total volume of capital sought in excess of $1.5bn. Their experience in 2012 will be a good indicator of whether the belief in Russian private equity among institutional investors is starting to pick up. Another thing to point out here is the investment community’s expectation vis-a-vis any particular county. In terms of expected growth over the next five years, based on forecasts by EIU, Russia (with 4% CAGR in 2012-2016) is behind China and India, which are both around 8%, but is in line with Brazil and South Africa. This contrasts with funds that were raised in 2010-9M2011: $5.5bn for Brazil and less than $150mln for Russia, though Russian economy is just 25% smaller than that of Brazil. Total funds raised by BRICs for private equity sans Russia in 2010-9M2011 was$32.6bn, which shows that in principal there is a strong investor appetite for emerging markets, and that Russia too has a good chance for a slice of the pie, providing PE teams are able to show the ability to manage portfolios and deliver competitive returns over a 5-10 year period. For now, based on this rough top-down analysis, there is not too much to show, except for a few teams.
Global trends impact on PE opportunities and returns in Russia
On the one hand, the amount of liquidity available for deployment into long-term risky assets, such as private equity, has no doubt decreased over the last few years and will likely continue to do so for some time. This makes competition for private equity allocations more intense. On the other hand, financial debacle makes the US and European markets less attractive in the mid-term, while investor appetite for high returns and emerging markets persists. Capital allocations to European and the US private equity funds over 9M2011 dropped by 70-75% from their 2008 dollar volumes. At the same time, emerging markets have not seen such a drastic loss of investments with 9M2011 fundraising volume shrinking only by 50% from the 2008 level. As was already mentioned, the volume of available capital allocations to compete for is significant ($32.3bn for 9M2011), while Russia at its peak in 2007 received only a modest $1.8bn in commitments, or just about 5% of what is in the pot today. Another effect that lower liquidity in Europe and the US may have on Russian companies is a more expensive leverage, but likewise it will have the same effect across other emerging markets as well. What is more important for Russia, if it wants to enhancement its competitive advantages, is to prove the ability to create internal growth drivers which are not predicated on natural resources only, as well as continue to improve its legal system. What is interesting, the crisis in Russia was actually to a certain extent good for PE funds with “dry powder” and not overleveraged portfolio companies. In the periods of financial turmoil, valuations generally go down and there is an opportunity to invest in quality companies at a discount to its normal market price. It is also logical that good deals are made in post-crisis periods when banks are busy with cleaning up their portfolios and fresh equity gives surviving companies a chance to turbo charge their success by taking competitors’ market share. According to IFC, in emerging markets it is better to count on growth and efficiency for PE investments rather than on leverage. Crises are also good as they “clean up” the economy of companies that are either inefficiently run or overleveraged. From this point of view, another good indicator for Russian PE funds to take into consideration when deciding on an investment into a potential investee company is to review how it weathered the recent economic crisis. In addition, the crisis widens potential investable universe of companies by decreasing their valuation expectations. Given that current Russian P/E multiples are on average 45% of their pre-crisis December 2007 levels, with the same ticket size per equity investment a mid-cap PE fund can acquire meaningful stakes in companies twice larger in size than the said ticket size would have them to before, owing to such companies reduced valuations.
Dealing with specific challenges of investing into Russian private equity
Probably key differential of investing in Russian private equity remains a limited number of teams that match potential LP requirements, specifically those of international institutional investors. Fingers on one hand are more than enough to count local funds that potential blue chip international LPs can consider, who would have a good and long enough track record of working as a team, and demonstrated through real deals their ability to select good targets and resolve difficulties in the portfolio when needed. However, as discussed above, historical returns of EBRD sponsored Russia & CIS PE funds are higher than the average return across all EBRD sponsored PE investments: 22.91% versus 17.56% respectively over ten years ending December 31, 2010. Performance of Russia & CIS PE “survivors”, i.e. those GPs that are expected to raise new funds, is even better: 23.83%, as shown in the table. This means that with the right partner in the Russian region an investor can really hit the jackpot. Another challenge is a lack of high quality local PE professionals in Russia which are essential to the success of a fund. Unfortunately there are not enough Russian individuals that understand the necessity of committing themselves to one company to unlock the benefits of working in a PE fund. This partially stems from the limited history of the Russian market economy itself, where there have not yet been enough success stories of PE teams and Russian entrepreneurs making fortunes and earning large carry over a mid-term period. Investment banks and investment holdings owned by one or several wealthy Russian individuals quite often offer better financial terms to staff than PE funds, while the carry philosophy, which is well-understood in more developed economies, is not yet shared in Russia (where a 10-year outlook typical for a PE fund’s life is too long a period to comprehend for PE professionals which then often change jobs). A few words also should be said about key peculiarities related to investing in Russian companies that a local GP faces.
First of all is that to succeed you need to have Russian high quality professionals in your team as they will facilitate the communication with entrepreneurs who are not used to PE specifics and increase significantly the probability of a deal.
Second is that the agreement with Russian entrepreneur should be reached in good faith on both sides. If you are trying to outsmart your potential partner assuming that he is less sophisticated financially, you will be eventually outwitted. And vice versa, if you have serious reasons to doubt credibility of your future partners’, whether in the dialogue with you or in reference to his prior partners, do not invest. He will let you down in a moment of crisis. Due diligence on your partners is no doubt one of the most crucial aspects of investing in Russia. Negotiation should be open and fair; both sides should have a healthy balance of give-take concessions to reach a win-win agreement.
Third, invest in teams that really impress you. It requires some time to understand in which way the team you are talking to is better than competitors, especially in a high context Russian environment, but never avoid this exercise as it is key to success. You can earn more with a good team in an industry which has moderate growth, than with a bad team in an actively expanding sector of economy.
Forth, negotiating valuation is in most cases extremely tough with Russian shareholders. The reason for that is once again relatively young age of the Russian market economy of only 20 years. This fact explains a lack of long-term view and understanding that with a proper PE partner a 50% stake in 3-5 years will be worth more than their 100% stake without one. Also if a potential partner is reasonable with price expectations, it gives more comfort to PE investors, as it means that your partner is commercially pragmatic and will seek to achieve fair outcome for the business in dealing with suppliers and customers.
Fifth, try to avoid “cash-out” type of investments in situations where key shareholders are holding management positions – money in hands generally lead to complacency of Russian shareholders.
Sixth, if you trust the management team, do not micromanage: you will achieve little but do a lot of harm. However, not to be confused with undoubtful benefits of mid-course corrections and ongoing monitoring how efficient the management is by hiring “your” CFO or an internal controller with experience in relevant business processes.
PE targets and capital providers
Though the universe of potential investment targets is very broad, there is often one critical factor which makes good companies hard to access or be highly sensitive to deal with. Namely, their owners. This challenge is magnified by a factor of 10 in situations where owners are also key managers at the same time. In these cases the stumbling point could be, as discussed above, that price expectations may be excessive or there can be a gap in perception of the expected role of a private equity partner. An average Russian entrepreneur tends to view the investor as a free rider of his success, which he then naturally starts resisting. They simply do not fully understand the value that a quality partner can add to their business. This notwithstanding, the truth is that out of already too few active PE teams in Russia even fewer are experienced enough to add real value to the business they invest into. So both sides need to learn.
Comparing returns across emerging markets
According to EMPEA, which tracks 10-year returns for various regions, CEE and Russian region combined looks quite favourable if compared with other regions: 18.33% ten-year return versus 11.96% for emerging markets PE&VC, albeit slightly behind Western European PE index. Interestingly, if CEE countries are excluded, Russia & CIS return stand-alone increases notably to 23.83%. For full disclosure, it should be noted that Russia & CIS stats above are based on perhaps the only source of complete objective data for PE funds in the Russian region – the EBRD sponsored GPs which have a follow-on fund (not a one-off fund, i.e. a descriptive sample frame for the industry). Generally, Private Equity performance data in Russia, where the number of active PE funds is small and they rarely disclose returns, still has years ahead to go to be fully credible for international comparisons. Still, existing performance data is more than enough to clearly point out a notable gap in perception between attractive Russian region PE returns and Russia’s place vis-a-vis other emerging economies private equity investments being the most “unloved” market. One of the best illustrations of this point is fundraising dynamics over the last few years. The assumption here is that institutional investors, other things being equal, should continue funding the country that has the most attractive PE performance. However, based on the latest EMPEA report on Private Equity developments, the volume of fundraising in other BRIC countries demonstrated better dynamic than that in Russia, as is seen in the table below. Reasons for this may be the following:
• Long-term nature of Private Equity business. Significant amount of capital was raised in Russia in 2005- 2007 – over $3bn versus $0.5bn in three prior years and was deployed at rather high valuations. Investees then stumbled at problems during the 2008-2009 financial crisis and needed time to recover. Potential LPs now need to see actual success stories in existing pre-crisis portfolios, and are reluctant to make an allocation only based on projected returns of post-crisis investments. • General perception of Russia, especially among large international PE groups. At the moment only few known international houses are present in Russia - and those mostly nominally. Sour stories from the 1990s are still vividly remembered, though some market players, for example TPG, after all re-launched activity in Russia despite bumpy prior experience. In this respect the initiative of the Russian Government to launch Russian Direct Investment Fund (“RDIF”) looks very logical and should help Russia regain credibility in the eyes of top international PE fi rms. Indeed, one of primary purposes of RDIF is to become a transparent co-investment platform for international private equity investors. But this will require time. • Importance of prior track record for raising new funds. New teams face a tougher chance to succeed in fundraising, especially amidst ongoing financial turbulence in Europe and the USA, aggravated by cautious view on Russia. • Lack of long-term capital sources inside Russia allocated to private equity funds, mostly due to restricted existing regulation for domestic pension funds. However, recognising highly attractive investment opportunities in Russia, several local teams launched fundraising process in 2011 with a total volume of capital sought in excess of $1.5bn. Their experience in 2012 will be a good indicator of whether the belief in Russian private equity among institutional investors is starting to pick up. Another thing to point out here is the investment community’s expectation vis-a-vis any particular county. In terms of expected growth over the next five years, based on forecasts by EIU, Russia (with 4% CAGR in 2012-2016) is behind China and India, which are both around 8%, but is in line with Brazil and South Africa. This contrasts with funds that were raised in 2010-9M2011: $5.5bn for Brazil and less than $150mln for Russia, though Russian economy is just 25% smaller than that of Brazil. Total funds raised by BRICs for private equity sans Russia in 2010-9M2011 was$32.6bn, which shows that in principal there is a strong investor appetite for emerging markets, and that Russia too has a good chance for a slice of the pie, providing PE teams are able to show the ability to manage portfolios and deliver competitive returns over a 5-10 year period. For now, based on this rough top-down analysis, there is not too much to show, except for a few teams.
Global trends impact on PE opportunities and returns in RussiaOn the one hand, the amount of liquidity available for deployment into long-term risky assets, such as private equity, has no doubt decreased over the last few years and will likely continue to do so for some time. This makes competition for private equity allocations more intense. On the other hand, financial debacle makes the US and European markets less attractive in the mid-term, while investor appetite for high returns and emerging markets persists. Capital allocations to European and the US private equity funds over 9M2011 dropped by 70-75% from their 2008 dollar volumes. At the same time, emerging markets have not seen such a drastic loss of investments with 9M2011 fundraising volume shrinking only by 50% from the 2008 level. As was already mentioned, the volume of available capital allocations to compete for is significant ($32.3bn for 9M2011), while Russia at its peak in 2007 received only a modest $1.8bn in commitments, or just about 5% of what is in the pot today. Another effect that lower liquidity in Europe and the US may have on Russian companies is a more expensive leverage, but likewise it will have the same effect across other emerging markets as well. What is more important for Russia, if it wants to enhancement its competitive advantages, is to prove the ability to create internal growth drivers which are not predicated on natural resources only, as well as continue to improve its legal system. What is interesting, the crisis in Russia was actually to a certain extent good for PE funds with “dry powder” and not overleveraged portfolio companies. In the periods of financial turmoil, valuations generally go down and there is an opportunity to invest in quality companies at a discount to its normal market price. It is also logical that good deals are made in post-crisis periods when banks are busy with cleaning up their portfolios and fresh equity gives surviving companies a chance to turbo charge their success by taking competitors’ market share. According to IFC, in emerging markets it is better to count on growth and efficiency for PE investments rather than on leverage. Crises are also good as they “clean up” the economy of companies that are either inefficiently run or overleveraged. From this point of view, another good indicator for Russian PE funds to take into consideration when deciding on an investment into a potential investee company is to review how it weathered the recent economic crisis. In addition, the crisis widens potential investable universe of companies by decreasing their valuation expectations. Given that current Russian P/E multiples are on average 45% of their pre-crisis December 2007 levels, with the same ticket size per equity investment a mid-cap PE fund can acquire meaningful stakes in companies twice larger in size than the said ticket size would have them to before, owing to such companies reduced valuations.
Dealing with specific challenges of investing into Russian private equity
Probably key differential of investing in Russian private equity remains a limited number of teams that match potential LP requirements, specifically those of international institutional investors. Fingers on one hand are more than enough to count local funds that potential blue chip international LPs can consider, who would have a good and long enough track record of working as a team, and demonstrated through real deals their ability to select good targets and resolve difficulties in the portfolio when needed. However, as discussed above, historical returns of EBRD sponsored Russia & CIS PE funds are higher than the average return across all EBRD sponsored PE investments: 22.91% versus 17.56% respectively over ten years ending December 31, 2010. Performance of Russia & CIS PE “survivors”, i.e. those GPs that are expected to raise new funds, is even better: 23.83%, as shown in the table. This means that with the right partner in the Russian region an investor can really hit the jackpot. Another challenge is a lack of high quality local PE professionals in Russia which are essential to the success of a fund. Unfortunately there are not enough Russian individuals that understand the necessity of committing themselves to one company to unlock the benefits of working in a PE fund. This partially stems from the limited history of the Russian market economy itself, where there have not yet been enough success stories of PE teams and Russian entrepreneurs making fortunes and earning large carry over a mid-term period. Investment banks and investment holdings owned by one or several wealthy Russian individuals quite often offer better financial terms to staff than PE funds, while the carry philosophy, which is well-understood in more developed economies, is not yet shared in Russia (where a 10-year outlook typical for a PE fund’s life is too long a period to comprehend for PE professionals which then often change jobs). A few words also should be said about key peculiarities related to investing in Russian companies that a local GP faces.
First of all is that to succeed you need to have Russian high quality professionals in your team as they will facilitate the communication with entrepreneurs who are not used to PE specifics and increase significantly the probability of a deal.
Second is that the agreement with Russian entrepreneur should be reached in good faith on both sides. If you are trying to outsmart your potential partner assuming that he is less sophisticated financially, you will be eventually outwitted. And vice versa, if you have serious reasons to doubt credibility of your future partners’, whether in the dialogue with you or in reference to his prior partners, do not invest. He will let you down in a moment of crisis. Due diligence on your partners is no doubt one of the most crucial aspects of investing in Russia. Negotiation should be open and fair; both sides should have a healthy balance of give-take concessions to reach a win-win agreement.
Third, invest in teams that really impress you. It requires some time to understand in which way the team you are talking to is better than competitors, especially in a high context Russian environment, but never avoid this exercise as it is key to success. You can earn more with a good team in an industry which has moderate growth, than with a bad team in an actively expanding sector of economy.
Forth, negotiating valuation is in most cases extremely tough with Russian shareholders. The reason for that is once again relatively young age of the Russian market economy of only 20 years. This fact explains a lack of long-term view and understanding that with a proper PE partner a 50% stake in 3-5 years will be worth more than their 100% stake without one. Also if a potential partner is reasonable with price expectations, it gives more comfort to PE investors, as it means that your partner is commercially pragmatic and will seek to achieve fair outcome for the business in dealing with suppliers and customers.
Fifth, try to avoid “cash-out” type of investments in situations where key shareholders are holding management positions – money in hands generally lead to complacency of Russian shareholders.
Sixth, if you trust the management team, do not micromanage: you will achieve little but do a lot of harm. However, not to be confused with undoubtful benefits of mid-course corrections and ongoing monitoring how efficient the management is by hiring “your” CFO or an internal controller with experience in relevant business processes.
PE targets and capital providers
Though the universe of potential investment targets is very broad, there is often one critical factor which makes good companies hard to access or be highly sensitive to deal with. Namely, their owners. This challenge is magnified by a factor of 10 in situations where owners are also key managers at the same time. In these cases the stumbling point could be, as discussed above, that price expectations may be excessive or there can be a gap in perception of the expected role of a private equity partner. An average Russian entrepreneur tends to view the investor as a free rider of his success, which he then naturally starts resisting. They simply do not fully understand the value that a quality partner can add to their business. This notwithstanding, the truth is that out of already too few active PE teams in Russia even fewer are experienced enough to add real value to the business they invest into. So both sides need to learn.
Competition with other capital sources
Competition with other sources of capital indeed exists, but only to a limited extent. For portfolio companies, key alternatives to private equity capital are arguably very few: private capital sourced from one or several wealthy individuals, and investment arms of large local banks, or International Financial Institutions (“IFIs”). The first group, which essentially falls under the category of the so-called financial industrial holdings, mainly targets larger companies than the investable universe of interest to private equity funds, and such industrial and financial groups tend to take full operational control of the business and are generally inflexible compared to private equity capital.
We have recently seen an increasing activity from the second group of alternative capital - investment arms of local banks, but they will require time to streamline internal procedures, as there is not enough experience of value-added investing within these banks. However, the amount of deals financed by this group of investors has been growing, although such investors also generally have a longer term investment horizon compared to private equity and a lower target return profile. Combined with core lending business this is potentially a serious emerging competitor type for interdependent private equity funds in Russia. The way through which Russian PE managers could be competitive going forward is once again flexibility, speed of deal execution and strong relationships with IFIs and foreign lenders with cheaper and longer term lending capabilities compared to Russian banks. IFIs, such as EBRD or IFC, quite often tend to acquire minority stakes and be a passive investor rather than an active minority. The process with IFIs is generally much longer due to an institutionalized formal approach to every aspect of the deal. Private equity GP are generally more flexible and efficient in terms of deal closing. In Russia, IFIs are typically seen as partners and co-investors rather than competitors to PE funds.
By Dmitry Mikhalov, Associate director, UFG Private Equity
EMPEA Q3 2011 EM PE Industry Statistics (http://www.empea.net/Main-Menu-Category/EMPEA-Research/Industry-Statistics.aspx)
IFC, Emerging Market Equity: Private Equity, Public Equity, Risks & Opportunities (http://www.ifc.org/ifcext/cfn.nsf/AttachmentsByTitle/EM+Equity+World+Pension
s+Council+Feb+2012/$FILE/EME_World+Pensions+Council+February+9th+2012.pdf)
Economist intelligence Unit, 5-year forecast tables for China (as of 1 February 2012), South Africa (as of 24 January 2012), India (as of 1 February 2012),
Russia (as of 10 February 2012), Brazil (as of 1 February 2012)
EBRD, 2010 private equity funds results, http://www.ebrd.com/downloads/equity/ 2010_private_equity_funds_results_1.pdf
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BLOOMBERG # 1
UFG Russia Select Fund ranked in Bloomberg Emerging Markets Top-10 »
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UFG`S INVESTOR TRIP TO RUSSIA
UFG Asset Management hosted its 3nd annual Investor Trip to Russia, April 24-26, 2012 »
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UFG`S INVESTOR CONFERENCE CALL
UFG AM held investor conference call on April 4 to share market insights and detail recent portfolio moves with regard to the unfolding global debt crisis. »
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UFG AM & DEUTSCHE BANK
Deutsche Bank to increase stake in Deutsche UFG Capital Management to 100 per cent »
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UFG AM RATINGS FOR YEAR 2011
