Better Lower Prices Than Higher Expectations

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For the third year in a row, the Russian market is expected to set a record for the volume of shares issued, through both initial and secondary public offerings. This raises the question of how sustainable this trend is, as well as concern that Russian companies are increasingly finding themselves obliged to sell out for low valuations.

Companies considering raising funds by introducing shares on the open market are attracted by a range of factors: active encouragement from the government, which wants to see further development in the local financial market; a natural need for capital to maintain value creation in an economy that shows little sign of slowing; and an ever-growing army of corporate finance agents, full of ideas of how to enrich corporate directors and stimulate banking fees.

It has been suggested that share issues are also occurring as a hedge against future political risk associated with the presidential election in March 2008, or because business leaders are keen to liquidate their assets before President leaves office. Another suggestion is that valuations are sliding as investor appetite wanes as a result of the volume of recent public offerings and the upcoming election. Neither of these arguments, however, stands up under analysis.

Equity coming to market can be grouped according to two characteristics: ownership (whether state-owned or private companies) or the purpose behind the share issue (as a cash-out or to finance further development).

In the case of state-owned companies, you would hope that the focus was on funding continued development. As civil servants, the directors of public companies would directly contradict their professional and moral responsibilities by enriching themselves.

State-owned companies will likely represent well over 50 percent of equity coming to market this year, and there is a clear logic to their capital growth needs. Sberbank and VTB need extra financing to meet uncontained demand growth and to maintain market share as foreign players increase their presence in the banking market. Utilities companies are desperately in need of capital just to keep running after years of financial neglect.

As for private companies coming to market, it is highly unusual to see the sale of more than a blocking, or 25 percent, stake. In most cases the existing owners dilute their ownership through an IPO, freeing up some cash for themselves, but the majority of capital raised is plugged right back in to promote corporate growth. Company owners remain directly dependent on the growth of their businesses in the future, meaning that they will be tied and committed to the Russian market well beyond next year's presidential election.

So much for the political risk argument.

The answer to concerns that businesses are selling out too cheaply is just as clear cut. The corporate financiers so adept at convincing businesses to go to market have a direct interest in raising as much capital as possible for their clients. The fees banks generate from IPOs far exceed those made by brokerage operations that trade in companies' shares after they have been issued. Investment banks are committed to getting the best prices possible.

So the question is: What is behind the decline in IPO valuations that is leading some companies to reconsider their decision to sell?

The global equity market has been enjoying an extended rally --MSCI's global equity index is up 23 percent since mid-May -- and the environment remains unusually benign today. The longer the good times last, however, the more nervous the investment community gets.

The prime time for a Russian company to have raise equity capital during this global economic cycle was probably the first quarter of last year. Emerging markets were more popular than ever and were pulling in money as never before. Foreign fund flows to emerging markets in the first quarter of 2006 exceeded even the record volume registered for the whole of 2005. Risk perceptions were exceptionally low. The mood changed in May, however, and most of the capital that had been rushing in rushed back out just as quickly.

The simple lesson here is that valuations are not fixed. They are dynamic and a natural factor of international investor confidence. While investors are positive about market conditions today, they are extremely sensitive to the possibility of another reversal in risk appetite.

Equally important, Russian companies increasingly understand the symbiotic relationship they have with their investors. The idea of squeezing out the highest possible issuance price is contrary to the principles of equity investing and has dominated the Russian market for too long. Any business can push its equity out to market at the maximum valuation, but such a move will most likely come at the expense of the very investors being asked to put their faith in the business. An IPO by which the company raises top dollar only to see the share price plummet on the open market cannot be considered a success.

The purpose of a successful IPO is to capitalize a company at a value that is sustainable and maintains its future growth as an interesting prospect. Investors always take substantial risks when putting money into newly issued equity. They buy the shares because they believe in the potential of the business. Any company that wants to survive has to keep in mind the interests of all its owners. The ability to finance operations and growth in the future is directly tied to market capitalization, so long-term business development and owners' chances at exiting profitably depend entirely on the success of the company's stocks.

Corporate financiers are aggressive and greedy, so they continue to price companies as ambitiously as market dynamics allow. When equity sells at the lower end of its price range, this does not represent a failure on anyone's part, but a meeting point for the interests of all those involved in the process -- the bankers that structure the deal, the company's owners and mangers, and the investors that are offering to support them.

James Beadle is a portfolio manager for Pilgrim Asset Management.