Golden Years Ahead For Russian Private Equity Despite Tax Risks

by Tatiana Smolenskaya, Tax-News.com, Moscow

09 October 2008

Private equity investment in Russia is expected to see a marked upturn in the remainder of 2008 and through 2009 despite the worsening investment environment in Europe, the United States and much of Asia, and the Russian industry's still-developing tax and legal foundations.

A report from Deloitte, the business advisory firm, has highlighted how Russia’s private equity players plan to use the current market uncertainty to their advantage. With the list of postponed IPOs increasing, public company valuations at 2-year lows and extremely difficult debt markets, private equity is emerging as the preferred financing solution for ambitious Russian companies.

However, while there seemingly remains potential for handsome returns for private equity investment in Russia, new entrants to the market may face a potential minefield in terms of taxation, an area which is still maturing in what is as yet a relatively young market economy. For example, many target companies may have the associated baggage of questionable tax minimisation schemes attached. These include the use of special purpose vehicles, false invoicing, under-the-table salary payments and the use of complex legal ownership structures to avoid other taxes such as VAT.

Although such practices are on the decline in corporate Russia, it gives rise to the possibility that target companies may in the future become the focus of a tax investigation by the authorities, leading to potentially heavy fines.

The Russian authorities are still learning how to deal with some of the more complicated transactions used by private equity firms in leveraged buyouts, meaning that there remains some ambiguity about how these will be treated in terms of tax.

Despite these tax and legal uncertainties, the Deloitte report suggests that the potential returns in Russia remains high. Of the 65 private equity houses surveyed by Deloitte (31 overseas funds and 34 local funds), 50% viewed the global liquidity crisis as a positive development for private equity activity in Russia at the same time as only 53% expected competition for new investments to increase (compared to 91% in 2007).

Stefan Reutter, head of Corporate Finance Advisory for Deloitte CIS, commented: “It is clearly a buyer’s market with funds which have just raised new capital being in the driving seat. Spending time to seek out the best companies at good valuations will undoubtedly lead to 2008 and 2009 being the best vintage years for private equity.”

Vitalij Farafonov, of Deloitte’s Moscow Corporate Finance Advisory team, added: “Currently most companies are really left with only 2 sources of funding; private equity or a strategic investor. This provides a great opportunity for private equity houses which can be more selective and buy well. However, the scarcity of capital could also have a negative impact on private equity in the future by slowing the economy and therefore slowing the performance of their portfolio companies. This is especially true for consumer-driven industries which remain the most popular home for private equity money.”

According to Ernst & Young, the volume of private equity transactions in Russia increased fivefold in 2007 to USD5bn. However, this still represents less than 5% of Russian-target acquisitions, much lower than the European average.

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