During the last few weeks of 1995, equity traders in Moscow all but gave up on the slumping Russian stock market. Turnover volumes fell to a meagre $40 million a week, down from $100 million a day at the peak of stock market activity last June. Instead of quoting share prices, bored traders offered spreads on the share of the popular vote the Communist party might win in the country's parliamentary elections on December 17. Early in November, the pessimistic Russian and foreign bankers were quoting 33% to 35% for the Communists. By early December, the mood was better, as expectations for Communist successes fell to between 17% and 19%.
But hopes that the recent government reform policies would survive the elections failed to boost the stock market back to the high levels seen during August and September 1994 and the summer of 1995, when speculative foreign buyers rushed into stocks. Even the best-known Russian companies suffered dramatic declines in their share prices during the second half of last year.
LUKoil shares traded as high as $7.50 during the summer but fell to $3.80 by late November. Norilsk Nickel fell from $14 to $3.85, shares in vehicle company Kamaz fell from $6 to $3, Rostelekom fell from $7.45 to $4.10. Oil company Tomskneft fell from $10 to $3. And there have been other even more dramatic crashes, such as oil company Komineft from $24 to $2.20 and Surgutneftegas from $0.55 to $0.11. The Moscow Times index of leading shares rose from 100 in September 1994 to over 120 in October 1994, fell to 60 in May last year, rose again to over 90 in June, before falling back to 60 at the end of 1995.
Mid-December brought some relief. One Russian broker began buying up shares - in what the market saw as a concerted effort by a large foreign portfolio investor to buy in at the bottom of the market. Prices nudged up. Russian equity brokers hope other big western buyers will follow, attracted by Russia's improving economic fundamentals - monthly inflation down to 4% from 16% early last year, a stable rouble, and hard currency and gold reserves rebuilt to $12 billion from $1 billion a year ago. But politics - presidential elections are set for June - will make for a volatile stock market. "For the next two or three years, the Russian market is likely to perform in phases, with large movements up and down of 60% and more, and high volatility," predicts Henry Anstey, director at ING Barings.
Amidst all the gloom, it is worth remembering that Russian capital markets have developed with impressive speed. Some 50% to 60% of the economy has been transferred into private hands within the last two years. A stock market, capitalized at around $20 billion, has grown up, along with a professional brokers' association, a screen-based trading system, a securities and exchange commission, a shareholders' association, some independent share registries and plans for a national depository and clearing system.
Thin spreads, harder times
Ironically, these very successes spell trouble for some Russian brokers. They have a tough winter ahead of them and some may not survive it. Many have emerged in the last two years, and until recently they thrived by buying cheap vouchers and stocks in Russian regions from the workers of privatized industries and the public, and selling them at a profit in Moscow. But that business is played out. Volumes have fallen, spreads have narrowed as a result of improvements in stock market infrastructure, and some segments of the broking business have dried up completely. Last year, dealing spreads on shares in Russian blue-chip stocks - the 30 or so most actively traded names - were around 4% to 5%, while spreads in illiquid stocks of the more obscure companies ranged from 50% to 100%. Now spreads have contracted to 2% for blue chips and to between 25% to 40% for illiquid stocks.
In part, this reflects gradual improvements in the system for registering purchases and sales of shares, and settling trades. A year ago all trades were over the counter and could have taken from two weeks to one month to settle. Now 10% to 15% of trades are conducted via screens on the electronic Russian Trading System (RTS), bringing greater transparency to pricing. Two Moscow-based counterparties with all their documentation in order might settle a trade in one day.
To the intense frustration of larger brokers, stock-trading and settlement mechanisms have not yet improved sufficiently to attract large volumes of foreign money that would boost values.
Just as frustrating for the armies of foreign investment bankers who have regularly trekked to Moscow and points east over the last two years, the process of bringing Russian companies to the international markets has proved longer and slower than many of them at first hoped. "There won't be international public market transactions out of Russia for 12 months," warns Boris Jordan, president and chief executive of newly created Renaissance Capital and until last May co-head of Russian operations for CS First Boston, the most active international investment bank in the country. "There is no proper domestic market infrastructure, no audited financial statements from Russian companies and what's more, very little interest in compliance by the Russian corporate community."
But Russian companies are crying out for funding. Following privatization, many enjoyed a short period of grace when they thrived by avoiding taxes and using cheap energy. That situation could not last. This year and next, the new company owners will seek working capital and long-term funding from the capital markets. For those investment banks and brokers that can survive a little longer in Russia, the good times may be just ahead. "This winter will force numerous small brokerages to close down. Some larger ones will either merge or go bankrupt," predicts Jordan. "Even the strong Russian banks and brokers will not survive just from broking equity. They must either diversify or be bought."
That buyers will come forward - at least one large international investment bank is now debating whether to set up an office in Moscow or acquire a Russian broker - demonstrates the enduring allure of Russia despite the depressed state of the stock market. Another international investment bank recently planned the budget for its modest-sized Moscow office. It expects to earn at the very least $10 million in 1996 and maybe as much as $25 million, if markets are favourable. It hopes to make as much as $50 million in 1997, just three years after setting up.
It is easy to understand the allure. Russia has the lowest ratio of market capitalization to potential economic output of any large country. "People will make real killings in Russia," predicts Charles Harman, partner at MC Securities, the brokerage firm headed by Hans-Jörg Rudloff. "Russia is so cheap compared to other emerging markets, and investors that were not thinking about the country a year ago, now are." MC Securities spent three weeks last year marketing a Russian index fund. Attendances at roadshows - 120 investors in London, 75 in Paris, 160 at various stops in Switzerland - were reminiscent of a multi-billion dollar developed market privatization, not a small emerging market country fund.
Although capital markets business has been no more than a trickle, foreign investor interest is mounting. Bankers in Russia were particularly pleased by the reception given to a $22.5 million private placement of American depositary receipts (ADRs) representing shares in Moscow electricity utility Mosenergo, led by Salomon Brothers. Although small - the deal was restricted to the amount of its own shares Mosenergo held as treasury stock - the deal attracted large blue-chip international investors from Europe and America, including US mutual funds which are restricted in the markets they can invest in by the US Securities and Exchange Commission (SEC). According to John Parker, head of emerging market equity sales at Salomon Brothers in London: "One large American client bought ADRs for its $2 billion utility fund, not for its emerging markets funds. That's the goal. That's what we are after. So far, up to $2 billion of foreign money has been dedicated to Russia by hedge funds and specialist investors. If we continue only supplying stock to these investors, this will be a small business. Our aim is to access the hundreds of billions of dollars in general global equity funds."
Mosenergo is the type of company that isn't supposed to exist in Russia. It has a strong management, reasonably transparent financial statements, dependable earnings protected by regulated tariffs and very little debt. One or two investors offered to buy the whole Mosenergo deal. In the end, Salomon Brothers placed it with 10 to 20 different institutions.
Custodial safeguards
In designing the Mosenergo ADR structure, Bank of New York and Salomon Brothers added several features designed to protect international investors against registry risk. Others are modifying their approach. Chase Manhattan has worked harder than any foreign bank to solve this problem - by inspecting the registrars of leading Russian companies and signing performance contracts with several. That makes Chase the only subcustodian in Russia that the American SEC has approved for regulated mutual funds to use for direct investments in Russian shares. Other banks are following suit and writing modified versions of its contracts with
registrars.
For example, Chase undertook as one part of its contract to inform investors if it saw something untoward at a registrar. Bank of New York placed more responsibility on Mosenergo under the contract for its ADR issue. "The issuer has taken on certain responsibilities as to the performance of the registrar," says Christopher Kearns, assistant vice-president at Bank of New York. "It will not guarantee to cover losses arising from registrar risk, but if for example, we see that share purchases have not been registered, we will inform Mosenergo which will then put pressure on the registrar, which is Mosenergo's paid agent." That contract was enough for US law firm Skadden Arps to decide that the ADRs would be eligible for US mutual funds to buy.
Although small, the Mosenergo deal was ground-breaking. Most investment banks in Russia admit to wishing they, and not Salomon Brothers, had led it. In four months, the issuer produced a prospectus, which included a Russian audit worked over by KPMG and a description of the company's operations, plant, bad-debt allowances - designed to enable investors to compare it with utilities in other emerging and developed countries. "We showed that, with the right structure and disclosure from a good company, it is possible to generate significant demand for Russian stock," says James Dannis, managing director for Russia and CIS at Salomon Brothers in Moscow. He estimates there was $60 million of demand for the issue.
Martin Andersson, director of Moscow-based brokerage Brunswick, says: "Until eight or nine months ago, no-one had heard of Mosenergo. Now it's a blue chip. If you look beyond the big natural-resource companies, there are exciting opportunities in pulp and paper, shipping, regional phone companies and utilities. The challenge is to identify the small handful of potential winners in each sector. Because any company now with good management that can raise some finance has a fantastic chance to establish strong market share."
Still, Mosenergo was not a routine sell. At a roadshow in Boston, one American fund manager asked Mosenergo's president, Nestor Serebryanikov, what the biggest risk of investing in his company was. He replied: "The biggest risk is that you will lose everything." Political uncertainty, even more than problems of stock market infrastructure, weighs heavily on share prices - especially after a year when American investors could have scored 30% returns at home. The Mosenergo deal was priced at $30 - the bottom end of its indicated range - despite the strong interest. Its share price has since fallen back to $27.
LUKoil's $320 million convertible bond, the only other large international placement from Russia last year, was something of a disappointment. American oil company Atlantic Richfield bought $250 million, and without its participation the deal would not have worked. Institutional investors took up just $70 million of bonds, not the $145 million originally sought. The terms and structure were partly responsible for this disappointing reception. Bonds were zero-coupon and mandatorily convertible into equity this April at a price of just over $6. In early December, LUKoil shares traded at around $4. The convertibles do not offer investors a current coupon - the traditional downside protection of a convertible bond. They are more a forward investment in LUKoil's equity.
The deal shows that investors still harbour reservations about Russia. "High-risk foreign capital has been in Russia for two years and so far has made zero returns," says Jordan. "The interest of the international community is limited. People have talked a lot about cheap values. We, as Russian investment bankers, now have to prove the point by realizing investments for our clients and showing them real gains."
Wall Street beckons
This year the level of interest among international investors, beyond the 50 or so hedge funds and specialists already active, will be tested. The shares of more Russian companies will begin trading in ADR form. Last September, the American SEC announced it was sufficiently comfortable with the workings of the Russian market to consider filings for Level I ADRs from Russian companies. Both Bank of New York and Citibank have secured mandates from several Russian companies to set up ADR programmes. LUKoil's should be operational from the beginning of this year. According to its agent, the Bank of New York, LUKoil's final application was delayed only by a compulsory waiting period of 40 days following the company's sale of convertible bonds. Other ADR programmes are likely to follow soon, for long-distance and international telephone company Rostelecom, oil company Chernogorneft, energy company United Energy Systems and department store GUM. A handful of companies may follow Mosenergo and attempt to raise funds through private placements of ADRs with 144A investors. Most though - perhaps as many as 10 - will opt for Level I programmes during the first half of the year.
In theory, these should be a first step for Russian companies to open themselves up to foreign investment, and should lead the way to more substantial fund-raising through international equity issues beginning perhaps as soon as late 1996, but more likely during the first half of 1997. "These very large companies need so much money - billions of dollars each over a number of years - that they have to make a start on mechanisms for raising that," says Stephen Marquadt, director at Merrill Lynch, which is advising Rostelecom. "If we could raise $1 billion for Rostelecom tomorrow, they could use it productively."
Russia is likely to launch a Eurobond next year and some large Russian companies will follow suit. But it will be tough for credit analysts at bond investors to work through their balance sheets. Most of these billions will have to come from equity investment. "The capitalization of the Russian equity market will be larger than all the markets in Latin America within five years time," Marquadt predicts. The process of preparing for an ADR programme should help Russian companies to understand the information foreign investors require and to develop their own internal models for projecting earnings and capital requirements.
Level I programmes are the simplest form of ADR. They allow for over-the-counter trading in receipts. They do not require additional financial reporting to international accounting standards (IAS), nor do they raise capital for the companies. Some bankers in Moscow question whether, amid considerable excitement at the prospect of ADRs, Russian companies have fully understood these limitations. "I think there is considerable confusion among Russian companies. And there will be some disappointment when they find that these instruments do not raise capital nor double their share price overnight," says Dannis at Salomon Brothers. "Few Russian companies have worked out what it takes to create an active secondary market in their shares. I think we will see some ADR programmes begin with no roadshow, no disclosure of information by management and they will be unsuccessful. Because confidence in the Russian market is so fragile, that could look bad for the whole market."
Even if ADRs enable previously excluded foreign investors to buy Russian stocks, there are other issues beyond technical ones that outside investors want to see addressed. If investors were fixated on registry fraud in 1994, this year they will increasingly look at the broader question of corporate governance - who runs Russian companies, for what motives and according to what controls. There are some startling differences in approach. LUKoil is generally portrayed as one of the more attractive investments in Russia. Charles Ryan director at United Financial Group (UFG), a Moscow-based broker with links to Paribas, says: "LUKoil's management consolidated their power at the company quite early on after privatization. Now they are very concerned with building a major oil company, expanding their networks, participating in international consortia. As part of that, they have a very clever capital markets strategy, bringing in a foreign bank to run the registry. They hope to increase the transparency of the registry and so increase the value of their shares."
A rule of thumb in identifying Russian companies which are beginning to be run for shareholder benefit is to look at those compnies which have appointed western auditors to prepare IAS audits. Companies will need to file these for three years before they can launch public international equity deals that are listed on a reputable stock exchange. The first listing of a Russian stock in New York or London will be the sign that Russia has been accepted by international investors. One investment banker recalls a recent call from an obscure manufacturing company in Siberia announcing that it wanted to list on New York the following month. In fact, it is unlikely that any Russian company will do so before mid-1997.
It is the increasingly familiar names which have armies of western accountants working through their books: LUKoil, Rostelecom, truck manufacturer Kamaz, Purneftegaz, energy company RAO UES, Yugansneftegas, Mosenergo, Irkutskenergo, Komineft, Megionneftegas, Chernogorneftegas, Kondpetroleum. It's a painstaking process. According to Kenneth Crawford, head of KPMG's more than 400-strong practice in Russia: "Even though the chief accountant of a Soviet factory was personally responsible if so much as a pencil went missing, it's unsafe to think you can take an old Russian balance sheet, make a few key adjustments and produce an international-standard balance sheet. A few of the old source documents may be useful, but it is almost better to go in and construct anew. "
The struggle for stakes
Many Russian companies are not ready for this process. They are still caught up in a scramble for control of their assets. Powerful interests including politicians, company managers and Russian banks have no desire to take actions which will drive share prices up. They are too busy fighting to win control of those shares as cheaply as possible. If anything, they want to drive prices down. Cynical brokers in Moscow were not too surprised when news of a large previously undisclosed tax liability at oil giant Yukos leaked out, just two weeks before the completion of its highly controversial loans-for-shares and investment tender privatization deals. They will likely see Menatep Bank emerge with control over a large stake in oil company Yukos from a bid widely thought to be supported by Yukos management. Menatep Bank is also agent for the auction. Clearly, it did not want to overpay for shares.
An investment banker in Russia reports that his firm won two mandates for large convertible bonds last year. These are a sensible vehicle for companies to raise capital. Scarcely any Russian company will have three years of IAS accounts before the middle of next year. A good way to raise funds would be to sell bonds now with a reasonable coupon, convertible into equity after mid-1997. A strong Russian company might command reasonable terms - despite the prevailing gloom in the stock market - if investors think that the company will have good financial reports by 1997 and that the whole infrastructure of the Russian market will continue to improve. But the deals never got off the ground. Why? "Various interested parties did not want convertibles with high premiums because they thought this might set a new high floor for the share prices."
Brokers contrast the situation at LUKoil with that at Yukos and at Sidanko, another oil company. In December, 51% of Sidanko's shares were due to be auctioned under the government's loans-for-shares scheme. Sidanko has plentiful reserves but its production sites and refineries are widely dispersed and need substantial investment. Management is described as weak by many brokers. Banks winning control of a 51% block might dominate the company and even fire many of its managers. But only after one group consolidates control will Sidanko, and other Russian companies like it, be run for the benefit of shareholders.
That will be the theme for later in 1996 and 1997 among Russian companies which have state holdings that are falling below 50%. Companies will start to sell assets, consolidate, merge, lay people off. But until the scramble for control is over, "in Moscow, the concept of portfolio investment has little impact", says Harman at MC Securities. "Russians buy to control assets, not to take a portfolio view on companies' potential long-term earnings growth." And when Russian companies do open up to outside investors and try to raise capital, they will be looking for portfolio investment in minority holdings. They will not wish to concede control.
Covering many of these companies during the battle for control is a difficult task for foreign brokers. Few Russian companies are open about their results, their profitability, even what other companies they own, for fear of being hit with high tax demands from the government. They often lie. One Russian securities analyst proffers a report on a Russian shipping company: "Treat this as a draft," he warns. "There are one or two points we are not clear on. Particularly, we don't know who owns this company."
Research means relationships
The whole process of conducting research on Russian companies is much more akin to classic corporate finance activity in any other country. "Clearly, just putting investors into one blue chip or another is no way to succeed," says Christopher Van Riet, associate director at Russian broker Alliance Menatep. "Most brokerage houses have their pet projects." These start with research reports on companies and hopefully develop into private placements or even public deals. Alliance Menatep for example is working with regional telephone company Irkutsk Electrosviaz. Alliance Menatep points out that the company has achieved both volume and margin growth in the last 18 months by focusing on long-distance and international traffic. It pitches the company as the "Russian baby Bell of choice" which is positioning itself eventually to circumvent Rostelecom's strong position in these most profitable sectors.
To date, the stock is thinly-traded, with a free float of 22% and just 5% in western hands. To researchers like Van Riet, it's an example of the strong company stories that lie beyond the more obvious oil and gas giants. Clearly, Alliance Menatep hopes to be involved in financing the company's future investment in modernization - perhaps in partnership with an international investment bank. But the firm has to work hard at its relationship. Other brokers have noticed Irkutsk and are pitching services to it. And the Russian brokers remember that while Brunswick had a close relationship with Mosenergo, Salomon Brothers led its landmark international placement.
"You need to talk to the company every day and remind them that they are important," says Van Riet. "And people at the firm have to remember that the company is the customer." Research is of doubtful value, in any case, to investors. Foreign liquidity is more likely to drive prices than company fundamentals. One broker recalls discovering that a large Russian oil company was about to make a dilutive new share issue to finance a buy-out of part of the company from the state. The broker told investors this was bad news and that the share price should fall. Instead, it rocketed because two country funds had just closed and had begun buying any blocks of stock in large Russian companies they could find.
Many research reports are directed at developing relationships with Russian companies rather than being primarily investor-driven. Brokers continue to produce research because it provides an introduction to company managers. Many company managers own substantial blocks of shares in their companies, which they acquired for next to nothing. Brokers will explain that by producing research, and familiarizing foreign investors with the company, they are beginning a process which might raise the share price and make managers extremely wealthy. Brokers also hope that companies will turn to them to lead new issues in the future. Harman says: "There is an enormous amount of potential business in Russia. Most companies want money. And investment banking relationships with these companies are up for grabs." It's a thought with which investment bankers in Russia will console themselves during the bleak winter months.
Beyond bread and butter
For now, some Russian companies are financing themselves through small private placements of equity, with foreign institutions included. These deals may be as small as $10 million. They provide bread-and-butter business for new Russian investment banks like Renaissance, which has just closed a small placement for restaurant chain Rosinter and is working on a few others. These deals enable banks to begin relationships with what they hope will be the giants of the Russian market in a few years - and to make some money - until the big deals start flowing in earnest.
That should happen before long. "I can scarcely think of a single Russian company with sufficient working capital, let alone enough development capital for the big projects like new factories and oil fields," says Andrew Cowley, managing director at United City Bank in Moscow. "Eventually, the banks and other new owners will have to begin financing these companies."
The key to future progress with this huge task may lie in the development of local markets even more than it does with ADRs and foreign investors. The often quoted figure for Russian flight capital is $43 billion. Half of that is the foreign-currency earnings of large Russian exporters held legitimately in foreign banks. But the other half might slowly flow back into investments in Russian companies. One foreign banker recalls taking a recent flight from Moscow to a meeting in Geneva. The plane was packed with Russians. "They know what the risks and returns are here in Russia, and now they have a couple of years of experience of returns at Swiss banks. I imagine many wealthy Russians have been shocked by that experience."
Russia boasts a high savings rate. Its insurance companies are growing fast, although for the moment they are putting most of their funds into high-yielding government bonds rather than equities. Scandals like the MMM pyramid scheme may have put many small investors off investment funds but some banks are exploring ideas to create domestic mutual funds. "In the end," says Cowley, "Russia will have Russian capital markets, not Anglo-Saxon or German ones." Perhaps the strongest signal that these markets will develop is the much criticized loans-for-shares deals. "It is enormously encouraging that, for the first time, Russian investors are putting up large amounts of cash," says Jordan. "Once they have risk capital at stake, they will be forced to restructure those assets to push values up. They will have to put proper controls in place to attract new money so that they can get their own capital out."
Towards safer custody
The doubtful status and performance of Russian share registrars has been one of the greatest obstacles to foreign investment in Russian companies. The only legal proof of an investor's ownership of shares in a Russian company is the physical book entry of its name in the registrar's computer records. Many companies run their own share registries. Investors fear that, because many Russian company managers dislike the influence of outside shareholders, unscrupulous managers might simply erase the names of unwanted investors from their registers, leaving investors with little hope of redress.
In fact, there have been few instances of such criminal behaviour in the last year. All brokers and bankers in Moscow claim that the problem is overstated and has not been a big concern since the early days of the Russian stock market in 1994. Recent market regulations introduced by the Russian SEC insist that large Russian companies - with over 1,000 shareholders - hand over their registers to independent companies, and several thousand registrars now operate within banks' brokerages and as specialist companies around Russia.
Bank of New York has invested along with IFC, EBRD, the Russian bank Oneximbank and Nikoil, the share registrar for LUKoil, in an ambitious venture - the National Registry Company (NRC). This is intended to become a share registrar for many of Russia's largest and best-known companies. But progress has been slow. Since it set up last August, NRC has attracted no new Russian clients to LUKoil.
Foreign investors' doubts are not entirely resolved. The Russian SEC is good at producing regulations but has almost no capacity to enforce them or penalize recalcitrant companies. Many have indeed moved their share registries - but only, it turns out, to separate but wholly owned subsidiaries either in a Moscow office or at the parent company's own headquarters. Chase Manhattan has made the most progress in Russia through this minefield. Its Moscow branch acts as subcustodian and de facto supervisor of Russian registrars for the Templeton Russia Fund. Chase entered into contracts with several registrars, which have agreed to maintain specified levels of service, to submit to monitoring by Chase and to recognize procedures for making claims for compensation for losses resulting from lapses at the registrar.
Armed with these contracts, Chase was granted status as an eligible subcustodian under the American SEC's rule 17f-5. That makes the Templeton Russia Fund the first American mutual fund allowed to invest directly in Russian securities. Peter Zorn, who ran Chase's custody operation in Russia for several months before returning to London to oversee all the bank's custody efforts in Russia and central Europe, says: "While there is still no functioning centralized registry or depository, we are seeing some consolidation in the regions whereby, for example, a number of issuers might move their registries to a local bank or independent firm. It's quite a positive step for these companies to understand the need for more standard registry procedures. And there is some comfort for investors. Often these do employ decent systems with an adequate audit trail."
But suspicions linger. Investors wonder, for example, just how sophisticated independent registrars are at backing up their systems. Many are small companies with few assets to press claims against, if investors suffer losses as a result of accident or incompetence. As one foreign banker admits: "You could end up suing just two or three people and a PC."
So far, Chase Manhattan is the only 17f-5 eligible subcustodian in Russia. This is a valuable service which it will only provide to a select list of existing US and international investing clients. Other banks and brokers are examining different solutions to the registry problem. Some banks, such as Credit Suisse, ING and Citibank, hope to follow Chase Manhattan's lead.
