The Russia report: A new thaw?
Diving commodity prices and currency devaluation have put Russia and the CIS on ice, but Asian investment and economic sovereignty are reheating the legal market
If the mood of a city can be gauged by the bustle of its shops and restaurants, then law firms active in Russia and much of the wider CIS region should not be especially fearful. Björn Paulsen, co-head of German firm Noerr's Moscow office, says despite the recent devaluation of the rouble coming amid prolonged economic turbulence, few tables are empty in the Russian capital's top eateries. 'The crisis has already reached the bottom and now the market is on the rise again,' he says.
While there have been numerous false dawns born of blind optimism over a Russian recovery in recent years, the consensus now is that economic and political woes have bottomed out, and lawyers, while talking as good a game as ever, have reason to be upbeat. Money is trickling into the region as foreign investors, particularly those from Asia, try to take advantage of cheaper assets. Government initiatives to create a more investor-friendly environment are welcomed by the region's elite legal advisers.
Alexei Roudiak, managing partner of Herbert Smith Freehills' (HSF) Moscow office, says: 'It would be too premature to say that the overwhelming apathy that we have witnessed over the last two to three years has been completely replaced by something more positive, but we do see signs of optimism and an uptick in various sectors.'
Igor Ostapets, executive partner in White & Case's Moscow office, is also tentatively upbeat about the immediate future: 'Perhaps people are spending less on luxury items, but in my view if you compare 2014, 2015 and 2016, each year brings more stability and more reserved optimism.'
But optimism rarely depends on hard statistics and the economic reality is bruising. Foreign direct investment into Russia has sharply declined, reaching $53.39bn in 2013 before falling to just $9.83bn in 2015. However, there are expectations of a recovery. The second Eastern Economic Forum – a Russian conference aimed at attracting Asia-Pacific investment into its far eastern region – held in Vladivostok at the beginning of September, was attended by 246 delegates from Japan, 227 from China and 128 from South Korea. A total of 214 agreements were signed worth more than $27bn, according to Dimitry Afanasiev, chair of Egorov Puginsky Afanasiev & Partners.
'There is a priority to improve the infrastructure in the far east [of Russia], which has been underdeveloped for quite some time,' comments Evgeny Zhilin, a partner at Russian firm YUST.
Asian and Middle East investment is predicted to waken a slumbering economy, but while the Chinese are appreciated for their interest in Russia, they often take longer than other nations to actually inject capital, according to Vladislav Zabrodin, the founder and managing partner of Capital Legal Services. With many major Chinese investors being state-owned enterprises or subject to government influence, fast commercial decisions are uncommon.
Afanasiev says many Asian investors are playing a waiting game as they seek cheaper assets through control deals, 'which are not always offered by Russian parties'. He adds that there are also restrictions on foreign government-owned companies obtaining control over assets in certain Russian industries. Andrey Zelenin, the managing partner of Lidings, says the firm recently advised a Chinese state-owned automotive manufacturer on establishing a local entity and manufacturing unit in Russia. The deal was especially complicated, as it had Chinese government backing and required special approval from the Russian authorities.
Despite clear obstacles to Chinese investment, the nation has been at the heart of a series of major acquisitions in Russia and the CIS over the last two years. China Petrochemical Corporation (Sinopec) acquired a 10% stake in Sibur, Russia's leading petrochemical company, for $1.34bn at the end of 2015. Vinson & Elkins advised Sinopec and Cleary Gottlieb Steen & Hamilton represented Sibur. Sinopec has also committed to acquiring another 10% stake in the company within three years of the deal. In addition, it acquired a 50% stake in Caspian Investment Resources, a Kazakh oil and gas company, from Lukoil in deal valued at $1.09bn. HSF advised Sinopec with Akin Gump Strauss Hauer & Feld representing Lukoil. And further illustrating the enthusiasm for Russian and CIS assets among Asian investors, India's ONGC Videsh acquired a 15% stake in Russian energy company Vankorneft for $1.3bn, with Dentons representing ONGC Videsh and Norton Rose Fulbright acting for the seller Rosneft.
Asian money flowing into Russia is symptomatic of its overall appetite for foreign capital. The Russian Direct Investment Fund (RDIF), Russia's sovereign wealth fund with $10bn of reserved capital under management, frequently co-invests in domestic businesses alongside foreign funds, banks and companies. Since launching in 2011, it has participated in $13.6bn worth of investments, of which $12.2bn was provided by co-investors. In one example, Capital Legal Services recently advised Agro-Invest Brinky on the sale of a poultry facility in the Leningrad region to Thailand's Charoen Pokphand Food (CPF), which was supported by RDIF in what was the largest-ever deal in the Russian poultry market.
Amid the potent cocktail of geopolitical tensions and economic sanctions, leading to collapsing commodity prices and currency devaluation, efforts to diversify the economy away from its dependency on oil and gas income have been welcomed. The promotion of domestic products at the expense of imports is at the centre of reforms to revive a flagging Russian economy, a policy that took hold long before sanctions did, and is expected to encourage more international businesses to localise operations in Russia.
Afanasiev says: 'Many segments of the Russian domestic market had been dominated by foreign suppliers for a long time, and the decision to support Russian enterprises and stimulate internal production made by the Russian government amid external pressure and sanctions was very reasonable.'
Zhilin agrees: 'I am convinced that the import substitution policy is to compensate against sanctions and give some support to Russian producers and to increase the demand domestically.'
Domestic players in sectors such as pharmaceuticals, agriculture, IT and technology, electronics and automotives should now benefit from the new economic sovereignty. Heavy restrictions on food imports from the West have led to a transformation of the local agricultural and food industry in Russia. Dentons' Russia managing partner Florian Schneider says: 'International companies that previously exported goods to Russia need to consider whether to continue selling to Russian clients or whether to establish local production in the country. A lot of pharma companies especially are localising certain production units.'
Meanwhile, Andrei Gusev, managing partner of Finnish firm Borenius in Russia, believes that international businesses are responding en masse to the new policy: 'Since we predominantly serve foreign clients, we see that they are expanding their local production and are launching new production sites.'
However, Capital Legal Services' Zabrodin is cautious about the overall effect of the new policy: 'The implementation is still rather conservative. A significant number of industries are still based on international or foreign components, materials or technologies.'
Others even go so far as to suggest that Russia overall has benefited from sanctions, forcing it to diversify its economy, to rely less on oil and gas incomes, to innovate, and look to new channels of trade and investment.
'There is a school of thought that these sanctions have been a blessing in disguise,' says Roudiak, dubiously. 'In the longer run I would like to see an economy that is more diversified, and less reliant on oil and gas and other natural resources, but I don't think that is going to happen overnight.'
The new Silk Road
The enthusiasm for cross-border deals with Asia and the Middle East comes not only because of trade sanctions with the EU and US, but also because transactional activity between CIS states and Russia is negligible, in large part due to the enmity between Russia and Ukraine (see box, 'Russia v Ukraine', above). 'No-one expects Ukraine to do business with Russia, not at this time,' Zhilin confirms.
Russia and Kazakhstan, the CIS's second-largest economy, are expected to be the principal beneficiaries of China's much-vaunted One Belt, One Road programme, an infrastructure initiative that seeks to augment trade along the historical Silk Road trading routes. China is looking to finance overseas infrastructure projects in the hope of sustaining its economic growth based on increased trade and in employing Chinese workers, skills, goods and materials. For example, Gulmira Isayeva, Kazakhstan's deputy agriculture minister, recently revealed that Chinese companies were in negotiations to invest some $1.9bn into Kazakh agriculture.
Unsurprisingly, Chinese money is pivotal to developments all over the region. A China-led consortium won a $375m contract in 2015 to build a 770km high-speed railway line between Moscow and Kazan, the eighth most populous city in Russia. The joint Moscow and Beijing project will see China develop a train capable of reaching 400km per hour. Another landmark deal between China and Kazakhstan signed in 2015 will see the development of the Khorgos-Aktau railway, running from Khorgos on the Kazakh/Chinese border to the Caspian Sea port of Aktau. The Khorgos Gateway, a dry port and cargo hub, began operating in August last year.
Schneider says Dentons is involved in several major projects in Kazakhstan, including a substantial oil field development in the North Caspian Sea and Karachaganak area. 'It's a tough market now,' he says, 'but Kazakhstan is an important part of the network and good for our worldwide business because the Chinese are especially interested in Kazakhstan and we are the only law firm offering a full range of services there.' Dentons is the only international firm to have offices in both Almaty, the country's largest city, and its capital Astana.
Zhilin says that while China has recently dominated the headlines, the Eastern Economic Forum showed that the Japanese and South Koreans are equally keen on investment in Russia and the CIS. At the Vladivostok conference in September, Japan's prime minister Shinzō Abe talked of a 'new era' in relations between Moscow and Tokyo. It was an especially tactful statement, given the long-running enmity that has existed since the Soviet Union seized four Japanese islands at the end of World War II. Ever since, Tokyo has steadfastly refused to sign a peace treaty with Russia until these territories are returned.
More formal ties between Russia and its Asian neighbours are also becoming a theme in the legal profession: for example, YUST signed a strategic alliance with South Korean firm Jipyong in 2015 and the firms now share office space in the same Moscow building.
Everything must go
There is a sense among international and domestic law firms that Russia and the CIS have moved beyond their lowest point and clients have acclimatised. Schneider notes: 'Companies have adapted to the current situation. No-one is waiting for sanctions to be lifted. They have settled into the new environment.' He argues that a persistently negative narrative about Russia is shifting as the world recognises that sanctions do not shut down a market entirely. A softening stance towards Iran has shown that commercial pragmatism can co-exist with geopolitical tension, even if some sanctions remain.
Ostapets says that at the St Petersburg International Economic Forum in May, 'subjects and topics were more business-focused rather than politics-focused', which was a relief to many. He adds: 'There has been a change in the way that foreign investors have developed enough understanding to feel comfortable that they may be sanctions-compliant and still be able to invest in the selected interesting projects.'
Noerr's Paulsen believes clients who have interests in Russia and the CIS are no longer willing to sit on the sidelines. He says that Noerr represents two German DAX 30 companies that have refused to retreat and are 'convinced that the Russian market is coming back'. He adds: 'There are over 140 million people and industries that need significant modernisation. There are companies that need this market. Perhaps they could still afford to stay out of it for two to three years, but I feel that companies want to return.'
For healthier businesses in these key CIS markets, there are opportunities to develop market share. Schneider Electric is one foreign multinational that is in the process of building out its presence in Russia. Earlier this year, it emerged that the company was planning to set up new production facilities. Heinz is also to expand its Russian production of ketchup for exports to the CIS region and other neighbouring states. In July, the Qatar Investment Authority announced plans to buy a stake in the operator of St Petersburg airport from Germany's Fraport.
For domestic legal advisers, this foreign interest in Russian assets is a boon, particularly as so many Russian corporates have reduced their legal budgets and often resist using outside counsel. Zhilin remarks: 'Something like 25% of the firm's turnover used to come from foreign clients, but it is now about 40% and will grow further. Russian clients have been trying to adapt to the new circumstances and that has had an impact on fees. Many clients have reduced legal budgets for work and there is more competition in the market for a reduced amount of work. Many large clients have increased their legal teams to reduce use of outside counsel.'
He believes that this shift is having a profound impact on the legal market. 'My expectation is that the legal market will shrink about 10% to 15% a year. Clients will have less money and those firms with an international clientele will feel better. Boutique and smaller firms will be more adaptable.'
Ukraine has been a particularly difficult market for international firms. Several have pulled out, including most recently Clifford Chance (CC) and Gide Loyrette Nouel – CC spun-off its Kiev office into an independent outfit Redcliffe Partners in 2015 with the two firms maintaining a best-friends referral arrangement. But according to Kostiantyn Likarchuk, a partner in the Kiev office of central and eastern European firm Kinstellar, '[Ukrainian] assets are relatively cheap and there has been a trend for stability in the economy for the last year and a half'.
Likarchuk admits that Ukraine has needed to redouble its efforts to balance an economy that used to trade so actively with Russia. He says that while 45% of Ukrainian exports went to Russia in 2013, this had declined to about 9% and is reducing further still. 'Some of our clients have had significant difficulties and it has not been easy to find replacement markets for their products,' he says.
For the size of its economy, law firms in Russia and the CIS are comparatively small. The vast majority are well under 200 fee-earners and few expect to see significant growth or consolidate in the future. Ivanna Dorichenko, a London-based partner at Ukrainian firm Integrites, understands why several international firms have found the situation in the region too harsh: 'For a Ukrainian law firm or Russian law firm, having the cost and profit centre in the region means it is comparatively less expensive to keep the firm in the country. It can be flexible and charge less.'
But firms can be tarnished by a retreat. Few international players have closed a foreign office only to make a successful return later – for example, Freshfields Bruckhaus Deringer reopening in Singapore in 2012 having pulled out of the jurisdiction in 2007. The sense is that those that have pulled the plug on Ukraine have done so for good.
Russia, however, is a different story. As Ostapets observes: 'Russia is not a market where you come in when it's good, leave when it's bad and try to come back when it's good again. The business is going to come back and will come back big time. The question is, when?'
By Chris Crowe
Legal Business, 03 November 2016