Market force

Russia is an attractive proposition for institutional investors at the moment, with a boom in bond issuances

Capital markets has been a tricky area to be active in for the past few years, but in Russia at least things seem suddenly to have picked up and law firms are contemplating a full and interesting pipeline. However, the work is not in the headline-friendly area of IPOs but rather in the field of debt.


Causing a stir at the moment are eurobonds. Issued most commonly in US dollars, but also occasionally in rubles, Chinese renminbi, Swiss francs and other currencies, eurobonds are a popular way for Russian financial institutions to raise money.

After a slowish 2011, with just $9.2bn (£5.9bn) issued in eurobonds by Russian institutions, 2012 went boom. The first quarter was slow with $1.5bn of bonds issued, according to the Bank for International Settlements, but the next three quarters proved much busier.

Regular issuers such as VTB and Sberbank were active, but the Russian state also issued $7bn in eurobonds in March 2012, in what was reportedly the largest issuance in hard currency from an emerging market since 2000. In total, Russian issuers issued $67.9bn in eurobonds last year, on top of an active domestic debt market.

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All sizes

Baker & McKenzie Moscow capital markets partner Roy Pearce says those issuing bonds have included small and medium-sized financial institutions as well as the bigger players.

“Traditionally, they’ve funded themselves through a mixture of sources, and capital markets has always been a good source of funding for the Russian state itself,” Pearce explains.

Morgan Lewis & Bockius partner Carter Brod, also based in Moscow, adds: “Russian eurobond issuances boomed in 2012 and that’s continuing. It’s accepted that this won’t last for ever but it hasn’t slowed down yet. Deals are being done every week.”

He cites recent issuances on which Morgan Lewis advised, such as a €1.5bn offering for VEB or the Credit Bank of Moscow’s $500m issuance as examples.

While financial institutions have tended to be the most common bond issuers – along with partially state-owned gas company Gazprom – this is slowly changing, according to lawyers.

Tamar Amara

“The Russian corporate world is taking advantage of low interest rates,” notes Clifford Chance debt capital markets partner Tamer Amara.

Linklaters’ Moscow senior partner and head of capital markets Dmitry Dobatkin agrees. He says that there are more lower-rated

issuers coming to market, along with an increasing number of corporates in sectors such as metal and mining.

“Issuers are taking advantage of favourable market conditions, both for Russian issuers and also more generally,” he points out. “Ever since March 2012, the markets have been normalising.”

New players are dipping their toes in the market – state-owned mortgage lender the Agency for Housing Mortgage Lending (AHML), for example, completed an offering of 7.75 per cent rouble-denominated eurobonds due in 2018 for RUB15bn (£314m). Although AHML’s eurobonds were denominated in rubles, Pearce, who acted for the agency, says 70 per cent of the book was sold into the US.

The risk equation

While Russia still raises red flags as a destination for investment for some, thanks to a judicial system that many see as being unreliable, its politics and its status as an emerging market, for institutional investors putting their money into eurobonds the risks are outweighed by the benefits of low interest rates and high yields.

“People who invest in this country understand Russian risk – it’s not the Wild East it was 15 years ago,” Pearce points out.

Carter Brod

Brod says the difference in economic health of developed and emerging markets is key to the rise in Russian bond issuances.

“Because interest rates are so low in the developed markets investors who buy bonds are desperate to get high-yield investments that pay higher interest rates,” he says. “Add to that an improvement in the credit quality of Russian issuers. Emerging markets are still generally more risky than developed ones but that’s why they pay a higher yield. There’s a convergence taking place between the emerging markets and the developed markets. Russian issuers are taking advantage of the positive environment and they can now get lower interest rates when they offer bonds.”

Brod says that many banks and corporates are using the capital markets now, while they can.

“A lot of issuers are front-loading in terms of taking advantage of the favourable market conditions. Now might not be the time when they actually need the money,” he adds.

“Investors are taking credit risks on the issuer and they’re also taking risks on the overall economic environment, but they’re secure enough to understand the risks and the returns,” Dobatkin says.

International banking regulation is also causing an uptick in activity. Russia implemented new laws incorporating the principles enshrined in the EU’s Basel III regulations on 1 March, and many banks issued eurobonds in 2013 in an effort to improve their capital adequacy ratios prior to this. Since March, subordinated instruments including subordinated eurobonds have to comply with Tier 1 and Tier 2 capital requirements under Basel III.

Withholding tax has been another issue on the regulatory table that has affected eurobonds. In late 2011 the ministry of finance decided that interest payments to non-Russian special purpose vehicles, including via eurobonds, would not qualify for tax relief under double tax treaties – although historically these have been exempt from withholding tax.

Negotiations led to a swift amendment of the tax code that applies until 1 January 2014. But there continues to be uncertainty over what will happen in January and whether withholding tax will suddenly apply again.


Derivative ideas

Other parts of the capital markets sector in Russia are also undergoing reform. Russian firm Monastyrsky Zyuba Stepanov & Partners (MZS) has been working with the government to advise on amendments to the country’s derivatives laws. Partner Vladimir Khrenov, who heads MZS’s derivatives and capital markets practice, explains the firm has been rewriting guidelines on derivatives transactions to bring them up to international standards.

The work has included expanding the definition of equity and fixed income.

“The next stage is to put in place a set of credit derivative definitions and we hope these will be in place before the year is out,” adds Khrenov.

The firm has also been working with the Moscow Exchange – which was created in late 2011 when the Moscow Interbank Currency Exchange and the Russian Trading System Exchange merged – on the clearing of securities according to G20 requirements.

Last year Russia established a central securities depository, the National Settlement Depository (NSD). The exchange is now implementing ‘T+2’ trading – bringing things into line with international standards. Central counterparty clearing is also under development, and in February Euroclear began accepting Russian ruble-denominated government bonds.

“It’s another mechanism to hold Russian securities without holding Russian domestic custody arrangements,” notes Dobatkin. “All these things make the Russian infrastructure more user-friendly,”

Khrenov adds that over-the-counter (OTC) products are also under scrutiny to enable those trading in OTC instruments to channel more trades through Russia rather than offshore vehicles, commonly set up in beleaguered Cyprus. Close-out netting legislation was implemented in 2011, but its effects are yet to be fully felt.

“Once we have a grown-up netting regime in place, significant growth in the domestic market will follow,. It has been growing through spectacular volumes in the past few years,” says Khrenov.

Equity let-down

One area that has disappointed is equity capital markets. Despite it being a promising pipeline following last year’s announcement of a sizeable privatisation programme by president Vladimir Putin, IPOs have been few and far between.

“I think everyone in capital markets is a bit disappointed about what’s happened,” says Pearce. “A number of Russian companies have announced plans or started the process of doing IPOs since 2008. A couple are going to market, but a number are putting plans on hold.”

Amara adds that while there have been some IPOs of Russian companies, the volume is “peanuts” compared to a few years ago.

Dobatkin says equity capital markets have been “patchy” worldwide recently. However, he points to some IPOs and a larger number of secondary public offerings (SPO) Linklaters has done as evidence things are not completely in the doldrums. Most recently, at the end of April VTB Bank announced a RUB102.5bn capital increase through the issue of 2.5 trillion new shares in a bid to increase its Tier 1 capital ratio.

The fact that many IPOs have been postponed does not worry Dobatkin too much.

“Russian equity capital markets have been notoriously patchy in this respect; the fail rate is significant,” he says. “What tends to happen is that deals get postponed and then happen later.”

IPOver here

What IPOs there are tend to head out of Russia to the London Stock Exchange. London has been the preferred exchange for Russian companies for some time, despite the efforts of the Moscow exchange and other countries to muscle in.

According to data collected by PricewaterhouseCoopers (PwC), 57 per cent of listings between 2005 and 2012 involving Russian companies were in London compared with 33 per cent in Russia.

“You sometimes get Russian companies listing on Nasdaq, but these tend to be industry plays,” says Brod.

Pearce suggests that Warsaw holds some attraction for smaller Russian companies as the exchange there has a reputation for listing companies from other parts of the CIS, notably Ukraine. It is closer to London’s alternative investment market (AIM) than the main London exchange but Pearce says the investor base understands the economy and culture of the CIS.

“If you’re a small Russian business you might not necessarily get the attention and liquidity in London. In Warsaw you can make a bigger impact,” he suggests.

Although Rusal’s HK$17.4bn (£1.4bn) listing in Hong Kong in 2010 grabbed headlines around the world, only one other Russian company has followed the aluminium company to the Far East. Commodities business IRC was spun out of London-listed parent Petropavlosk in October 2010 with a Hong Kong IPO.

“Other companies haven’t found the same commercial argument to go to Hong Kong over London or Moscow,” notes Dobatkin.

Putin and his government want to make Russia’s domestic exchange more attractive, and lawyers think this could lead to more dual listings. Certainly, the privatisation programme, if it ever takes off, is likely to focus on Moscow IPOs.

International domination

The fact that most IPO work is focused outside Russia, and the majority of eurobond and other debt capital markets issuances are in US dollars and other non-Russian currencies, has helped international firms to a leading position in capital markets work.

According to PwC, the leading advisers in IPOs over the past seven years were Cleary Gottlieb Steen & Hamilton, Debevoise & Plimpton, Freshfields Bruckhaus Deringer, Latham & Watkins and Skadden Arps Slate Meagher & Flom, all of whom advised on seven IPOs. White & Case acted on six and Clifford Chance won work on five, with the remaining 31 IPOs divided between other firms.

UK and US firms also dominate in debt capital markets work.

“I’d welcome Russian firms in international capital markets,” says Dobatkin, before adding he does not think it likely domestic firms would be able to break into this field.

Brod explains that debt and equity capital markets are structured along international lines and require both English and often New York law expertise, effectively shutting most Russian firms out.

“The Russian market is different from other emerging markets as many big international firms are strong in Moscow,” adds Brod, who moved to Morgan Lewis last year along with the rest of collapsed firm Dewey & LeBoeuf’s Moscow office.

“We haven’t really seen the domestic firms competing in this market,” Pearce agrees. “The deals are almost all English law, sometimes New York law.”

At Clifford Chance, Amara says the cross-border quality of most of the work makes it almost impossible for a local firm to advise.

“Except in limited circumstances people prefer the work to be done by a single firm, not broken into local and international chunks,” he says.

Khrenov, however, agrees with this when it comes to pure debt and equity capital markets, he says that in specialised areas, such as derivatives, or where Russian law is involved, domestic firms can provide a “more competitive” offering.

Firms optimistic

Despite the uncertainty, lawyers are reasonably upbeat about Russian capital markets work. Eurobonds look likely to retain their popularity for a while, unless there is a major change in interest rates or in the attraction of emerging markets for investors in developed countries, and equity work could pick up again.

“It’s difficult to look more than two to three months into the future,” says Amara. “It’s done in cycles and we move from one to another. But low interest rates will be there for some time to come, so people will look to keep borrowing.”

“Investors and investment banks are optimistic about the capital markets, and the law firms are on board with that view,” concludes Brod.

Key figures: Russia

GDP: $1.86tr

Inflation: 7%

Population (2012): 143m

Life expectancy at birth: 69

Unemployment (March 2013): 5.7%

Source: World Bank, Federal State Statistics Service