On October 12th 1998 CEO of Telecominvest and his young energetic CFO were in New York, continuing their meetings with international institutional investors. The CEO was scheduled to speak at the investor conference at the New York offices of CAIB Investmentbank AG, which hosted the conference. For both men this was the first time they appeared in front of an audience of portfolio investors, and they were looking forward to acquainting the world with Telecominvest and the post-crisis business environment in Russia in October 1998. The CFO was also eager to make sure that his new boss understood the importance of these meetings and saw how different they were from industry and hardware supplier-oriented events.
When introduced to an international equity analyst from one of the leading investment companies, the CEO of Telecominvest was disappointed to learn that the analyst had never heard of Telecominvest and its business before. Having spoken at international industry and supplier conferences almost on a monthly basis and having made extensive connections among Western European telcos, the CEO was bewildered with his discovery. A leading telecom player in the northwest Russia and St. Petersburg in particular and a relatively small private company, it was completely unknown in the universe of emerging markets financial investors. Clearly, whatever the CEO and the company board had in plans for Telecominvest, they had a long way ahead of them[1].
Introduction
Telecominvest is a holding company with investments in telecommunication businesses in North-west Russia. Backed by its influential shareholders, St. Petersburg telephone Network, St.Petersburg Long Distance and International Telephone Company and First National Holding S.A. – a Luxembourg affiliate of Commerzbank A.G. of Germany, the company developed rapidly, creating and occupying niches in most lucrative segments of telecommunications industry. At the end of 1998 the TCI group had a 65% share of the cellular market outside St. Petersburg, 88% of the cellular market of St. Petersburg, 9% of fixed line telephony, 22% of the internet services and operated 94% of St. Petersburg’s payphones.
With a number of important investments planned on the holding and subsidiary company levels for the not so distant future, the main challenge for Telecominvest management was to secure the sources of long-term financing. This task was especially difficult; given the after-crisis stock market conditions at the end of 1998, extremely negative sentiment of portfolio investors towards Russia and potential conflicts of interests between strategic partners of Telecominvest.
Russian Economic and Political Situation in 1998
Political and Economic Transformation
Before 1985 Russia was a centrally planned economy. In April of 1985, Gorbachev came into power with an understanding that something had to be done about the collapsing economy. In 1986 Gorbachev proclaimed perestroika and glasnost and in 1987 decentralized economic decision-making. In an address to the nation on December 25, 1991, President George Bush declared that "the United States recognizes and welcomes the emergence of a free, independent, and democratic Russia, led by its courageous president, Boris Yeltsin". By the end of December the Soviet Union had been dissolved, succeeded by 12 newly independent states. Boris Yeltsin was elected President of Russia, the largest of the new states. As president of the Russian Federation, he held much of the power over Gorbachev who had been elected President of the Soviet Union in 1990.
In January of 1992 prices were freed leading to a tripling overnight. Three and four figure inflation followed through to 1995, coupled with a constant decrease in output. In June 1992 Russia was admitted as an associate member to the group of major industrial powers, the G7, with the right to attend meetings as an observer. Unhappy with observer status only, Russia is seeking formal admission and a name change from the G7-plus-one, to the G8. In 1997 Russia joined the Paris Club of creditor nations, and undertook a deal in which it agreed to reduce its claims on third-world debtor nations from 100% to 75%, in exchange to win back some of the $140bn lent to Soviet allies during the cold war.
A multi-tier economy has developed in Russia. The old state sector, which is now largely privatized, has three tiers. The first tier is primarily oil and gas production. This sector showed small declines (5-10%) and is now growing at 3-5% a year. The second tier includes electric utilities, telecommunications, weapons and the chemical industry. These industries are growing slowly after a decline of 20-30%. The third tier is the rest of old state economy. It is comprised of textiles, apparel, agriculture and manufacturing. These sectors have declined by 80-90% and are still declining. The entrepreneurial sector, outside of the former state economy, is burgeoning and there is money to be made. The sector is spreading into telecommunications and parts of manufacturing.
Economic Crisis
The economic crisis had been building throughout 1998 starting with the crash of the Russian stock market in mid-1998, coming to a head on August 17th as a result of key decisions made by Prime Minister Sergei Kiriyenko’s reformist government. Significantly, the Central Bank widened the scope of currency fluctuation it was prepared to accept before intervening in the market. Currency speculators had spotted a weakness in the Russian economy, and the central government could no longer to artificially support the Ruble without dramatically affecting the foreign reserve position of the state. In mid-August the Ruble was trading at Rb7/$1 but plunged to a low of Rb20/$1, finally stabilizing at Rb16/$1 after an unexpected intervention by the Central Bank. Adding to the currency crisis, in August 1998 the government unilaterally extended the maturities of short-term government bonds (GKO’s and OFZ’s) from 3-three months to maturities ranging from 3 to 5 years yielding between 20-30%. In so doing, the government had effectively defaulted on Rb281,000m of government debt, (equivalent to $43bn). Investors wishing to convert bonds to cash received one fifth of the value. Some foreign investors were hurt, but more importantly, it hurt the Russian banks. The banks were heavily exposed to the GKO market causing many banks and inter-bank operations to freeze. A three-month moratorium was placed on Russian banks’ debt repayments to foreign lenders. Many small banks were lost, with larger banks being saved by the government with little regard to private depositors losses. Within two weeks the Ruble lost two thirds of its value.
Shortly after the crisis, international economists and investment banks operating in Russia were making rather gloomy predictions of the future economic situation. The obvious concerns were the exchange rate and the inflation rate. The consensus year-end exchange rate forecast in October-November 1998 was Rb32/1$ in 1999 and Rb70/1$ in 2000.
The Russian economy relies heavily on commodity exports for foreign revenue, and it was largely believed that fall in world commodity prices was in part to blame for the economic collapse. The fall in prices impacted on Russia’s foreign exchange reserves and placed the government in a debt repayment crisis. To many Russian companies, the crisis was a double-edged sword, companies held funds in the defaulted short-term government bonds and thus lost much of their investments. Moreover, the rapid depreciation of the Ruble led to a huge increase in the cost of purchasing equipment from foreign countries. The EIU forecasts that Russia’s economy would have shrunk 5% by the end of 1998. Within a single week in August, the reformist government ceased to exist and was replaced by the new government of Yevgeny Primakov. Since taking office, Primakov has brought a measure of stability to the economy and has appealed for the restructuring and refinancing of both Russian and Soviet debt.
Investment Risks and Concerns
After the crisis, Moody’s investment service cut Russia’s speculative-grade foreign currency rating from B2 to CAA1. It also downgraded its long-term foreign currency deposit ratings for 11 Russian banks, and lowered its financial strength ratings from D+ to E+ for 8 banks. The economic crisis has thus far not changed the fundamentals of the government’s privatization policy and the first deputy prime minister in charge of the economy, Yuri Maslyukov, stated that there would be no nationalization and no return to the planned economy. However, the Duma (Russian Parliament) set up a committee to review controversial sell-offs of state assets between 1995 and 1997, as well as considering a new “re-nationalization” bill that could reverse many of the post-soviet privatizations. The bill would have a range of criteria allowing it to renationalize companies. One criterion was a firm with “special significance to state interest”; another was a firm with a dominant position in the market. The government has launched a number of suites against winners of investment tenders that failed to keep their pledges to invest in privatized companies. Russia has cancelled the proposed sale of a stake in telecommunications giant Svyazivest in October 1998.
The implication of the financial crisis of 1998 on the financing opportunities for both new and established companies was devastating. Public equity markets, both domestic and international were closed for Russian companies; western commercial lenders hardened their requirements, making bank borrowing prohibitively expensive. Russian commercial banks were struggling to survive and keep at least some of their assets. Only two categories of investors remained remotely interested in investing in Russian companies, strategic investors and private equity investors to a lesser extent.
The strategic investors would only invest if they felt that they could participate actively in managing the investee companies and possibly gain control in the longer term. Private equity investors in emerging markets were known as high-risk takers, but even they were skeptical about the Russian economy. For potential investors, the critical question regarding investing became the investing strategy, and the use of offshore financial structures that would allow the investment to be governed by corporate laws of more stable jurisdictions (Cyprus, Luxembourg, Jersey, Guernsey, Isle of Man, etc.), the optimization of taxation and the repatriation of company profits.
Telecommunication Industry in Russian Federation
History
The current Russian telephony infrastructure is a carry-over from the highly centralized telephone network that was built around the defense and security needs of the former Soviet Union. By 1994 Russia ranked 33rd in the world, and 21st in Europe for telephone penetration at approximately 14 telephones per 100 persons. There were only 27.6m telephones in Russia at the end of 1996, of which 19.7m were private, compared to 36m in Spain, 44mm in Belgium and 69m in Switzerland.
Telephone links were prioritized towards the center of the network while inter-regional links were neglected. As a result of this, the ability to direct calls between regions, while avoiding the necessity of being connected via the center, remains extremely limited. This in turn dramatically hindered the economic growth in regional markets. A trunk backbone capable of providing network expansion on a nation-wide basis has not been developed in Russia, and as a result expansion into the rural regions is slow and expensive. Residential telephone service was traditionally regarded as a social service and not a commercial enterprise and was mostly free of charge; while long distance and international call facilities available to the general public were firmly restricted. Accordingly, telephone users in Russia were used to poor quality, inexpensive telephony service.
The low priority afforded by the Soviet state to improving the public telephony service during the cold war era has left the network in a technologically poor state. Many exchanges on the long distance network based on the electromechanical system and significant portions of long distance calls are manually switched
Telecommunication in Russian Federation after Privatization
After the breakup of the Soviet Union and subsequent liberalization of the former republics, the demand for telecommunications services in both private and public domains has grown significantly. The government telecommunications sector has experienced substantial difficulties in meeting this demand and has actively encouraged market liberalization, privatization and foreign investment in the telecommunication industry.
The transition to a market economy and the liberalization of the telecom sector has resulted in the appearance of a number of new operators in the Russian telecom space. Under the new regulations, foreign companies are prohibited from full ownership of the regional fixed line operations, however, companies such as Siemens, Acatel (France), Ericsson (Sweden) and US West (USA) are all active in the local market through joint ventures with local companies. Another way these foreign companies participate in the market is through the offering of credit and lease agreements for telecom equipment. Under this arrangement the central government has issued over 600 new licenses to these joint ventures. This investment has resulted in dramatic growth in the regional development of fixed-wire overlay systems, private networks, cellular and data services.
Regional telecommunication companies are investing heavily in their infrastructure, making use of government financing where possible, but resorting to foreign investment and partial ownership in most instances. By mid 1998 it was estimated that approximately $750m of foreign direct investment had been directed towards the telecommunications sector. This was however only a fraction of the estimated $100bn that was needed to bring Russia’s antiqued network up to world standards. There are currently no restrictions on cross-holdings between cellular and regional fixed-line companies, as a result, several regional fixed-line operators have established cellular subsidiaries or have invested in joint ventures with foreign cellular companies.
By 1991 approximately twenty new licenses had been issued allowing companies the right to operate in the lucrative international service market, effectively ending the monopoly previously held by state owned Rostelecom. The government does however own a controlling stake in 89 regional communications companies and in Rostelecom through the holding company Svyazinvest. In July 1997, the government sold 25% plus 1 share of Svyazinvest for $1.875bn to Mustcom Ltd, a Cyprus based company representing the interests of several investment funds.
The Russian government took an important step in securing foreign investment in the telecommunications industry by passing a new set of laws that would govern the industry moving forward. The law promulgated on February 23, 1995 effectively removed regulatory power from the government and placed it in the domain of established law practice. The new regulations placed control of the Russian telecommunications network in the hands of investors and local citizens. It also established a number of important principles in the sector including, but not limited to, the guarantee of equal access for all providers of services and safeguards for private business activity in the sector. More importantly, the Law extended these principles to foreign companies and individuals, further encouraging their participation in the market. In September 1997 the regulatory body was centralized and the new State Committee on Information and Telecommunications replaced the old Ministry of Telecommunications. This new body was responsible for the issuing licenses for both mobile and fixed line networks, and the allocation of frequencies for cellular and radio operations.
Telecommunications in St.Petersburg
Under Stalin, Moscow, and later St. Petersburg telecommunications were upgraded as part of the military strategic objective. This upgrading consisted primarily of the installation of new copper wire lines. The local St. Petersburg network did not received much attention after this until the arrival of foreign business in the early 1990’s. The local networks were incapable of supporting clean and uninterrupted data transmission, leading to an investment in digital overlay networks and fibre-optic links. As a result of the high installation costs, these digital and fibre links are aimed at the lucrative high-volume business market and wealthy individuals.
St. Petersburg Telephone Network (PTN) operates a portion of the telephone network serving St. Petersburg and the surrounding region. PTN has 1,8m lines in operation, amounting to a nominal penetration rate of 36%. The intra-city traffic is carried through a network of 34 transit exchanges distributed throughout the city, and connected to each other in a cobweb fashion. This network is outdated and overloaded resulting in heavy congestion, interference, and poor transmission quality. Currently only 17% of PTN’s exchanges are digital/electronic, and some of its equipment is over 40 years old.
PTN routes long distance traffic through a gateway exchange operated by St. Petersburg International and Long-distance Telephone Company (SPMMT). This traffic is then passed to the Rostelecom’s long distance network for delivery to the rest of the Russian Federation and international destinations. SPMMT operates as the gateway for international calls to and from St. Petersburg, and it has a number of options for the forwarding of these international calls. Calls can be directed to an international gateway controlled by St. Petersburg International, a joint venture between British Telecom and SPMMT, and then via direct satellite connection to UK. Alternatively, SPMMT has access via Rostelecom to the undersea cable between Russia and Denmark for international traffic. Finally it has the option to route international traffic through the international gateway in Moscow.