Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Private Equity volume featuring discussion and analysis of emerging trends and hot topics within key jurisdictions worldwide.

1 What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?

Although investment conditions remain challenging in Russia due to the application of international sanctions on certain industries and market participants, market conditions slightly improved in 2018 and the first half of 2019. In 2018, the overall number of deals increased by almost 20 per cent (principally driven by major Russian state-backed players (such as Sberbank, VTB and RDIF) and Asian and Middle Eastern sovereign investors), although total deal value declined by 7 per cent (largely due to the absence of ‘big ticket’ M&A) and the number of inbound deals fell by 21 per cent. This indicates that, while there is an availability of buy-side opportunities for participants familiar with the Russian market and ready to deploy capital in search of yield, investors remain cautious of executing big ticket M&A and certain foreign investors have adopted a ‘wait and see’ approach, deferring M&A decisions into the second half of 2019 and 2020.

With the Russian economy continuing its recovery from the 2016 recession and growing by 2.3 per cent in 2018, and with further modest growth predicted in 2019 and 2020, investor confidence and market activity is on the rise. Growing investor confidence has been supported by Russian government policy aimed at maintaining an export-friendly exchange rate, efforts from the Central Bank of Russia to reform the banking and insurance sectors, the fact that the Ukraine conflict has not escalated and that international and domestic investors have increasingly adjusted to the realities of international sanctions and increased geopolitical risk. With the rouble depreciating 15 per cent against the US dollar in 2018, production costs in Russia offer significant competitive advantages to investors localising production in Russia for export (although investors face some difficulties in planning and valuing investments given recent currency fluctuations). These trends indicate that, notwithstanding ongoing geopolitical challenges, the size, depth and liquidity of the Russian private equity market continues to grow.

Unlike in other jurisdictions, an initial public offering (IPO) is not a common exit strategy for private equity in Russia, and therefore there is not as strong a correlation between changing stock market valuations and private equity activity. The only notable IPO in 2018 and the first half of 2019 was the listing of HeadHunter (a leading Russian online job search portal) on the NASDAQ exchange (the first listing of a Russian company on the NASDAQ exchange since 2013); although, as discussed below, there were numerous negotiated private equity exits in this period.

Overall, we view the outlook for 2020 and 2021 as increasingly positive with several companies touting possible IPOs, such as Yandex.Taxi (the largest Russian online taxi booking service) and Rambler Group (a major Russian internet and media holding). However, it remains to be seen whether this pipeline of exits will materialise in light of ongoing sanctions and other geopolitical factors.

2 Looking at types of investments and transactions, are private equity firms primarily pursuing straight buyouts, or are other opportunities, such as minority-stake investments, partnerships or add-on acquisitions, also being explored?

Buyouts (whether by management or otherwise) and public-to-private transactions tend to be relatively unusual in Russia. It is more common for investors to take minority stake investments. Where control is acquired, these investments tend to be carried out by way of a consortium deal. One of the main drivers for this is financing. As with any jurisdiction, investors can access larger deals by clubbing together, but this increased financial resource is particularly relevant in Russia where deals tend either to involve limited debt financing or none at all.

Finance is just one reason why foreign investors often seek out local investors with whom to partner. Russia has a reputation as a jurisdiction in which it is desirable to have a strong local partner to achieve a successful business operation. A local partner brings local knowledge and connections that can be indispensable for foreign investors who are unfamiliar with the Russian regulatory system and lack relations with the Russian authorities. Partnering with a local private equity house may make obtaining investment committee consent easier, as comfort is taken from the experience, expertise and influence of the local partner. For the Russian investor, involving an international partner may provide access to funding from banks based in the same overseas jurisdiction as the foreign investor and carries with it a certain cachet that can be of particular leverage when trying to negotiate an exit. In addition to funding, international investors can bring a greater depth of deal experience and sector knowledge to what is still a developing private equity market.

3 What were the recent keynote deals? And what made them stand out?

The key deals in 2018 and the first half of 2019 have centred around three broad themes:

  • the ‘pivot east’, evidenced by the increase in inbound investments from Asian and Middle Eastern sovereign funds to Russia;
  • the diversification of private equity investments across a broader range of sectors (outside the traditional extractive industries), with particularly strong performance in the innovation and technology sector; and
  • the increase in the number of private equity investments by major Russian state-backed players (such as Sberbank, VTB and the Russian Direct Investment Fund (RDIF)).

Throughout 2018 and the first half of 2019, a number of significant inbound investments were executed by Asian and Middle Eastern funds. This included:

  • a consortium of RDIF, the Russian-Chinese Investment Fund (RCIF) and several Middle Eastern funds acquiring a 28 per cent stake in Alium (a top 10 pharmaceutical company in Russia);
  • a consortium of RDIF, RCIF and several Middle Eastern funds acquiring a 9.5 per cent stake in Intergeo (a mining and smelting company that is part of the ONEXIM Group); and
  • a consortium of RDIF and Mubadala Investment Company (an Abu Dhabi sovereign fund) acquiring a substantial stake in Russian Fitness Group (the operator of the World Class fitness chain) and (along with other investors) investing US$40 million in Ivi.ru (a leading Russian content streaming service).

Another standout deal involving a Middle Eastern player in the period was the acquisition by Emirates NBD Bank (a Dubai government-owned bank) of Denizbank (a Turkish bank) from Sberbank for US$2.8 billion.

According to public reports several further potential deals are already being negotiated, for example a consortium of RDIF, RCIF and several Middle Eastern funds is in discussions to buy an up to 30 per cent stake in Eurasia Drilling (a major developer of offshore drilling equipment), and RDIF and Saudi Aramco are in discussions to make a substantial investment in Novomet Group (a major developer of oil related equipment). We expect the trend of significant inbound investment by Asian and Middle Eastern sovereign funds to continue as these investors increasingly adapt to the realities of international sanctions and, as explained later, the RDIF continues to stimulate interest among international funds.

The second key trend of 2018 and the first half of 2019 was the diversification of private equity investments across a broader range of sectors (outside the traditional extractive industries), including banking and insurance, innovations and technology, consumer markets, communications and media, and healthcare, which all saw strong performance. The diversification of private equity investments reflects the general increase in investor confidence and the increased availability of quality private equity targets in consumer-facing sectors, which has in part been driven by lower domestic production costs from the relatively weak rouble and the shift in consumption towards domestically produced goods. This trend has also been supported by the government’s focus on diversifying the domestic economy and export base, which has traditionally been dominated by extractive industries; a policy priority that looks set to remain a key government focus in the coming years.

The innovation and technology sector has been a stand-out performer in 2018 and the first half of 2019 and we expect this trend to continue in 2020. Notable deals included the acquisition of AliExpress Russia (a major e-commerce platform) by a group of investors consisting of MegaFon, Mail.Ru Group and RDIF at a valuation of US$2 billion, and the signing of a letter of intent by Sberbank and Mail.Ru Group to establish (subject to regulatory approvals and finalisation of legal documentation) a joint venture to create a US$1.58 billion online-to-offline services platform focused on food and transportation.

Sberbank (a major Russian state-backed bank), which was mandated by the government to build a world-class digital ecosystem, has been very active in the innovation and technology sector. In 2018 and the first half of 2019, Sberbank acquired substantial stakes in Speech Technology Centre Limited (a Russian developer of face and voice recognition technology), Shiptor (a logistics technology company), Yandex.Market (a leading Russian online marketplace (described by some commentators as the Russian equivalent of Amazon)), Intercomp (a leading Russian business process outsourcing company), Rambler Group (a leading Russian internet and media holding) and Rabota.ru (a leading Russian job search portal). According to media reports, Sberbank is set to continue its acquisition spree in 2020 and is actively considering acquiring a large Russian online retailer, such as Ozon or Avito.

Another Russian player, the private investment fund Elbrus Capital, which has a track record of investment in the innovation and technology sector, is also expected to be active in this sector as the period for it to deploy capital under its Fund II is expected to expire in 2020 or 2021.

The third key trend is the increase in the number of private equity investments by major Russian state-backed players (such as Sberbank, VTB and RDIF). As described above, both RDIF and Sberbank have been very active in 2018 and the first half of 2019. VTB, a major Russian state-backed bank, has also made several major investments in this period, for example VTB increased its stake in PIK Group (a major Russian real estate developer) from 7.57 per cent to 23.05 per cent, acquired control of Rustranscom (the leader in rail transportation of grain in Russia and Kazakhstan and of timber and mineral fertilisers in Russia) and, along with a consortium of investors, acquired International Restaurant Brands (which is the largest KFC franchisee in Russia and owns almost 25 per cent of all KFC restaurants in Russia). This trend looks set to continue in 2020 and beyond as Russian state-backed players continue to grow in confidence and experience, and have capital available to deploy on private equity investments.

Finally, many ‘classic’ private equity deals continue in the market. For example, the strategic acquisition by Mitsubishi Corporation of a 20 per cent stake in Wenhua Holding Limited (one of the leading online automotive information and communications platforms in Russia) and the acquisition by ONEXIM Group (a Russia-based investment fund) of a 39.42 per cent stake in Internal Financial Club (a Russia-based commercial bank). The acquisition in 2018 by VTB of a 29 per cent stake in Russia’s second-largest food retailer Magnit from its founder Sergey Galitskiy for US$2.5 billion, and subsequent on-sale by VTB of an 11.82 per cent stake to the Russian investment firm Marathon Group, for US$1 billion, was also a headline deal. Other noteworthy deals in 2018 include Yandex entering an e-commerce joint venture with Sberbank at an enterprise value of US$1 billion and a taxi booking services joint venture with Uber at a valuation of US$3.8 billion.

4 Does private equity M&A tend to be cross-border? What are some of the typical challenges legal advisers in your jurisdiction face in a multi-jurisdictional deal? How are those challenges evolving?

Most private equity deals relate to Russian targets and, despite some investment activity by international funds (particularly based in Asia and the Middle East), foreign investors are still in the minority. Outbound investment by Russian private equity sponsors in overseas investment opportunities is rare, although LetterOne is proving comparatively active in this respect, acquiring Holland & Barrett, Europe’s largest health and wellness retail chain, for £1.7 billion in 2017, and entering into a business merger with BASF in 2018 to create Wintershall Dea, the largest independent oil and gas exploration and production company in Europe. Also in 2017, Rosneft acquired a 49 per cent stake in the major Indian company Essar Oil Limited, and a consortium of international investors, formed by UCP Investment Group and Trafigura, acquired another 49 per cent stake, at an enterprise value of US$12.9 billion. The bulk of private equity transactions nevertheless involve the acquisition of Russian assets by Russian bidders. However, these deals have traditionally had a strong cross-border element since, as a result of various tax, regulatory and legal considerations, the deals still tend to be structured using offshore acquisition vehicles. Although these structures may face increasing challenges in the future, they continue to dominate market practice.

Typical challenges to be dealt with by legal advisers working on cross-border transactions in Russia include:

  • the complex regulatory landscape and marrying the applicable requirements of the Russian legal system with those of the chosen governing law of the transaction;
  • the complexity of sanctions issues;
  • the rapidly evolving taxation regime;
  • the lack of established market practice and relatively few precedent deals against which to benchmark transactions;
  • the related lack of experience of private equity dealmaking among the business community; and
  • managing relations with the Russian regulators and government, particularly where the transaction involves entities operating in ‘strategic’ sectors such as significant mass media, subsoil industries and aviation.

Russia is a market that is continuing to develop and, as its own laws are revised to include concepts that are commonly used in other markets, we see increasing interaction between differing legal frameworks. It is critical to ensure that advisers have a full understanding both of what international investors expect and the features of the Russian market.

5 What are some of the current trends in financing for private equity transactions? Have there been any notable developments in the availability or the terms of debt financing for buyers over the past year or so?

Acquisition finance being used to leverage private equity acquisitions is not a prevalent feature of private equity investment in Russia. The significant majority of deals are equity-only and the restraints on access to international financial markets, resulting from international sanctions, make the ability to ‘self-fund’ more important than ever. That said, there are examples of state banks providing debt financing for acquisitions – for example, VTB provided debt financing to the consortium comprising UCP Investment Group and Trafigura for their acquisition of Essar Oil Limited, as described in question 4, and VTB also reportedly provided debt financing to Marathon Group for the acquisition of an 11.82 per cent stake in Magnit for approximately US$1 billion. It is also reported that VTB partially financed the acquisition by Qatar Investment Authority in 2018 of an 18.93 per cent stake in Rosneft. Domestic financial institutions and funds such as VTB Capital, Sberbank CIB and RDIF can, at times, offer the ability to refinance post-investment, which gives them a competitive advantage over other private equity sponsors.

6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?

Recent years have been marked by the desire on the part of the government to make Russia more attractive to foreign investors and to support the growth of a local private equity market, although efforts have been made more challenging by the imposition of EU and US sanctions. That said, the ongoing corporate dispute over control of Vostochny Bank, and related criminal proceedings (described further below), has negatively impacted foreign investor confidence in recent months and is being closely followed by many foreign investors.

The emergence of government-backed sponsors and financial institutions over the past several years has transformed the Russian private equity market. In particular, Rusnano, a US$10 billion private equity fund established in 2007 to invest in the nanotechnology sector, and RDIF, a US$10 billion fund established in 2011 to make equity co-investments with major Russian and international players, have significantly impacted the market. RDIF, which initially partnered with the China Investment Corporation to form the Russia–China Investment Fund, has established investment funds with international partners from a range of countries, although with a focus on Asia (including Korea, Japan, Vietnam and India) and the Middle East (including Abu Dhabi, Saudi Arabia, Bahrain, Kuwait, Turkey and Qatar). This trend continued in 2019 with several new funds being established, for example, the China-Russia Regional RMB Fund, the Russia-China Science and Technology Innovation Fund and the Russian-Turkish investment fund. These funds have generally committed to investing a substantial percentage of their capital into Russia and, over the past couple of years, as described above, RDIF and various sovereign wealth funds have made significant investments across Russia.

As mentioned, private equity transactions (even with only Russian participants) have in a significant number of cases been structured through non-Russian acquisition and joint venture vehicles. Russian policymakers’ efforts to try and stem the high level of capital flight from Russia have been two-fold.

First, the government has sought to stimulate private equity houses to move their assets onshore through the ‘deoffshorisation’ initiative. The deoffshorisation campaign is now in full swing following the introduction of the controlled foreign companies (CFC) legislation and several prolongations of the tax and capital amnesty. In particular, the government has recently passed the third regulatory package prolonging the capital amnesty until 29 February 2020. Unlike previous iterations of the amnesty, the present amnesty will only apply if (as applicable) individuals transfer all funds in the declared accounts to Russia or the CFCs declared are redomiciled to Russia.

Court practice is rapidly developing in the area of application of double tax treaty reliefs, which have so far been largely negative to taxpayers. The Common Reporting Standard, launched in Russia at the end of 2017 (the first exchange of information occurred in 2018), is expected to significantly contribute to the ability of Russian tax authorities to trace evasion schemes. We expect a further hardening of tax and regulatory requirements in the coming years. The government’s impetus for greater transparency around offshore involvement in Russia-focused transactions is also seen in the new foreign investment laws, which were introduced on 30 July 2017 and apply greater scrutiny to transactions where a foreign partner acquires an asset in Russia, or a Russian investor acquires an asset in Russia through a foreign vehicle, especially if the asset is strategic in Russia.

In parallel, the government has continued its efforts in creating a more favourable legal and business climate onshore, as evidenced by Russia’s ascent in the World Bank Ease of Doing Business Index from rank 124 in 2010 to rank 31 in 2018. Russian civil and corporate law has been subject to numerous amendments in recent years with the aim of adapting the legal instruments commonly used in Western jurisdictions to be used in Russia (such as warranties, indemnities and option agreements) and enabling investors to implement a number of typical Western-style corporate governance and shareholder agreement arrangements at the onshore Russian company level. Conversely, the scarcity of court decisions interpreting these new provisions, combined with newly implemented rules limiting minority shareholders’ statutory rights to access corporate information, results in market participants remaining cautious in implementing the new legislative instruments. Overall, there are signs of building momentum for a bigger role for Russian law in private equity transactions.

Additionally, there is some possibility that the government will seek to create more domestic investment opportunities through a privatisation programme. The possibility of a privatisation programme was first announced in 2017 (when the Kremlin stated its intention to sell stakes in VTB, the shipping company Sovcomflot and Novorossiysk Commercial Sea Port) but was subsequently put on hold in the context of the relatively weak global economic climate and improved Russian government finances. More recently, the Russian government has announced that detailed planning for a privatisation programme in 2020–2022 is underway and that private discussions with potential foreign investors are already taking place. As a first sign of this potential new trend, the privatisation of 50 per cent +2 shares of TransContainer (a leading Russian container operator) is scheduled for November 2019 at a price of more than US$550 million.

Another area the government has addressed in recent years is investor concern about the legal robustness of Russia as a dispute resolution forum. Over the years, for a number of reasons, Russian private equity market participants have shied away from investment structures that lead to significant corporate disputes being adjudicated in the Russian courts. At the same time, there has been significant uncertainty as to whether such disputes could instead be referred to arbitration. In an effort to address this, Russian law now expressly allows corporate disputes concerning Russian entities to be handled by arbitration institutions, provided that they have registered with Russian regulators and, in most cases, provided that the place of arbitration is in Russia. At the time of writing, the Hong Kong International Arbitration Centre and the Vienna International Arbitral Centre have obtained a licence to administer Russian corporate disputes and several other eminent international arbitration institutions have shown interest in doing so.

7 What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?

Historically, the private equity industry has been widely supported and championed by Russian policymakers and there have been no signs of the political or public scrutiny of the private equity industry experienced in other major jurisdictions. This may have been, in part, because of the novelty and relatively low prominence of private equity industry in Russia, as well as the political and economic headwinds it is facing in the present environment, which have discouraged some foreign players without prior experience in Russia and created opportunities for local private equity investors.

While these conditions generally remain true, there has been a spike in political and public scrutiny of the private equity industry in Russia in 2019, as a result of the widely publicised battle between Baring Vostok Capital Partners (a leading private equity firm based in Russia) (BVCP) and Russian businessman Mr Artyom Avetisyan over control of Vostochny Bank. Vostochny Bank is reportedly one of the 30 largest Russian banks by assets.

The battle concerns (among other matters) whether Mr Avetisyan has the right to exercise a call option against BVCP, which would result in him obtaining control of Vostochny Bank, and involves litigation in the Russian courts, the London Court of International Arbitration and various offshore jurisdictions. This corporate dispute attracted widespread international news coverage when Mr Michael Calvey (CEO of BVCP) and other senior employees of BVCP were arrested and charged with criminal fraud in relation to their dealings with Mr Avetisyan. Commentators have contended that these criminal charges (which are ongoing) were unlawfully instigated at Mr Avetisyan’s request to pressure BVCP into handing over control of Vostochny Bank. These events have negatively impacted foreign investor confidence in recent months and are being closely followed by many foreign investors.

Another notable corporate dispute in 2018 was the battle between entities affiliated with Mr Vladimir Potanin, Mr Roman Abramovich and Mr Oleg Deripaska (three prominent Russian oligarchs) over control of mining giant Norilsk Nickel. The battle culminated in an entity affiliated with Mr Deripaska challenging in the High Court of England a transfer of shares in Norilsk Nickel from an entity affiliated with Mr Abramovich to an entity affiliated with Mr Potanin (which would have tipped the balance of control of Norilsk Nickel in favour of Mr Potanin) on the basis that it violated an earlier settlement agreement between the pair. The High Court of England ruled in favour of Mr Deripaska. In October 2018, the media reported that Mr Potanin had decided to suspend his dispute with Mr Deripaska over Norilsk Nickel until there is more clarity around the international sanctions regime.

The prevalence of low free floats and controlling shareholders means that it is unlikely that the levels of activist and turnaround investment experienced in the United States and the United Kingdom will become a regular feature in Russia.

8 What levels of exit activity have you been seeing? Which exit route is the most common? Which exits have caught your eye recently, and why?

The only notable IPO in 2018 and the first half of 2019 was the listing of HeadHunter (a leading Russian online job search portal) on the NASDAQ exchange (the first listing of a Russian company on the NASDAQ exchange since 2013). There were also several secondary public offerings, such as the US$300 million offering of global depository receipts by TCS Group (a leading Russian financial group, which includes Tinkoff Bank). At the same time, several companies are touting possible IPOs in 2020 or 2021, including Yandex.Taxi (the largest Russian online taxi booking service), Rambler Group (a major Russian internet and media holding), Ozon (a major Russian online retailer), Roistat (a Russian online business analytics service) and VkusVill (a major Russian food retailer), among others. However, it remains to be seen if this pipeline of exits will materialise in light of ongoing sanctions and other geopolitical factors.

A number of negotiated exits by private equity funds have been reported, such as the sale by Goldman Sachs of its stake in KazStroyService Global BV (a Russian EPC company), the sale by United Capital Partners of its stake in Fashion Continent (a Russian fashion retailer) and the sale by VTB of its stake in Russian Fitness Group (the operator of the World Class fitness chain). Another notable exit announced in August 2018 is the sale by Bonum Capital of Vozrozhdenie Bank to VTB for an undisclosed sum.

That said, the secondary market for private equity exits in Russia remains relatively small, and there are a limited number of sponsors willing to take on IPO mandates. Given that the strategic market predominantly relies on foreign investors who offer the most attractive terms, and that the current geopolitical climate is not conducive to foreign investors entering the market, it remains a challenging environment for exits by private equity sponsors in what remains an investment market.

9 Looking at funds and fundraising, does the market currently favour investors or sponsors? What are fundraising levels like now relative to the past few years?

The Russian private equity funds market is in its relative infancy. As such, there is not sufficient volume to determine which side of the investment relationship the market favours. The general sentiment is one of trying to support and grow the industry as a whole, rather than favour one constituency over another.

Russian-focused private equity fundraising levels have been relatively muted recently. Increased geopolitical risk (including sanctions), moderate global growth (as major central banks remove policy accommodation and global financing conditions tighten) and low growth in Russia are all likely to challenge fund closings, but there are still some funds being formed. In 2018, the Russian Venture Company (RVC) (a Russian state-owned venture capital fund) and investment fund Da Vinci Capital formed the Da Vinci Pre-IPO Tech Fund (with up to 6 billion roubles under management) to invest in established start-ups that are planning stock exchange listings. Also in 2018, RVC partnered with private investors to establish the Terra Fund II to invest in advanced technology businesses (with up to 6 billion roubles under management). In 2019, Verno Capital and SPRING, two leading fund managers specialising in Russia, announced plans to merge their public asset management businesses to create a US$500 million investment management firm focused on Russia. As mentioned, RDIF has also been active in the past couple of years in establishing new investment funds in partnership with international state-backed funds.

10 Talk us through a typical fundraising. What are the timelines, structures and the key contractual points? What are the most significant legal issues specific to your jurisdiction?

Russian fundraising has tended to follow the patterns and structures used elsewhere, with fund vehicles established in onshore markets such as Luxembourg or typical offshore centres such as the Cayman Islands or the Channel Islands. Luxembourg has the benefit of being an established, regulated environment and since January 2014 has had an amended double taxation treaty with Russia.

Cyprus has been a key jurisdiction for investments into Russia (given the favourable terms of its double tax treaty), but it was rarely used as a fund domicile, except in club or friends-and-family deals. Following the European debt crisis, Cyprus is being used even less in Russian fundraising deals as investors look instead to more traditional markets and structures.

Where investors are taking on greater portfolio risks than in more mature markets, they want to minimise risks from using non-traditional fund vehicles. Due diligence remains key with investors that spend a great deal of time on understanding the team, its governance structures and its approach to investments. This will lengthen the fundraising periods. Fund documentation will also reflect the enhanced portfolio risks in terms of the fund governance arrangements and, of course, the target returns and performance fee triggers.

11 How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?

Private equity sponsors operating in Russia are not subject to additional regulation over and above that applicable to other businesses operating in the jurisdiction. In particular, there is no body, whether self-regulated or otherwise, charged with overseeing the private equity industry. However, there are still key regulatory issues that any entity operating in Russia needs to be aware of. For example, in relation to anti-monopoly regulation that falls within the remit of the Federal Antimonopoly Service or regulatory approvals in relation to ‘strategic’ companies.

12 What effect has the AIFMD had on fundraising in your jurisdiction?

As Russia is outside the European Economic Area (EEA), where Russian managers are raising and marketing funds within Russia or elsewhere outside the EEA, the AIFMD does not apply. To the extent that Russian managers are marketing or managing EU AIFs or marketing a non-EU AIF to EU investors, the AIFMD will be relevant because of the directive’s extraterritorial effect. As mentioned, many onshore funds are based in Luxembourg, which offers some flexible solutions to the AIFMD, including its securitisation vehicles.

13 What are the major tax issues that private equity faces in your jurisdiction? How is carried interest taxed? Do you see the current treatment potentially changing in the near future?

Russian legislation dealing with CFC, which came into force in 2015, continues to develop. Russian CFC rules are broadly consistent with the approach of the Organisation for Economic Co-operation and Development and the European Union. While court consideration is, so far, limited, the tax authorities have started gaining experience in application of these rules. Nevertheless, Russian CFC rules have already started heavily influencing the choice of traditional private equity investment structures.

The CFC legislation sets out rules in four areas of tax structuring. First, it addresses the taxation of profits received by the controlled foreign companies of Russian residents but not yet received by the residents themselves. Second, it requires Russian residents holding shares in, or controlling, foreign companies or non-corporate entities to notify the Russian tax authorities of such shareholding or control. Third, it lays down the test for determining the tax residency of legal entities. Lastly, it introduces the concept of beneficial ownership of income for the purposes of double tax treaties.

It is clear from the law and recent court practice that the government’s aim is to restrict the availability of double tax treaty benefits for recipients of Russian-sourced passive income where offshore structures are deliberately established to obtain tax treaty benefits for the ultimate beneficial owners of such income. This focus of the government’s recent reforms is of key importance to the private equity sector.

As part of the same trend, interest taxation rules have been heavily amended, with specific transfer pricing regulation introduced for interest in 2016 and thin capitalisation rules revised with effect from 2017. Amendments to the thin capitalisation rules effectively codify the recent court practice and restrict deductibility of interest under loans extended by foreign sister companies. However, according to the most recent amendments to these rules, interest under a loan relating to an investment project should not be subject to these restrictions if the borrowed funds are used solely to finance investment projects in Russia, the repayment of the loan is deferred for at least five years, the lender’s direct or indirect ownership of the Russian borrower does not exceed 35 per cent and the lender’s place of registration (tax residence) is a state with which Russia has a double taxation treaty.

In addition, changes to certain obligations have been imposed on the members of international groups of companies. They are obliged to notify tax authorities that they are parts of such groups. If the consolidated revenue of a group exceeds certain limits, its members are obliged to disclose various information, such as the structure of ownership and control of the group, main indicators of activity, profits gained and losses incurred and taxes paid. Starting in 2018–2020, a breach of these obligations will be punished with fines.

Apart from this, the Russian government has shown a trend towards increasing the tax burden on business. The VAT rate was increased by 2 per cent starting from 1 January 2019 and amendments to the profit tax regime (which are mostly disadvantageous for taxpayers) were introduced in 2017–2018. The ability of the regions of Russia to introduce profits tax incentives is gradually being limited. Loss carry-forward was amended such that only half of carried losses can be deducted in a given year (although the carry-forward itself is now unlimited by time).

All these developments illustrate the continuing trend of Russian tax legislation becoming significantly more complex and nuanced. Alongside this, Russian tax authorities are adopting an increasingly sophisticated and rigorous approach in their assessment of applications for double tax treaty relief. In the past 24 months we have seen a greater examination of the substance of ownership structures and the nature of the relationship between, and the functions of, the different entities in these structures. The risk is that where foreign companies or non-corporate entities are acting as mere conduits or agents for the ‘true’ beneficial owners of income, they may be disregarded for tax treaty purposes. Court practice on the matter is developing rapidly, and most of the cases resolved are not in favour of the taxpayers. Private equity investors need to be alive to this issue in the context of their investment structures and to seek detailed legal advice accordingly.

For private equity managers themselves, there are no special rules in relation to carried interest in Russia and so many of the more complex structures seen in other jurisdictions are not present here.

14 Looking ahead, what can we expect? What might be the main themes in the next 12 months for both private equity deal activity and fundraising?

As mentioned, market conditions are improving and private equity investors have been increasingly active in the Russian market, although fundraising in Russia remains limited. Chinese and Middle Eastern sovereign funds and major Russian state-backed players have been particularly active over the past year and we anticipate that they will continue to make their presence felt in the coming 12 months. Opportunistic and experienced local players have also continued to deploy capital through ‘classic’ private equity deals.

The low relative value of the rouble (following a 15 per cent depreciation against the US dollar in 2018), means that production costs in Russia offer significant competitive advantages to investors localising production in Russia for export and the economic turbulence of the past few years has gone some way to reducing the valuation gaps between sellers and investors that have been prevalent in the Russian market. These factors, combined with the government’s localisation programme and improving investor confidence generally, suggest that the trend of diversification of investment activity across a broader variety of sectors is likely to continue. We expect that the energy, retail, innovation and technology, and media and telecoms (particularly e-commerce) sectors will continue to be active areas of the Russian economy and provide opportunities for domestic and international private equity investors in the remainder of 2019.

The continuing development of the government’s deoffshorisation programme has an impact on overall investment activity. This, in hand with changes to the Civil Code aimed at creating a more flexible onshore legal environment, has put further pressure on Russian private equity investors to return capital to Russia and to invest directly in Russian companies. That said, the traditional approach of structuring deals using overseas intermediaries has not fundamentally changed as a result of this deoffshorisation drive.

Current trends indicate that market conditions in Russia are improving and this trend looks set to continue into 2020. Major players in the private equity market will continue to watch global economic, political and regulatory changes, including sanctions, closely, as these will play a key role in determining whether Russia can continue to develop into a market with substantial scale, depth and liquidity in 2020 and beyond.

The Inside Track

What factors make private equity practice in your jurisdiction unique?

The current international sanctions regime and constraints on international liquidity have enhanced the challenges posed by the heavy influence of government-backed sponsors and financial institutions, and the general political environment. When this is combined with the often novel legal issues that arise when dealing with the interface between the Russian legal regime and international business practices, clients rely heavily on their lawyers to help deliver legally robust and commercial outcomes.

What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?

  • Can counsel provide seamless advice on Russian legal, regulatory and tax issues and the legal, regulatory and tax issues across the range of other jurisdictions and governing laws involved?
  • What experience does counsel have in dealing with local counterparties and regulatory authorities?
  • Does counsel have experience of negotiating and bringing to fruition complex transactions based on practical experience across Russian and other markets?

What interesting or unusual issues have you come across in recent matters?

Corporate governance and shareholder arrangements for Russian private equity investments always raise important issues. This is true now more than ever, as deoffshorisation and other legislative reforms have encouraged a number of international and local investors seeking to explore, under Russian law, Western-style arrangements in respect of Russian companies. In a number of recent transactions, we have worked with our clients to resolve the structuring challenges that arise as a result of both the Russian legal framework being new and evolving, and certain standard Western protections (such as put and call options, certain anti-dilution protections and shareholder information rights) being beyond the scope of Russian law.