Distressed investing in Russia

Russian distressed debt professionals love to refer to art in discussing current affairs. Vedomosti, the leading finance newspaper in Russia and the organiser of the largest annual distressed debt conference in the country, has a tradition of showcasing a famous painting at the start of their events.

The artwork shown at this year’s Distressed Debt Conference was Hylas and the Nymphs. It was painted in 1896 by John William Waterhouse, a prominent British artist. It depicts a scene from an ancient Greek legend, where water nymphs tried to abduct Hylas, a servant of Hercules, and drag him into the water.

Was it an allegory for the Russian distressed market and what did it mean?

Russia’s NPL market: worth the risk?

It is no secret that investors find the Russian distressed debt market intriguing. After all, Russia, the largest issuer of corporate loans and the biggest holder of non-performing loans (NPL) in Central and Eastern Europe, made it to the top three list of the most prospective distressed investing markets in the region in 2017 (PwC). The post-COVID-19 environment may present investors with even more possibilities amid steadily increasing number of loan issuances by banks both in Russian roubles and in foreign currencies.

By stating the above, I am by no means attempting to advertise Russia as a goldmine for immediate and exciting risk-adjusted returns. Russia’s NPL market is still at an early stage of development, and this is well known. NPL quality is still generally low. In his interview with Vedomosti, Alexander Sokolov, President of Bank TRUST, commented that out of the Bank’s total RUB 2 trillion (USD$27 billion as per CBR exchange rate on 08.18.2018) portfolio, no more than 25% of assets were recoverable - and if the full 25% was recovered, this would be a great achievement, industry analysts say.

In addition, the country’s legal ecosystem provides limited instruments for debt restructuring and insolvency. Finally, the volatile macroeconomic environment makes Russian distressed investments a challenge to exit due to limited foreign private capital.

But having worked in this market for quite a while, I wanted to highlight another perspective of Russia’s NPL market, the one that doesn’t get the international press coverage. Despite the well-documented challenges and harsh economic, legal and political conditions, local investors still manage to find opportunities – and the improving legal ecosystem gives hope that this emerging market will gain credibility with international investors.

To discover the state of Russia’s distressed debt market, current investor attitudes and how to best approach the emerging market for opportunities, I spoke to a wide range of industry professionals, working in the Russian NPL market, in banking, advisory, legal and others, including London Business School Professor Florin Vasvari, who teaches the elective Distressed Investing for the School’s Degree programmes.

Gargantuan market, which will continue to grow

Figure 1: Russia’s debt market vs. other CEE countries (bubble size equals loans issued, USD-nom.), 2018Y

Source: Oxford Economics, World Bank Group, European Banking Federation, CEIC, CBR, LBS analysis

Russia is by far the largest NPL market in Central and Eastern Europe (see Figure 1) and it is expected to continue to grow amid the current epidemiological situation. One of the key drivers for its growth is an increase in bank loan funding over the three years between 2017 and 2020. During this time, the Central Bank of Russia eased its monetary policy by gradually reducing the key rate from 17% in 2014 to 5.5% in April 2020 to stimulate the economy and help it recover from the oil and geopolitical crises of 2015 and 2016. 

In addition, over the past five to six years, the Central Bank significantly tightened bank supervision procedures and started to revoke licenses of private banks which were in distress and hiding their true NPL levels. As a result, the number of banks in operation was reduced by almost 50% - from 922 in 2011 to about 500 in 2018.

These actions by the Central Bank contributed to a rise in corporate NPL ratios countrywide, which were circa 12% for SMEs and 4% to 5% for large businesses as of May 2020. Such trends are expected to continue beyond 2020, thus expanding the market.

Crucial legal improvements are on their way

Russian legislation, related to debt restructuring and insolvency, has several limitations, compared to the US and UK. Some of which are as follows:

• Out-of-court restructuring provisions are relatively standard but do not recognise the possibility to purchase equity in exchange for loan forgiveness. As a result, realising debt-to-equity swaps and some of the classic distressed investing strategies, such as loan-to-own, may be challenging.
• There are limited tools for in-court workout of distressed debt. In its current wording, the Russian Insolvency Law makes the procedure a bureaucratic process, provides limited grounds for conducting operational turnarounds and may incentivise borrowers to participate in fraudulent trading.
• The Russian Insolvency Law does not provide for value-preserving instruments, such as Chapter 11 in the US. Its analogue to the UK’s Scheme of Arrangement, named ‘Amicable Agreement’, bears significant bankruptcy stigma and can trigger default clauses in loan agreements. As a result, about 98% of all insolvency cases result in liquidation.

Amendments to the Russian Bankruptcy Law are expected to come into force in 2021. These amendments include reducing the number of insolvency stages (existing four stages to be reduced to two: Debt Restructuring and Liquidation). In addition, supervision procedures will be simplified.

Restructuring options will be clarified and key features of Amicable Agreements will be added. This includes moving the creditors’ majority rule in approving the restructuring plan into the Debt Restructuring stage. These amendments should significantly shorten the overall insolvency period, reduce the number of liquidations and help the domestic Scheme of Arrangement-like process to shed its bankruptcy stigma.

The amendments will also make it possible to sell a company as a whole during the insolvency process, without the need to liquidate and divest assets separately; something which was not defined in the previous versions of the law. This is a crucial step in developing a value-preserving legislative system, saving businesses and jobs.

Sale of companies or their assets under the liquidation stage will also go through a newly introduced Anglo-Dutch auction. Allotments will be assigned to the highest bidders, however, if a start price does not satisfy any bidders, auction may continue with decreasing price offers. Russia’s Ministry of Economic Development, the author of this amendment, hopes that this could give more opportunities for distressed investors and create a separate ‘bankruptcy marketplace’.

Interim management will still be required during the newly amended stages, but it would be selected exclusively by court through a strict, ratings-based selection criteria process. Such an approach would be introduced to reduce the number of ‘controlled insolvencies’, where the Anti-Crisis Manager engages in value-destroying activities by working exclusively in the interests of a particular shareholder or a group of shareholders, delaying liquidation, allowing shareholders to conduct fraudulent trading activities and move cash and assets out of the company.

These amendments still require clarification from an operational standpoint. For example, it is not yet clear how the Anti-Crisis Manager will be ranked and how to ‘destigmatise’ Amicable Agreements. Also, there are no indications that the legislators will incorporate more advanced tools at this stage, such as cross-class cram-down, debtor protection from accelerated contract termination by trade creditors or pre-pack administration.

Nevertheless, industry professionals, in general, seem to welcome the amendments to Russia’s Insolvency Law and hope that they become a base for further improvements.

Currency risk - a big opportunity

Russia’s long dependence on the oil and gas industry resulted in its elevated exposure to foreign exchange risk. This was especially problematic during the 2015 crisis when economic sanctions forced the Central Bank to abandon its foreign exchange interventions to maintain the value of the rouble. (see Figure 2).

Then in March 2020, when Russia and Saudi Arabia failed to agree on oil production cuts sparking an oil price war between the countries, the rouble once again bore the brunt, falling steeply against all major international currencies.

While currency volatility can be deterring to investors, especially foreign ones, it can also provide a distress investor with a wide range of opportunities. After the 2015 crisis, initiatives related to localising production, especially in agriculture, pharmaceuticals, chemicals, and other manufacturing sectors, were in vogue and resulted in the construction and commissioning of new standalone production facilities.

To finance these initiatives, businesses were attracted to dollar or euro-denominated bank loans with interest rates up to six times lower than those for rouble-denominated loans even after the 2015 crisis. Businesses with rouble-denominated cash flows remained exposed to the risk of repaying their principals and interest in foreign currency at a much more expensive exchange rate.

This created significant opportunities to invest in healthy but overleveraged businesses.

Figure 2: The Russian economy at a glance

Source: CBR, Federal Statistic Service, LBS analysis

Investment targets: the importance of predictable cash flow

To find out which industries are most attractive the distress investor, we looked at primary and secondary research.

Regarding primary information, we asked our interview respondents working for private distressed investors and for NPL workout organisations to comment on the industries they prioritised for potential distress investment targets during the COVID-19 pandemic. They highlighted three sectors:

Real estate: Typically, mortgaged Class A commercial property with stable cash flows. Land plots and residential property in construction are rarely considered due to elevated uncertainty, as well as a lengthy and bureaucratic process in obtaining construction permits and land plot plans (GPZU) from government authorities. A new 214-FZ legislation, introduced in 2019, created additional barriers by prohibiting residential construction companies from raising finance via prepaid sales from property buyers. Private investors must now either inject their own equity or arrange for a construction loan from a bank if they wish to invest in residential construction.

Production facilities: Raw material extraction businesses and metals and mining players (except oil) were highlighted, as well as companies with predictable and preferably contracted revenues. Other manufacturers flagged were small-to-mid-cap chemicals, ceramic products manufacturers and producers of generic pharmaceuticals, including those participating in the country’s efforts to localise production and reduce its dependence on imports.

Agriculture-related companies: Most interesting for distressed investors were those higher up the value chain, like animal food processing. Some of our interview respondents hold a reserved view on raw food producers, such as fruit and vegetable and meat and fish farms because this market is fiercely competitive with limited bargaining power and, secondly, because they are highly prone to weather and environmental factors which are difficult to control.

As for secondary research, we looked at the financial position of the largest 30 companies in Russia by revenue (Figure 3). These companies have an aggregate debt exposure, exceeding USD$135 billion, which is about 15% of the total amount of corporate loans issued in Russia, and about 30% of the aggregate large corporate loan portfolio in the country as of June 2020. The 1 June 2020 last 12 months (LTM ) revenues of these companies constitute circa 30% of the Russian GDP.

Figure 3: Financial position of 30 largest companies by revenue, 01.06.2020, LTM

Source: National Credit Rating Agency of Russia, Capital IQ, LBS analysis

Based on this data, Real Estate and Construction seems to be the most interesting distressed investing opportunity in the large-cap segment. This refers to Etalon Group and LSR, major Russian real estate players with 5.0x+ Total Debt to EBITDA ratios as of 1 June 2020. Other notable companies include Rusal, a leading aluminium producer, and Mechel, a major steel manufacturer, whose total debt to EBITDA ratios were respectively 8.8x and 10.5x as of 1 June 2020.

But a note of caution with regard to Rusal and Mechel - apart from the fact that they are significantly overleveraged, they tend to receive a disproportionate amount of attention from the government. A private investor should take this into account if they consider investing in these companies.

Figure 4: Russian NPLs by industry, August 2019, %

Source: CBR, Federal Statistic Service, LBS analysis

Resilience, timing, and innovation are crucial when approaching state-owned NPL sellers

Figure 5: Largest banks in Russia by corporate loans issued, % of overdue corporate loans, May 2020Y

Source: CBR, LBS analysis

State-owned banks comprise most of the total banking assets in Russia and are the largest providers of NPLs in the country. Another major supplier of NPLs are NPL Workout Vehicles. These players, such as National Bank TRUST, Sberbank Capital and GPB Asset Management LLC, are either related or separate from the special situations departments at major Russian banks and are almost exclusively related to the state. Their main purpose is to recover as many NPLs as possible from a pooled list of bad loans from their respective bank or from financial institutions, sanctioned by the Central Bank. NPL Workout Vehicles may allocate NPLs on their own balance sheet or work under management or consultancy agreements with their parent banks without taking on bad loans. The role of state-related financial institutions is expected to continue increasing in the following years, and therefore, knowing how to approach them is critical to investors interested in Russian distressed debt.

Figure 6: Common distressed investing structures held by Russian private investors

Source: Interview Respondents, Civil Law of Russia, LBS analysis

Our interview respondents outlined some tips on negotiating with these stakeholders.

#1 Consider approaching state-owned banks and NPL Workout Vehicles no later than three months prior to the target’s repayment date. Major state-owned banks have strict internal loan monitoring and NPL flagging systems and are often highly bureaucratic. Bank employees may also consider an NPL sale to be risky for their business reputation. As a result, such institutions may require additional time to approve NPL cession agreements and a late approach may make it easier for them to proceed with an out-of-court restructuring instead.

#2 Try and avoid in-court workout actions this year (2020) given the limitations of the Russian Insolvency Law and the fact that amendments to it are not arriving before 2021. Our interview respondents also suggest that the lockdown moratorium on bankruptcies, imposed by the government to help businesses during the pandemic, could result in a mounting number of bankruptcies in autumn and winter, especially in the SME sector, where about 20% of businesses across the whole country are already planning to liquidate. Courts may simply be unable to cope with such a large wave of cases without compromising on the quality of their decisions, which in turn, may result in elevated risks for a distress investor.

#3 In selected cases, structuring a deal as an advisory services contract with equity as compensation may be more effective than directly investing in NPLs. Our interview respondents indicated that state-owned banks and NPL Workout Vehicles may have limited incentives to offer investment-worthy discounts for NPLs. The Russian Law is strict about privatising government-owned property, and both investor and bank executives may face an elevated risk of criminal investigation if anything goes wrong pre- or post-deal. This is especially relevant to NPL Workout Vehicles, whose NPL portfolio quality and recovery rates are often worse than those within internal special situations departments of banks. Therefore, managers at NPL Workout Vehicles may be afraid of failing to meet their recovery KPIs and thus, be hesitant in selling NPLs at a discount. This could limit risk-adjusted return opportunities for investors.

An example of an equity call option deal is shown in Figure 6. In this role, an investor’s scope of work would be similar to that undertaken by professional turnaround consultants, such as Alvarez & Marsal. Instead of a fixed and/or a performance management fee, an investor would usually request a stake in the distressed business or a profit share. Russian quasi-PE investment vehicles often structure such deals by first acquiring 1% of the borrower’s equity for a nominal purchase price from either banks or the respective NPL Workout Vehicles. This would allow them to receive a seat on the Board of Directors of the borrower and have the power to execute operational improvements. The sales-purchase agreement of the 1% equity stake would then include a call option for the quasi-PE to purchase significantly more equity, even a controlling stake for a predetermined price.

A call option would be conditional on whether the quasi-PE vehicle’s actions resulted in debt recovery for the bank or NPL Workout Vehicle. The SPA would also have a put option to sell back 1% to the bank or NPL Workout Vehicle at the same price, should the investor fail to meet her commitments related to the bank with regards to the advisory services agreement. This strategy is commonly applied by the Russian distressed quasi-PE funds. Direct investing as well as co-investing into distressed borrowers’ equity is also common among quasi-PE funds.

#4 Possessing well-functioning assets in Russia will be viewed positively
Our interview respondents indicated that Russian banks and NPL Workout Vehicles can be highly selective of NPL buyers. Banks and NPL Workout Vehicles would more likely sell NPLs to a strategic investor, who is well-established in Russia, and who possesses superior experience and therefore, capabilities, to integrate the distressed business into its existing asset portfolio. In fact, according to the interview respondents, NPL sales to non-strategic investors have been rare in Russia over the past decade.

Watch out for corporate conflict investors

This aggressive strategy is often utilised by competing domestic quasi-PE funds and family offices, focused on distressed investing. Such corporate conflict investors may incorporate elements of hostile takeovers, vulture funding and corporate raiding. Therefore, an unprepared investor may be left severely exposed to economic, legal, and even political risk.

For instance, a raw materials supplier could consider acquiring its client, which earned higher margins. In this process, it might attempt to undermine target’s valuation by using aggressive tactics, such as utilising legal tools to cut off supplies, putting a strain on its customer’s operations and subsequently, putting it on the verge of insolvency and force its initial investor to exit target’s equity at significant discount.

A corporate conflict investor may also acquire minor, but multiple strategic positions. For example, minority equity stakes, junior debt, or even insignificant overdue supplier contracts within the whole legal structure of the borrower. This could allow them to pressure creditors and initial investors by threatening to bankrupt strategically important legal entities or to participate in legal, but value-destroying activities.

A distress investor must conduct careful due diligence of its target to identify such threats before proceeding with a prospective deal.

Work with expert advisers

External advisers with deep expertise and extensive connections in the Russian market can be an excellent source of information and guidance for distress investors looking at this challenging sector.

Our interview respondents provided us with some insights on selecting and working with advisors.

Always work with domestically established lawyers. There is a great variety of boutique legal advisory firms with deep expertise in Russian law, as well as extensive exposure to all relevant stakeholders. International legal firms, such as Clifford Chance or Latham & Watkins, have extensive knowledge of the internal processes and loan portfolios of leading Russian banks. This is because Russian banks usually have an internal policy to hire international lawyers to prepare financing agreements in case a deal structure extends beyond Russian legislation. This is especially relevant for deals structured under the UK Law, common for large businesses.

Consider approaching major consultants for restructuring advice when considering investing in large-cap businesses. Companies, such as EY, KPMG, and Alvarez & Marsal have advised on the largest restructuring deals in Russia and are experienced in leading negotiations on behalf of creditors and borrowers. Their dedicated restructuring teams possess deep expertise in dealing with Russia-specific problems of distressed borrowers, such as financial reporting, party transactions and wrongful trading. They also extensively advise on operational restructuring, liquidity management, as well as assist distressed companies by taking position of chief restructuring officers (out-of-court only) and leading turnaround project management offices.

Conclusion

Russia is a complicated market, with its own rules, different to European, British, and American legislations. It is a country without a transparent secondary debt market. It has gone through geopolitical and currency crises, an oil price war with Saudi Arabia and now battling the COVID-19 pandemic.

So, it is not surprising that the painting, mentioned at the beginning of this article, divided the Vedomosti conference participants. To many of them, the nymphs did not appear seductive but rather represented hopeless businesses, desperate for help, even if it meant dragging banks, private capital providers, suppliers and other stakeholders into their swamp.

Positive changes are coming, but are they sufficient to make the Russian market attractive to foreign investors straight away? No. Nevertheless, by ignoring the market, a distress investor may risk missing out on good opportunities. The number of local, distressed-focused PE and family offices is gradually increasing.

Even selected government-related NPL Workout Vehicles have started launching their own, early-stage quasi-PE vehicles, which actively track the loan portfolios of competitors and are making pilot investments. It is of course impossible to predict when sanctions will be relaxed, and economic conditions improve. Nevertheless, sentiment is shifting, and domestic players are sensing it.

Acknowledgements

We would like to express thanks to representatives of commercial banks, distress investment funds, NPL workout organisations and advisors for their support, agreeing to be interviewed by us and providing additional information and feedback for this article.

This article also incorporates comments, made by the speakers at the Vedomosti Distressed Debt Conferences, which were held on 19 May and 4 June 2020.

Sergey Tsoy MIFFT2020 is VP Events, LBS Turnaround and Restructuring Club.

Before joining the LBS Masters in Finance programme, he was a lead manager at VTB Capital responsible for executing EUR 100m+ corporate loan deals.