Articles/Публикации

Russian Business . Leap Function

By Tatyana Gurova

Graph 1. Прямые инвесторы заметно реагируют на тенденцию к росту российской экономики

Graph 2. Лидеры в привлечении прямых инвестиций - небольшие, прежде всего, европейские страны, а также наиболее успешные из "старых" развивающихся стран

Graph 3. По валютным резервам Россия выглядит вполне привлекательно

Graph 4. Делая прямые инвестиции в развивающиеся страны иностранные инвесторы предпочитают сравнительно развитые, но неслишком богатые государства

Graph 5. Инвесторы не любят ни страны-консерваторы, ни страны с высоким риском

Graph 6. Высокая доля ППИ часто сопровождается слабым платежным балансом

Looking at the present day Russian market with its rather unstable market opportunities one may catch sight of a number of companies who achieve market breakthroughs totally unexpected by an outside observer. The trading network "Pyaterochka" that operates on the most complex market "for thrifty housewives" suddenly expands and opens one shop after another. Nidan Company from Novosibirsk that sells juices dares to compete with the strongest market players in Moscow. Porcelain factory in Lomonosovo after a long period of hardships works out a clear-cut concept of development and occupies the niche of high-quality porcelain articles. These three examples have at least three features in common: firstly, all three companies operate on the consumer market, and secondly, all three of them have direct investments funds as their partners.

Direct investments funds are just one of the multiple financial market instruments. However, in the nowadays Russia the activity of these funds often makes it possible to make another step forward for the companies that have already gained foothold on the market, but do not have enough cash flow for development.

It is therefore that we wanted to ask about the methodological principles of operation of such funds and get answers to the following questions:

- What is the role of direct investments funds in the general investment process?

- What companies are of most interest to direct investments funds?

- How promising seems the nowadays Russian economy for investors of this kind?

These questions were put by Expert magazine to Alexei Kalinin, the joint manager and a partner in the Baring Vostok Company that specializes in the management of direct investments funds, and to Andrei Kostyashkin, a partner in the same Company. Mr. Kalinin replied to the first question with a counter-question.

Alexei Kalinin (hereinafter referred to as - АК1): Do you have an idea of how a mechanical separator works?

- Rather vague.

- In my opinion this is the best possible model for better understanding of the system of financial instruments. Mechanical separator is a device that consists of a set of sieves with meshes of different diameter. When any stuff passes through the separator from top to the bottom the large grains are sifted out at the upper sieves, and the smallest grains accumulate at the bottom.

We deal with the same kind of financial separator. It consists of a large number of instruments, including strategic investments, credits, venture investments, etc. Direct investments that we deal with are just one of such financial instruments.

Each of such instruments has its own purpose, and each of them has a certain size of the mesh, i.e. the extent of investment projects that they operate with. Large investment projects (amounting to several hundred million dollars) are for strategic investors. The small investment projects (amounting to several hundred thousand dollars) are of interest for venture investment funds and for their competitors, i.e. relatives and friends who may lend money for the project. Our scale is scores of million dollars aimed at one project. However, it is important to take into account not only the amount of invested money, but the degree of participation in the project as well. If you consider both indicators, we certainly play at a lower level than strategic investors, but at a much higher level compared to venture funds and portfolio investment funds.

- What about private investors? Namely those who are expected to return to Russia the capital that was earlier transferred abroad?

- Private money plays practically speaking at all levels. And we feel most serious competition from their side.

But let us get back to the scheme and to the way this scheme works. For example, if your projects gets into the hands of an expert in the investment bank, he will immediately "sieve" it and determine where to send it: to a venture fund, to IPO, to portfolio investors or to us, the direct investments fund.

- That is to say that in search for money the best thing is to turn to the middleman, i.e. to an investment bank?

- Not necessarily. You may "sieve" the project independently. It is simply important to understand where it is most logical to go. As a rule, people do not understand this. They have a project worth four hundred thousand dollars and they come to us. I tell them: "This is not our cup of tea. We would really like to help you but this project is out of our range".

- Following your scheme one may suggest that for any country, including Russia, there is quite a definite amount of money that a country can receive from direct investments funds.

- This is true. Every individual fund has upper and lower limits. Lower limits mean that it is simply not profitable to manage small amounts of money. It is necessary for the fund to keep a team of professionals, and to maintain a certain infrastructure. In other words we require a certain supporting level. If in the nowadays Russia you have twenty or thirty million dollars under your management, you will most probably be unable to keep a company that would play the role of direct investor. In my opinion the minimum amount of money required for such kind of management companies is one hundred million dollars.

- You have about four hundred million dollars under your management today. Are you able to "swallow" more?

- Yes, we can do that in principle, but this is the point where the upper limits start to interfere. The direct investments fund invests money for the period of six or eight years. It is a natural thing that during this time the market situation can notably change, and therefore every fund is hedging its risks by investing in several markets compensating mutual risks. There is no iron hard rule, but there is a custom to limit the investments in one project to ten-fifteen percent of the fund's money. This is the first constituent of the upper limits.

Then, every fund has a team of a certain number of employees and of certain competence. For example, our team today can manage thirty projects, but is unable to manage sixty. Besides, this team has a better knowledge of certain markets, and worse knowledge of other markets. This is to say that the internal resources of the fund also serve as the limiting factor in the management of too large amounts of money, and these internal resources are increasing gradually, and not all of a sudden. This is the second upper limit.

And finally, the markets in each country have a certain capacity for projects that are suitable for direct investments funds. In Russia these projects are worth from thirty to sixty million dollars. All limitations taken into account it gives us about four or five hundred million dollars that may be effectively used by direct investments funds.

- What if we take a broader look? One may often hear critical remarks nowadays that in such a big country as Russia with the population of one hundred and fifty million people it is ridiculous to discuss in earnest direct investments in the amount of four or eight hundred million dollars. What is the real cash flow that Russia can expect from direct investments funds in general?

- It is difficult to give an objective forecast. Investors are people who often make emotional decisions. But the logic of large international investors is as follows: "We observe a large field with a lot of players. And we are watching when and where the conditions become ripe for this or that financial instrument. When conditions are ripe we introduce the corresponding financial instruments in such country". Direct investments fund is one of such instruments. But there are other kinds of funds, and some of them are virtually not known in Russia. For example, there are special infrastructure funds that invest money for the period of thirty years and charge small interest, but their investments are guaranteed by the government of the country. Such funds are typical for the really developing countries, say for countries in the Latin America where infrastructure was well behind the general rates of the growth of economy. There are bridge funds that specialize in the financing of the companies who wish to convert from one class to another, like the funds that invest in the companies who prepare to enter IPO market. In general there is a lot of instruments and the large international market players watch how ripe are conditions for the use of these of those instruments. When conditions are ripe they start to use the corresponding instruments.

- Still, what are the amounts of feasible direct investments in Russia nowadays?

- I believe that for Russia in general there can be talk these days of not more than four billion dollars of direct investments annually. But there is certainly a tendency for growth.

Who and why

- Who invests money through direct investments funds?

- The main sources of money in the world are pension funds and insurance companies. They are a head above all others as concerns the amounts of money at their disposal.

- Why do they need you?

- No doubt, to increase profitability. And it is clear that these market players are rather conservative. They invest the lion's share of money in conservative financial instruments with limited profitability. As a rule, these are government securities. But they also allocate a small share for more risky investments. Probably instruments like ours are used for investment of not more than 0.5 percent of the total amount of money managed by the pension funds and insurance companies, but this 0.5 percent is nevertheless a large sum of money.

- What circumstances are taken into account by such investors when they decide to finance projects through direct investments funds in various countries?

- Generally speaking there are three factors that are of importance. The first is the political situation in the given country. The second is the macroeconomic situation in the country and the development tendencies. And the third factor is history. People always believe in success, and success is illustrated by historical examples. The more positive examples (successful projects) can be demonstrated to investors in the country, the more money flows there.

- And if in more detail? How do you convince investors that it is possible, and even high time to invest in Russia?

- There are three simple questions that require answers: why in Russia? Why now? Why using us? As for "why in Russia?" the answer is simple. While the whole world is stagnating and the growth of economy does not exceed a half of one percent annually, our country demonstrates quite acceptable rates of growth. Two years ago it was a difficult task for us to persuade investors to invest in Russia. Today, following three years of economical upturn it has become much easier.

- But two years ago you also raised money. What arguments did you use t that time?

- We used many various techniques. I must admit it was partially like voodoo, but it worked.

From the view of investor we are competing with developing countries. At the same time, we do not position Russia as a developing country, because, if we take infrastructure, for example, we cannot consider it to be at the same level as in the developing countries, since we have energetics, railways, etc. Therefore comparison in these fields works in our favor. We can also show how Russia looks with regard to external debt. If you take the sum of external debt and divide it to GDP, and then compare the result with other developing countries, you will see that Russia's situation is not that awful. We can also compare the level of education, and many other aspects.

- Why do you say "in Russia", and why "today"?

- Because of the same things discussed above: we tell investors what happened after default, and show the dynamics of economic indices. We persuade investors that there is a stable tendency for economic growth in Russia and that Russia has potential for future growth.

You ask why they need us? We have a strong argument in this respect. To earn money in Russia it is necessary to exercise control. Basically, it would be certainly easier to operate using portfolio investments. They have better liquidity and better opportunities for hedging risks, and they do not require participation in the operations of the companies where investments are made. But the problem of managerial control is still pressing in Russia.

- Why Baring Vostok in particular?

- Because of our past history, and demonstration of completed projects. This is to say that when we speak about ourselves we trade in our success, and this is the best basis to persuade any investor. You should agree that it is one thing when a team of clever young guys who have all graduated from Harvard, but who do not have work experience comes to investor, and it is quite a different thing when we come and tell the investor: "Look at the history of completed projects. Here is how we made decisions in complicated situations. Here is how we survived during the crisis". We show the investors that we have suffered serious blows, but we have managed to overcome the difficulties.

- How?

- Do you want an example? Take one of our projects in timber industry on the Sakhalin Island. We invested money, but the timber company was inadequately controlled. Simply speaking it was on the way to bankruptcy. In those conditions we managed to form from that time shareholders a certain pool of new shareholders, who founded a new company after the bankruptcy of the former company. Today this new company is slowly but surely overcoming the crisis.

- Do you often have to change the structure of owners in crisis situations?

- It is important to understand what are the roots of the problem. Why is the given enterprise unprofitable? Is this due to a systemic reason, or due to inadequate management? If this is a systemic reason, then it does not make sense to spend money for nothing. Have you heard of the so called "Vietnamese syndrome" when the situation becomes worse and worse, but people pump in more and more money? Psychologically this phenomenon can be understood. People have sold idea to investments committee and have put on stake their good names. And then they fail. When a person makes a mistake, it is very probable that he would try to save his reputation by further pumping in of money. But it is not worth doing. It is most likely better to take a pragmatic, I would even say cynical stand and find out what is the reason for the project to go down. If the reason is systemic, that is to say that if the current market is such that you cannot expect better results, then the project should be closed. If the problems are due to poor technology or inadequate management, this can be rectified.

- Was it the matter of inadequate management in the mentioned case of Sakhalin timber project?

- It was the matter of management and technology. We have resolved the matter of management, but there still remain problems with technology. Infrastructure there is very poor: lack of electrical power, expensive transportation, etc. When drafting business plans people often fail to be realistic. In this case they did not take into account high logistical expenses.

- How deep should be your involvement in the management of a company to make such decisions? Какие позиции вы должны занимать?

- We should be certainly represented by a number of members in the Board of Directors. But this is the formal side. As for the content of the matter, it is important that the partners have distinct rules of behavior. When we are managing a project, we try from the very beginning to tell honestly what we intend to do, how we plan to make the investments, and when and how we plan to step out. Then we work through the Board of Directors and apply the main mechanism, i.e. recruitment of the right personnel. The ideal thing for us is certainly when all this happens on its own, but this is a rare occasion. In reality we always have to go into the heart of the matter.

What is your profitability?

- What rate of return is considered acceptable for Russia?

- Thirty percent at the life of the project of four-six years. Such rate of return (higher than interest rate charged for credits) is explained both by the current state of economy and by the risks that we take contrary, say, to the lending institutions.

- And what is your real profitability?

- It corresponds to the figures mentioned above. For the implemented projects it varies fro twenty eight to twenty nine percent.

- How do these twenty eight or twenty nine percent look as compared to other developing countries?

- Quite decently. Baring practices global meetings with its partners operating in various countries. Two years ago when the number of technological projects was growing rapidly, the profitability of our colleagues in India or in Hong Kong was very impressive. There were projects that gave the internal rate of return from one hundred to one hundred and fifty percent. But currently their results are more modest than ours.

- And what if compared to Europe?

- Not bad at all. Our European partners show lesser profitability of ten-fifteen percent. The situation there is more stable, since the growth period ended in the beginning of the nineties. In principle we may expect another stage of economic growth in Europe as integration between the countries will increase, but this is a double-edged weapon. On the one hand, integration always brings about the growth of some companies. On the other hand, East-European companies will find themselves in a more complicated competitive environment, and it is uncertain whether they will be able to grow at all.

- A self-contained question is the question about China. The general opinion is that China had been almost the most powerful magnet for external investments for quite a long time.

- It is true that China is a special case. They have very strong governmental protectionist policy. It means for investor that it is easy to bring in the money, but the only thing that you may bring back are the products manufactured in China. It is rather complicated and difficult for capital to flow out of the country.

- Does this mean that Russia currently is almost the most attractive place compared to all other developing markets?

- No, this is far from true yet. Investors only begin to forget about the year 1998. And the normal period required for the "loss of memory" is five or seven years. Certainly, everybody would like to believe that Russia's time is coming. But the economic boom has not begun yet. Strictly speaking only the conditions for the future boom are created currently. If nothing extraordinary happens in the future year or two, such conditions will become ripe.

- How will this boom look like?

- Large investments will follow. The competition between the companies seeking investments will be replaced by the competition among the investors. At the same time, naturally, the price of money and the profitability will fall. But, probably, this is not the main thing. The main thing is that in the conditions of powerful inflow of capital an integral system of financial institutions will be formed. The whole chain that I mentioned in the beginning of this interview will start to work. The system is inefficient when there is not enough money for all of its components. After all, to maintain the field of our operations there is need for venture funds in the country that would breed the projects to the size of the scale of the funds like ours, and there should be portfolio investors who ensure liquidity. In turn, the liquidity will push those who want to enter IPO market, and so on. That is, everybody should play his own role on this market. If one link is missing, the market is deficient.

- Do we have a deficient market currently?

- No doubt we do. And this is a material hindrance in our work. For example, we engage in a project. Both for us and for the project it would be good not to invest the whole sum required, but to cover part of investments by credits. But even we sometimes fail to find a credit at acceptable terms, since the credit system is not developed. However, despite our wishes, the process will develop gradually. The natural course of events very rarely resorts to the leap function.

Searching for projects

- Now I would like to ask how you search for projects. At our first meeting you said that when the Investment Committee decides that time has come to invest money you are sending out your investment officers for search of specific projects. How do they look for projects?

- As a matter of fact, this is not an easy task. No officers coming from abroad will find any projects in Russia. Every such company has a certain circle of relations and a certain niche for operations that is filled only with time. Nothing else works, but time. You have to work on the market for a long time to be noticed and known. You have to sit and speak at various conferences. You have to agree to interviews like this. And when you become well known, the projects will come all by themselves.

Then you are facing another problem: you receive a lot of poorly presented projects that have good potential and a lot of well presented projects that are of no commercial interest. We select the commercially attractive projects and develop them to the state when they may be presented to our Investment Committee.

Andrei Kostyashkin (hereinafter referred to as - АК2): I recall the book "The dog's heart". There is a brilliant sentence: "Polygraphovich, how do you find them? " - "I feel them with my heart".

But, to speak seriously I would be very cautious when speaking about the commercial attraction of any project. For us this is not an abstract thing, since we have a very certain commercial ideology. The most important thing for us is how we will step out of the project after five years. For example, there is a number of industries that do not suppose stepping out for five years. Take the packing industry. Many people believe that the packing industry is very attractive. This is true, but at the same time it is very dangerous for investors.

- Why?

AK2: Because this is a rapidly developing business. It has low barriers for entry. You do not require much money to start the business. Your will require a lot of energy, a lot of desire and a lot of connections. For us it means that when we want to step out and sell the company to a strategic investor the only argument in favor of buying it will be the market share of such packing company. But it is very difficult to maintain the share we have won on such market, since it is constantly growing, and we have to reinvest money all the time. In other words this project will absorb a lot of financial and human resources, and then the funniest thing may happen. We have pumped a lot of money in the project, we have maintained our share of market, we propose the company to strategic investor, but all of a sudden it is more efficient for him to build a whole new super-factory.

- And what if you put this company on sale on the public market?

AK2: Not for a while yet. The companies are too small.

Another example illustrating how complicated it is to make the choice are service companies. The market is growing very well and provides high profits, but the questions is what do we sell to investor? Such companies do not have real assets worth talking about. The basis of their business is management services, ability to develop and adapt to the changing situation. Although I believe that we will find promising projects in the field of service rendering as well.

Another commercial factor important for in connection with the future stepping out of the project is whether the time for entering a market is ripe.

- But this seems to be simple: the earlier the better. Be the first and you will be appreciated.

AK2: Nothing of the kind. Early entering of the market has more disadvantages than advantages. It is not clear how the market will develop. Even if you work with a large market player the risk is very high. Market tendencies are not evident and in the event early entering of the market you have to rely fully on the market player's flair of the market. And what if this flair will fail him?

AK1: Basically, one of our most important investment criteria is successful history. We like to invest in the companies who have already achieved success, and who want to expand their business on the gained ground. We do not like early entry of the market because it looks good on the paper, but the reality may be different.

AK2: It is like the story about a man who was asked: Do you play the piano? The man answered "No, but I may try".

Usually, when people study the requirements that we set forth, they say: "Look at those wiseacres. If the company meets your requirements, why would such company turn to you for help"? I know the answer why. The most interesting projects for us, as investors, are consolidation projects. Imagine there are several market players. And they understand that if they consolidate their companies they will create something much stronger. They have been managing their companies for long time, and they know everything about their businesses, but the time has come when they should conceptually and mentally rise to another level. And this is where they need help from us. This is the promising field of activity for us. And there are many industries now where situation is such as I have described.

- Can you give an example?

AK1: Let us say that we are currently considering several projects of this kind related to foodstuffs, service rendering and manufacturing.

- What about brand names? There are many brand names that are advertised now. Is this a signal for action to you?

AK2: You know, it is not. We are very cautious in this respect. After the year 1998 the advertising has become extremely cheap and it is very cheap to create a national brand. I believe that with time this foam will settle and the brands that appeared as soap bubbles will go up in smoke. Therefore we are very careful about the brand market. We are considering whether this or that brand is real, who stays behind this brand and how it should be supported. Is there anything material, or is it simply an advertising campaign. If you act in haste, you will face the risk to acquire a heap of old soviet factories that will carelessly manufacture whatever they want, and every engineer will periodically introduce some kind of improvements in the process. As result you will get nothing but a lot of headache.

- As far as I understand your main commercial requirement is convenient stepping out of the project.

AK2: Yes. And we are fully aware of this. We always clearly explain to our potential partners that we there will be a certain period of time when we will closely work side by side, and then we will step out. Not because we do not like them, but because such is our role.

However, there is one more factor, which is very important to us in addition to stepping out. У проекта, который нас заинтересует, должен быть мотор. A project of interest for us shall have a driving force behind it, be it a manager, an entrepreneur, or anyone else, but somebody should be aware that this is his business. If there is no such person in the company, and if we do not see that any of our partners is able to head the company, we refuse to participate in the project.

All our other requirements create more or less comfortable environment for our work. If a company has any strong positions that make it difficult for competitors to enter the same market (for example, licenses, or expensive high-tech equipment), it is good. If a company has advantageous geographical location, it is also not bad.

- Entrepreneurs often complain about complicated relations with local authorities. Is this a serious limitation to you?

AK2: In reality these problems are self-inflicted. Very often when we meet with the region's governor for the first time he would ask: "What are your special requirements? How do you see the role of local authorities, local legislation, etc.?" There is only one answer to this: "We do not have any special requirements. Let us work in accordance with the rules that have been already formulated. We do not require anything else, thank you". Because as soon as this talk starts, the problems start too.

- And at the end the whole thing will become more expensive.

AK2: Exactly.

- Somehow you have not mentioned the financial situation of an enterprise. Is this aspect of no concern to you?

AK2: It is of very much concern to us. As a rule, we are talking about transparent financial situation at an enterprise which is not burdened with large debts. Basically speaking the debt does not mean that the project is sentenced to termination. In many cases we can bargain with entrepreneurs about the terms of participation in the project. But our entrepreneurs still like to say: "Why are you looking at our finance documentation? We are hiding and optimizing our earnings. In reality we have bags of money". Then I ask a straightforward question: "Where are those bags?" And finally it becomes clear that the bags of money in reality are just small paper cones. "So, what is your estimated "gray" turnover? About thirty percent?" And all lies stop at these thirty percent. Because even all our problems taken into account, and all the ruses that a Russian fellow applies when dealing with the government, Russia is not a country of exorbitant wealth. And it is not that they attempt to deceive us. More often they simply do not know how to calculate the required return of capital. And what they believe is profitable, is not profitable in reality.

Management buy-out

- Has the situation with the projects changed in any way in the recent time? Are there more or less projects nowadays; are they better or worse than in the past?

AK2: You know, the situation has really changed. And I am just beginning to understand what we managed to create in the past ten years. The most interesting and important projects come from our former partners. These projects do not lie on the surface. They cannot be noticed from Moscow. The can be seen only there, in the province. Our former partners who conduct their businesses there come to us and say: "We want to invest money in the project. But we do not have enough money. But this is an interesting project". Thus we began to co-invest Russian money and immediately expanded the field of investments very substantially.

AK1: By the way the opportunities for entering new fields of activity have also become broader. In Russia there is mostly talk about to ways: entering IPO market, or finding a strategic investor. But if you take America in the sixties or seventies, for example, the most popular way for institutional investors was management buy-out.

- That is to say when you sell your share to the partner?

AK1: Yes. And we already use this scheme in Russia. For example, there is a young, energetic and ambitious entrepreneur. But, as often happens, he does not have enough own money for expansion of his business. At the same time he says that five years is not enough for him. He says, he will substantially expand his opportunities during this time, but has no plans to retire. He says, help me, and after that I would like to head the whole business. This is a normal scenario. But I would like to add that in order for this scheme to work properly we require a complete financial system. This way of development is very efficient for the country. Who but the key manager is better in understanding all of the resources of his business? But he must get an opportunity to buy it out. Probably he will not be able to buy out this business even in five years and he will not be able to offer the right price that suits us. He could take a loan, but where?

- What is usually the scale of such businesses?

AK1: Turnover of fifteen-twenty million dollars. Middle-sized companies.

AK2: I would like to expand on the topic of projects. Many new and quickly developing projects have appeared in the recent time. And they have nothing to do with the old undervalued assets that are shuffled as cards by RTS. What we talk about is an entirely different business with institutionally sound basis.

AK1: Yes, the situation has changed radically. When we started our business the lion's share of projects dealt with undervalued enterprises, and there were almost no such projects that Andrei has described. Now the projects related to undervalued enterprises comprise about thirty percent of the total number. The rest are entirely new businesses.

- I have a question in this connection. What is your forecast for the future five years? You see positive changes at the microeconomic level, but how will be the situation at the macroeconomic level look like?

AK2: It will probably be a very bold statement, but we are not very much concerned with microeconomic level. We invested money in 1998, and we invested money in 1995. Crisis or not, life does not end. I can see that economy has become sounder at the microeconomic level. I got this feeling as far back as in 1999. And this feeling is still there despite all the fluctuations during this year. We receive more and more interesting projects, and if the macroeconomic situation improves, if enterprises have more opportunities to get credits, we will feel even better.

- Yes, we can trace the positive tendency in the economic development, but there exists a point of view that all projects, both at microeconomic and macroeconomic levels, if you sum them up have a certain natural life span. Today the country suffers from the lack of sufficient investments, and if no radical measures are taken for raising additional investments, then all those positive tendencies we observe today will fade out.

AK1: As I said earlier, the nature almost never implements the leap function. And this is true for economy as well. There is no leap demand for investments. The demand of investments is evolutionary. And evolutionary development of economy is to a great extent a guarantee for stability.

Graphic illustrations by Pavel Bykov

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