As sanctions were imposed on Russia for its role in the Ukraine crisis, capital has flown out of the country and M&As have dwindled. With sanctions likely to remain in place for a while, should businesses stay away or will ignoring Russia as an investment destination prove a short-sighted strategy?
Sanctions against Russia are likely to remain in place for the foreseeable future. A significant diplomatic breakthrough between Kiev and Moscow – and the rebuilding of trust between the Kremlin, the White House and Brussels – is needed before EU and US sanctions are lifted entirely.
Although the EU has tied the sunset of sanctions to the fulfilment of the Minsk accords – which include devolved power to rebel regions in the east of Ukraine, the withdrawal of foreign militias from the country and the restoration of Ukrainian control over its border with Russia – internal divisions between EU member states could see a progressive lifting of so-called ‘sectoral sanctions’ in July, which have primarily affected the banking, defence and energy sectors in Russia. The EU has called for the settlement of the peace accords by December 2015, but full compliance with the terms is unlikely since some of the measures – such as the devolution of power to the breakaway regions in the east of the country – face strong opposition in the Ukrainian parliament.
The US appears more resolute in its stance on Ukraine’s territorial integrity – demanding the return of Crimea to Ukraine – and US sanctions are likely to remain in place longer.
Is investing in Russia possible in the current climate?
Since sectoral sanctions were first introduced in July 2014 – curtailing Russian access to western financial markets and placing restrictions on activities in the oil and gas sector – we have witnessed substantial capital flight and a grinding halt to M&A activity in Russia.
Many western firms have shown a reluctance to invest, compounded by the economic uncertainty created by depressed oil prices and Russian currency uncertainty, while others have been prohibited from continuing their operations. ExxonMobil, Shell and Total have all suspended joint shale oil and Arctic projects in Russia owing to bans on the provision of technology and services for exploration in these areas.
Nevertheless, a number of investors remain that take an overall positive view on investing in Russia and believe that, despite the risks, ignoring Russia as an investment destination could be short-sighted.
Where has there been investment?
Sanctions have not prevented new investments in Russia. Some of these deals include:
- The acquisition in March 2014 by Russian state oil major Rosneft of a 13% stake in Pirelli. Rosneft’s chief executive, Igor Sechin, also took a seat on the board of the Italian tyre manufacturer. Rosneft is under EU and US sanctions and is prevented from accessing capital markets and certain oil field technologies, while Sechin is subject to a US visa restriction and asset freeze. Although the deal was agreed before sanctions were introduced, Pirelli maintains that it remains in compliance.
- The December 2014 acquisition by US pharmaceutical company Abbott of Veropharm – one of the leaders on the Russian pharmaceutical market.
- A December 2014 deal between Italy’s Finmeccanica and Russian Helicopters – a unit of the US-sanctioned public holding company Rostec – to build 160 helicopters for Rosneft.
- The acquisition by Phoenix Mecano – the Swiss producer of industrial components – to acquire control of Electroshield-K, a Russian supplier of components for the nuclear industry, controlling approximately 15% of the market.
Even in the strategically sensitive oil and gas sector – which has borne the brunt of economic sanctions against Russia – investment activity has continued. Sanctions have not derailed the agreement between Norwegian offshore drilling company North Atlantic Drilling (NAD) and Rosneft, which would see NAD purchasing rigs from Rosneft in exchange for a 30% stake in the company. However, the closing date of the deal was recently postponed to 2017 primarily owing to the collapse in the oil price and the limited access of Rosneft to capital markets.
In response to western sanctions Russia has introduced its own restrictive measures, notably prohibitions on food imports from the EU, US and others. Beyond formal sanctions, the greatest concern for investors is the sense of increased Russian isolationism and growing hostility towards western investment, which manifests itself less overtly – most often in the form of a harsher regulatory environment and arbitrary refusals to grant licenses or approvals to invest.
Nevertheless – despite fears that Russia would close for business when western sanctions were introduced – there are plenty of examples where the Russian government has allowed investors to enter the market – often after some initial hesitation – as outlined above.
The case of Schlumberger
A key litmus test for foreign investment was the recent provisional approval of the Russian government’s foreign investment committee – which oversees investments in strategic sectors – to allow Franco-American oilfield services company Schlumberger to purchase a 46% stake in Eurasia Drilling Company (with the option to acquire the entire company) – the largest Russian drilling contractor.
The deal looked set to collapse when Russia’s Federal Antimonopoly Service (FAS) intervened on the eve of its completion, despite claims from the parties involved that the deal was not anticompetitive. It was eventually agreed that the deal could be allowed to proceed on the condition that Schlumberger sells its Eurasia Drilling assets to a Russian investor, if the company is required to suspend its operations in future owing to sanctions.
In a similar vein – the FAS announced in April that it had extended its examination of an application from Halliburton and Baker Hughes – two major US oilfield services companies – to merge their assets in Russia. Approval is ultimately expected, but the merger will likely require approval by the foreign investment committee.
The foreign investment committee will also weigh in on Glencore’s decision in March 2015 to acquire 49% of Russian oil company Russneft. It is likely that the committee will rule in Glencore’s favour given the Russian government’s need to attract foreign investment – particularly in the hard-hit energy sector.
How to avoid sanctions exposure
Thorough due diligence is key to avoiding exposure to a sanctioned entity. When considering an investment in Russia, it is also worth considering the likely trajectory of sanctions to understand if a counter-party, which is not sanctioned today, may be sanctioned tomorrow.
Predicting the likelihood of sanctions is not an exact science, but ongoing monitoring of the political landscape, following the situation on the ground in Ukraine, and understanding where a company and its owners sit within Russian structures of power and influence, has so far proved a useful indicator of new targets, as sanctions have been deployed progressively. Understanding the political landscape is particularly important now because the atmosphere of increased adversity between Russia and the West has led to a less stable and more unpredictable business environment.
Thorough due diligence on a counter-party must include a review of its formal ownership structure and assessment of its owners’ links to political elites. Investors should bear in mind that Russian individuals and companies may have sold assets or changed their ownership structure to hedge themselves against the possible fallout of sanctions. Following the imposition of US sanctions on Gennady Timchenko, co-founder of the oil trader Gunvor, Timchenko sold his 43% stake to co-founder Torbjorn Tornqvist.
In addition to understanding a counter-party’s ownership structure, it is necessary to look into its directors, who may exert control over the company. ‘Control’ over a company is a term used by the EU in its sanctions compliance requirements and does not necessarily mean that an individual or entity owns more than 50% of a given entity.
The biggest hidden risk lies in dealing with a counter-party that is acting on behalf of a sanctioned entity that is attempting to circumvent sanctions. In addition to due diligence, lawyers advise obtaining representations and warranties from the counter-party attesting that they are not acting as intermediaries for a sanctioned entity and including an option to terminate a contract if it transpires that the counter-party is acting on behalf of a sanctioned entity.
Lawyers also note the importance of checking a company’s compliance with the US Foreign Corrupt Practices Act (FCPA) and the UK Bribery Act 2010 when investing in Russia because – in the atmosphere of heightened scrutiny – there will likely be increased inspection of adherence to these regulations.
Adam Lewis is a political risk analyst at GPW Ltd