Interview with Florian Fenner, Managing Partner of UFG Asset Management
UFG Asset Management, an independent investment management firm specialising in traditional and alternative investments in Russia, launched a new hedge fund on 1 November 2006. UFG Russia Alternative is launched as a hybrid investment vehicle to capitalise on less liquid investment opportunities in the Russian equity market, but will also invest in non-listed companies that will come to the market within 12-24 months. The fund pursues a very opportunistic investment strategy that focuses more on actual access to deals than on a pre-determined and static strategy. UFG Russia Alternative will consider companies active in all sectors of Russia’s economy.
UFG raised US$10 million in initial funds from investors. After the first month, the fund returned 13.4% gross of performance fee and 10.7% net of all fees.
What is the rationale behind UFG Russia Alternative’s a) Russian focus, and b) targeting small-cap and pre-IPO investment opportunities?
The combination of the bull market in global energy stocks and abundant domestic liquidity keeps propelling the Russian stock market. There is an overflow of liquidity in the Russian financial system due to massive trade surplus (16% of the GDP) and the central bank’s rapid reserve accumulation. As a result, money growth is booming and interest rates are very suppressed (money market rates are negative in real terms). Furthermore the domestic demand is very robust and conditions are in place for a credit boom in the years to come. The return on equity in Russia is above domestic borrowing costs and the gap will widen further as rates continue to decline. This indicates a friendly environment for equity owners as shareholder value is created when the corporate sector on average borrows to invest.
The decision to invest in Russia is not binary anymore, but investment returns will depend more on picking the right stocks and sectors than getting exposure to beta. Following the re-rating of the Russian market, and the oil sector in particular, we believe that the future investment returns will come from companies that are currently either less liquid or in a pre-IPO stage.
Does the fact that your fund pursues opportunities across the public and private equity markets offer any diversification benefits? More specifically, how does its performance compare to that of UFG’s private equity and hedge fund portfolios?
Yes, UFG Russia Alternative will compliment our flagship product, UFG Russia Select, a long/short fund capturing opportunities in the broader liquid market and UFG Private Equity fund. Basically we tried to come up with a hybrid investment vehicle to capitalise on less liquid investment opportunities in the Russian equity market, but will also invest in non-listed companies that will come to the market within 12-24 months.
The fund was launched on 1 November 2006 and earned 13.4% gross and 10.7% net returns accordingly. The Russian blue chip market was up 10.1% (RTS) and second-tier market was up 7.2% (RTS 2).
The market rallied in line with recovering crude prices, which gained 8% during the reporting period. It is important to point out, however, that despite rallying crude prices non-oil stocks outperformed oil stocks by a wide margin in November. A trend that will continue in the future, we believe.
How does Russia compare against other emerging markets in Europe in terms of opportunities for alternative investment funds? Is there a case diversifying geographically in the region?
We believe Russia is in a very special situation due to its unique macroeconomic situation. The only market with conditions similar to Russia is Poland due to its growing domestic demand and credit boom in the economy. Other emerging European countries have already enjoyed a re-rating rally and P/Es are among the highest within the emerging markets world. In any case the fund will not seek to invest outside of Russia and former Soviet Union states.
What are the risks associated with a single country-focused fund such as yours? How do you manage the same? On a more general note, what risk management practices does the fund have in place?
The fund will focus its investment activity in the Russian Federation but may also invest in certain other states of the CIS, including Ukraine and Kazakhstan. The risk factors regarding the Russian Federation generally also apply to Ukraine, Kazakhstan and other states of the CIS. Specifically, these include, but are not limited, to risks relating to political and economic volatility, corruption and social instability, lack of physical infrastructure, lack of access to capital by companies domiciled in such markets, developing legal and judicial systems and uncertain and potentially capricious tax systems.
We will draw on the proprietary study and investigation of its own professionals and affiliates, as well as on material prepared by major broker-dealers in the market.
We, along with the fund's prime broker and administrator, are primarily responsible for risk management/compliance issues. The fund's portfolio is monitored on daily/weekly/monthly basis; regular reporting is provided to the fund's board of directors.
Could you take us through the steps in the fund’s process of evaluating opportunities in non-listed/non-liquid equities?
First of all, it’s important to stress that this theme is quite new for the Russian market. As single company reports are usually being published occasionally on a case-by-case basis, we do proprietary research starting with:
evaluating macro-economic, industrial and market data;
country risk assessment;
technical analysis; and finally
Given that the primary focus of your fund is small-cap and pre-IPO investment opportunities, what are the typical holding period and liquidity associated with your portfolio?
The typical holding period will be anywhere from 6-8 to 12-24 months. This is the reason behind the fund’s very tight liquidity terms.
What sort of exit strategies do you pursue, and under what circumstances?
Increasing stock liquidity due to overall market developments, IPO or additional stock placements. Since we are not aiming to acquire controlling stakes, we will generally seek to exit through traditional stock market mechanisms.
What is the sectoral breakdown of the opportunities that UFG Russia Alternative pursues and why? How dynamic are allocations to the same?
The fund focuses on (but is not limited to) the following industry sectors:
Retail services and trade
Banking and insurance
Non-oil natural resources
Not more than 15% of the fund’s NAV will be invested in any single portfolio company.
Do you foresee a crowding out of opportunities for alternative investment in the Russian markets any time soon? What is your fund’s main edge over its competitors?
While there is no shortage of money in Russia, there is a shortage of western investment capital. Most private equity-like investment in Russia is done basically by individuals who profited from privatisation in the 1990s. Pools of capital available to such investors dwarf organised equity funds, but most smaller and medium-sized companies are apprehensive of such investors and their motivations. This means that there are probably several thousand companies with great potential which need equity investors but have no access to them.
The fund is managed by UFG’s hedge fund team headed by me. It will also utilise research capabilities of our private equity team, consisting of ten investment professionals, although the portfolios will not overlap. The fund utilises UFG AM’s unique access to Russian businesses and government circles to generate a superior pipeline of deals. There are very few peer groups in the Russian market who can demonstrate solid track records both in the hedge fund and private equity universe. We believe that given the experience and credibility of the team, the fund has a unique opportunity to combine international hedge fund and private equity practices and techniques with local flexibility in identifying and pursuing lucrative investment opportunities.
Could you share with us your outlook for Russia in the near and medium term?
As we think that Russia is still a in a cyclical bull market, we expect public market returns of some 25% in 2007 in blue chips stocks. In an environment of stable high oil prices and robust domestic growth, we see this upside coming from 12% earnings growth and some modest multiple expansion, reducing Russia's 30% discount to global peers. Risks we feel are somewhat skewed to the upside.