In 2013, the state plans a minimum of three major IPO privatizations: the sell-offs of 10-25% VTB, 7-14% Alrosa and 25-50% Sovkomflot. VTB privatization is likely to be the first in line: tighter capital adequacy ratios prompt the bank to seek extra cash in H1, says a source close to VTB. There must be an interval between major transactions, therefore Alrosa and Sovkomflot will probably be slated for H2.

Late last week, VTB President Andrey Kostin said the state-owned bank will ‘set an example’ for placing the bulk of the privatized stock in Russia. This will be preceded by Moscow Exchange IPO, likely to happen as early as February. This ‘strategic move’ will demonstrate to other issuers that LSE placing is not mandatory, explained a source close to the Exchange top management.

Meanwhile, upon close inspection, despite partial improvements, a number of key issues prevent Russia from hosting major IPOs on par with London and New York.

A problem that looms large with Moscow placements is lack of domestic long-term investors. At the end of last November, Moscow Exchange listed some 1 million individual clients, only some 70000 of which were active, with more than one trade a month. Compare this with some 90 million individual investors in the USA, 94 million in China, 20 million in Brazil.

More importantly, institutional investors that account for the bulk of major IPOs, are few and far between in Russia as well. “What is the key to success of the Warsaw Stock Exchange IPOs? It’s obvious – Polish pension funds sweep it all up at almost any price”, chuckles a top-tier fund manager. Pension funds account for up to 90% bids in Warsaw IPOs.

While Russian pension funds make up a mere 10% GDP versus almost 100% in the USA and Great Britain, rapid capital market development is unlikely, mused Renaissance Group CEO Steven Jennings in last autumn’s Vedomosti interview: “Brazil, Chile, Singapore – they all win from their pension savings systems allowing domestic investors take part in financing”.

A mere 2% of Russian pension savings is invested in shares, while the National Welfare Fund abstains from investing in local bonds or shares, Sberbank CIB analysts point out in Moscow Exchange IPO report: “In October 2012 it was announced that the National Welfare Fund could become an investor in domestic securities, and yet how soon this will become reality remains unclear”. Analysts also state that the coming pension reform (the savings part to be squeezed from 6% to 2%) could slash the volume of investment in securities even further.

Pension funds and insurance companies own over 70% locally traded shares in New York or London, while in Russia the number is under 10%, agrees an investment bank top manager. “Why does the Russian state stake so much on foreign investors?!” — gasps Swedbank Robur Rysslandsfond portfolio manager Elena Loven. “They will arrive if local pension funds are the first in line for company acquisition — that is the way it works in Warsaw and other emerging markets. Why does it not work like that in Russia?” Today, Russian pension funds can not invest in IPOs, it is crucial that they are given the opportunity, concurs Rothschild Russia/CIS Co-Head James Friel.

Today, Minfin has set up a working group to draft pension law amendments, but these amendments will be introduced to the government only by May, says a source close to the group. Following the liberalization, even conservative pension funds could account for 20-30% Russian IPO demand, says Finam President Vladislav Kochetkov.

Kostin says there are no serious objections to VTB exchange placement, but “the infrastructure must be fixed”. Recent months saw two breakthroughs in infrastructure aimed at attracting foreign investors — the Central Depositary has been established, and European settlement systems Euroclear and Clearstream gained access to the Russian market. However, both breakthroughs are partial.

The Central Depositary is not fully operational yet, since it has not opened accounts at all registrars. A Central Depositary representative told us that by 1 April, accounts will be in place at 1000 key registrars, while the rest will join the system by 6 November, as stipulated by the law.

As for Euroclear, it opened the CD account in end-December, yet the account is inactive. This account will only work in the bonds market, as Euroclear will gain access to the shares market only next year. This has to be amended: Euroclear’s access to Russian shares is crucial, says Kostin.

Privatizations are likely to be discounted, unless Euroclear takes part, funds that have not invested in Russian shares will be hard to count on, warns Elena Loven of Swedbank Robur Rysslandsfond. Many funds have regulatory restrictions — they must invest in euroclearable securities only, says Matthias Siller of Baring Asset Management. Not all funds have tested and tried Russian domestic market investment technologies, concurs VP at Blackrock David Reid.

Another vital issue is that the Central Depositary has been established, but the global financial community has yet to accept it, but so far many foreign investment funds have not even heard about the recent developments in Russia, says Investment MD at BNP Paribas Vladimir Tsuprov. The Association of Global Custodians (AGC) has deemed the Central Depositary compliant with US Securities and Exchange Commission (SEC) rules, and will soon make an official statement to this effect, says a source close to the AGC top ranks.

“Many banks will begin to revise their local Russian securities restrictions only after the Central Depositary becomes fully functional, all checks will take months, slowing down the process”, admits an investment banker. If privatization goes ahead before the infrastructure is modernized, the proceeds could be considerably lower, many foreign investors could be lost, warns a source at an investment bank that arranged the Sberbank SPO. Primarily this concerns global funds investing in emerging markets, but lacking limits for investing in the local Russian market, elaborates the source.

Deputy CEO at Moscow Exchange Andrey Shemetov says the fears are overrated: “Moscow Exchange infrastructure and IT is ready for Russian IPOs, and Moscow Exchange’s own IPO is proof of that”. He says the Central Depositary is compliant with Rule 17f-7 SEC, therefore nothing stops long-term institutional investors from coming to the Russian market; Euroclear and Clearstream’s access to the shares market does not have any discernible effect on these funds. Head of Federal Financial Markets Service Dmitry Pankin shares this opinion.

Another hurdle for foreigners is the absence of a familiar deposit-free settlement system in the Russian market — the so-called Т+N, where ‘Т’ equals trade date, and ‘N’ is settlement period (normally 2 to 3 days). Russia’s current system is T+0: to execute a trade, you have to deposit cash beforehand.

This is inconvenient for brokers and major institutional investors, says MD at Otkrytie Yuri Mintsev. T+N trades allow more effective liquidity management, there is no need to deposit cash that could be invested in the market, he explains: “If you have huge turnover, the money is substantial”.

A Moscow Exchange representative told us that T+N would be gradually implemented in 2013. However, he declined to comment possible 1H launch. The implementation of T+N is so overdue that many have lost faith in it ever happening, complains a foreign fund manager. Besides, it is good business for the exchange, he points out: “Temporary deposits are a profitable business — why lose it, if it brings good money?”

Good money it is. According to VTB Capital’s pre-IPO report, 48% of the Exchange income is generated by interest. Launching deferred payment trading could cost the exchange up to 20% in interest-generated proceeds, or some 10% total revenue, states a similar report by Deutsche Bank.

There is also the reputation. Investment bankers have been selling Russian companies for years to clients in foreign exchange-traded ADRs, not local shares, says a major investment bank source. “We initially warned them of Russia’s high infrastructure and legal risks”, he says.

While infrastructure is improving, legal risks remain. “ADR investors are better protected: any rights violation will stir up global-scale backlash, they will appeal to a court they are familiar with – whereas in Russia nothing is transparent”, argues General Director at Capital Asset Management Andrey Gritsenko. In Britain, entire courts specialize in private equity funds and handle tricky financial instruments, while Russian judges take on a wide range of cases with little market experience, says a major Russian private equity fund manager.

Many foreign investors know next to nothing about the Russian financial market, especially in the US, says Partner at Link Capital Taras Vazhnov, who brought a CIS Acquisition Fund road show to New York late last year. Foreigners have a limited knowledge of the Russian market rules (they know the Chinese market better), hence the fear of regulatory risks, explains Vazhnov: “Heads of the largest hedge funds managing tens of billions USD asked weird questions such as “Can Russian companies pay dividends to foreign shareholders?” or “Are any of the Big Four auditors present in Russia?”

Russia is in need of some good PR — the President of Brasil, for instance, has repeatedly visited the USA to promote the national stock exchange, while Russian authorities are not giving enough attention to the local financial market, thinks a global stock exchange manager. “We call it the Mickey Mouse Market – apparently, they intend to get something done, but it’s not really serious yet, everything is small-scale”, he concludes.

“Privatization could bring a lot of new investors to Russia — there is global interest, and IPOs could increase their share”, says Siller. The decision to float in Russia makes the task more difficult but realistic nonetheless, he insists: “Floating in the local market is par for the course in any country — you can’t have a discount for normalcy”.

“We see interest among institutional investors in the imminent VTB and Alrosa privatizations, however it will not automatically bring many of them to Moscow to buy the assets”, says the less optimistic Friel. Raising USD 300mln in Moscow “is doable, we can even talk USD 500-700mln”, a global investment bank representative commented the Exchange IPO in a recent Vedomosti interview: “The quality of the issuer and the right investor strategy are crucial here”.

The quality of the issuer is the prime factor: a lucrative asset with clear growth prospects will raise enough money without Euroclear, Clearstream and the Central Depositary, says Head of Investments Department at Capital Asset Management Alexey Belkin: “We bear in mind that foreign money has found a million ways to get to Russia, with its total lack of infrastructure, and buy Russian companies – if they saw growth potential”.

Alrosa suggested floating in Russia from the start — the market is ready for these IPOs, said a source close to Alrosa management. A source close to Sovkomflot countered that the market is not ready, it is clear that no premium is to be expected, the shares will be floated at a discount. Dozens of less important companies are unlikely candidates for foreign IPOs and should be privatized locally, while the majors should have the opportunity to be listed outside Russia as well, he said.

The success formula for local privatization is as follows, thinks a foreign investment fund manager: the Moscow Exchange IPO, access to shares for Euroclear and companies putting in an effort to regain investors’ trust. “The market is up, investors are buying emerging markets again. If you fail, the fault will be your own”, he claims.

Margarita Papchenkova, Anton Trifonov

Trading infrastructure, Project Group №1, Andrei Kostin, Dmitry Pankin, Anton Shemetov