Heyday for private equity in Kazakhstan still lies ahead
The country is proving a tough nut for private equity practitioners to crack. Guy Norton reports from Almaty on the challenges facing the alternative investment industry.
FOR MOST OF the first decade of the century, private equity managers in Kazakhstan found themselves in a state of almost permanent frustration. Although the economic backdrop in the country seemed perfectly suited to private equity investment, with GDP expanding by roughly 10% a year from 1998 to 2007 on the back of fast-growing commodity exports and quickly rising domestic consumption levels, fund managers found themselves sitting on the sidelines, twiddling their thumbs as the majority of corporates opted to fund their expansion through cheap, plentiful loans provided by domestic banks, which indulged in an orgy of Eurobond issuance to fund their fast-expanding loan portfolios.
"The private equity industry in Kazakhstan has very good potential, but only if there is a cultural change"
However, with the onset of the credit crunch, which hit Kazakhstan in September 2007, the Eurobond funding route for Kazakh banks disappeared entirely and with it went the availability of local debt funding for all but a chosen few corporates. The conventional wisdom seemed to suggest that private equity investors would be greeted with open arms by cash-strapped firms but the reality has proved otherwise. "The private equity industry in Kazakhstan has very good potential, but only if there is a cultural change," says Askar Yelemessov, chairman of Russia investment bank Troika Dialog in Kazakhstan. He adds that many business owners have yet to recognize the potential benefits of private equity capital compared with debt capital. "The heyday for the private equity industry in Kazakhstan still lies ahead of us," Yelemessov says. "The Kazakh banking system brought $100 billion of debt capital into the country, now it’s time to try equity capital." Eldar Abdrazakov, chief executive of investment banking boutique Centras Capital, agrees: "In Kazakhstan we need to have a have a real alternative source of funding to bank lending."
David Herbada, head of private equity at Almaty-based Compass Asset Management, says that although there is no shortage of funds available for private equity investment in Kazakhstan, there is still a lack of suitable investment opportunities. "There are a lot of zombie-type companies in Kazakhstan – they’re financially dead, but they just don’t know it yet." Michael Carter, chief executive of Kazakh investment bank Visor Capital, takes a similar view: "There are companies with, say, $70 million in revenues but with debts of $500 million, whose owners still think they’re worth billions." One of the key challenges for private equity investors, therefore, says Herbada, is finding owners who take a realistic view of the true worth of their businesses. "There are a lot of people who don’t understand the difference between the equity value versus the enterprise value of their companies," he says.
Nevertheless Herbada remains confident that the general outlook for private equity in Kazakhstan is improving, a view bolstered by the fact that in the past year Compass has been able to close two investments for the Tau Capital fund it manages on behalf of Spencer House Capital Management. Established in 2007, Tau Capital is a hybrid fund, comprising both public and private equity investments. It is notable for being listed on the Alternative Investment Market segment of the London Stock Exchange, which gives it a higher public profile than most private equity investment vehicles in Kazakhstan. Its recent transactions include a $21.5 million investment in drugs distributor Stopharm and a $4.5 million commitment in junior oil company Lucent Petroleum.
"KCM has made a big financial and educational push to help establish equity investment as a viable alternative source of funding to the bank lending that dominated before the credit crunch"
One of the main additions to private equity in Kazakhstan in the post-credit crunch period has been Kazyna Capital Management (KCM), the private equity arm of Kazakhstan’s sovereign wealth fund, Samruk-Kazyna, which was founded in 2008. KCM has made a big financial and educational push to help establish equity investment as a viable alternative source of funding to the bank lending that dominated before the credit crunch. Abay Alpamyssov, KCM’s chairman, says that KCM has so far supported the establishment of nine private equity funds with a total capitalization of about $2.5 billion. As a result, Alpamyssov expects KCM-backed funds to target investments of $1 billion to $1.2 billion in Kazakhstan in the next three to five years – a big advance given that in previous years private equity investments have been measured in the low tens of millions. Alpamyssov says that KCM has also been active in education, issuing guides on private equity investment to local corporates and encouraging municipal authorities to put forward potential investment projects to be considered by KCM-backed funds.
Although it’s still too early to judge if the KCM experiment will ultimately be successful, its achievements so far have won it widespread admiration. "The basic premise behind KCM of creating a fund of funds and bringing Kazakhstan to the attention of the global private equity community is a very sound one," says Abdrazakov at Centras. "The key point is how many mistakes KCM will make and whether it learns from them."
But although KCM has succeeded in attracting private equity investors and foreign fund managers to Kazakhstan, it still remains to be seen how quickly and productively the financing it has provided can be put to work. "There’s a lot of financial firepower out there with a shrinking investment time horizon," says Herbada at Compass. However, among the private equity funds backed by KCM there’s a cautious optimism about the investment outlook given the combination of an improving economic climate – GDP this year is expected to grow by 7% – and proposed changes to the country’s capital markets and taxation infrastructure.
Raj Morjaria, a partner at Aureos Capital in London, which manages the $70 million Aureos Central Asian Fund, says: "Kazakhstan has faced a few challenging years following the global financial crisis. Businesses have required not only growth capital but also basic working capital as debt markets have dried up. But things are starting to pick up slowly and we continue to see a steady stream of opportunities." This has enabled his fund to invest about $20 million of its committed capital to date, with deals in the leasing, cable TV/internet and paint industries, all of which are poised to benefit from higher domestic investment and spending levels. Morjaria says that although investment in Kazakhstan has been sluggish to date, it is set to accelerate.
"We are working on a number of deals, including some that will complement our existing portfolio companies," he says. "Our investors understand how the dynamics of the region’s economy have shifted and they have adjusted their expectations in line with the changed market conditions."
There’s a similar message from Orinbasar Kuatov, director of ADM Capital, the Kazakh subsidiary of Hong Kong-based Asia Debt Management, which manages the ADM Kazakhstan Capital Restructuring Fund. Established in June 2010 with a first close of $100 million, including commitments from KCM and the European Bank for Reconstruction and Development, the fund has still to close its first investment. However, Kuatov says: "We’ve never felt under pressure from our investors, who have been extremely supportive. We’ve not originated any deals yet, but we hope to make our first investment soon." The firm is targeting investments in the range of $8 million to $25 million with a minimum stake of 15%, ranging up to 100%. Typically it is looking at well-run businesses burdened by heavy debt loads made worse by the economic downturn in 2008, but which are poised to benefit from the recovery in the country’s financial fortunes.
Kuatov says that ADM Capital is looking principally at companies in the services sector, especially those related to the high-growth oil and gas and metals and mining sectors. It is also keen on domestic consumption plays in the agricultural sector, especially the food-processing industry. He says that even in economic sectors such as real estate, which have yet to see any meaningful recovery, there is an increasing sense of optimism, while this year there has been a small but important increase in bank lending, which was up 3% in the first six months of this year. "Kazakhstan faces a new reality – people know where they stand now financially versus the panic they felt in 2007. The growing availability of financing is positive for any economy."
With a view to closing its first deals, Kuatov says ADM Capital has already interviewed suitable candidates to manage its investee companies. "We prefer to have local staff rather than expats so that they can hit the ground running, but we will selectively bring in foreign managers with specific technical skills if needed."
One of the key developments that Kuatov believes will give a fillip to the fund’s investment momentum will be the long-awaited introduction of legislation relating to debt write-offs by the local banks. At present banks have to pay corporate income tax on any debt write-offs, but the government is set to bring in new tax legislation in the autumn that will remove that tax liability. Kuatov says that ahead of the new legal changes, the local banks have become more open about the distressed assets they are looking to offload from their balance sheets.
Michael Eggleton, chief executive of Eurasian Bank, says that although there is resistance to the new legislation from the tax authorities, which are unwilling to relinquish a source of income, he describes the changes as "a must-have step for the cleaning up of the banks’ balance sheets." Eggleton says that Eurasian Bank would certainly consider selling off distressed assets to private equity buyers but adds that the bank would want to be paid from the current cashflows from their investment rather than the promise of funds from a potential future exit.
Murat Koshenov, chief risk officer at Halyk Bank, also believes that private equity could form part of the solution to the non-performing loan problem in Kazakhstan. "Selling off distressed assets to private equity firms is definitely one way of improving NPL levels in Kazakhstan," he says. "We’d certainly be happy to sell bad debts to good clients."
Another initiative that could help the cause of private equity investment in Kazakhstan is the People’s IPO programme. Although initially conceived as a plan to establish a retail equity investment culture in Kazakhstan through the sale of shares in government-owned companies to the general public, it is hoped that ultimately the People’s IPO programme will entail the total overhaul of the capital markets infrastructure in the country, which would turn the dream of a local stock market exit for private equity investors into a reality. "The proposed changes to capital markets regulations and legislation are substantive, but it will be a number of years before the Kazakh stock market becomes an attractive exit option for private equity investors," says Carter at Visor Capital. "We’re talking about a long-term process rather than a single event."
Improving corporate governance
Michael Weinstein, the Almaty-based director for Kazakhstan at the EBRD, agrees: "The People’s IPO programme was announced with an incredible sense of urgency but now there’s a realization that it will take longer to come together." Weinstein says the EBRD is acting as an adviser on the People’s IPO programme, helping to construct a road map for improvements in corporate governance, financial transparency and minority shareholder rights that it is hoped will lead to a better overall investment climate in the country as a whole. As well as providing seed capital for a trio of private equity funds in Kazakhstan, the EBRD’s direct-equity financing activities have also attracted private equity investors to the country, says Weinstein. The latest such example is Singapore-based Capital Advisors Partners Asia (Cap-Asia), which at the end of April paid $50 million for a 19.2% stake in Kazakhstan’s leading private-sector power firm, Central-Asian Electric Power Corporation (Caepco). "Seeing the EBRD as an investor in Caepco helped to attract CapAsia to Kazakhstan," says Weinstein. CapAsia invested in Caepco through the Islamic Infrastructure Fund, jointly established by the Islamic Development Bank and the Asian Development Bank.
Commenting on the rationale for the transaction, Johan Bastin, CapAsia’s chief executive, says: "We consider Kazakhstan as a main market for the IIF due to the commitment of the government of Kazakhstan to attracting private-sector financing to develop the infrastructure of the country."
Kazakhstan has also been attracting the attention of private equity players based in neighbouring countries in Central Asia. Davran Akhmedov, head of equity financing at Ansher Capital, the investment banking subsidiary of the Uzbek financial-industrial conglomerate Ansher Group, says that two of its existing private equity funds – the $500 million Ansher Global Silk Road Fund and the $300 million Ansher Regional Property Fund – are likely to have a big Kazakh component. "Due to its enormous natural resources, favourable investment climate and strong economic growth, Kazakhstan has been the leader in terms of investment attractiveness within the Central Asian region," Akhmedov says.
Similarly, he says that Ansher Capital is looking to attract private equity investment into its Ansher Gold, Ansher Metals and Ansher Petroleum companies, which have two-thirds of their total assets in Kazakhstan. "It is envisaged that all three companies will be eventually listed on international stock exchanges, which will ensure that private equity investors will be provided with a profitable exit strategy," he says.
Although the vast majority of private equity interest is focused on mid-sized companies in Kazakhstan and the region, there has been some activity at the small and micro-sized company level through development agency-backed investors such as the Small Enterprise Assistance Funds initiative. Seaf, backed by the US Agency for International Development, the International Finance Corporation and Switzerland’s State Secretariat for Economic Affairs, established the $11 million Central Asia Small Enterprise Fund (Casef) in 2002 and attracted outside backing from institutions including the Kazakh National Innovation Fund and the Swiss Investment Fund for Emerging Markets. It has since made 14 investments across several sectors in its target countries of Kazakhstan, Kyrgyzstan and Uzbekistan, including a fish farm, a leasing company, a gas distributor, a pharmaceuticals company, a medical diagnostic clinic, a dermatology clinic and a hotel chain.
Donald Nicholson, regional director for Seaf, says that Casef has found a ready audience for its mix of venture capital and early-stage and working-capital funding. "The financial infrastructure in Central Asia varies between the more-modern largely private institutions in Kazakhstan to the less-modern state-dominated institutions in Uzbekistan," he says. "Financing for start-ups is largely unavailable and even existing SMEs have difficulty obtaining funding for expansion and/or working capital if they do not have assets to pledge as collateral." Although Casef has been successful in attracting third-party funding for the companies it has invested in, Nicholson says that overall private-sector interest in the small business sector still remains limited.
"Hopefully this will change," he says, "but the individual countries need to do their part by eliminating bureaucracy, reducing corruption and making the overall business environment safer and easier to understand."
The principal difficulty that Casef now faces, Nicholson says, is to find buyers for its portfolio companies ahead of the fund’s scheduled closure in June 2012.
"In addition to the challenges of investing in and building a business, there are only a few strategic investors standing in the wings looking to acquire companies, and thereby providing the means of exit for the initial investors," he says. "For Casef this has been a major challenge as we are now approaching the end of the fund’s life and need to return the invested capital to our shareholders.
"What we do with any unsold holdings is a subject of current discussion, with the most likely solution being a trusteeship arrangement whereby Seaf and myself will look after them until they are finally disposed of and the proceeds paid directly to the shareholders."