Ilya Sherbovich: Management should maximize profits, not hide them
Managing partner of UCP told Forbes about the current dispute with Transneft, corporate governance and investment climate in Russia.
With many years of experience in international financial institutions, financier Ilya Sherbovich established UCP back in 2006 and now is its largest shareholder (77.7%).
In 2008, UCP considered a sponsor’s role in management buyout of Sibur, but the deal did not go through. Sherbovich then was a member of the Supervisory Board of Sberbank and worked on the boards of directors of Rosneft, Transneft and FSK. His extensive ties with business and authorities gave rise to journalists calling him an agent of the Kremlin or a protégé of Igor Sechin. In an interview with Forbes, 41-year-old Sherbovich denies having large sponsors and calls himself an activist investor.
About low valuation of Russian assets
This issue is the effect of many factors accumulated over many years, but the main reason for it is unfavorable investment climate. I wish Russia would become a market where investors feel protected, where they are willing to invest their money in private and public companies. Unfortunately, this is not the case and we see no investment boom yet. There was a post-privatization moment in Russia when investors understood that not only Russia is cheap, it also is committed to developing market economy and stock market institutions, and will actively protect private ownership and shareholder rights. Market activity then was phenomenal: everyone acquired Russian assets, participated in Russian IPOs, new funds were launched with focus on Russia. But in recent years, international investors started perceiving us with caution. The reasons are known: numerous cases of public abuses of shareholders’ rights, loss of focus and the lack of priority for achieving capitalization growth of the flagship Russian companies – large government-controlled corporations. Recently, complicated relations with the West and mutual economic sanctions have been added on top of the above issues. Unfortunately, many investors now tend to perceive Russia as an unfriendly country.
I’m pretty sure that there is no such hostility towards investors at a political level. But there is a broad misunderstanding as to “what is good and what is bad” in corporate governance. Hence, the “excesses” are happening at the level of individual companies and state bodies. Naturally, this has an impact on assets valuation. Given the poor investment climate and capital flow limitations driven by political decisions, there is an inevitable imbalance in asset valuation. While we have an average PE ratio of 6-7, the US market is approaching PE of 18. This means that US businesses are on average 3 times more expensive than Russian. But it is never too late. I believe that with joint efforts of state and the investment community, the situation can be improved radically.
About capitalisation of Russian companies with government control
Post-Soviet economic disruption has been successfully overcome, political control over key sectors of the economy has been established, it is time to engage in efficiency and increase capitalisation of assets. Should this be achieved, a huge number of opportunities would appear immediately, including those for further global expansion. If capitalization of Gazprom would be $500-600 billion as not as low as current $50 billion, if all investors could be convinced in real motivation of management to raise capitalisation and hence would be willing to buy Gazprom shares, then the company’s growth prospects would have been completely different. And raising capital for growth would not be a problem. It would always be possible to issue a 2% stake and raise $ 10 billion for any interesting deal in a few hours. Also it’s a great feeling when you run a company that investors “want” very much.
I think that we will have to work hard to adjust the mentality and educate all parties. There are still a lot of people in the public and corporate sectors who do not understand the markets deeply, do not feel the interdependence of their actions or the negative impact on the investment climate. Look at how much money we spent on investment conferences in recent years for convincing investors to come to Russia, etc. Compare these costs and the losses from the collapse in the market capitalisation with the amount of undone tender offered and unpaid dividends. The result turns out to be dull. We spend and lose thousands of times more than we gain.
About the reaction of private businesses to the falling stock market
Many of our entrepreneurs who have brought their businesses to an IPO have been disappointed in recent years with low, in their opinion, market valuations and think that for some reason investors do not treat them “fairly”. We are surprised. It’s like having an honest conversation with a mirror. How can you feel offended by investors if you think that your company is undervalued by three times? If you work in good faith, do not syphon money out of the company trhough grey schemes, do not anything wrong, but in your opinion the valuation is low, so go and buy your shares, attract bank financing or use your own savings for this purpose. There can not be anything better than investing in a company that you own at a low price!
About investing in developed markets
Currently global investors are in a difficult situation. It is not easy to find targets for investment in developed markets: stocks are expensive, bonds also offer very low yields. It is not obvious what is a proper strategy for an investor. We, for instance, keep quite a large percentage of our assets in gold. Gold performed well during this year, especially in the first half. Paradoxically, the two main reasons why investors buy gold coincided right now and are the following: firstly, there is a permanent expectation of inflation, which is not yet officially rising, but may emerge unexpectedly. Secondly, systemic risks are increasing, e.g. growing probability of a sharp drop in the developed markets stock indices as they reach new highs, or growing geopolitical tensions and terrorism.
Meanwhile, I would not disregard the developed economies completely. Even in an overheated market, there are always interesting stories and opportunities for investors, especially given the innovative nature of these economies. But we do not want to buy fashionable stories at a late stage and at crazy multiples. Given the fierce competition of investment capital for ideas, search for such situations at early stage is a complicated task requiring physical presence in these markets. At the same time, we often see foreign companies that are traded with PE rations of 100 or more after ambitious, hard to execute, plans are announced, e.g. Tesla. We look at such stories and come to a conclusion that the stock has a high probability to trade lower at some point within the next 2-3 years. Therefore, we take a “short” position on such stock. As an example, we earned quite good profits on our short position in Twitter stock made following its IPO. We were also satisfied with our bet on the collapse of US airlines stocks, which traded at 20-year historic highs. Overall, we have a quite decent short position for the US S&P index.
About focus on Russia
So far, our main focus is still on Russia. Despite all the difficulties with the investment climate, we remain optimists! In Russia almost everything is cheap, but we should be very careful. It was cheap five years ago also, but the RTS index corrected by another 30% over the past five years. We use the following principle: there are growing businesses and we invest in them with great pleasure. Recently, however, due to dampened economic growth in Russia, we focus on companies with no obvious growth but that are still undervalued. However, we do not specialise on any single sector. If you look at our deals, we have companies from different sectors – oil and gas, metallurgy, Internet, infrastructure, retail, finance and so on. The core of our team are former investment bankers, who worked with a wide range of companies for 15-20 years. We have a good understanding of each of these sectors, and look at the fundamental factors.
About work with co-investors
In a complicated market in Russia in recent years, we fundamentally changed our investment model. Initially we had ambitions to attract as much external capital as possible, but now the backbone of the funds under management is the money of the partners who work at UCP. We use borrowings and only a very small portion of client money. We deliberately avoid the problem with internal pressure that a typical hedge fund faces. When the fund has hundreds of investors who consider himself a financial guru, then it is almost impossible to work effectively in a difficult market for too long. Investors often panic and begin rapidly and simultaneously withdraw their money and then the manager has nothing to do but to sell assets at low prices and fix record losses. Often, sell down happens at the most inappropriate moment at the lowest point of the market. And then, when the market recovers, losses can not be offset: what was sold cheaply was sold. This is the problem of collective investments within the hedge funds: “everything is fine as long as the market grows.” UCP partners are united by the long-term strategy. We do not withdraw funds from projects in case of negative market fluctuations. In addition, there is no rush or pressure to make a certain amount of investments. If we make one good investment in a year, then it’s good. If we make five, that’s fine. There is also no pressure to sell anything by a certain deadline, because the term of the fund is expiring or something else of the sort. Need to wait for five years? We will wait. Need ten? We will wait for ten years.
UCP is the second largest shareholder of Transneft after the government. Since 2011, one of the UCP structures acquired 484,952 preferred shares of Transneft, or 6.8% of its authorised capital. On March 17, 2016 UCP filed a lawsuit against Transneft for 100 million rubles. The shareholder was not satisfied with the dividend policy of the oil transport monopoly. In 2013, the company paid shareholders of preferred stock only 724.21 rubles per share versus 1221.38 rubles paid per ordinary.
Situation where profit and dividends are artificially understated, all while owners of ordinary and preferred shares with the same par value receive different dividends, is unlawful and unfair. The problem of profit streaming from Transneft parent company to the level of its subsidiaries is well known. This practice affects all shareholders, and, primarily, the government. We hope that the government will restore order with regards to this matter without interference from other shareholders. As for the unequal distribution of dividends, the situation here is quite ugly. In 1999, the term about preferred dividends amount equal or larger than dividend for ordinary shares mysteriously disappeared from Transneft charter. But even after such “tricks”, shareholders were protected by the Russian law, given that our shareholders rights are defined by emission documents published at the time of the share issuance and not by the charter. No changes in the rights of preferred shareholders of Transneft have ever been registered. Therefore, any discrimination on dividends is not substantiated. And historically it never occurred: all Russian public companies with preferred shares, including Transneft, paid owners of preferred shares not less, but often more than to owners of ordinary shares. The first “experiment” with understating dividends for preferred shares was undertaken by Transneft in 2013.
About fundamental nature of the dispute with Transneft
For us, this issue is not as much financial as it is fundamental, related to the culture of attitude to shareholders and, most importantly, to the investment climate in the country. The amount of our claims to Transneft on the law suit about dividends for 2013 is about 100 million rubles. My UCP colleagues and I have already decided to donate this money to one of the state-sponsored charity funds, so that there is no impression that we somehow are trying to offend a “poor” state company. Transneft has many shareholders, not just us. Among them there are dozens of international funds and many Russian investors. The government now approaches the same investors as part of the privatization process. But how can we discriminate investors with regards to one state-owned company, and at the same time invite them to co-invest in another?
About other lawsuits against Transneft
We do not have a goal to make the judicial system busy with our claims. This is our reaction to the illegal actions of the company that are detrimental for the shareholders. The first lawsuit addresses lowered dividends to holders of prefs for 2013. The second claim is a reaction to the fact that the company does not provide us with information about its activities for months. There is a law. We forwarded requests for information more than nine months ago, and confirmed that we were not going to publicly disclose the answer. We, being the largest shareholder (after the state) wanted to analyse certain issues. We got no answer and so we went to court. The third lawsuit is connected with the “petty dirty trick” of Transneft lawyers: at the shareholders meeting in summer this year, and as a result of charter amendments the rights of preferred shareholders deteriorated. At the same time, owners of preferred shares were not invited to the shareholders meeting, nor they were provided with an opportunity to vote. Here the practices of 1990’s come to mind. Now we need to regularly monitor the availability of our shares in the register to make sure they haven’t been stolen. In the near future there will be another claim – for dividends for 2015. In this case also there was an understatement of dividends for preferred shares, and as the deadline for contesting is approaching, and the decision for 2013 dividends is not made yet, we are forced to file our claim.
About the impact of Transneft actions on the investment climate
The example of Transneft clearly shows to what extent in some cases the concept of a “joint stock company” in Russia can be spoiled. What is a joint-stock company? It is a group of shareholders who appoint the management and set a goal to maximise the company’s profits. As a result, the value of shares is growing, dividends are growing. All companies have one main goal stipulated by the charter – making profit. The bigger the profit, the higher their capitalization, this is obvious. In case of Transneft, the question arises: how comes that management for some reason leaves more than 90% of profit on its subsidiaries and, in fact, artificially syphones this profit from the parent company? I personally was a member of the board of directors of Transneft, and raised this issue repeatedly. The reply then was the following: “Yes, the current situation is temporary, we will shift to international reporting standards, move to full consolidation, etc”. However, after 4 years passed since then situation has not changed.
About the statements made by the head of Transneft Nikolai Tokarev
In Russia, the share of state property in public companies is high. But in the case of Gazprom, Sberbank, VTB, Rosneft, Alrosa and other companies, we have never heard the CEO say openly and publicly that “I am not interested in shareholders”, “I do not consider them shareholders”, “We are not a public company”, “I do not care about capitalization”, etc. These are all practically word-for-word quotations, I am not making them up.
About dividends of state-controlled companies
How had the decisions about dividends historically been made in state-controlled companies in Russia? Discussions about the potential amounts of dividends started towards to the end of the year. Usually everyone makes public statements on this issue: officials from different departments, and heads of companies, all of whom come up with their own opinions. Initially investors take seriously every speaker deemed to be an official state representative, but gradually they realise that something wrong is going on, because opinions often contradict each other. Further, the fight around the dividend policy continues, but for some reason no one realises the fact that the companies whose dividends are disputed earn their annual profits before the end of the calendar year! So after December 31, the discussions can be continued, but given that under the law dividends are based on the amount of annual profits under the Russian Accounting Standards, the government flexibility in decision making is limited.
For example, this year the debate over Transneft annual dividends for 2015 was very vigorous until May, but for some reason all the participants forgot that Transneft had generated a profit at the end of December 2015, and the IFRS profit was less than 9% of the group’s total profit. So the management of Transneft narrowed the discussion down to the following choice for the government: “How much of the 9% of the total profit do you want us to pay you in the form of dividends?” This situation has been repeated for several years. Shareholders ask: how many more times can you make the same mistake? Is similar situation with regards to the dividends for 2016 going to happen? Will there really be an empty discussion again, instead of a clear request to the company: “So, colleagues, let’s lift profits from the “subsidiaries” to the parent company, let’s change the contractual structure, show all the profits at the parent company level, so that we as a state have full flexibility as to how much we want to be paid in dividends, we are the main shareholder!”
Once again: management should maximise profits, not hide them. I believe that any activity aimed at reducing the profits of parent company is illegal and violates interests of shareholders, especially the owners of preferred shares. The charter stipulates that we receive 10% of the profit. At the same time, we do not vote and do not form a position on contractual relations with “subsidiaries”, we operate on the basis of assumption that the Board of Directors and management act in our interests, as they would do in a normal joint-stock company. It turns out that owners of voting shares can theoretically hide 99.99% of profits in “subsidiaries” and somehow this is legal? Absurdity.
In April 2013, unexpectedly for everyone, UCP announced the purchase of a 48% stake in VKontakte from Vyacheslav Mirilashvili and Lev Leviev, who were the partners of the founder of VKontakte, Pavel Durov. They sold their shares in sight of the conflict with Pavel. The deal was called political: allegedly Sherbovich acted in the interests of Igor Sechin. Later, Sherbovich and Durov disagreed in their views on the development of the social network.
References to the “political context” always come up when our opponents run out of arguments against our shareholder claims for legitimacy and justice. When we started asking VKontakte management questions about strategy, business plan, costs and financial results, and also began to advocate for prioritising an IPO, soon after a PR campaign was launched claiming that UCP was a Kremlin agent, FSB agent, protégé of Sechin and so on. Now, when we ask Transneft questions about unfair dividend distribution and how they lost 100 billion rubles of company’s money on derivatives and deposits with unstable banks, we are now called “the agents of the State Department and Browder”. Take a look at how it all spans out: we are agents of the Kremlin and agents of the State Department at the same time. For us, the situation here is quite obvious. When financial questions are answered by political nonsense, it means there’s something shady going on there.
About raiders and activist investors
The difference is fundamental. Initially, in international practice, a term “corporate raider” appeared which meant someone who organises completely legitimate deals on hostile takeover of public companies using borrowed financing. To us the raider means the invader of someone’s property busing illegal means with the use of counterfeit documents, “bought” decisions of courts, criminal cases, “pressure”. Activist investor is not an invader and, as a rule, does not even seek to have a controlling interest. Activist investor buys a significant, but not a controlling stake, and comes up with a constructive public capital appreciation programme addressed to the management, the board of directors and other shareholders. We consider ourselves to be activist investor only in those companies where we are forced to defend our interests. We want to increase the value of our stake. To make it worth more, the entire company should be worth more. For the company to be worth more, the corporate governance rules should be respected. That’s what an activist investor is fighting for.
On corporate battles in developed markets
In the developed markets disputes and opposition between shareholders and management happen quire regularly. There it is a much more common and understandable process for the public. In Russia activist investors appear rarely in recent years. In developed markets, on the contrary, investor activism is growing, they actively advocate for growing capitalisation of their companies. It is easier for them to achieve the results, as in those markets corporate legislation is much more advanced and there is a general concept of fiduciary duty, which is a duty of any manager and director to act in the best interests of the company and all of its shareholders. In Russia, if you start explaining the meaning of fiduciary duty, it appears that many people never heard about it.
There is a lack of understanding of the civilised corporate governance rules which is the basic law for any joint-stock company. Still not everyone has a clear idea that CEO of company should act in the interests of the company, not in his personal interests, avoid conflicts of interest, work to maximise profits. In developed markets, there is no need to spend time explaining these concepts, all of this is perfectly clear. There are disputes but they rather over details and nuances: e.g. whether a certain strategic move is profitable for the company or not. The situation where the head of the company goes public and says: “I absolutely do not care about capitalisation and a certain group of shareholders” is impossible by definition. Such statements would immediately result in resignation of the CEO.
In developed markets it is difficult to imagine a situation in which company directors would meet and decide between themselves something like: “Let’s retain more profits at the “subsidiaries” level so that we don’t have to pay dividends to our shareholders.” There it would be impossible, immediately taken to court, and resolved momentarily. Unfortunately, we continue to lag behind in terms of understanding the abnormality of such things.
Authors: Maria Todorova, Dmitry Filonov, Irina Mokrousova
Original article: Forbes