How to do Due Diligence in Russia

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How to do Due Diligencein Russia

• October 11, 2006
• Marriott Tverskaya, Moscow

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How to do Due Diligence in Russia

• Introduction (V.Ismailov, AEB)
• Commercial and Financial Due Diligence (T.Dix,
  KPMG)
• Integrity Due Diligence in Russia (A.Sokolov,
  KPMG)
• Corporate Governance Due Diligence (O.Shvyrkov,
  Standard Poors)
• Business Valuation (V.Khrapoun, PWC)
• HR Due Diligence (T.Carty, EY)

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Dr. Vladimir ISMAILOVAEB, Finance Investment
Committee

• 7 years in Public accounting/ consulting, 8 years
  in Telecom, 2 years in Financial services
• Due Diligence projects performed over 10 in
  Russia and CIS, 80 resulted in acquisitions
• Sections provided Why Russia?, Credit rating
  as a tool for effective Due Diligence,
  Financing a transaction, and Financing your
  business

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AEB Finance Investment Committee - Mission

• To assist in and contribute to the continued
  improvement of the investment climate in the
  Russian Federation for European business
  interests by addressing critical finance issues
  including
• Accounting and Financial Reporting
• Auditing
• Capital Markets

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How to do due diligence in Russia - Project
Goals

• To produce a Brochure (DDR) that would be
  practical guide to those who is about to make an
  investment in Russia.
• The Brochure will assist in improving investment
  climate in Russia by increasing market awareness
  about specifics of Due Diligence in Russia

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Due diligence is

• For the purposes of this brochure, "Due
  Diligence" engagements are those where a company
  considers stock exchange and other flotation,
  acquisitions, mergers, and disposals, rights
  issues, offer documents and any similar
  transactions ("transactions") and performs an
  investigation and evaluation, into the details of
  existing and/or future state of the business in
  order to identify benefits, disadvantages and
  risks.

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How to do due diligence in Russia -
Team/Resources

• All work was undertaken by professionals working
  in Russia from
• AEB Finance Investments Committee
• KPMG
• PWC
• Standard Poors
• EY
• A.T.Kearney
• Carl Bro AS

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FDI in BRIC countries
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FDI in Russia
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Thomas Dix, PartnerKPMG, Transaction Services in
Moscow

• 13 years with KPMG, 10 years in Russia, 7 years
  transaction experience
• Acquisition and vendor due diligence, contract
  assistance, and stock exchange reporting
• Sections provided Commercial Due Diligence, and
  Financial Due Diligence

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Why do Due Diligence?

• Caveat Emptor Let the buyer beware
• Russia vs. West
• Assurance over fundamentals
• Understanding of business model, commercial /
  organisational structure
• Assessing value / price, upsides and downsides

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Changing Deal Environment

• Corporate governance
• Financial reporting
• Regulatory framework
• Competition
• Deal process

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Commercial Due Diligence

• Helps verify business opportunities and
  associated risks
• Answers the question Is the companys business
  plan achievable under current and projected
  market conditions?

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CDD What is Involved?

• Market analysis
• Competitor positioning
• Customer referencing
• Supplier referencing
• Assessment of revenue projections

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Commercial DD Challenges

• Competition mechanisms
• Tender processes
• Sustainability of relationships
• Detective work
• Limited / inconsistent market data
• Administrative barriers

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Financial DD Challenges

• Impact of specific business practices
• Lack of reliable information
• Understanding of local business and accounting
  practices

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Financial Due Diligence Issues

• Specifics of financial reporting
• Impact of tax avoidance / minimisation schemes
• Management accounts
• Financing and capital structure
• Working capital issues
• Contingencies
• Projections / budgets

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Alexander SokolovDirector, KPMG Forensic

• 9 years with KPMG, including 6 years in KPMG
  London
• 5 years with KPMG Forensic
• Fraud investigations, Anti-money laundering,
  Integrity Due Diligence
• Extensive experience in Russia and the CIS
• Section covered Integrity Due Diligence in
  Russia

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Business Environment in RussiaWhy Integrity Due
Diligence?

• The emerging economies of the Former Soviet Union
  countries offer lucrative opportunities but
  present a number of challenges.
• High levels of corruption
• Generally low levels of transparency despite
  recent improvements
• Exposure to organised crime
• Significant impact of political environment on
  business processes
• Legacy of early transition

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Integrity Due DiligenceOverview

• Integrity due diligence manages the above
  challenges by assessing three broad categories of
  non-financial risks

Reputational risks
Undisclosed commercial risks
Political risks
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Integrity Due DiligenceHow to perform?
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Integrity Due DiligenceCase study

• A recent integrity due diligence of a Russian
  financial institution (an acquisition target) and
  its top management revealed the following
• a large proportion of its client base consisted
  of shell companies related to management and
  shareholders
• a number of customers were involved in
  potentially illegal transactions
• a controversial individual with extensive
  connections to Russian organised crime had
  influence over management
• there was ongoing tax scrutiny of the bank.

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Dr. Oleg SHVYRKOVStandard Poors

• 3 years with SP, Ph.D. in Management
• Assigning and surveillance of Corporate
  Governance of major Russian companies companies
• Sections provided Corporate Governance Due
  Diligence

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Governance in Russia an overview

• Governance in Russia
• (to non-Russian audience) its probably better
  than you think
• (to Russian audience) its probably worse than
  you think
• Blatant abuses of shareholder rights are a thing
  of the past, and yet governance is one of the
  principle risk factors for companies and
  investors
• State maintains equity positions in many large
  companies, which hampers growth in governance
  standards in entire industries.
• governance practices at state-owned enterprises
  and holding companies are very weak
• Most companies are driven solely by legalistic
  compliance in their governance practices. However
  several companies go beyond legal requirements in
  developing a culture of fairness, accountability
  and transparency

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Governance as a risk factor

• Average premium - investors would pay for a
  well-governed company by country and region
• - Global Investor Opinion Survey McKinsey Co.
  (July 2002)

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Governance and valuations in Russia

• Source Standard Poors CGS, P/B - Renaissance
  Capital

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Corporate Governance Scores Benchmarking and
Measuring Governance

• In response to inquiries from investors, in
  1998-1999 Standard Poors has established a
  capability to objectively benchmark and compare a
  companys corporate governance practices.
• Corporate Governance Scores (CGS) is Standard
  Poors opinion on the effectiveness of corporate
  governance practices and mechanisms
• Based on interactive analytical procedures
• Done with consent of companies (self-selection)
• CGS provides an assessment of non-financial risks
  related to ineffective or self-interested
  management practices. CGS Can facilitate the
  capital raising process by isolating key
  governance related risks of concern to investors
• Monitoring corporate governance provides greater
  transparency for investors and a positive
  incentive for companies to improve their
  governance standards

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SP Corporate Governance Score a global
instrument

• Stimuli for development of governance
• top-down (legal regulatory influences)
• bottom-up (market-based mechanism, beyond
  compliance)
• CGS has no sovereign ceiling

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SP CGS methodology
1. Ownership structure and external influences

• Interactive analytical process
• Four main mechanisms of mitigating risks -- Four
  components of analysis (and 11 sub-categories)
• Scores from 1 (the lowest) to 10 (the highest)
  sub-scores and overall score

4. Board structure and effectiveness
2. Shareholder rights and stakeholder relations
3. Transparency, disclosure and audit
1
10
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Selected Governance Scores (CGS) and Governance
Assessments (GA)
- assigned globally in 2001-2006
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Selected comparative governance data on Russian
companies
Note 1 data in columns 2, 3, 5 represent
percentage in the total number of companies in
the relevant group Note 2 all data for 54
companies is based on public sources ()
aggregate share of the corresponding stakes in
total market capitalization of the companies in
the group () including only 56 independent
audit committees
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Vadim KHRAPOUNPricewaterhouseCoopers, Advisory
Services

• Over 12 years in public accounting, valuation and
  consulting
• Due diligence and valuation services to a number
  of large domestic and multinational clients
  including Gazprom, Alfa Group, RAO UES Russia,
  LUKOIL, TNK-BP, Surgutneftegaz, Central Bank of
  Russia, BAT, Mobile TeleSystems, Nestle,
  McDonalds, Danone, Sumitomo
• Certified appraiser and a member of the Russian
  Society of Appraisers. Member of the Association
  of Chartered Certified Accountants (ACCA, UK) and
  a candidate member of the American Society of
  Appraisers (ASA)

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Table of content

• Key features of the Russian MA market
• Valuation methodology what is different?
• Inherent limitations of the target businesses
• External factors affecting valuations
• Conclusions

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Key features in the Russian MA market

• Non-transparent approach to MA deals
• Economic rationale vs. just want to do this
  deal
• No perceived undervaluation of assets
• Continued market consolidation

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Valuation methodology what is different?

• Choosing appropriate value premise
• Customizing valuation methodology
• Making comprehensive risk assessment
• Selecting reliable information sources

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Inherent limitations of the target businesses

• Non-existence of business plans and financial
  forecasts
• Complicated ownership structure
• Sufficiency of reliable operational and financial
  information
• Lack of deal experience

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External factors affecting valuations

• Maturing microeconomic environment
• Developing capital markets
• Formal or informal agreements between the parties

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Conclusions

• Increasing need for fair and competent valuations
• Creativity in executing valuations
• Placing the valuation results in the context of
  the whole deal
• Communicating valuation results to the parties in
  unsophisticated way

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Tim CartyAEB, HR Committee

• 15 years in Personnel related consultancy. 8
  years in Russia
• Due Diligence projects performed in Russia 5 in
  last 2 years
• Sections provided HR Due Diligence

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HR Due Diligence

• Three Main Components
• Technical Issues
• Benchmark Issues
• Cultural Issues

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HR Due Diligence Technical

• Are there any technical exposures in the target
  that could cause problems
• Labour Relations
• Pay
• Payroll taxes

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HR Due Diligence - Benchmarking

• Are there any areas in which the target is behind
  the market
• Compensation levels
• Job Grading Employee Structure
• Headcount levels

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HR Due Diligence - Cultural

• Are there any major HR issues at the
  organisation that will require investment and
  attention
• degree of employee satisfaction perception of
  the target as an employer
• alternate employers available
• Trade Union or other outside bodies influence

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How to do Due Diligence in Russia

• QA