Creating Capital Markets in Russia

1. Thursday, February 19, 2009
The Moscow Times » Issue 4089 » Opinion
How a Russian FedEx Could Save the Economy
19 February 2009 By Thomas Nastas
In his recent Davos World Economic Forum keynote speech, Prime Minister Vladimir Putin stated
that excesses, irresponsibility and greed with governments asleep at the wheel formed a perfect storm
to wreak havoc on global economies. The result has been an unprecedented fall in global demand,
production, employment and wealth.
Putin welcomed dialogue from all to find solutions to the crisis and to chart the way forward. While
it may seem that there are more important short-term crisis-management issues to deal with when
Rome is burning, it still makes sense to think of the long-term future growth in Russia.
A pressing need in Russia is the creation of a set of institutions that invest medium term money into
small and medium-size enterprises, or SMEs. Accomplishing this objective requires changes in
Russian legislation in multiple areas, including permitting Russian pension funds, insurance
companies and like-minded institutional investors to invest in this economic sector.
Like many other developing countries, there is no institutional source of medium- and long-term
capital for Russian SMEs. Large companies borrowed from international creditors to fund projects
that take three to five years to bring to market. But SMEs lacked this access, and they financed their
needs with multiple short-term loans from Russian banks, renewing them at maturity, about every 12
or 18 months. While expensive, because it duplicated transaction costs for SMEs at each refinancing,
it basically worked when the credit markets functioned. Russian banks make short-term loans
because they themselves lack sufficient and reliable sources of long-term money.
When credit dries up as it has now, SMEs can't refinance their loans and are forced to curtail
production, cut back on purchases, shrink employment and cut salaries. These exacerbate economic
difficulties for all. While private equity is available in Russia, SMEs require between $500,000 and
$5 million. This amount was too small for risk-seeking investors in 2007 and 2008, who were
looking to invest from $30 million to $100 million per transaction. Since the beginning of 2009, the
financing gap has grown larger as Russian banks curtail lending and private-equity investors invest
to stabilize current investments.
In 1958, a U.S. government agency called the Small Business Administration launched the Small
Business Investment Corporation program to solve the financing gap in the United States. SBICs are
licensed and regulated by the SBA but privately managed by private sector managers. The minimum
equity to establish an SBIC was $5 million raised from private investors. What made the SBIC
program innovative is that additional capital, leverage -- three times private capital -- is provided to
SBICs from the sale of SBA-guaranteed bonds. This guarantee feature opened a new source of
capital for SMEs, traditional buyers of bonds like pension funds and insurance companies that seek
safety first and yield second. In 2007, for example, SBA bonds had a coupon of 5.8 percent,
approximately 106 basis points over risk-free, 10-year U.S. treasuries.
Since its conception in 1958, SBICs invested more than $50 billion into more than 100,000 SMEs
with more than $25 billion invested in SMEs less than three years old. Well-known brands that

2. received SBIC funding in their early growth include America Online, Amgen, Apple, Callaway Golf,
Costco, Federal Express, Intel, Outback Steakhouse, Palm Computing and Staples, to name just a
few. It was through the SBIC program that U.S. SMEs accessed affordable long-term capital and
institutional investors diversified into a new and higher-performing asset class -- clearly a win-win
situation for all participants.
What's needed now is for the Russian government to establish the legislative framework for an SBIC
industry to emerge in the country. A first step is the creation of a bond guarantee program for the
SME sector. With debentures guaranteed against default of principal and interest, bonds are priced at
quot;market rates,quot; which are less than the rates on nonguaranteed bonds because they are risk-free. This
enables SBICs to raise funds at low cost, and unlike institutional investors that seek extraordinary
returns from venture capital and private equity, SBICs have more modest return expectations,
partially because they receive a continuous stream of cash that compound returns to meet semi-
annual interest payments.
A guarantee program is useful to build the financial market in Russia. SBICs finance either emerging
or established SMEs that are not quite good enough for a conventional bank loan due to their short
length of operating history, nature of cash flow or mix of hard and intellectual assets. A guarantee
program can tip the balance in favor of loan approval. Guarantees also make it possible to extend
repayment terms -- for example, from 18 months to 48 months. SBICs are more risk-tolerant than
banks, and because their funding sources demand less return than venture capital investors they are
not as aggressive in seeking high payoff ventures.
There are other benefits to applying an SBIC program to Russia. In the United States, for example,
SBIC led to more specialization and product development in the financial sector as some SBICs
invested only debt, while those with a greater tolerance for risk emphasized equity and equity-linked
structures. The investment skills of SBIC staff sharpened as they had to better differentiate SMEs
with the potential to create the maximum venture-capital rates of return versus lifestyle companies
more suited to debt only. This enhanced learning led to prudent risk-taking in the financial sector and
ultimately provided the foundation for the venture capital industry to emerge in the United States.
Development of a greater number and variety of financial products was achieved as financiers better
learned how the balance sheet of SMEs could support different layers of capital with different terms,
conditions and maturities with little increase in risk. Financial product development included various
forms of subdebt, second-lien debt and preferred shares with or without conversion as examples, and
the development of new products for certain industries -- for example, factoring for the retail trade.
The best and most effective way out of a crisis is through experimentation and adaption. It is
extremely important to search for new innovations. Governments need to think about how to best
direct investment to address not only today's problems, but also those which are right around the
corner that are not yet being used as driving forces in the market.
This is not an easy task, but stepping up to the plate during tough times is what leadership is all
about.
Thomas Nastas, founder of Innovative Ventures Inc., is member, Board of Directors, Sotsgorbank
and the Independent Directors Association (Moscow), and professor of marketing at the American
Institute of Business & Economics in Moscow.