OREANDA-NEWS. November 25, 2008. The report from PricewaterhouseCoopers, titled ‘Seeking differentiation at a time of change’, highlights the need for private equity firms to diversify and differentiate their businesses through this period and outlines the key challenges the industry must address in order to respond to today’s contracted markets.

A new report reveals that larger funds are broadening their investment criteria and geographical horizons. The holding period for portfolio companies is extending and private equity managers are demonstrating active portfolio management with this in mind.

The report also showcases comprehensive global investment and fund-raising data for 2007. In total, some US297 billion of private equity and venture capital was invested in the year, up 26% on the 2006 level of US235 billion. Although the environment has changed dramatically in just a few short months, the historic data showed global buyout activity still growing in 2007, while expansion capital and high-technology activity had flattened. Similarly, while investment activity was growing in emerging markets and the United States, it was flat in Europe.

Jonathan Thornton, Partner, Transaction Services PricewaterhouseCoopers in Russia, comments:
“The private equity industry is witnessing a dramatic downturn in deal activity and is suffering from a lack of leverage caused by the turmoil in the financial markets. This has a major impact on the ability to finance larger transactions but also creates a lack of buyers for existing portfolio companies. Private equity players will need to adapt to the longer term holding periods by looking at how they create value for portfolio companies.

Private equity managers are now looking at the diversification of their investment strategies and are seeking to differentiate their businesses during this time of change. Without doubt, we will see the industry reshape in order to adapt to the new order. Investors, in the current climate of focus on quality, are seeking access to those alternative investment managers with strong brand recognition that are seizing the opportunities and delivering returns in a transparent way. We must not forget that uncertain times also bring great opportunities for the patient private equity investor and investments from this vintage are likely to generate high returns.”

Among the key findings, the report highlights the need for sustainable growth and diversification and examines the growing pressure on fair value accounting and mounting tax risks. It also looks at the opportunities for private equity in the BRIC economies.

Jonathan Thornton continues:
“Companies also need to consider the accompanying risks when expanding into BRIC economies, whether these are the fundraising and investment trends, the key legislative and tax considerations, or the structures utilised in each jurisdiction. The industry needs to have emerging market strategies and careful planning and due diligence will be essential”.

Russia
The Russian private equity market has grown rapidly over the last five years. Transactions have become larger, reaching an average of US60 million in the first eight months of 2008, and the number of deals has steadily risen, with 28 closed in the same period.

Local players have dominated so far, with an estimated US10 billion under management, but potentially as much as US40 billion at their disposal. Some are arms of investment banks. Others are connected to leading financial industrial groups. However, foreign players have struck many of the largest private equity deals.

The largest was the April 2008 US800 million acquisition by TPG, a US buyout group of a 50% stake in SIA International, Russia’s largest pharmaceutical distributor. Prior to this, the largest private equity transaction was the October 2007 US500 million acquisition of Nidan Soki, Russia’s leading juice producer, by a UK buyout group. However, most transactions have ranged between US10 million and US50 million. The most active sector has been consumer products and retail, but activity has been robust also in infrastructure, manufacturing, construction and real estate, and financial services.

With favourable macroeconomic conditions, Russia has been increasingly viewed as an attractive investment destination. It is not always perhaps the simplest place globally to invest, but the potential rewards can more than adequately compensate for the necessary additional effort. Since foreign direct investment has been comparatively low and the consolidation process still under way, there are many first mover advantages for new entrants.

Jonathan Thornton adds:
“Rapid growth, high margins and low competition — and numerous attractive target opportunities — add up to an attractive environment for private equity. Private equity investors can still make substantial gains from introducing higher quality management and controls. In more developed markets, operational gains often come from cost-cutting measures – in Russia the major challenges are frequently coping with growth and with upgrading technology.”

Although the world financial crisis is also affecting Russian companies’ liquidity positions, it may reduce valuations of Russian companies and open up opportunities for private equity to finance companies that were previously planning to raise finance through initial public offerings (IPOs) or have outstanding short-term debt instruments.

Yet Russia presents substantial challenges as well as compelling opportunities. Private equity firms should be repared to understand these challenges and adjust their business approach in order to address them successfully. Five challenges could be faced closing private equity deals in Russia:
Local business culture will influenceы the structure and timing
An understanding of ‘soft’ or cultural differences is often a key to success in negotiations with vendors. Proper due diligence is even more important in Russia than in developed markets in order to have a clear picture of a company’s finances, operations and competitive position.

High level of uncertainty
It is important to understand that tax legislation in Russia was put in place only approximately 15 years ago and is still developing. Lack of official interpretations, guidelines and precedents add to the uncertainty in assessing tax risks associated with investments.

Presume complex debt pushdown strategies

Galina Naumenko, Tax M&A Partner PricewaterhouseCoopers in Russia:
“Pushing debt down into the operating companies is a typical requirement of lending banks, since they require direct access to cash for debt servicing and to the assets in the case of default. Moreover, the tax savings from deduction of acquisition debt interest at the level of operational companies may have a considerable impact on the economics of the deal for private equity investors.”

Cash flows managing
While the deal structure usually does not directly affect the generation of cash from operations, it may significantly affect the practicality of moving cash quickly for servicing the debt.

Complex security packages

Galina Naumenko comments:
“The provision of debt financing is conditional on providing an adequate security package to banks. This is most commonly achieved through a combination of pledges on shares and assets, and provision of guarantees, ideally by target companies. On the one hand, Russia does not have any financial assistance rules, which often complicate structuring security package in some European countries. On the other hand, banks typically require that extensive cross-guarantees be provided by operational and holding companies.”

Jonathan Thornton in conclusion:
”Despite the gloom on the financial markets, we see private equity as having a promising future in Russia — it is one of the few remaining sources of financing open for businesses today as loans from banks are harder to obtain and IPOs are not an option. The PE houses are estimated to be sitting on several billion dollars in capital specially designated for investment in Russia and they are looking for investment opportunities. So we’re entering a challenging but exciting period for private equity investors in Russia for which we expect the share of international funds to increase significantly within the next two years.”