The Rules of the Game

As one seasoned investor might have put it, you will have a tough job succeeding in Russia if you don't know your Bulgakov from your Pushkin.

A new presidential term is looming, and President-elect Dmitry Medvedev is standing in the wings, ready to assume the mantle of power within weeks. Yet investors — perhaps more now than ever before — still have a minefield to navigate if they are to make sense of the investment climate in Russia.

Outwardly, much has become clearer. A key bill, focused on investment in strategic sectors, swept through its third reading in the State Duma in early April. The much-awaited legislation, which sets out the parameters for foreign and domestic investors, has been seen as an essential move toward clarifying the so-called rules of the game.

The new bill outlines the list of strategic sectors and goes far beyond energy and mining to include sectors such as telecoms and media, the acceptable levels of investment by a foreign company, and the size at which a deposit assumes federal importance.

"It is a big step forward," said Andrew Somers, head of the American Chamber of Commerce in Moscow. "But we will have to see how it is implemented."

The rules of the game have assumed increasing significance in recent years as several large investors, both foreign and domestic, have fallen foul of the government, which has pursued a policy to restore lucrative and strategic projects to state control.

"The uncertainty is that nobody quite knows if this list of strategic industries is complete or whether it might change," said Chris Weafer, chief strategist at UralSib. "The state companies are seen to be in such a strong position, that they might change or bend the rules later."

Under President Vladimir Putin, some of the methods by which Russia has reclaimed certain assets have blurred the lines for foreign investors.

Last year, Shell was forced to cede control of Sakhalin-2, while TNK-BP was pushed out of the Kovykta gas project, in both instances to make way for Gazprom, the state-owned gas monopoly.

Shell has lambasted the government publicly, arguing that officials have underestimated the enormity of the job at hand if Russia is to develop its oil and gas complex at a rate fast enough to replace depleting fields, and as exploration moves toward the harder-to-reach reserves, located in eastern Siberia and on the Arctic Shelf.

Smaller companies have faced their share of problems. Imperial Energy, a British-listed oil company, saw its shares seesaw in London on contradictory statements from the Natural Resource Ministry's environmental watchdog, the Federal Service for the Inspection of Natural Resources, or Rosprirodnadzor, that its licenses might be withdrawn over infractions.

Peter Hambro Mining, a London-listed gold miner, faced similar problems several months earlier. Its shares went into a tailspin after the watchdog's deputy head, Oleg Mitvol, accused the company of violating environmental rules.

"We had big problems 18 months ago or thereabouts when Rosprirodnadzor was unhappy and asked to inspect our compliance," said Peter Hambro, head of Peter Hambro Mining, who said ultimately the company was obliged to pay a $700 penalty.

"The way it was treated by the media was very different. The media spent a lot of time listening to Rosprirodnadzor without really understanding what their power and position was," Hambro said.

In 2004, AIM-listed Sibir Energy made an unpleasant discovery when it found that its 50 percent stake in a joint venture with Sibneft (now Gazprom Neft) had been diluted to just 1 percent. Four years of legal battles later, the oil company seems no closer to reclaiming its share.

"There is an action in London against Roman Abramovich, Millhouse and Boris Berezovsky," said Henry Cameron, Sibir Energy's chief executive. "We are not the pursuer, the liquidator is.

"That is a very serious action and is being handled with great skill on the part of those who represent us. We undertook to our shareholders to pursue this to the very end," Cameron said.

There can be little doubt that the Kremlin is aware of the importance of foreign investment, and it has proclaimed the doubling in foreign direct investment to $27.8 billion last year as a sign that Russia has emerged as one of the most attractive and sustainable markets for investors. The economy is growing at impressive average of more than 7 percent per year since Putin took power, and its emerging middle-class is a powerful draw for niche investment.

But for every step forward, negative developments, widely examined and sensationalized in the media, can set Russia back another two.

Bill Browder's Hermitage Capital, the largest portfolio investor in Russia and a strident defender of shareholders' rights, stunned investors earlier this month when it opened the lid on the authorities' crackdown on the company, which started with the refusal of a Russian visa to Browder in 2005.

In a strongly worded dossier, Hermitage revealed a tale of thuggery and intimidation, detailing how rogue Interior Ministry officials roughed up the company's lawyers and confiscated documents, which Hermitage alleges were used to engineer a widespread identity theft relating to its legal entities in Russia.

It is an account more reminiscent of Boris Yeltsin's Russia of the 1990s — the days of banditry and mafia wars — than of Putin's Russia of the 2000s, and it has everyone talking.

And witness the trials of British oil major BP, Russia's most significant direct foreign investor, whose Moscow-based employees have had their visas revisited following the detention of a colleague in a case of purported espionage.

Badly burned in the late 1990s, BP re-entered Russia in 2004 in one of the last landmark energy deals. Two years later, it supported the controversial IPO of Rosneft along with state-friendly businessmen, and it agreed to exit Kovykta last year, a promising gas-export project.

After Kovykta was taken from TNK-BP, "the management expressed publicly [and] also privately that they were happy to work in Russia," said Andrei Illarionov, Putin's former economic adviser turned Kremlin critic, at a recent briefing in Moscow. "What kind of lessons does Russia get from these statements? It is an invitation to do more things like that. … If you thank [them] for such attacks, you invite these attacks further."

Others believe that the government is merely working through the last of the big legacy issues.

"It is the last deal in strategic industries that remains outside the terms. Most people expect that is only a question of time before that company is restructured," Weafer said.

"Doing it in a forceful way would destroy [Russia's] reputation. Investors will want to see that the inevitable end result is that shareholders will get something out of it," he said, adding that he believed BP would be forced to reduce its stake to less than 50 percent, and possibly even to a 25 percent blocking stake.

The view was supported by a source familiar with the talks between the state and TNK-BP, who said the government — via Gazprom — was seeking a stake of at least 50 percent in the company from the Russian shareholders, Alfa Group, Access Industries and Renova.

But in another twist, state-owned Rosneft is reported to be studying a share swap with BP for a stake in TNK-BP, a move which could give it some leverage over Gazprom in future deals.

The TNK-BP spat comes at a time when relations between Russia and Britain are at their lowest since the end of the Cold War. Medvedev's victory in the March election was welcomed by many investors who see him as a Western-friendly face who can balance the contradictions in Russia's domestic policy and its need to attract foreign investment while maintaining stability with the appointment of Putin as his prime minister.

But to some, Medvedev is seen as a little more than a figurehead, while the real power behind the throne will lie with Putin. Medvedev, a lawyer by training and longtime chairman of Gazprom, has burnished his investment-friendly credentials with encouraging statements on issues such as how to battle the "legal nihilism" that has enveloped the country, but it remains to be seen whether he can deliver on his promises.

The country's legal system, and the perceived lack of independence, is one of the largest obstacles to investment.

"On the one hand, the legal environment is getting better," Somers said. "But at the same time, there seems to be a trend toward bringing criminal actions in parallel with civil lawsuits.

"Companies are put in the difficult position of deferred tax payments and a criminal investigation is opened in the middle. Sometimes, the civil act is resolved, but the criminal investigation continues," he said.

Cameron, of Sibir, who has been investing successfully in Russia since the late 1990s, said the onus is on the company to offset the legal risks.

"Russia is a young country, despite its heritage, and the obligation of anyone working here is to anticipate where you might run into difficulties," Cameron said. "You must be thinking ahead and taking steps so as not to encounter that conflict."

Medvedev's May inauguration will mark the turning point in a political transition that has so far been smoother than many could have hoped for, and a swath of deals and investments have been announced, even as the Western markets are in the midst of the credit crisis.

"The political transition didn't result in major upheaval or loss of the stability," Weafer said. "Investors saw political stability as the single biggest criterion."

But others argue that the Kremlin changeover has been glossed over and the risks lie far beyond the scope of high politics.

"There is a tendency for Western investors to oversimplify Russia. They say the Putin / Medvedev transition went very smoothly, so we have nothing to worry about," said Charles Hecker, head of the Russia & CIS practice at London-based consultancy Control Risks. "They forget the subtleties beyond the Kremlin politics."

Under the new rules, the most significant investment to date might be Renault's acquisition of a 25 percent stake in AvtoVAZ, the Lada car producer, which the state stepped in to save nearly three years ago. Remodeled and repackaged, the state started to scout around for an outside investor and courted a number of prospective buyers.

There has been a raft of smaller, but no less significant deals, too. HSBC recently announced that it would invest $200 million in expanding its business in Russia, while Barclays is to acquire Expobank in a bid to break into the country's attractive banking sector. Richard Branson's Virgin Group is eyeing opportunities to establish a Virgin-branded airline in the country.

While it might be getting easier to break into Russia, no investment can be risk-free.

"Size matters. For large companies, certain issues surrounding the market entry will be easier because of critical mass and the importance of a large investment, but that doesn't mean it's trouble-free, because big investments bring their own specific set of risks," Hecker said. "Smaller investors in Russia don't have the same opportunity to exert influence, but they also don't attract the same level of attention with their investments, and so they bring a different set of risks."

Investors typically identify opportunities in the fast-growing consumer sector, and particularly retail, which is not included in the strategic-sector bill.

"[There has been] a phenomenal growth of the middle class, phenomenal GDP growth, [and] phenomenal opportunities outside of Moscow and St Petersburg and in the regions," Hecker said.

The opportunities are increasing all the time, he said, as the population becomes wealthier, and the economy is increasingly integrated into the global economy. At the same time, the government is leading an investment-heavy program of upgrading and restructuring. Sochi, host of the 2014 Winter Olympics, will also benefit from a substantial facelift.

Local know-how is perhaps the single most important component of investing in Russia, long-term investors said. Choosing a local partner can be fraught with pitfalls, but few doubt that it is an uphill struggle without a Russian partner who is both well-connected and understands the vagaries of the system.

"Wherever you are in the world, you need to know how to get things done," Hambro said. "You can either read the rule book or ring up someone and say 'How do I make my Windows notebook work?' As long as you have got someone who knows how to do it, you will succeed faster."

Cameron said he was in constant consultation with Shalva Tschigirinsky, the biggest shareholder in the oil company. "He and I would talk on average half a dozen times a day — it is simply a seamless arrangement where we discuss everything," he said. "I rely on him and his partner Igor Kasayev to guide me on issues that have special Russian interest."

But the last word must go to Hambro.

Asked what he would advise investors to do, he responds, "It's very hard to understand any country if you view it from the position where you currently sit. You have got to take the trouble to understand every country from the inside.

"First of all, I would read 'Natasha's Dance' to understand the history [and] definitely read 'Master and Margarita' to understand the arcane ways of former Russian life, which still so shapes a part of what you see now."