Last month, Russian president Boris Yeltsin sacked deputy prime minister and leading reformer Anatoly Chubais. The immediate dispute was over Chubais’s rigorous approach to macroeconomic stabilization: the project to which he and his aides have devoted themselves in recent months. But Chubais’s greater legacy to Russia is the privatization programme he masterminded, one of the largest and most controversial anywhere in the world. Arguments over its merits and faults will run and run.
If volume were the only measure of success, Russia’s reformers would have a record to be proud of – they privatized 15,000 small and medium-sized enterprises in two years from mid-1992 to mid-1994 before turning their attention to larger companies last year. But those deals have generally raised no money for the companies and precious little for the state. They have simply transferred ownership from the state to a shadowy group of new owners: old company managers, banks and Russian entrepreneurs. “The first stage of the privatization process was never intended to raise money. It was a legal form of bribery, designed to involve everyone from company managers to the general public,” says Roger Gale, resident representative of the IFC in Moscow.
Whether new owners prove as adept at running companies as at acquiring them will determine the success or failure of the whole Russian privatization programme. The early signs are mixed.
The process bred cynicism. In many cases, large blocks of shares were sold to new owners through investment tenders. Rather than paying a purchase price, they promised to invest large sums in improving the companies over the years to come. But these new owners have been slow to deliver on their promises, and there is no mechanism for taking companies back from owners which renege on their agreements.
A drawback of the privatization process was its administration by local state committees. These took a rather Soviet-style approach. “They were mostly interested in figures, in the numbers of companies being privatized and whether they were meeting their quotas. They did not even consider that new owners might not make the promised investments. They just assumed the system would work properly,” says Andrey Kosogov, chairman of Alfa Capital, a Russian investment group. “Most did not realize that the purpose of these economic reforms was to make companies perform better.”
Often it is unclear who now owns even some quite large companies. “That’s more than a little worrying,” concedes Maxim Boycko, chief executive officer at the Russian privatization centre. “It’s one of the valid criticisms of privatization in Russia. It’s unclear where the pressure will come from to restructure these companies and make them competitive.” But he defends the process. “These companies were highly politicized. Difficult compromises had to be made in order for companies to be sold in the mass privatization.”
Wrong people
Many company managers are secretive about and protective of their newly won shareholdings in companies where they have worked for years. That’s not surprising. One day those holdings may make them fabulously rich. But the prominence of long-serving managers is not usually to the companies’ advantage, says Martin Andersson, president at brokerage Brunswick. “In some cases, incumbent managers are not the best people to run and own these companies,” he says. “The best privatizations are those which have enabled outsiders to come in and to force changes.” Andersson estimates that around 20% of Russian company directors have been fired or replaced since privatization began in earnest in 1993.
But what credentials do these outsiders boast? Many Russian entrepeneurs began their careers trading computers in the early 1990s before moving into raw materials and then amassing industrial assets. Some might call them criminals. “They could scarcely operate in Russia today without ignoring certain regulations and even breaking some laws,” says one foreign banker. “And they may occasionally use strong-arm tactics. But what is important is that they will be real owners of these assets. They have money. Now they want to change, to become respectable.”
Other owners are also keeping their heads down. Russian banks own more industrial companies than is widely recognized, a result of the country’s unusual credit situation. “Credit is very tight,” points out Andrew Cowley, managing director at United City Bank. “There is very little bank lending at a time when many companies are desperate for working capital. Instead of making six-month or 12-month loans to companies, many banks have been making great returns in GKOs [government treasury bills]. If they like a company enough to lend to it, many bankers think they might just as well buy the company.”
Many Russian banks are fronts for trading operations. Their growing power suggests that these banks, or the groups behind them, may eventually control a large part of the economy. The heads of many Russian banks are Jewish and, in a country with a history of periodic outbursts of anti-semitism, they may be wary of a hue and cry that they have bought up Russia’s best companies on the cheap. But they could not avoid publicity during the latest round of large company privatizations.
At the end of last year, the Russian privatization programme descended into a series of dubious insider deals, with banks at the centre, as reformers finally grappled with the country’s huge natural-resource companies. Desperate to begin the privatization before December’s elections brought in a more conservative Duma, worried by the depressed state of the Russian stock market and still keen to raise some proceeds for the state budget, the government resorted to the now notorious loans-for-shares technique.
Under this system, Russian banks lend the government money and are granted shares in large companies as security. If the loans are not repaid this September, the banks will gain full control of the shares. They can then sell them, returning 70% of profits to the state and retaining 30%. If the banks do retain the shares after September 1996, they then have until December 1998 to dispose of them or ownership reverts to the state. These onward sales should be open, transparent and competitive. Meanwhile the banks have enough power over the companies to sack managers, but not enough to restructure them fundamentally by selling off factories and divisions, issuing new shares or raising large loans.
The structure of the scheme meant that foreigners were prevented from bidding for stakes in Russia’s large oil companies, which control vast reserves. However, foreign money has played some part in the programme, for example, through the asset-management arms of Russian brokerage firms. It is also widely rumoured that foreign finance has stood behind several Russian bidders in loans for shares and that the foreigners involved are waiting in the wings to buy blocks of shares, perhaps after Russian banks sell them on to affiliates or partners acting as intermediaries.
No-one in Russia expects the government to repay the loans. The programme was set up to look like an auction, with banks bidding for shares, not lending against collateral. Nor is it expected that all Russian banks will rush into disposals after September. Rather, observers speculate that the foundations are being laid for a number of financial and industrial groups to emerge in Russia. The banks may only appear to dispose of the shares, perhaps to partners or affiliates, while still retaining their interests. If the firstloans-for-shares deals are any guide, the subsequent onward sales will be anything but transparent, open and competitive.
Russian bankers like to compare themselves with the German banks which built portfolios of strategic investments in large industrial companies after World War II. Officials of Uneximbank, whose strong growth and dynamic management make it one of the few new Russian banks to impress western financiers, often say it will become Russia’s Deutsche Bank. A spokesman for Uneximbank claims that it was the first to suggest the loans-for-shares scheme, last April.
In November, Uneximbank won control of 38% of the shares of Norilsk Nickel, one of the world’s largest nickel producers and a great prize in the loans-for-shares programme. A minimum bid was set of $170 million to be lent to the government in return for trust ownership over the shares. Uneximbank organized the auction, which it duly won with a bid of $170.1 million. A competing bid of $350 million from another Russian bank, Rossiisky Kredit, was disqualified on technical grounds. Doubts were raised over whether Rossiisky Kredit had sufficient cash to make the bid.
Power game
Even more doubts were raised about the whole process. “It was a total inside job,” says one western investment banker in Moscow. “Bids had to be presented at Norilsk Nickel and the company even threatened to close the factory gates if a rival investor group showed up. That really turns people off.”
Although Uneximbank technically holds these shares for nine months as a guarantee for its loan to the government, bank officials and company management met in December to thrash out a three-year strategic business and investment plan. Uneximbank hopes to bring up to $1 billion of Russian and foreign investment into the company.
Norilsk Nickel was the subject of the second loans-for-shares deal. The first, for 40% of Surgutneftegas, Russia’s third-largest oil company, was equally dubious. The winner of the stake was the company’s own pension fund. “Surgutneftegas now seems to be owned indirectly by management and this creates a problem,” says Boycko. Russian privatization is often described as a raw game of power. Power over Surgutneftegas now appears to rest in the hands of its senior manager, Vladimir Bogdanov who, unlike many Russian oil barons, is rarely seen in Moscow, preferring to remain in far-off Surgut running a successful oil company. No-one knows for sure how profitable it is and Bogdanov has offered no encouragement to outside investors until now. But one of his first acts after consolidating control was to sound out the Bank of New York about the possibility of setting up an ADR programme. Maybe he is thinking of pushing up the share price and realizing some of his paper wealth.
Bidding challenge
More controversy followed when, to no-one’s surprise, Bank Menatep won a combined loans-for-shares and investment-tender bid for 78% of the shares in Yukos, the country’s second-largest oil company, in an auction which Menatep organized itself. Yukos management supported Menatep’s bid which was publicly denounced by other Russian banks including Rossiisky Kredit, Inkombank and Alfa Bank.
To be valid, a loans-for-shares auction required at least two bidders. Finding a rival bidder so that this requirement could be fulfilled often became a tough challenge for a major participant. To qualify, bidders had to deposit the entire bid amount, free of interest, with the finance ministry one month before the auction. This often ran to many millions of dollars – $500 million in the case of Yukos. That meant withdrawing money from the high-yielding GKO market, which has provided 100% dollar returns. Few banks cared to forgo such rewards to take part in auctions that were almost certainly going to be rigged. Likely winning bidders sometimes had to prompt their own affiliate companies to bid in order to give an appearance of true competition.
Few foreign investment bankers have a kind word to say about the conduct of the loans-for-shares programme. But controversies over individual auctions are already fading. Now potential investors are more interested in how the banks will influence and manage the companies that have fallen under their control. There are plenty of sceptics. “Unexim and Menatep managers are busy running their banks, never mind being venture capitalists – changing company managers, finding new markets and so on,” says Stephen Marquardt, director at Merrill Lynch. Yet he does see some role for the banks. “Maybe they can act as in-house financial advisers for these companies, which need so much money.” A Russian sovereign Eurobond is likely in the first half of this year. Some of the larger Russian companies, arguably better credit risks than the state itself, might follow.
Another opportunity for the banks will be to take any cash in hand at the companies and invest it, for example, in the high-yielding GKO market. Banks have become eager for any outside source of funds since the near-collapse of the interbank funding market last year. If they can redirect companies’ cashflows through their own accounts this will leave them less dependent on the interbank market. Even just acting as sole third-party suppliers of banking services to very large companies should net them some profits. “They love this idea of being compared to Deutsche Bank,” says one foreign banker, “but really they haven’t the first idea about managing oil companies.”
One positive thing about the loans-for-shares scheme, say foreign bankers, is that it sends a buy signal for Russia. Domestic investors are buying assets with real money. “Loans for shares has been a rather obscure scheme,” says Brunswick’s Andersson, “but I don’t see how the banks can be worse owners than the government. Their interest should be enhancing the value of these companies, not stealing from them. Even though the process has been somewhat strange, we may look back in two years and judge it a good way to get these assets out of government control.” He adds: “Many of the people who amassed assets in 1993 to 1995 are now restructuring them, developing new functions, like marketing, distribution and finance.”
A similar revolution can be detected at some state-owned and part-privatized Russian companies. Under the old Soviet system, it never hurt a company general manager’s prospects to appear ambitious in front of a central planner from Moscow, requesting extravagant investment to expand production. Now managers are realizing that finance is scarce, and the best of them are absorbing western financial concepts such as return on equity. Even the mighty Gazprom, potentially the world’s largest company, controlling one-third of the planet’s gas reserves, has reined in some of its more ambitious projects. Plans to drill and lay pipelines under the Arctic permafrost of the Yamal peninsula have been scaled back. Current gas prices make the project uneconomic. “Managers now talk about margins, rates of return and profits, and are less interested in expansion for its own sake,” says Philip Lambert, director at Kleinwort Benson, which is working on a possible sale of up to 9% of Gazprom’s share capital. This will probably start with a convertible bond sold to a handful of strategic investors.
The biggest risk for western gas companies is the uncertainty of exploring for and securing gas reserves but Gazprom already has reserves equivalent to 70 years’ production. Gazprom’s management has therefore become more focused on pressing details, such as problems of supply and late payment. In the Ukraine, the company has taken assets to compensate for late payment. The quest to make its domestic market pay has even led the company to take over some customers and suppliers. “They are adapting their thinking to cope with the extraordinary situation they are in. Westerners often criticize Russian managers in a patronizing way. They should remember that these managers aren’t working in the west,” says one banker.
Gazprom is essentially the old Russian gas ministry. It supplies half the country’s primary energy and almost a third of Europe’s gas. It has a recognizable strategy of striving to be an international company, not just a supplier, with a large presence in Germany and Finland as well as stakes in consortia building pipelines across Europe. It is by some estimates 10 or 15 times larger than Lukoil, Russia’s largest oil company.
Recognizing Gazprom’s unique position, the Russian government has taken much more care over its partial privatization than those of other companies. It has appointed western advisers and accountants. At any one time, more than 50 Price Waterhouse accountants have been sifting through the company’s records and financial statements. They have already produced two preliminary financial reports. Later this year they will produce an international accounting standard audit of the company’s balance sheet and Gazprom will use this as a basis for reporting its P&L.
Big deal
Kleinwort Benson has suggested a convertible bond, perhaps converting into straight equity two or three years after launch, partly because political uncertainty has dragged Russian stock market valuations unacceptably low. The firm is targeting investors which have already decided that they can live with Russian country risk and that already deal with Gazprom. The sale of 9% of the company may then proceed through two or more tranches.
It would be reassuring for the Russian government and for prospective foreign investors if one large conventional privatization could be completed with a sale of a large stake in a leading Russian company either to a single strategic investor or to portfolio investors. Svyazinvest, a holding company owning stakes in 85 regional Russian phone companies and licences to operate in long-distance and international markets, was supposed to be that deal. In December, Italy’s Stet was ready to pay up to $1.4 billion for a 25% stake in Svyazinvest, which the Russian authorities marketed as a potential competitor to the better-known Rostelekom. But the deal fell apart at the end of last year (see page 20) when Stet asked for more formal guarantees over a list of legal and regulatory conditions before committing to a hefty purchase price and substantial programme of investment.
Stet was probably right to be cautious. Svyazinvest is an odd creature. The joke among foreign bankers in Moscow is that it is the only telephone company that does not have a fax machine. A handful of employees oversee its stakes in 85 regional phone companies, which include the Petersburg Telephone Network and Moscow International and Inter-city Operator. “It is at best a virtual company,” sniffs one investment banker who prefers Rostelekom, itself being guided towards the international capital markets by Merrill Lynch. Had the Svyazinvest deal worked, it would have been a feather in the cap of Chubais, Boycko and the other Russian champions of privatization. And it would have proved that conventional case-by-case privatization of companies, developing an investment story for each, as opposed to mass privatization, could work in Russia.
Mixed bag
The collapse of the Svyazinvest deal is a serious setback. But it would be wrong to think that privatization in Russia halted after the mass sale of businesses in 1994 and only started again at the end of 1995 with the troubled loans-for-shares scheme and big projects such as Svyazinvest. Ordinary auctions have proceeded across Russia, both sealed-bid cash tenders and investment tenders. Bidders have come from existing local business and financial groups. This process has thrown out a mixed bag of well-run and poorly-run regional companies in many sectors including pulp and paper, shipping and ports, cement and food. Some, such as fertilizer companies, generate substantial hard-currency earnings and are tremendously undervalued.
Victor Huaco, president of trading com-pany AIOC Capital, says: “Attractive small companies are being acquired all the time through the privatization process. Generally, these aren’t shown to the market. If a broker finds one, it will try to keep some equity for itself and place the remainder with one or two favoured clients.” It may be that these small-to-medium companies, not the more widely covered oil and gas and metal company giants, will be the key to the future for Russian industry. “Some of the medium-sized companies, not the blue chips, seem to have been most successful,” says Boycko. “I am a bit sceptical about the bigger companies’ ability to change quickly.”
Alfa Capital is one Russian investment company that has specialized in amassing stakes in small-to-medium companies. During the first voucher auctions it aimed to acquire at least 29% of companies selected according to four rough and ready criteria: that the company should produce something for which there would be great demand in the immediate future, such as food, industrial and construction materials, or pharmaceuticals; that it should have some of the modern equipment installed at many Russian companies during the Gorbachev era; that it should not operate in regions of great political tension; that foreign investors should also be interested.
Alfa Capital built a portfolio of companies concentrated in specific sectors: cement, glass, soap, cooking fat, crackers, tea. Where managers were weak, it strove to replace them, often deploying new managers from Moscow to the regions. That sometimes incurred the displeasure of local authorities. “We settled things with the local authorities, so that our regional businesses were not boycotted,” says Kosogov, without explaining how generous these settlements were. It also had to deal with criminal gangs, sometimes through use of force. “But these problems were as nothing to our economic problems. The biggest problem of all was the high net cost of our products and the fact that most managers did not know how to make costs lower, or even understand the purpose of doing so.”
At some companies it changed the management entirely, at others it did away with unprofitable products. It reorganized. It drew its cement holdings into one company, Alfa Cement, attracting Switzerland’s Holderbank as one of three equal shareholders. It now intends to finance the company with loans from abroad. But Alfa Capital will be holding on to its remaining equity investment. “The potential price of Alfa Cement is much higher now than when we started. In a few years, it might be 10 times higher still,” says Kosogov.
To date, the dominant theme of Russian privatization has been the distribution of ownership. Business restructuring and the evolution of corporate governance will become increasingly important this year. The goal for Russian and foreign investors is the tremendous return that Kosogov foresees for Alfa Cement. That prospect should console them and the Russian economic reformers through the controversies and the Svyazinvest-style setbacks. In the words of IFC’s Roger Gale: “There’s no such thing as a bad privatization, only a slow one.”
