with Stanislav Song, Xenon Capital Partners, Xenon Capital Partners
Mr. Song, you have actively participated in the restructuring of the sector in the past decade, which reshaped the sector entirely! At the same time, significant global economic events such as the financial crisis occurred too. As an introduction, can you tell our readers how –from your point of view– you have observed M&A activity in the sector in recent years?
In recent years the Russian power sector has gone through a comprehensive restructuring. Today, the sector is quite similar by design to what can be observed in Western European countries and other markets. From this perspective, the transition from a vertically integrated national monopoly to our current situation is quite an achievement.
One of the key drivers for the restructuring was the creation of a situation where electricity prices formed by the market would be of such a level that it would attract private investment. Immediately following the start of the restructuring of the former monopoly RAO UES, a process was initiated to attract strategic investors into the sector — both foreigners as well as Russians.
To a large extent I believe the restructuring process has been successful. International companies such as E.On and Fortum have become mayor players in the Russian generation sector. Naturally, there have been a number of domestic private groups who have invested in the electricity sector as well.
If you would conduct a cross comparison among the sub sectors in the power sector you will find that the generation sector is the most advanced in terms of restructuring and in attracting investors. Looking at other sub sectors, the process has been slower for obvious reasons. The transition to market based mechanisms in infrastructure sectors such as transmission takes longer because business had to be fine-tuned before the privatization process could start.
So, if you step back and look at M&A activity in recent years, you will see many deals in the generation sector but little deals in other power sub sectors. I believe that international and domestic players were interested to invest in the Russian electricity sector because they anticipated a lot of upward potential. In turn, they also undertook significant investments in constructing more generation capacity.
In general, an investment in the power sector requires significant commitment of capital. Due to external economic shocks and the global financial crisis, the demand to the sector has declined. Consequently, European utilities –that have been most active on the Russian market– experienced constraint on their M&A budget.
This year, you played a leading role in the largest ever private equity transaction in the Russian power sector: the purchase of a 26.4% stake in Enel OGK-5 by a group of four investors, including Rusenergo Fund, AGC Equity Partners, RDIF and MRIF. Was this a milestone transaction in your experience?
It was certainly a significant transaction from a number of perspectives. Looking first at the current investment climate, one can blame the government for inconsistencies in reforms. In reality, however, one should balance the interests of producers and its investors as well as consumers – the general public and the common macro economic targets, which the government needs to observe in order to stimulate the rest of the economy. It is evident that for Russia access to attractively priced energy resources is one of the economic advantages. The sector cannot really afford to boost electricity prices to international levels in just one day. You need to adjust for a transition period, which would allow key energy consumers to invest in energy efficient technology to become competitive with international markets.
In addition, we have observed a change of leadership in the political circles this year. This has contributed to a significant decline in interest for the power sector. As we are a dedicated investor in the power sector, we have an idea which companies represent lesser upward potential but a more solid investment case.
OGK-5 has a good asset mix, which is comprised of three gas field generating facilities all located in attractive regions of Russia with a good level of demand for electricity. The setup also comes with a crown jewel—a coal fire plant located in the Urals. This plant generates significant margins and represents a large part of the company’s results.
We felt this would be the right investment: with the overall decline in asset prices we could make a sizeable investment in a good company. The total acquisition cost of around USD 700 million, however, was too high for a single fund. Therefore it was our challenge to find investors willing to participate in this investment. It was a tough challenge because the overall interest of traditional private equity investors and other investors in Russia is limited compared to what you can observe in other BRICS countries. Furthermore, investing in the Russian power sector was considered a risk.
Over the course of one year we managed to build a global network of investors with an interest to invest in Russia. The partners we found were all keen to continue and truly believe in Russia. This was a good milestone to achieve.
Our approach regarding OGK-5 was perhaps difficult from an execution perspective but certainly much better received by today’s investors. We found an attractive opportunity and presented this as a single purpose fund. I believe this is the model to go forward in the next few years until investors become less cautious.
From our perspective, this was the first significant deal concluded in the private equity segment. This has helped us to establish ourselves not only as an advisor but also as a principal investor. Moreover, we managed to create a circle of investors who are keen to continue to invest with us in further projects.
These investors also include Rusenergo Fund, the largest state-owned energy fund for over which Xenon has a mandate as investment manager. Could you elaborate on this fund to our readers?
This fund was created when RAO UES came to the final stage of its reorganization in 2008. Rusenergo initially acquired a significant portion of shares in RAO UES. Since Xenon took over the management of the Rusenergo Fund in 2010 we initiated the process of reorganizing its portfolio. Today, we have about 12 positions in the Fund—all of them focused in most attractive companies in the sub power sectors.
Currently we are the largest institutional investor in RusHydro, INTER RAO UES, FSK, MRSK Holding, OGK-4 and as previously mentioned our investment in OGK-5. Furthermore, we maintain positions in medium sized generation companies. In each sector we have only picked clear leaders—companies which we believe will outperform their competition.
We also wish to invest in specific private equity situations where we could obtain larger stakes in particular companies in order to exercise a more direct management control of the asset. In OGK-5, a consortium of four investors, we have a 26% stake in the company, thus we influence the management on a shareholder level. We also have three members on the board, we participate in companies’ committees and we maintain a regular dialogue with the management. This is a model we would like to replicate in the future.
It seems there is a lot of close involvement from the different directors as you mentioned. How will this reflect on the future of Xenon as a company—will we see for example significant growth in the people you need to attract?
That is certainly our expectation. We aim to grow in areas where we have the most expertise: the energy sector in a broader sense.
In addition to the Rusenergo Fund we hopefully conduct more of similar transactions in the future. We are also hopeful to set up new funds dedicated to the infrastructure sector.
Would you have a final message to the different international investors reading this report?
Despite what the Russian power sector is going through at the moment, we firmly believe that the sector will recover. The government made a clear decision that the sector will be financed by private capital. In order to do this, the conditions in the sector need to be attractive. This means that the government will continue its path of liberalization, creating long term and stable conditions for private capital to enter the sector. Our investment in OGK-5 shows that we can generate returns in the range of 20 to 25%, which is still considered a conservative investment.
Today is an opportune time for new investors to come to Russia. One obviously needs to be selective on where to invest, but more important is that there are attractive investment opportunities in this country and financial investors who are willing to invest capital into the power sector.
The environment is such that you do not see a huge deal of competition for us, which is a good opportunity for smart investors. Finally, I would certainly encourage professional investors to come and look for opportunities. We are happy to meet and invest time to educate investors and hopefully make investments together.