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. Last Updated: 07/27/2016

Foxes Look to Nab UES Hens

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Unified Energy Systems is at a turning point. The painful restructuring process is at last entering the implementation stage. In one or two months the board is expected to approve the company's strategy for the next five years. By the end of June representatives of many Russian industrial groups will appear on the boards of UES itself and of many of its regional subsidiaries alongside representatives of portfolio investors in the same companies.

These so-called strategic investors are obviously not interested in being portfolio investors in UES and its energos, the local subsidiary power companies. They want to become controlling owners of UES' assets, enabling them to cut costs and improve efficiency, supply their own operations with cheap electricity or run these assets profitably as stand-alone businesses.

These guys were dreaming of grabbing Russia's generators long before Anatoly Chubais unveiled his first proposal for UES restructuring in early 2000, and these dreams have only become more intense since then. In its first restructuring plan, UES management proposed splitting up the company into hundreds of small entities, which were supposed to be sold at then (and still) very low prices, leaving UES with a small part of its assets in the form of transmission and distribution networks.

These transactions would have represented an unprecedented destruction of shareholder value, undermining government efforts to improve corporate governance and make the country a more attractive place to invest. Luckily, portfolio investors in UES and a least some Russian authorities were stubborn enough to confront this proposal and eventually defeat it. As a result, it was no longer possible to get at large chunks of assets through the back door by making deals with UES management. So Russian industrialists had to buy shares in UES to at least get their foot in the door.

The big question is: What comes next? On the one hand, I am convinced that owning shares alongside other state and non-state shareholders makes people like MDM Group an important ally to these other co-owners. It would simply be against MDM's own interests if they were to use their new influence over UES to force the company to sell a large part of its asset base for cash or investment, as it is highly unlikely that owning UES shares will give them any advantage over cash-rich competitors interested in buying the same assets from UES in an auction. So Russian industrial owners of UES shares will only have an advantage should any potential bidder for underlying assets absolutely need to own UES shares to gain control.

In this case there are two approaches that UES can apply to restructure itself and de-monopolize the sector. One is pro rata distribution of its underlying assets to UES shareholders, the concept first proposed by myself and Vadim Kleiner of Hermitage Capital to the working group established by President Vladimir Putin in spring 2001 and seemingly enshrined in the restructuring laws. Another is allowing potential bidders to use UES' own shares as a means of payment to acquire generators from the company, with UES retiring shares it receives for its assets. The beauty of pro rata distribution is that it is a very straightforward concept. Each UES shareholder will keep his title over all UES assets by receiving direct stakes in each of the consolidated subsidiaries. Its main disadvantage is that it takes a lot of time. Pro rata distribution will have to be packaged as a company reorganization in full accordance with Russian legislation, and will take between one year and 18 months to get to formal completion.

Using UES' own shares to buy the company's assets from itself is a kind of shortcut to the same goal of de-monopolizing the sector. If it is chosen over pro rata distribution, the result will be keen interest in the stock from strategic buyers interested in participating in tenders for UES assets. However, portfolio investors will run a risk of being essentially squeezed between the state, gradually increasing its stake in the residual part of UES (once more assets are sold for shares and those shares are retired, the Russian government will see its part of the remaining outstanding shares go up considerably), and Russian industrialists, actively snapping up the generators.

Accordingly, the government, as UES' largest shareholder, is likely to receive more by subsequently privatizing the stakes in generators it received during pro rata distribution, not by essentially outsourcing privatization of these assets to UES management. Also, much (and, I should say, too much) will depend on the exact details of the process, for instance, who has a right to participate in these UES shares-for-generators shares tenders.

These details, as the history of Russian privatization tells us, can sometimes be quite devilish indeed.

For instance, Chubais is still playing with an idea to attract so-called management companies to run UES-owned generation assets. If this idea is not rejected, as in my view it should be, these management companies will be chosen from a pool of strategic investors. The fox will be taking care of the hens. Strategic investors, running the assets they are interested in buying, will be able to stave off or outmaneuver other potential bidders by putting poison pills in the target companies, (mis)using privileged access to information, possibly even diverting cash-flow.

Much will depend on the future makeup of the UES board. The election will be held May 30. Russian industrial investors are likely to get as many as three out of 15 seats on the board.

It is a pity that there is more competition among portfolio investor candidates for fewer votes, available to them following aggressive purchase of shares by Russian investors over the last 12 months. This should result in portfolio investors getting just one seat on the board compared to the two that they have now (if you do not count Alexander Lebedev of National Reserve Bank, who will, in my view, keep his seat).

Six months from now, there will be much more clarity on all points. UES strategy will hopefully be in place, the prime minister will sign the resolution outlining a time frame for the entire reform, and we will have a better sense of how quickly things are moving forward and if in the right direction.

Alexander Branis, UES board member and director of Prosperity Capital Management, contributed this comment to The Moscow Times.