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Equity train puts on the brakes

16 Oct 2007

In last October’s EuroWeek Russia report, the headline for this feature read: "The golden age of Russian IPOs". If the age is not over, the gold is looking a little tarnished. In 2006 the Russian Trading System exchange rose by 66%, continuing a staggering trend of growth since 2001; by mid-October this year it had grown by a measly 13%. Julian Evans asks why and finds out what the market is doing about it.

It has been a difficult year for Russian equity markets. Other emerging markets enjoyed a great first half of the year, with the Turkish exchange up 43%, Egypt’s up 25% and the Shanghai exchange up 107%, while Russia’s RTS stayed essentially flat.

To be fair, it has since put on a spurt, rising 14.7% from July to mid-October. But this performance is still a little wan, considering that the fundamentals of the economy look great: GDP growth is set for 7%-8% this year, oil is around $84 a barrel, the government has around $300bn of foreign exchange reserves, fixed investment grew by 20% in the first six months, and the consumer sector has become as much a driver of GDP growth as commodities. So what explains the RTS’s dismal first half performance, even before the global credit crunch hit in August?

Partly, oil stocks are responsible. That is because the oil price dipped in the first quarter, the Kremlin’s high taxes ate into oil and gas companies’ profits, and the controversy over ownership of the Kovykta gas field pulled down the share price of TNK-BP and hurt other private oil companies as well. Oil and gas stocks account for around 50% of the RTS, so when that sector underperforms, so does the whole market.

Another problem has been the flood of IPOs. Matthias Siller, manager at Baring’s emerging Europe team, says: "Russia has lagged behind other emerging markets this year partly because of the massive amount of new issuance we have seen [before then]." Around $25bn in new issuance came to the market in the first half of the year, as companies rushed to raise capital before the election season began.

Deals included Sberbank’s $8.8bn secondary domestic offering in February, VTB’s $8.2bn IPO in April, Magnitogorsk’s $1.1bn IPO in April, and other big offers by Polymetal ($600m), Sitronics ($400m), Pharmastand ($880m) and Integra ($750m).

One sector that has been a surprisingly rich source of new issuance is the real estate sector. Meinl European Land and Immoeast, two central European property funds, each raised around $3bn on the Vienna Stock Exchange in May, while Russian company Open Investments, by now something of a veteran of capital raising, raised another $325m in Moscow, also in May.

Property’s mixed fortunes
But the market began to turn nasty that month, when property developer AFI Development tried to sell what was then the biggest ever Russian property deal, a $1.4bn offering lead managed by Morgan Stanley and Deutsche Bank. Reinout Koopmans, head of CEEMEA equity capital markets at Deutsche Bank, says: "There was incredibly strong momentum around some of the larger real estate deals earlier this year, as they provided the first liquid opportunity to invest in the Russian real estate market. So there was very broad interest in the offerings. But then the market was hit by global real estate and subprime concerns, which affected the after market."

The deal tanked in the secondary market, losing 20% of its value in two weeks, and is now down around 40% from issue price. Perhaps the banks priced the deal too expensively, although by that time investor anxieties about the US subprime market were beginning to spread to other financial markets, and global equity market conditions were turning unfavourable.

Another real estate group, PIK, came to the equity capital market in June with Deutsche Bank, Morgan Stanley, Nomura and Merrill Lynch arranging the sale. One banker who worked on both the PIK and AFI deals says: "The evaluation of the PIK deal was significantly different to AFI, and bookbuilding was more challenging. It was already a different market by then."

Perhaps because of the less ambitious pricing, the deal has done better in the secondary market, and is up 12% from the offer price. Maxim Seltzer, Nomura’s recently-appointed head of Russia and CIS, believes the bank’s innovative tapping of the Asian investor base was a crucial factor in the deal’s success: "The Asian investor base helped ensure the success of the PIK deal, and improved valuation. Asians are very familiar with the type of mass residential housing that PIK provides." Around 30% of the deal was sold into Asia.

Russian depositary receipts
Following the PIK deal, the equity capital market has seized up, and several deals have been delayed. The biggest is Rusal’s $8bn IPO, which would have been the first Russian company to do an ordinary shares listing, as opposed to a global depositary receipts listing, on the London Stock Exchange.

Deutsche Bank’s Koopmans says: "In general, we’re seeing a number of Russian issuers looking at listing ordinary shares in London." The reason for that, he says, is that a listing of ordinary shares opens deals up to a much bigger pool of investors. If a company does a big ordinary listing, it can be included on the FTSE, and will gain access to the large pool of FTSE tracker funds. A successful example of such a deal is the Kazakhmys IPO in 2005, which saw the Kazakh copper company become the 40th biggest company on the FTSE.

Koopmans says that GDR listings, by contrast, can only hope to raise a maximum of about $2bn from foreign investors, because they are only usually bought by dedicated emerging markets funds.

However, an ordinary share listing brings new problems with it. Firstly, companies registered in Russia have difficulty meeting the requirements for an ordinary listing on the LSE, so banks usually recommend that they register as a UK company first. This, for example, is what Kazakh conglomerate Eurasian Natural Resources Company is doing in preparation for its ordinary listing on the LSE. But registering as a UK firm and then only listing your shares in London can sometimes attract the ire of the Russian regulators, who think that such offshore structures deprive the young Russian market of much needed liquidity, while also avoiding Russian taxes.

Lawyers have devised a way for Russian companies to deal with this problem — Russian depositary receipts (RDRs). Hugo Stolkin, a partner at Linklaters, explains: "It’s a GDR in reverse. Russian companies register in the UK or in another foreign tax regime, but then issue shares to a Russian bank, which then issues deposit receipts to Russian investors. It’s a good way of dealing with political pressure from foreign listings, while also opening a deal up to the growing pool of local investors in Russia." Stolkin says several companies, including supermarket chain X5, are preparing such deals.

Red tape, pulled deals
But another problem for ordinary share listings is the degree of corporate disclosure necessary for the FTSE investor base. Koopmans says: "The way GDRs have developed is that investors investing in these instruments are aware that some of the standards are driven by local requirements, so sales are more focused on investors that have good knowledge of the customs and business practices in the local markets. Listed ordinary shares tend to be distributed more broadly and hence some of these issues are more sensitive."

Bookrunners’ concerns about disclosure and reputation risk may have been one of the factors behind aluminium company Rusal’s decision, in September, to delay its IPO to an indefinite date sometime in the next three years. Morgan Stanley, Deutsche Bank, UBS, Credit Suisse and Goldman Sachs are the bookrunners.

Rusal’s largest shareholder, Oleg Deripaska, is involved in a legal dispute with former partner Michael Cherney, who claims he set Deripaska up in business and was a 50% partner in his aluminium holdings, and that Deripaska still owes him around $3bn. His holding company, Basic Element, denies the allegations, and Deripaska himself told the Financial Times newspaper: "I have no business relationship with that man."

Whatever the reason for the delay, Rusal is not alone in pulling deals. Several other Russian IPOs have been pulled this year, and some before the global credit crunch. Charles Lucas, head of CEEMEA equity capital markets at ABN Amro, says: "This year, there has been much more of a debate on valuation between banks and shareholders, and between banks and investors. Sometimes global banks have walked away from deals and local banks have picked them up. And sometimes shareholders have decided not to go for an IPO, like [fertiliser company] Uralkali or [insurance firm] Reso-Garantia."

Lucas says that investors have become much more discriminating about what deals they buy. That is partly because there are more stocks on offer in hitherto new territory such as metals, property or consumer stocks, so investors can pick and choose between deals.

Reopening awaited
The question now is how long it will be before the market for new issues reopens. There are certainly companies hoping to access the market. These include Eurasia Drilling Company, which has begun marketing for a planned $600m offering in the fourth quarter 2007; Teorema, a St Petersburg property company which plans a $500m IPO also in the fourth quarter; and Alisher Usmanov’s Gazmetall and Gazprombank, the third largest bank in Russia, both of which are aiming to do an IPO next year.

One deal has braved the new market already. OGK-2, one of the companies spun-off in the restructuring of electricity monopoly Unified Energy System, which raised $1bn in a secondary offering in early October. The deal was $600m less than the power company hoped to raise, and two thirds of the deal was bought by Gazprom, which may have scared off other investors.

UES has so far been something of a disappointment in terms of new issuance. The company’s CEO Anatoly Chubais at one point was talking about bringing $20bn in new deals to the equity markets, but so far only around $3bn has been raised, with most privatisations happening through strategic sales.

How many deals get done in the next six months depends on whether investors come off the sidelines and re-enter the market. "There’s real uncertainty out there in the market at the moment," says Nomura’s Maxim Seltzer. "There have been significant redemptions by emerging market funds, even though emerging markets are relatively well insulated from US subprime problems." Siller of Baring Asset Management says: "Volumes are very low at the moment, even below $1bn a day in trades on Micex. A lot of cash is parked in money accounts."

There are some signs that the market is picking up. The RTS rallied 3% in a day after President Putin announced he might stand for prime minister when his term ends next year, meaning that political uncertainty around the Duma and presidential elections would be minimised.

Even so, it remains something of a riddle why the Russian stockmarket doesn’t perform better when the Russian economy is doing so well. Many fund managers blame the Western media for being excessively critical of Russia, and making it out to be some sort of gangster paradise.

Perhaps it is the fault of the media, perhaps it is partly the fault of the Kremlin’s obstreperous foreign policy towards the West that can be blamed for political tensions. In any case, Russia still trades at a distinct premium to other emerging markets, while its fundamentals grow ever stronger. Sounds like a good time to buy.

16 Oct 2007