Beyond BP -- What Lessons for Investors?

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BP's decision to purchase 50 percent of TNK is a remarkable example of how pragmatism can triumph over the most frustrating of experiences. After four years of abuse in the wonderland that is Russia's legal system, BP has pledged the equivalent of 20 percent of all Russia's foreign direct investment in the post-Soviet period to its chief antagonist.

The question for other potential investors is whether this is the most important signal yet that things have changed, or just the corporate equivalent of shellshock.

The answer lies in the lessons learned by BP -- the most important of which is that outside investment is only welcome in Russia once the most lucrative battle for assets is already over. The oil sector was the first sector of the economy in which ownership went through the full cycle, from state to public to magnate. With the struggle essentially completed by the end of the 1990s, the beneficial owners have been able to let company valuations rise to more realistic world levels, and then to sell on to waiting foreigners.

Arguably, the electricity sector is going through the same rite of passage, and the gas sector is also preparing itself for purgatory.

A brief description of the BP saga is illustrative (or at least entertaining). At the peak of Russia's bubble in 1997, when LUKoil was valued at 99 times its annual earnings, BP spent $500 million on a 10 percent stake of Sidanco, owned by Vladimir Potanin's Interros financial group. At the end of 1997, as optimism was peaking and investment and GDP showed their first post-Soviet signs of growth, BP's investment appeared -- for a brief and bright moment -- to be justified.

It wasn't. Over the following three years, BP became the biggest advertisement for the inadvisability of doing business in Russia.

Sidanco's major asset, Chernogorneft, was quite legally removed from the company. TNK bankrupted it by buying a small proportion of its debt and refusing to let the subsidiary repay. During the bankruptcy process, local courts ruled in TNK's favor and handed over the assets to external managers who had a remarkable tendency to heed the advice of TNK. And when the external management decided to auction off the assets, the conditions of the tender proved "selectively insurmountable" and TNK was announced the winner.

After four years of futile legal action, BP took its revenge by employing the novel stratagem of giving TNK another $375 million to increase its stake in Sidanco from 10 percent to 25 percent. And now, in the final irony, BP has agreed to pay $6.75 billion for 50 percent of TNK, its effective adversary for the past four years.

In a weird echo of 1997, the deal has been hailed as Russia's most important post-Soviet investment and the boldest move yet by an international oil major into the Russian market.

The lessons to be learned from BP's experience have important implications for the whole of the Russian equity universe.

In 1997, BP made the mistake of trying to join what was essentially a Russian insiders' party -- the consolidation of assets into the hands of the oligarchs. The company hoped that legal institutions would protect their rights as a minority shareholder. They were wrong. Only after the industrial elite had decided it was in its interests has BP been given a guarantee that its ownership rights will be protected.

By seizing this opportunity, BP has gained the first mover advantage in what is globally one of the most exciting oil markets. Having paid roughly a third of the price per barrel it would have paid elsewhere for TNK's billion barrel reserves, BP is likely to have made a very lucrative purchase.

During the feeding frenzy that surrounds the consolidation of a sector, foreign investors -- particularly those with minority stakes -- are well advised to remain firmly on the sidelines. While perhaps the biggest gains in the aluminum, pulp and paper, agriculture and gold sectors are to be had during the initial consolidation period, they will accrue to Russian insiders. Only after ownership is fully determined and the assets spruced up will the foreign investor community be invited to participate.

The institutional backdrop to investing in Russia has improved. The court system, enforcement agencies, Federal Securities Commission and the bureaucracy in general have been kicked into better shape over the past three years -- with sharpened teeth, better incentives and greater accountability. However, they are still rarely a match for the aggressive heavyweights who dominate industry. The good news is it is now in the interest of big business to improve the infrastructure for doing business because lower taxes, greater transparency, protected ownership rights and less red tape benefit big companies at least as much as foreign investors and start-up businesses. The bad news is that when the interests of domestic big business do not coincide with those of smaller players or foreign investors, then protection often evaporates. In other words, at exactly the moment when an investor most needs the assistance of the state, it proves ineffective.

The most recent example of this is in the electricity sector. We are arguably now undergoing the power equivalent of the loans-for-shares auctions and their immediate aftermath: Manipulation of the restructuring process to consolidate the sector's assets into the hands of powerful domestic players. Minority shareholders who have attempted to stand in the way of the juggernaut have fought an admirable rear-guard action, but have now been largely squeezed out. When assets are finally consolidated, reform will begin in earnest. In an attempt similar to that of minority investors a year ago, several large industrial stakeholders are currently attempting to use their recently expanded ownership rights to put their candidates on the UES board of directors. It would come as no surprise if these future board members prove considerably more effective than their minority shareholder predecessors at pushing the reform agenda forward.

Now that the extraordinarily painful process of ownership consolidation in the electricity sector is virtually complete, we can expect to see the reform process accelerate. Only after restructuring, when the sector has been largely revamped and valuations are approaching those of Russia's emerging market peers, will the doors to foreign investors be thrown open.

Thus, the main lesson for equity investors to be drawn from BP's experience is to stick with the still-considerable opportunities in those sectors that have already undergone consolidation -- oil, metals, mobile phones and consumer goods -- and to leave the rest to Russia's insiders.

Roland Nash is head of research at Renaissance Capital. He contributed this comment to The Moscow Times.