On the frontline

“Sometimes events occur that are unintended and change the course of history. This was one such event.” These words from BP chief executive Bob Dudley, uttered a few days after July’s downing of a Malaysia Airlines plane in Eastern Ukraine, convey how low East-West relations have fallen since political turmoil began erupting in the former Soviet republic.

As early signs suggested flight MH17 came to ground after being hit by a surface-to-air missile, which many thought landed in separatists’ hands with at least the indirect involvement of the Kremlin, European powers and the US staged a rare show of unity to impose their most stringent sanctions against Russia since the end of the Cold War. Moscow, showing little intent to de-escalate the standoff, retaliated with a wide-ranging ban on food imports from the European Union (EU) and US and continued to amass troops near the Ukrainian border.

For the Russian Direct Investment Fund (RDIF), an institution launched in 2011 by then-president Medvedev to attract foreign investors to Russia, the worsening tensions do not bode well: Vnesheconombank, a state development bank of which RDIF is a 100 percent subsidiary, features on both the EU and US sanctions lists.

Yet, on other fronts, history is taking a more promising turn for the fund. Kirill Dmitriev, RDIF’s chief executive, in July announced the launch of a multi-billion-dollar infrastructure vehicle jointly with other sovereign funds from the BRICS – a grouping comprising Brazil, Russia, India, China and South Africa, the world’s largest emerging markets. The move came alongside the founding of a $100 billion development bank and $100 billion reserve fund, in an explicit bid to rival the Western-dominated World Bank and International Monetary Fund (IMF).

The project could still founder if the BRICS, which besides their common heft share little in terms of political and economic philosophy, fail to see eye to eye on the details. But RDIF’s achievements to date indicate that a growing portion of global capital flow now bypasses Western powers. Launched barely three years ago, the fund has already enlisted support from sovereign giants from all around Asia and the Middle East, in the form of multi-billion-dollar partnerships with the likes of China Investment Corporation (CIC), Korea Investment Corporation (KIC), Abu Dhabi’s Department of Finance, and Kuwait Investment Authority (KIA).

Some of this money has already been put to good use, with sizable projects going ahead despite the Ukraine crisis. In May, RDIF, a group of unnamed foreign investors, and Gazprombank, injected over $700 million in the CIS’s largest Liquefied Petroleum Gas (LPG) terminal, located in the port of Ust-Luga.

The fund also partnered with Macquarie Russia & CIS Infrastructure Fund to develop a smart grid programme aimed at reducing electricity leakage. Other recent transactions include a $1.9 billion tie-up with Rostelecom to reduce digital inequality among Russian regions and the construction of the first Russia-China bridge across the Amur river, undertaken in partnership with CIC.

On the face of it, RDIF seems to find itself in a make-or-break situation. The rapid build-up of its profile suggests it could achieve much in Russia, being one of the few channels trusted by international investors to access the country. Yet, in the short to medium term, the broader geopolitical climate is putting a serious obstacle in the way of its efforts to improve Russia’s image – perhaps even threatening, some say, to cut short its mission.

MINORITY STAKES

Observers close to the fund certainly see it as a rare success story among Russia’s efforts to modernise its economy. Steven Eke, a senior analyst on Russia and the former Soviet Union at consultancy Control Risk, notes that it stands out compared to a number of “white elephants” launched by the administration – most notably the Skolkovo Innovation Center, a technology hub near Moscow announced with much fanfare in 2009 but which has since been plagued by financial irregularities and managerial problems.

This success probably owes a lot to the fund’s sound approach to investing, which Dmitriev describes as “in accordance with the highest standards and best practices set by the global private equity industry”. The $10 billion fund eyes both greenfield and brownfield investments in all key infrastructure sectors, with typical equity cheques of between $50 million and $500 million. It has an investment horizon of five to seven years (potentially longer for greenfield investments), after which it seeks to exit assets through sales to strategic buyers or public listings. A key criteria, Dmitriev emphasises, is profitability: the fund typically targets internal rates of return (IRR) in the high teens.

But the defining feature of RDIF’s investment strategy, and the very raison d'être of the institution, is its obligation to attract capital from overseas: the fund can only invest as part of a consortium, and is limited to disbursing no more than the total committed by its co-investors. The rules for choosing these are clear-cut: RDIF seeks to partner with “premier funds” that have more than $1 billion of either assets under management, market capitalisation or turnover; or an EBITDA exceeding $150 million.

The fund has typically two to three partners for each infrastructure co-investment, “based on their experience and preference for different sectors and deal structures”. They would generally include both infrastructure-focused funds and sovereign wealth funds, with all the due diligence information and costs shared among co-investment partners. Dmitriev says both RDIF and its co-investors can initiate transactions and then invite others to participate.

In addition to allowing for larger transactions, he explains, the co-investment structure helps address potential concerns investors may have about the fund’s independence. “Protection of capital is important both to us and our partners; we won’t take part in non-economically viable projects and neither will they. So this effectively acts as quality control.”

The fund’s supervisory board – which alongside Russian political and corporate heavyweights includes Laurent Vigier, chairman and CEO of France’s CDC International Capital, and Dominique Strauss-Kahn, former head of the IMF – also helps ensure that the fund “consistently advances to the highest standard of corporate governance”.

Market sources Infrastructure Investor spoke with, which included both local funds and international institutions, hold the 120-strong team in high esteem. “We have worked with RDIF in quite a number of transactions and we are impressed with their knowledge and professionalism,” says Thomas Maier, managing director for infrastructure at the European Bank for Reconstruction and Development.

A Moscow-based investment professional claims that Dmitriev has become a bit of a celebrity in Russia and elsewhere (with perhaps the risk of having the organisation too closely entwined with his own personality, he adds).

UPHILL BATTLE

Yet more critical observers see the team’s independence as being somewhat limited.

“In terms of its day-to-day decision-making, it doesn’t appear to be particularly frequently interfered with by the administration. But nonetheless the investment priorities, certainly in terms of the strategic industries and their designation, that’s something that’s very much the prerogative of central government,” argues Eke. He adds that, while the economy remains statist with investment flows influenced by broader political dynamics, the fund can’t be said to be fully independent.

His comments resonate with the way the Russian economy continues to be perceived, especially in Western quarters. “The general sentiment for Russia is quite negative, with concerns about corruption, stability and political interference. We have no plans at all to invest in infrastructure within Russia and we certainly have no pressure from our clients for deploying money in the country,” says a European-based fund of funds manager.

“Normally when you make an investment you wonder about the return on your money – not the return of your money,” adds a partner at a US-based infrastructure firm. A placement agent is similarly coy about the market, suggesting he would be “laughed at” if he were to call investors to sell them a Russian infrastructure fund.

Unflattering statistics about Russia’s investment climate indeed suggest the $2 trillion economy remains plagued by structural problems. “If you’d asked me a year ago my view wouldn’t have been too dissimilar to now,” adds the US manager. Russia is ranked alongside Pakistan and Nicaragua at 127th – out of 177 nations – by Transparency International; its public institutions and level of competition rank respectively 118th and 135th of 148 nations in the World Economic Forum’s latest Global Competitiveness Report.

This, of course, is one of the greatest challenges faced by RDIF as it endeavors to make Russia a more popular destination for foreign investment. Which is why, in addition to the above mandate, the fund has taken it upon itself to carry out a broader marketing exercise. Last June, RDIF launched “Invest in Russia”, an online platform with a plethora of data and information aimed at drumming up investment in Russia’s regions. The fund also partakes in other initiatives to improve the Russian business environment, including providing legislative input on public-private partnerships and project finance.

In the mind of some investors, however, these long-standing issues are trumped in importance by the immediate geopolitical climate – not least the latest wave of EU and US sanctions, which now target whole sectors such as the energy and finance industry. Yet this is precisely where headlines can easily lead one to conflate problems, according to Dmitriev. The sanctions, he explains, only forbid transactions linked to the long-term financing of blacklisted Russian companies and their subsidiaries by US and European entities in the form of equity or debt.

All other transactions are permitted, he notes, posing no threat to RDIF’s investment activity. “RDIF does not directly attract equity or debt financing but instead invests only its own funds together with co-investors. We have never attracted such direct financing and are not planning to do it in the future.”

Equally, as outlined in a statement issued by RDIF in July, the fund’s constitutional documents prevent it from acquiring control in any business, implying that sanctions should have no impact on its portfolio companies.

It’s also worth noting that the fund, which finances up to 80 percent of its projects with leverage, has access to debt funding provided by the National Welfare Fund, an $88 billion rainy-day vehicle set up by Vladimir Putin in 2004. In addition to being attractively priced – with RDIF able to finance up to 40 percent of total project cost at the rouble cost of funding of inflation + 1 percent – this domestic liquidity is by definition sheltered from international sanctions. “None of our infrastructure projects have been cancelled or delayed,” observes Dmitriev.

THE GREAT DIVERSIFICATION

Not that the sanction regime and its consequences cannot impact the fund in indirect ways. With a portion of its cash flows protected via availability-based mechanisms or long-term contracts, RDIF’s portfolio doesn’t look too exposed to the expected slowdown in Russian GDP growth resulting from the crisis (the IMF slashed its forecasts to 0.2 percent growth from 1.3 percent for 2014 in July).

But should the economic situation worsen further, some say it is RDIF’s very funding – so far shielded from budget cuts by the government – that could be at stake. “Russia needs to ensure the government actually keeps to its budgetary and fiscal discipline and that the ring-fencing of infrastructure investment is preserved,” says Eke.

The latter part of this proposition seems to be holding, at least for now. In fact, perhaps in the hope that infrastructure investment can make up for a lack of structural reforms and budget discipline, the government seems to be going in the other direction: it recently allowed the National Welfare Fund to invest up to 60 percent of its money in infrastructure, with 10 percent earmarked for projects overseen by RDIF.

The sector indeed seems to be a long-standing priority of the government: Eke observes that Russia has been making “incredible leaps and bounds” to upgrade its infrastructure, with for instance 300 railway stations modernised over the last 10 years. RDIF reckons private investments in Russian infrastructure could amount to $25 billion to $40 billion between now and 2020.

Eke also notes that the government has earmarked very large amounts of cash for Crimean infrastructure development, including a new airport and bridges connecting it to the Russian mainland. Notwithstanding the reputational issues that would come with that move, he thinks “this is something we’re going to see the fund evolve towards over the next two to five years”.

Fearful of the political backlash that would likely come with it, Western institutions may refrain from taking part in such projects – just as they may avoid taking part in Russian-led joint ventures in the near future. But arguing that this compromises RDIF’s mission would miss an important point about the fund.

Perhaps even more than attracting a larger volume of foreign direct investment into Russia, a crucial objective of the fund is to diversify the sources of such capital – so as to make FDI less vulnerable to Western political sensitivities and connect it with other affluent regions. “If sanctions were to go much further, Russia would probably accelerate its turn towards the East,” says Sergei Moiseyev, co-founder and managing partner of Moscow-based buyout fund Unicorn Capital Partners.

In that respect, the fund has fared pretty well so far. RDIF has deployed more than $7 billion since inception, of which more than $6 billion came from its co-investors. And aside from deals, it has been busy crafting partnerships worth more than $15 billion with the world’s largest sovereign wealth funds. Crucially, 90 percent of this capital comes from Asia and the Middle East. “Some small deals have been done with French and Italian partners but the fund essentially is involved in geographies where there is latent cash and which by and large enjoy good diplomatic links with Russia,” says Eke.

Some observers remain doubtful. “If it was purely on an investment basis, I doubt the fund would raise a cent. But if there’s political motivation for some of the sovereigns to do that, I’m sure they’ll raise money from them.”

Notwithstanding the political acquiescence most of RDIF’s connections undoubtedly require, the composition of the fund’s international advisory board, which includes private equity luminaries such as Apollo’s Leon Black, TPG’s David Bonderman and Blackstone’s Stephen Schwarzman, may prove this reasoning too cynical. It is notable that, with the exception of Josh Lerner, none of the fund’s Western advisers have so far resigned. Good relationships with the Kremlin and access to the world’s sixth-largest economy may be too prized to let go.

But investor support cannot be taken for granted. Should some of RDIF’s projects encounter significant cost overruns or corruption problems – as has allegedly happened, for instance, in the case of the Amur bridge project – some could easily decide to walk away. “There is enormous potential for FDI in infrastructure in Russia; nonetheless they need to get to grips with the financial management of it,” says Eke.

“Investors are getting involved with a network of corrupt officials and a system that is still fairly opaque in terms of investment flows. And if you’re talking about billion-dollar investments, you’d rather be sure the money ends in the right pockets.”