An easy story to sell

A SUPPLEMENT TO EUROMONEY – APRIL 1997

The Russian story should be an easy one to sell to international equity investors. Russian blue chips ­ such as oil producer Lukoil, natural gas producer Gazprom and national long-distance telephone company Rostelecom ­ are perhaps not yet household names. But they are already well known in the investment community. The Russian natural resource sector, featuring companies with vast reserves and low valuations, has become an investment byword for bargain. Even infrastructure companies appear attractive, with brokers pointing out how undervalued telecoms companies are compared with their counterparts in other emerging markets. It is all the more surprising then that there have been so few successful international equity offerings from Russia.

Privatization in Russia, though undertaken on a vast scale, has not been synonymous with capital-raising ­ only now are companies seriously looking to the international markets for funding. The planned-economy mentality ­ always being able to rely on the government for more money ­ is finally breaking down and companies are realizing that they have to raise money.

But it takes time to prepare international issues. The consensus among bankers in Moscow is that it will take at least until 1998 for companies to raise equity capital in the international markets on a significant scale. “I think you’re going to see some offerings in 1997,” says Alan Apter, managing director at Renaissance Capital, “but the real flood will be in 1998.”

One of the main factors determining the time-scale is the mundane issue of accounting, according to Andrew Balgarnie, vice-president at Morgan Stanley. Apter adds: “More and more companies have realized that to raise fresh capital successfully in the international markets, they’ve got to play by the rules of the game. That means transparency: audited financial statements, either US Gaap or IAS.”

Unfortunately, even with properly audited accounts not every Russian company will be able to come to market. Privatization and equity issuance in Russia has, from the start, been influenced as much by political objectives as economic ones. The mass privatization programme was engineered to hand out Russia’s assets to the people, not to raise much-needed capital. More recently, the controversial loans-for-shares scheme ­ whereby banks with close connections to the government were able to snap up Russian companies for a fraction of their value ­ also raised questions about the government’s priorities.

Add to that, confusion over the best way to proceed to raise capital, and equity issuance is reduced to a snail’s pace. Take the case of Svyazinvest, the holding company that controls Russia’s local telecom companies, including Rostelecom. Should it come to market this year, it could be the “biggest and hottest deal to come out of Russia”, one banker predicts.

But, judging from past attempts to raise capital for Svyazinvest, not all deals get off the ground. According to one banker who advised the government on the sale of its stake in Svyazinvest: “The government kept changing its mind about what it wanted to do and how it wanted to approach it.”

Initially, selling the stake to a strategic investor, an international telecoms company, was favoured. This proposal was then dropped and the possibility of raising money in the international capital markets, through a pre-IPO convertible, was seriously considered. But according to the adviser: “The government thought, well ­ should we really be giving this company to foreigners? ­ why don’t we let Russian financial institutions have the first go?” This too came to nothing as the government was unwilling to sell its stake at the price Russian banks were willing to offer. “So now it’s up in the air again,” says the banker. He predicts that “something will happen” this year.

Similar confusion surrounds companies in which the government holds stakes. In February, it said it would resume its privatization programme, selling stakes in a number of companies, including Unified Energy Systems (UES), the holding company that controls many local electricity utilities. But uncertainty about government strategy meant the announcement was virtually ignored. Bankers were already disillusioned by the government’s sale of an 8.5% stake to a group of Russian banks last December. “It was sold in a very Russian way ­ a closed auction, and the pricing achieved as a result of this was sub-optimum,” notes a banker.

The government’s mixed objectives are not the only issues complicating Russian share issues. What companies can and can’t do is confused further by the privatization law. It bars companies that have a significant government stake from raising new equity within a specified period of time ­ or until the government stake is below 10%. Alex Knaster, head of Credit Suisse First Boston in Moscow, says that this precludes share issues from some of the most interesting companies, including UES and Rostelecom.

A further complication is the tension between holding companies and the companies they control. Telecom companies, controlled by Svyazinvest, and local electricity utilities (the energos), controlled by UES, are some of the most actively traded stocks in the Russian market. In principle these are extremely suitable for international equity offerings.

Two companies in these sectors ­ Moscow power utility Mosenergo and Moscow telephone provider MGTS ­ have appointed advisers for Eurobond issues. However, ownership complications have made it impossible for them to issue equity. Holding companies have proved extremely reluctant to allow the companies they control to issue equity independently.

Investment bankers are also concerned about long-term factors that could affect international capital markets issuance by Russian entities. These include the non-payments crisis in Russian industry: a large proportion of revenues, if paid at all, are paid in kind rather than cash. By far the biggest worry, however, is the heavy taxation burden on Russian enterprises. Athough basic Russian taxes look reasonable, a large number and variety of additional imposts make effective rates extremely high. This affects dividend payouts and other benefits that might accrue to shareholders. Worse still, it also creates a tension between investors’ needs for transparency and full disclosure and companies’ desire to keep their activities secret to avoid scrutiny by the tax authorities.

Although the head of a major investment bank’s Moscow office confidently predicts that there will be no equity issues from Russia in 1997 because of the problems outlined above, possible exceptions include Lukoil. Bankers say the oil company is likely to be in the market again later this year with a substantial offering raised as a level-three American depositary receipt (ADR). Some 15% of the company may be up for sale in a deal that would be worth well over $1 billion at current market prices. The company was in the market as early as 1995 with a mandatory convertible issue worth some $346 million, although this was placed largely with a strategic investor rather than portfolio investors.

Looking further ahead, some of the other newly created oil holding companies ­ the vertically integrated companies (VICs) ­ also have considerable freedom in issuing new equity. Although several are not currently actively traded in the domestic market they could become among the largest companies in Russia by market capitalization.

Vladimir Kuznetsov, general director of Salomon Brothers in Moscow, predicts that issues for two of these companies, Surgutneftegas and Yukos, majority owned by a group of Russian financial institutions, “will be the largest transactions coming out of Russia over the next two years”.

Bankers are also keen to see Gazprom in the market again ­ though the company’s distinction between domestic and foreign investor shares was putting pressure on its ADR price in March and is a problem that may need to be addressed. The foreign share price is some four times the domestic price and foreign investors have understandably tried to buy shares domestically, playing on a lack of clarity about whether this is allowed.

Last year, Gazprom placed 1.15% of its shares with international investors, raising some $429 million. Bankers expect another deal, as the company is entitled to sell up to 9% of its shares overseas.

Investment bankers suggest that despite a shortage of supply international investors have taken an increased interest in Russian equities since Gazprom’s offering last year. According to Salomon’s Kuznetsov, it raised awareness that “there are major Russian companies that can come to market, achieve very good valuations, raise hundreds of millions of dollars in equity and reach not only hedge funds and speculative investors, but a wide group of equity funds”.

Apter at Renaissance, which did the Vimpelcom deal immediately after Gazprom came to market, agrees that the investor base for Russian issues has broadened out from hedge funds and specialist Russia funds. In the case of Vimpelcom, sector funds and growth funds also participated. “It’s been very clear, particularly this year, that finally the broader, global emerging market funds are starting to have an asset allocation in their portfolio for Russia,” Apter adds.

Russian companies that are making their shares more accessible to international buyers by setting up level-one ADR programmes are the ones most likely to go for greater equity exposure. “By doing roadshows, by getting brokerage houses to put out research and act as informal sponsors, companies set the stage for future capital-raising,” says Apter. “Once you’ve got some familiarity and interest built up, it’s a lot easier to sell… A number of companies that have done the level one have done so to set the stage so ­ once they’re ready for more transparent disclosure and financial statements ­ [they can] raise capital.”

Eight companies ­ Gazprom, Lukoil, Surgutneftegaz, Tatneft and Chernogorneft in the oil and gas sector; utility Mosenergo; department store GUM; and Seversky Tube ­ have already set up ADR programmes.

Bankers expect 10 to 20 more ADRs to be put in place over the next year or so. “There’s a huge pipeline,” says one banker. According to a recent Salomon Brothers report, companies planning to do ADRs this year include Megionneftegaz and Purneftegaz in the oil and gas sector, utilities UES and Irkutskenergo, and Rostelecom. A number of Russian banks are also expected to set up programmes for the first time this year.