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Growing Pains

By Nicholas Moody

Russia continues to offer great rewards and great challenges for its wealthy. The process of getting rich, however, is different to the process of staying rich. The fourth annual UBS/Campden Wealth report, Russia’s Wealth Creators, highlighted corruption, too much regulation and the greater need, but limited ability, to secure qualified management and staff, as the key challenges facing Russia’s entrepreneurs. These particular challenges have grown dramatically in importance when compared to last year’s survey.

Balanced against these challenges are the positive signals. The survey – based on in-depth interviews with 20 entrepreneurs who had founded businesses with annual turnover ranging from $50 million to $1 billion – found confidence to be robust on the part of Russian entrepreneurs in their investment outlook, far greater than Campden Wealth’s research has found in Asia and Europe. Many plan to expand their business, relying heavily on internal cash flows, and many have heightened investment returns. The question among all of this is: Will these changes drive a shift to long-term planning? The short answer is not yet, however, indicators suggest this may be changing.

Two trends are unchanged from 2012: overall business sentiment remains broadly in line with last year and Russia’s total wealth continues to soar. All entrepreneurs surveyed said the business environment has not changed at all since 2012’s presidential elections. Russia ranked 13th in the number of high net worth individuals, with 180,000 households worth $1 million or more, in Boston Consulting Group’s (BCG) annual global wealth report. When it comes to ultra-high net worth individuals – those worth $100 million-plus – Russia is ranked 10th, with 328, according to the BCG rankings.

Growing appetite for family offices
Campden Wealth’s head of research, Andrew Porter, said one of the most interesting findings of this year’s research is the growing local interest in the family office model – though still nascent when compared to global trends. This ties in with Russian attitudes to wealth succession. Russia stands out from the crowd as an example of how entrepreneurs, for the most part, do not favour involving their spouses or children in business. This year’s study is no different, with 90% of participants indicating that none of their family members hold stakes in the companies they own; only 10% of them said children would be entitled to hold a stake in the future and even less foresee family business involvement in the future.

Porter observed that as these entrepreneurs age, the challenges of succession will only be amplified by the difficulties posed by the return of children who have been educated abroad. This mirrors a trend with Asia’s ultra-wealthy and their succession planning.

“Here, interestingly, we believe that the family office model will be useful in developing governance vehicles, as well as educating family members and implementing successful transition plans,” said Porter. “Once those long-term views set, we’ll start to see a more fruitful discussion about the model.”

Stumbling blocks
Corruption continues to be the biggest brake on wealth creation in Russia. One of the respondents put it plainly: “A very peculiar phenomenon of today’s economic reality in Russia is that corruption is broadly supported by the government. The power at the federal level is involved in business by exercising its control over business, which does not promote the business culture in any way and significantly slows down the development of the country generally.”

Sixty-five percent of entrepreneurs identified corruption as the biggest challenge to growing their businesses, compared to just over half in 2012. This reflects an upward trend in awareness and concern over the course of the four-year study. Corruption impacting on their businesses increased dramatically from 2011, when it stood at 10% and from 2009, when just 4% of the interviewed entrepreneurs regarded it as a main challenge.

The second major brake is over-regulation. In April this year, the Organisation for Economic Co-operation and Development (OECD) underlined this drag on Russia’s economy citing over-regulation and corrupt officials as two of several culprits holding back the world’s eighth largest economy. The survey found a dramatic increase from 10% who reported regulation as being a key business challenge in 2012, to 50% in the past 12 months.

Similarly, identifying and securing qualified management and staff to help run businesses has also seen a big jump in Russia in 2013, as 45% of respondents identified it as a challenge compared with just 10% in 2012 and in 2011.

The Cyprus Effect
The Cyprus banking crisis affected Russia’s wealthy much more than other countries due to the high level of assets held in the country by Russian investors. It also appears to have affected their choice of offshore domiciles. Credit rating agency Moody’s estimated Russian banks and companies had about $19 billion in Cypriot banks at 1 September 2012. Only 10% of the entrepreneurs surveyed said they had been affected by the EU-imposed haircut on deposits in Cyprus,which required a deposit levy on Cypriot accounts of 48% for shareholders, bondholders, and depositors with more than €100,000 in the two largest banks.

Many wealthy Russians however, did take their money out of the Mediterranean island. Just under two-thirds of the entrepreneurs interviewed reported that they saw opportunities out of the recent economic turmoil, fewer than last year.

There is also a shift in jurisdictions where Russian entrepreneurs domicile their offshore wealth. The most preferred offshore jurisdictions in 2013 became the Caribbean and Switzerland, despite the latter giving up on many of its banking confidentiality policies. Data from the Bank of Russia showed Russian residents channeled $32 billion to the British Virgin Islands in the first quarter of 2013, compared with $7 billion in the fourth quarter last year, according to the Wall Street Journal. This preference for Switzerland continued despite the Swiss franc having lost some ground among Russians against currencies such as the US dollar and the Russian ruble.

A shift to long-term planning?
Surprisingly, cash flow was identified as less of a problem this year, with just a 10th of respondents seeing it as a concern, down from about half in 2012 and 2011. Also, M&A stood out as an attractive option, reflecting perhaps a shift toward a long-term planning perspective among this segment.

In a nod to the increasing development of a longer-term view on wealth planning and succession, the percentage of those who developed no wealth plan fell considerably this year. The research authors suggested this indicated entrepreneurs had realised that the global economic turmoil, coupled with local uncertainty, can affect their wealth if they do nothing. Consequently, the number of respondents who admitted they developed a wealth management plan for the next five years tripled from 2012.

When asked to comment on the most important considerations for selecting a wealth management firm, reputation and referral stood out as priorities. While it is unsurprising that cost is not the most important factor in selecting a wealth manager, it is interesting that performance is not ranked higher.

Even fewer Russian entrepreneurs were using wealth management services in 2013, according to the survey, than in previous years. The use of wealth management services has declined since 2011 when 45% of the entrepreneurs (42% in 2012) were still using such services, but their use declined to just 25% of respondents this year, almost a third of the 72% in 2009. Interview responses indicated that entrepreneurs have cooled on wealth managers because of their underperformance.

“Given my background in investment banking, I do not use services of any wealth management firms. I have sufficient knowledge to look after my assets and capital,” said one respondent.

Services at home versus abroad
Lawyers, both local and international, played the biggest advisory role in developing asset protection strategies, followed by banks. So, while Russian entrepreneurs express clear preference for local relationships, be it in the form of legal advice or accountancy, they continue to hedge, via international banking and legal arrangements, against domestic political and economic uncertainty.

A second-generation entrepreneur with a fortune of $500 million said: “We very rarely use the services of wealth management firms. However, we regularly use both international lawyers and accountants. We only use international banks, as we mostly deal with foreign partners. As most Russian banks are state-owned, there is always a risk of instability and assets appropriation by the government.”

As many as 85% of those surveyed say they now favour working with local lawyers (versus 35% last year) and 75% also turned to international law firms, versus 41% in the previous year, to implement strategies aimed at protecting their assets. In 2012, all of those surveyed favoured banks in obtaining advice on how to protect their assets, while this year only 80% of them still consider that path. More than double the respondents said that wealth management services haven’t helped them achieve their financial goals this year. As a result, less perceive international banks to be more professional than local banks (40% in 2013 versus 84% in 2012).

Time to give back
Russian entrepreneurs are also increasingly interested in philanthropy, despite the relative youth of much of their wealth. While Russian entrepreneurs are growing increasingly untrusting of private wealth managers, 80% of respondents say that they are involved in philanthropy, more than last year’s 60%. In terms of causes that Russia’s entrepreneurs support, social welfare and poverty are the two clear favourites, with 33% of them stating that philanthropy is one of the factors helping to better communicate values to the next generation.

A respondent who is involved in a charitable foundation restoring old churches and cathedrals said that the concept of charity always existed in Russia.

“Merchants built churches, hospitals, theatres, and museums. Unfortunately, this very old tradition had been completely forgotten during the Soviet era. I am happy to see that philanthropy has significantly grown in Russia in the last couple of years,” he said.

Double-digit returns
Russian entrepreneurs expectations for investment returns have risen noticeably in the past twelve months. Nearly 90% of respondents say they expect an annual return of 10% to 20% for both stocks and real estate and the remaining ones saying their returns could even go as high as 50%. Even more respondents (93%) see a 10% to 20% annual return from their investments in bonds, compared with 100% expecting returns of 5% to 10% in 2012.

While local real estate appears to be the preferred asset class, its weight in investment portfolios has decreased, with stocks gaining significant ground. As many as 80% of respondents say they invest in international stocks, a massive increase from 37% in 2012, while 60% of them invest in local stocks, almost double last year’s figure.

The attractiveness of local fixed income investments among respondents fell to 5% this year from 11% in 2012, but rose for international bonds at 40% this year from 21% in 2012. Preferences for investments in the international currency market more than doubled to 40% this year from 16% in 2012, but stayed almost unchanged in the local currency market, at 10%.

No quick fixes
Single-digit returns remain unattractive to this group of risk-takers, as expectations on returns on investment show in this year’s research. Here again we see the Russian entrepreneur setting themselves apart from their global, ultra-wealthy peers. Interestingly, this risk and return profile is most similar to entrepreneurs in the Middle East, who also deal mostly in energy and invest primarily in real estate, both at home and abroad. The issue for these entrepreneurs is that some of the challenges they report: corruption, bureaucratic red tape and skills shortages, are not quick fixes. They will continue to put a drag on business expansion, meaning their double-digit growth rates may be in jeopardy. 

For more details on the report or to obtain a copy please go to www.campdenresearch.com

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