Is Russia Really Ready For Hedge Funds?

Is Russia really ready for hedge funds?

Stuart Fieldhouse
Originally published in the June 2006 issue

Seasoned Russia investor William F. Browder has been talking up a storm in recent weeks following his unexplained expulsion from Russia, a country his firm, Hermitage Capital Management, has roughly $4 billion invested in. Historically, Browder has been unusual amongst large hedge fund managers in his readiness to speak to the press on issues related to his emerging markets investments. He has regularly focused his statements on the condition of corporate governance in Russia, and now on the way the Russian visa system is being cynically manipulated to keep him out of the country. Browder had his visa privileges revoked by the Russian immigration authorities, but feels he has not been given a satisfactory reason for this action. It is a strange way for a country which has ostensibly embraced capitalism, to treat a major investor in its companies.

What is perhaps the more worrying aspect of the affair for foreign investors is the seeming lack of a proper explanation from the country's immigration authorities. The rising oil price means the stakes in the oil and gas game are getting ever higher, and as a successful foreign player in the market- and arguably the largest foreign portfolio investor in Russia – Browder is being subtly told to stay out while others feast on the pie. While both Hermitage, and incidentally the UK Foreign Office, have sought a response from the Russian government for the incident, none has been forthcoming. A characteristic silence seems to be the stock response from the Russian authorities when its administrative bureaucracy is again used to browbeat a foreign investor.

Russia has earned plaudits from some quarters for the ongoing Putin-inspired crackdown on its small coterie of oligarchs. Its high profile trial of Mikhail Khodorkovsky, for example, seems to have sent a signal to both foreign investors and ordinary Russians that high level corruption is being rooted out, and that the massive oil and gas empires a small group of businessmen controlled in the Yeltsin era, are now more accountable to both employees and shareholders.

But are they? Browder remains a big fan of Russia and of its president Valdimir Putin, but is also an outspoken proponent of corporate reform within the country. He points to a recent process whereby economic power has been taken away from 20-odd supremely wealthy oligarchs, and passed onto some 10,000 Russian bureaucrats. "The economic cost of corruption has declined dramatically," he told Newsweek last month. "But the number of people implementing corruption has expanded."

If Browder is to be believed, many of the 10,000 beneficiaries of Putin's munificence are his former colleagues in the KGB, so-called 'siliviki', whom he needs to stay in power. These are people with a degree of administrative power that can make the lives of fund managers very difficult if they so choose.

Browder is sanguine about the market – he stresses a lot worse things can happen to investors in emerging markets "who tread on people's toes." China, for example, is even more challenging, he argues, citing the case of some Chinese American businessmen who have ended up in jail. A visa being revoked is, in his view, minor by comparison.

"Essentially there are a lot of ways people can be administratively harassed," he told The Hedge Fund Journal. "Every year Russia is getting better in this respect. Many emerging markets are a lot worse."

From a practical point of view, banning him from visiting the country does not hamper the management of his fund: it is up around 40% since the problems began. "It does not create as many problems for financial markets investors," he says, "but it can be harder for private equity or real estate investors, for example."

Although pointing to his visa problems as potentially part and parcel of the rise of the 'siliviki' clique within the Russian power superstructure, Browder says the Yeltsin era was far more problematic for foreign investors. "It is a question of two steps forward, one step back," he says. "If you compare a snapshot of Russia today with Russia six years ago, you will see a lot has improved."

His views are echoed by Petek Kutucuoglu, Head of Research at GEM Global Equities Management, an investment advisory firmbased in Germany and Turkey which has been managing emerging markets hedge funds since 1993, and has a lengthy track record in Russia stretching back to the Gorbachev era. "Corporate governance in Russia significantly improved during Russia's process of transition to a market economy," says Kutucuoglu. "However, further improvements are still needed to bring it to the same level as international standards."

Examples of other problems foreign investors have had to tackle include asset stripping (the sale of subsidiaries/assets to management affiliates/relatives at cheap prices); transfer pricing; inefficient reporting and asymmetric information sharing with different investor classes; dilution of shareholders with restricted share sales at cheap prices; and high capital expenditures to maximise benefits to management rather than all shareholders.

"It is certainly the case that an improvement in corporate governance significantly affected company valuations in Russia," says Kutucuoglu. "Gazprom, Sberbank, and Ues are clear examples."

Gazprom: a case study in corporate malpractice?

Gazprom has become almost a household name these days. The world's biggest gas company, and Russia's largest corporation, period, it has a massive valuation gap compared with its global peers. Corporate governance problems of the kind Browder has complained of have played a big role in its depressed valuation. Prior to the management of current CEO Alexei Miller, Gazprom was seen to commit several corporate governance bloopers: in 2000-01, it was accused of a lack of information regarding its shareholding structure, the classic selling of assets at cheap prices to management affiliates, dilution of shares, and a lack of independent boards of directors. It was capitalism, but perhaps not as it is recognised in the City of London.

Among the myriad of detrimental related-party transactions, the outstanding deal was the transfer of sizeable gas reserves, almost for free, to a company controlled by management affiliates. The appointment of Miller in 2001, on the recommendation of President Putin, marked a major turnaround, bringing changes to financial reporting, transparency in other types of information dissemination, changes to the corporate structure, and a new era of fairer transactions with third parties. After adopting the goal of improving corporate governance as a major item in its strategic plan, Gazprom completed the first phase in its planned two-stage internal reform program. A new auditor was assigned to the company, and new procedures for shareholder oversight and approval of asset transactions have been adopted. Gazprom management has even approved a corporate governance code, requiring that two thirds of its board of directors be independent. The second phase of restructuring is ongoing, with the aim of breaking the company into separate business units for purposes of cash-flow reporting.

It seems as if some of the agitation, both public and private, that Hermitage and other foreign investors have displayed, may have helped the regime in Moscow to institute reforms. However, there has also been a demand for reform inside Russia that does not get the international coverage Browder commands. Some retail and institutional investors have formed independent organisations to improve Russian corporate governance practices, for example. These bodies are monitoring and rating the corporate governance practices of Russian companies, helping to appoint independent directors to company boards, and providing training for Russian directors. Importantly, they have also conducted public awareness campaigns in support of corporate governance reform.

Alexander Ikonnikov is a Partner with Board Solutions, a Russian-based consultancy which advises local firms on board-level issues, particularly those relating to IPOs. He also helps them to recruit competent independent directors, frequently from overseas. "The relationship between managers and owners is improving as more companies are looking at IPOs," Ikonnikov says. He thinks that the more highly competitive consumer industries in Russia are seeing a much faster pace of reform than in the more politically sensitive energy sector.

While the creation of some internal corporate governance guidelines and the appointment of a board of directors looks good on the surface, businesses in Russia are having to come to terms with the fact that the governance has to be real. "Investors have to look at the company and see if they are rubber-stamping the books," Ikonnikov says. "Look at the attitude of the chairman and the CEO. Are they qualified? How have they sourced their directors? What are their procedures and rules?"

Some firms in Russia still resort to tried-and-tested tricks of the trade, like inviting personal friends to become directors, often people with a low level of business experience. "It is difficult to convince Russian owners, who still have a Russian mentality, that they should embrace a separate structure," Ikonnikov says. In addition, he thinks fund managers used to being appointed to the board on the basis of a minority shareholding may find it a more difficult tactic with Russian firms "They generally do not support the election of minority shareholders," he says. "It is partly due to problems with communication, but I think if you had representatives of a hedge fund on a board, there could be problems."

It is not all coming from the grass roots: the Russian Federal Securities Commission (FCSM) has instituted its own reforms: it enacted the Russian Code of Corporate Governance based on input from various parties, including institutional investors and the management of leading Russian enterprises. Adherence to the code is voluntary at the moment, but in the view of GEM Global's Kutucuoglu, "it certainly set out a good basis [for] evaluation of companies." In addition, the FCSM has been rewriting corporate legislation to address major issues like transfer pricing and management practices in group companies. "Notwithstanding a few exceptions, Russian laws and regulations in the area of corporate governance have substantially improved during the last few years," Kutucuoglu says. "However, enforcement and implementation of these laws and regulations has still been weak, inconsistent, and without widespread practice. Although major blue chip companies in Russia have made great progress, proper corporate governance practices are not widespread among all public corporations."

One successful Russia manager who takes a slightly different tack is George Ninias, who runs the Denholm Hall Russia Arbitrage Fund. The fund primarily lends money to small and medium-sized Russian companies by purchasing domestic promissory notes called veksels, which represent the largest short-term Russian domestic debt market. Veksels are considered a powerfully-protected form of debt in Russia. Holders have the right to apply to courts to seize assets in the case of defaulted payments, a right that is automatically granted and recognised through decades of practice (laws regulating their issuance were codified in 1936, although the market has exited since the Tsarist era).

"We are very hands on," Ninias says. "We have people on the board, and we own the assets of the companies we lend to. There are disagreements on strategy, but this is normal for any company. Our process is long enough and detailed enough to flush the wide boys out." Those companies not comfortable with the way Ninias operates don't benefit from a relationship with his fund. As for exposure to the booming gas and oil industries, he has acquired this via by financing companies in the energy construction space, for example building pipelines and refineries. "A lot depends on the management," Ninias explains. "I would say companies with large amounts of money being passed around are more difficult to control."

Column inches

Since his expulsion from the country, Browder has been commanding column inches in many mainstream financial publications. He has also been lobbying politicians in both Washington DC and London to intervene on his behalf, and is hoping that diplomatic pressure will eventually lead to his visa privileges being restored. "Bill has been one of the most successful hedge fund managers in Russia – he's incredibly outspoken," says Ian Bremmer, President of Eurasia Group, an independent political risk consultancy which specialises in emerging markets. "You can only go so far doing that, however. Noone else has been nearly as outspoken or investigative. Russia may have a president, but it does not have a presidency – this is going to be other people's problem as well."

Bremmer is seeing a transition of power from the oligarchs to a coterie of Kremlin insiders, which he says is nowhere near complete. It is part of a strategic process to create a number of 'national champions', massive Russian mega-corporations that can compete on the international stage. Much of this focus has been on the natural resources industries, which have vital strategic importance for Russia's economy. "It is very important to understand the key actors in the Kremlin," Bremmer says, "the corporate executives, and their relationships with the government. The better you get at this, the more successful you become. If anything, Browder was too successful."

Bremmer says it is still worth investors appealing to the Kremlin for help, and the administration there has acted in favour of foreigners before. Much depends on which sector they are operating in.

The Hermitage issue remains a concern for foreign investors in emerging markets, particularly hedge funds that believe there are serious investment opportunities to be realised in the oil and gas sector, as these firms benefit from the high oil price. Hermitage is not the only hedge fund that has fallen prey to shadowy bureaucrats seeking to protect their economic privileges – even mainstream long-only mutual funds have suffered from the vagaries of the immigration system in Russia. Boris Jordan, manager of the Sputnik venture capital fund, the man who persuaded BP to become the first foreign investor to take a stake in the Russian oil industry when it acquired 10% in Sidanko in 1997 (and later went on to help Gazprom take over controversial Moscow broadcaster NTV in 2001), has had his own share of visa problems. Browder says many managers experience these kinds of red tape entanglements, but simply accept it as part of the cost of doing business in emerging markets. Unlike Browder, they don't go on the record about it, hoping simply that it will go away, and they'll be allowed to continue to do business.

As Russia continues to clean up its corporate governance act, Browder, and other managers like him, are hoping that life will get easier. Large profits still to be had in the country's energy sector mean they will have to continue to put up with the inconveniences that operating a Russia fund continues to throw out at them. Russia, they argue, still needs their investment dollars. A rap across the knuckles from the immigration department is considered a small price to pay. Experts like Bremmer remain positive about the pace of reform under Putin, but are also advising their clients that a potential risk scenario exists in 2008, when the president will step down. He may retain considerable influence in Moscow, but in Ian Bremmer's view, come 2009, "there will definitely be risk there."