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. Last Updated: 07/27/2016

Direct Investment Funds Look to Long Term

Russia's stock market may be drifting aimlessly, but foreign direct investment is set to take off. Stephanie Baker-Said surveys the field of Russian private equity funds.

For foreign investors, Russia by and large has been a place for speculative money looking for fast and high returns. But things are beginning to change.

Investors who made stellar gains on Russia's equity and debt markets over the past two years have been humbled by the recent world market turmoil, which ripped through Russia last October. Now, money is beginning to pour into direct investment funds, which buy significant stakes in illiquid or little known Russian companies with bright prospects for being sold at a future date.

Unlike portfolio funds, which invest in traded stocks and bonds, so-called private or direct equity funds hunt for young companies in need of an injection of outside capital or management expertise.

A handful of new private equity funds expected to get off the ground this year could pump more than $1 billion into companies hungry for cash to finance expansion. For a country of Russia's size, the funds are unlikely to turn the economy around. But with foreign direct investment a measly $4 billion last year, they could make a noticeable dent.

"The more money that comes in through private equity, the more Russia will be recognized as a target for investment," said Jack Barbanel, president of EPIC Russia, formerly Sector Capital, which runs a $40 million direct equity fund and is currently raising money for another fund.

Russia's high-yield bond and equity markets captured the lion's share of foreign investment last year, but Russian companies rarely benefited from the flow of funds because trades usually involved existing shares.

"People are looking for value further afield," said Rory Landman, head of emerging European investments at Barings Asset Management, which launched one of the first private equity funds in 1994. "The market has had such a good run, it makes other investments in companies that need capital more attractive."

The global market turmoil and recent Cabinet shake-up hasn't made it any easier for fund managers to persuade institutional investors or high-net-worth individuals to sink their money into Russian private equity funds, which often require minimum investments of $5 million. But signs of an economic recovery have kept Russia on the global financial map. Russia's economy grew by a modest 0.4 percent last year, halting a six-year slide. And inflation is expected to drop below 10 percent in 1998 from the sky-high levels of a few years ago.

Many investors are betting that the real growth opportunities are in the country's rapidly developing consumer goods-and-services sectors, which are barely represented on the Russian stock market.

"Direct investment funds are aimed at getting way down below the radar screen," said Roger Gale, chief executive officer of AIG Brunswick Capital's $300 million fund. "What we are investing in now will become blue chips in a few years."

Fund managers say there are hundreds of little Russian companies that are privately held but could go public or be sold to a strategic investor in a few years if given some working capital. The most attractive areas for direct equity investments include consumer goods, pharmaceuticals, construction, communications and transportation -- all of which are expected to boom once the economy picks up.

Some of the funds that got an early start can already point to success stories. The $82 million Framlington Russian Investment Fund, launched in 1993, invested in the start-up telecom firm Vimpelcom before it became the first Russian company to be listed on the New York Stock Exchange. The fund also bought a 12 percent stake in the hugely successful water bottling company Saint Springs, which made $13 million in profits last year and is set to double production this year.

For fund managers, the challenge is to spot the next Vimpelcom or Saint Springs. The AIG Brunswick Millennium fund, for example, has invested in nine companies since its 1996 launch, but it has looked at more than 600.

After weeding out the bad companies, fund managers face the next battle: helping the company grow. In contrast to passive portfolio investors, they often help clean up a company's accounts, design strategies for expansion, arrange debt financing or bring in sector specialists to advise management.

"What private equity needs to bring to the table is capital and experience in finance and strategy," said Barbanel of EPIC Russia. "You really have to roll up your sleeves."

Some express doubts, however, that the fund management companies now turning from stagnating stock funds to private equity investing understand the need for this hands-on approach.

"I am not sure that the people who manage liquid funds have the experience to do private equity," Barbanel said.

For the critics, the new interest in private equity has grown out of the frustration of fund managers with fickle investors who yank their money out of blue-chip funds at the first sign of volatility. Unlike liquid portfolio funds, most of the private equity funds in Russia require investors to lock in their money for 10 years before realizing returns.

"If I were a cynic, I would say these new funds are nothing more than the old funds repackaged to provide less liquidity," said James Fenkner, managing director of CentreInvest Capital Management, which has no direct equity funds.

But fund managers say the returns on private equity investments are potentially much higher than portfolio funds.

"The returns for private deals will most likely be higher over the long term because the market prices in such a discount on less liquid investments," said Bill Browder, head of Hermitage Capital Management in Moscow.

Hermitage is planning to add to its stock funds by launching a direct equity fund in the coming weeks that will acquire stakes in Russian companies to be sold through privatization or restructuring.

But while the returns may look promising, the risks are high. The Sputnik Funds, a direct equity fund run by Moscow investment bank MFK Renaissance, led a group of shareholders in a battle against Soviet-era management at Novolipetsk Metallurgy Plant, which blocked their nominations to the company's board. Theinvestors won in the end and established an important precedent in the defense of shareholders' rights, but only after a two-year fight that did little to increase company value.

"Novolipetsk is the exception," said Greg Bedrosian, managing director of the Sputnik Funds. "These transactions tend to be friendly and negotiated with the general director."

Sputnik is now pushing ahead with plans to streamline management and operations at the plant. Since its launch in 1995, Sputnik has focused on large deals, investing nearly $500 million out of the $900 million it has raised in just six companies.

Most private equity fund managers say they shun high-profile fights with management and look for companies led by dynamic entrepreneurs who share their investment aims.

"We are not interested in hostile takeovers," said John McGuire, head of Pioneer Investments in Moscow, which is currently trying to raise $150 million for a direct equity fund. Private equity funds generally take a significant minority stake -- usually 25 percent plus one share -- in a company to give them a seat on the board of directors and enough say to block key decisions. But given persistent violations of shareholders' rights, there are no guarantees that management will stick to its promises.

Despite several successful bets, for example, the Framlington Russian Investment Fund has written off two investments after problems arose between the joint venture partners.

Barings' First NIS Regional Fund also ran into troubles with two investments, but made up for the losses through other profitable deals, including stakes in the mineral water company Borzhomi, the restaurant chain Patio Pizza and Vimpelcom.

For all the deals that have gone sour, fund managers say there are as many success stories and dozens of opportunities.

"There is a lot of room for strategic investment to come in," said Jack Orchard, chief investment officer at United Financial Group's Croesus Advisors, which runs a $25 million fund and is planning to launch a fund devoted to technology companies soon. "There is so much out there. All you have to do is go look for it."