Bear Market

(This feature is taken from Private Equity Europe, the pan-European publication from the publishers of unquote")

For a while it seemed as if the global financial crisis would not diminish emerging market appeal. Despite the onset of adverse symptoms in Europe and the US in 2007, emerging market figures maintained an upward thrust, indicating they had indeed decoupled from the West. In fact, global emerging markets' private activity peaked in Q2 2008, meaning they grew for a full year after more developed markets peaked in Q2 2007.

Jump ahead to the present and confidence in emerging market economies has crashed and the decoupling theory has been swiftly debunked. As Fitch downgraded Russia's investment grade from BBB+ to BBB this February - the second lowest rating and inches away from junk - the leaders at Davos were also clear: BRIC growth has considerably slowed and key indicators forecast further drops. Rather than proving the motor that pulls the world out of a recession, the world looks likely to drag emerging markets down with it.

In Russia times are particularly tough. The downgrade damage has been compounded by a deadly cocktail of exposure to foreign loans, rapidly falling world oil prices and loss of confidence in the ruble. While China's annual GDP growth has been reduced from 9% to a predicted 6%, Russian growth dropped from 8% to 5.6% in 2008, and the forecast for this year is close to zero. Putin's boldly issued comments about Russia's immunity from the global recession appeared borderline ridiculous as he back-tracked in a speech at Davos.

The private equity fallout
"The market will be tricky going forward," predicts Alessandra Pasian, senior banker at the European Bank for Reconstruction and Development (EBRD) - the largest investor in Central and Eastern Europe. "2009 does not look positive, not just for Russia but for the whole CIS region."

The most immediate repercussions of the crisis are identified as amplified risk for portfolio companies and a halt on new investments. "Our fund managers are currently looking after their existing portfolio companies and trying to preserve and add value. They keep an eye out for new opportunities but are cautious in taking on new exposures," Pasian confirms.

Mike Calvey, co-managing partner of Baring Vostok Capital Partners, upholds Pasian's projections. He particularly highlights "liability management issues" in existing portfolio companies, especially in light of the recent substantial currency devaluation. Many Russian companies are dependent on foreign loans and with the ruble's value hitting historic lows, interest rate payments are becoming threatening.

Calvey also draws attention to the lack of fundraising activity in the current climate, with LPs running scared and investor confidence waning. Indeed, Russia's foreign direct investment situation can best be described as record capital flight. Of the massive influx of foreign capital that poured in over the last few years, more than $83bn has left since August, indicating how quickly speculative capital departs.

"Only the most successful funds with long-term established LP relationships have a chance of raising new capital," asserts Calvey, who also claims that existing players will have to attract considerably more LPs to reach fund targets, since LP 'bite sizes' are now much smaller.

Invest now, prevail later?
Typically every doom and gloom scenario has a silver lining and here is no exception. Like in other economies the crisis has driven down stock prices, making assets appear undervalued. Russia's RTS index has reversed its upward growth trajectory - it rose by a compound annual rate of 40% from 2004-2007 - and this could mean sweet pickings for acquisition-hungry private equity firms.

"Given the fall in stock market valuations there might be a chance now to de-list companies that would not have been possible two years ago," Pasian says. "It might be possible that some fund managers will start looking at listed companies as possible acquisition targets to take them private."

When it comes to sector attractiveness, the silver lining is harder to locate. "In the last few years private equity has looked at investments in every sector, from retail, to IT, to financial services. It was truly opportunistic. Now it is hard to predict a sector focus," Parsian notes. Of course more resilient sectors will be targets of new investment, but it remains to be seen which industries will pull through.

Meanwhile the instability in valuation upsets investor insecurity and makes the market fairly inactive. As with elsewhere in Europe, vendor price expectations remain pie-in-the-sky vis-à-vis those buyers are willing to pay.

Lessons in Putinomics
Since the onset of low oil prices and recession symptoms, Russia has spent approximately $200bn - about one third of its substantial foreign reserves - in an effort to combat currency depreciation. While the country has clearly learned the lessons of the 1998 ruble crisis and made policy revamps, this is now proving insufficient to weather the storm.

Putin's tone can best be described as sincere flip-flopping. Since last autumn he has transitioned from blame-oriented and critical of the west for its role in the downfall of global capitalist system, to Mr. Team Player. At the recent Davos forum, Putin noted: "We cannot afford being isolationist or economically selfish. We are all in the same boat."

It seems his cooperative sentiment is both strategic and true. In the long-term, Russia's way out of the crisis is dependent on the US and Europe's way out, and nowhere is this more true than in private equity. The perceived insulation from the downturn turned out to be a lag effect and trends in the country now mirror those of Western Europe in early 2008. The question is, can Russia learn from its Western rivals and get on the path to recovery before the whole system comes crashing down?

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