The emerging markets of Russia and Ukraine (the region) have been caught by the economic malaise currently gripping the world. A consequence of this malaise is that interest in capital markets has stalled. That is not to say that there is a lack of interest in going to market; there is just no market to go to.
what went wrong?
Worldwide banks have seen their balance sheets decimated and many have been forced to go cap in hand to national governments for bail outs. Without debt markets or capital markets (the most popular routes for companies from the region to finance their expansion) companies (and their owners) from the region are desperate for financing. Their desperation results in emerging opportunities for a prudent investor as oligarchs and minigarchs are keen to protect core assets and to do so will sell off ancillary holdings.
Not all doom and gloom
The volatility of capital markets internationally and risks in the banking sector, coupled with what appears to be a worldwide property bubble coming to an end, means that there are not many options open to a prudent investor with capital. The world is currently beating a path to the door of those investors (sovereign wealth funds, private equity houses, and individuals or syndicates of individuals) with capital to invest.
The factors that made the region a hotbed of investor interest still remain. The area is resource-rich, has an educated and motivated workforce, and has been, to date, underdeveloped. When the recovery comes it will be these resource-rich areas that will be the first to see growth, given that resources are the starting point for global production.
The devaluation of local currencies against traditional holding currencies (such as the US dollar, euro and pound), when taken together with the lack of alternative sources of capital (capital markets, governments and banks) for the region’s companies, means that there are excellent discounts available for the moneyed investor.
It is true that no-one knows when global consumption will return but, to a certain extent, we do know that it will need the raw and semi-finished materials that are found in abundance in the region. That being the case it is in the region that the first ‘green shoots’ may actually be seen. However, to be in a position to harvest those shoots, the prudent investor will have to ensure that their investment is secure and the route to security is to carefully consider how to structure their investment, in terms of corporate and legal mechanisms used to protect those holdings.
As is well known in the region, maintaining control of assets after an investment can be problematic. However, the current economic climate will allow an investor to stipulate corporate ownership structures to minimise risk and prepare the target company (the target) to maximise the return on investment when the markets do pick up.
Risks for investors
The key question (as always) for investors is the balance of risk and reward as to where they will achieve the greatest return on their investment. Once they have their target they will need to secure it, reform it and then, to realise their investment, take it to market.
One risk that the courts in the region have made all too apparent is choice of jurisdiction. It has been said that the region’s appetite to reform its courts is inversely proportional to the price of oil. With the volatility in the price of oil, the rumblings from Kyiv and Moscow as to court reforms and stamping out corruption are welcome. However, the prudent investor will continue to rely on foreign law jurisdiction clauses (England and Wales) together with international arbitration courts (American Arbitration Association (AAA), International Chamber of Commerce (ICC) or London Court of International Arbitration (LCIA)) that is enforceable in the region. Using local arbitration courts, such as the ICC in Kyiv, saves the local parties’ money and also encourages them to take part in the dispute resolution procedures.
Best practice
It is best practice that, once the target is identified, the asset itself is hived off from its current corporate structure. This ‘new’ company will then form the basis of the investment. All of its shares should be held offshore through holding companies and trusts. Cyprus, the Netherlands and the British Virgin Islands (BVI) are the most popular routes. Local advisors are essential to ensure that the hive off is effective and that the investment asset has been transferred properly.
Know your area
Local advisors are also essential to ensure that the region’s taxes are properly considered. Vladimir Putin, the current Prime Minister of Russia, has budgetary commitments and with the volatility in the price of oil it appears that the region’s tax collectors will have to replace black gold in the immediate future.
Control
Once the new company is created and the offshore investment structure is secure, the physical elements of the new company will still need to be controlled. Anyone familiar with the region will be aware of the almost Byzantine fascination with stamps and seals. That being the case the new company seal should be held offshore as well. Moreover, there will have to be diligent supervision of local company managers and of those appointed as directors of the new company. This is no different to the supervision required in any emerging market. The distance of ‘remote control’ management is inversely proportional to its success.
The corporate structure chosen for the target should be one recognisable to western norms. The prudent investor is looking to maximise growth on the investment. An analogy would be to the pre-crash housing market with the steps being to identify a property in need of refurbishment (the target), buy it (the new company) carry out the renovation (new offshore corporate structure) and then, when ready, put it on the market to realise your capital gain (FTSE/Alternative Investment Market (AIM) listing or further private placement).
Pre-investment due diligence on the target will include a review of its contractual documentation. These contracts should, as much as possible, be removed from local jurisdiction. This, alongside the revised corporate structure, is the ‘renovation’ of the target. It is crucial to get this stage correct and shortcuts should be avoided. It is this structuring, corporate and commercial that adds value to the target. It is vital to do a physical inspection of the target (often using private investigators to ensure that the seller owns what he is selling).
Comment
By carrying out a proper renovation on the target the prudent investor will have created a ‘turn-key’ company to take to market. Such companies will be best placed to attract further private placement investment in the short term and as time passes they will have the balance-sheet depth for the capital markets when they return.
There are still risks in going to an emerging market. However, with risks come rewards. Russia has clearly stated where national economic security issues arise. In those areas there is no point in trying to lock down an overly advantageous contract as this can lead to complications.
Fair and open dealing is the way to achieve results. Investors should also have some cultural understanding of the region. A contract is often seen as only one stage in an ongoing relationship as opposed to a concrete and fixed statement of the terms of engagement. As with the most successful marriages, the keys for success are communication and compromise.
In a world of investors betrayed by complex financial products and ponzi schemes it is easy to understand why simple, resource-based opportunities in the region are an attractive alternative for investment and growth.
By Yuri Botiuk, head of Russia and Ukraine desk, McGrigors LLP.
E-mail: yuri.botiuk@mcgrigors.com.
