PRICE Quantifying “Oligarch Risk” POINT® November 2018 TACKLING THE SANCTIONS FACTOR IN EM CORPORATE In-depth analysis and insights to inform your decision-making. BOND INVESTING

KEY POINTS ■■ Governance risk has always been central to emerging market credit analysis but, given recent sanctions developments, Russia’s corporate landscape currently presents its own set of challenges.

■■ For bond investors, putting a price tag on “oligarch risk” calls for assessments of both the business risk and the sanctions risk associated with these billionaire businessmen. Samy Muaddi Portfolio Manager, Emerging Markets ■■ Building sanctions risk into fair value for Russian bonds helps compare local Corporate Bond Strategy issuers, but it can also help evaluate Russian issuers against opportunities elsewhere in the world.

In April this year, aluminium producer The objective of this analysis is not Rusal’s bonds plunged more than 60% just to avoid tail risk, but also to try after the U.S. Treasury announced and put a price tag on risk and make sanctions against seven high-profile relative valuation judgments—both Willem Visser Russian businessmen and 12 of among Russian companies and Credit Analyst, EMEA their companies. Emerging market between opportunities in Russia and (EM) corporate bond investors are other regions. We recently did an no strangers to governance risk, but exercise that combined both qualitative Russia’s corporate landscape brings a and quantitative information in a set of challenges all its own. How should systematic framework, seeking to arrive analysts think about building “oligarch at a risk-adjusted fair value for nine risk” into their models? Russian companies.

Oligarchies and corporate governance STEP 1: PROFILING THE OLIGARCHS issues are by no means unique to Russia, but recent developments in Specially Russian President Vladimir Putin has Designated Nationals (SDN) sanctions by effectively put 25 oligarchs in control 1 the U.S. Treasury have brought Russian of 80%–85% of corporate Russia. For governance into sharper focus. Analysis investors, it’s important to understand of sanctions risk is increasingly relevant who these influencers are and to what today as the U.S. has become more extent their interests are aligned with proactive in imposing sanctions, notably those of bondholders. We scored each also on Turkey and Venezuela. oligarch on several criteria:

FOR INVESTMENT PROFESSIONALS ONLY. 1This is based on an assessment of their wealth relative to the total Forbes list of the world’s billionaires. NOT FOR FURTHER DISTRIBUTION. 1. Political connections. Business FIGURE 1: Scenario Analysis of Oligarch-Sponsored Companies benefits tend to accrue to members As of June 2018 of Mr. Putin’s inner circle. How close Probability of Risk-Adjusted Upside/ is his connection to Mr. Putin? Is it Current Price family, business, political? Or, like Sanctions Fair Value Price (Downside) Gennady Timchenko,2 is he a judo Company A 5% 97.65 97.98 0.33 sparring partner? Company B 25 97.07 88.25 (8.82) 2. Historical behavior. Information Company C 30 103.76 90.25 (13.51) about how oligarchs climbed the ladder and dealt with competitors— Source: T. Rowe Price. For illustrative purposes only. notably the winners of the Siberian Aluminium Wars of the lawless 1990s—can tell us something about STEP 2: ASSESSING designated oligarchs.5 OFAC cited his how emotionally invested they are in SANCTIONS EXPOSURE detention in France for allegedly failing their companies’ survival. While our first assessment focuses to pay taxes and laundering funds through the purchase of villas (France 3. Capital allocation. Are investors on business risk—essentially how has since dropped the charges). all treated fairly, or is there an bondholder-friendly the individual is— imbalance? Is the sponsor using the Russia’s unique environment calls for a 4. Cost of sanctions to the U.S. As business as a cash cow to fund his second filter based on sanctions-specific we’ll discuss shortly, sanctions on own needs? In 2015 the Kerimov factors. For example, being close to some companies would increase family, which had a 40% stake in Mr. Putin may historically have been commodity costs for U.S. businesses, Polyus Gold, took the company good from a business perspective, but while others would have less impact. private.3 The loan financing made in today’s environment it carries a higher 5. Facilitating cronyism. For example, them dependent on dividends sanctions risk. We ranked oligarchs Mr. Mordashov controls 6% of Bank from the company to service their based on factors that tend to come up Rossiya, which was one of the firms debt, which left little scope for on the U.S. Treasury’s radar or have sanctioned in April and is sometimes improvement in the company’s previously been a trigger for sanctions. referred to as “Putin’s bank.”6 Bank credit metrics. 1. Political connections. Mr. Putin’s Rossiya has been associated with 4. Net worth and asset diversification. inner circle includes names such the illegal transfer of funds from The larger and more diversified the as Chelsea football club’s Roman the Russian state for the benefit of oligarch’s asset base, the more able Abramovich, who is seen as an senior officials. he will be to extract funds from other influencer and dealmaker among businesses if the company needs a the oligarchs and close adviser to STEP 3: SCENARIO ANALYSIS cash injection. Two who score well on Mr. Putin. Those with lower profiles Can anecdotal and qualitative information this are Severstal’s Alexei Mordashov include NLMK’s Vladimir Lisin. be incorporated into bond valuations in and USM’s Alisher Usmanov. a meaningful way? For nine companies, 2. Ownership. Does the oligarch based on our analysis of their sponsors 5. Other information. This includes fall foul of the Treasury’s Office so far, we did an exercise in which we qualitative measures such as: of Foreign Assets Control (OFAC) assigned a probability to a Rusal-type How extravagant is the oligarch’s 50% rule? Mr. Mordashov scored scenario where sanctions escalate. The lifestyle, and how erratic or risky is highest on our scale of bondholder- table in Figure 1 shows an edited extract his behavior? For example, Mikhail friendliness, but his 77% stake in from the study. Prokhorov’s flamboyant lifestyle Severstal makes him a potential has been perceived as one of the sanctions target. Mr. Lisin is also at In the first example, we believed contributing factors to the divestment risk, with an 85% stake in NLMK. Company A, a large and growing of his stake in Norilsk Nickel.4 3. Fraudulent activities. In commodity producer, faced relatively April, Mr. Kerimov was one low sanctions risk, largely because of of the U.S. Treasury’s seven the potential impact on the price of that

2edition.cnn.com/2014/03/21/business/russia-sanctions-targets/index.html 3ft.com/content/201894b6-678d-11e5-97d0-1456a776a4f5 4nytimes.com/2007/07/08/business/yourmoney/08nickel.html 5home.treasury.gov/news/press-releases/sm0338 6ft.com/content/ac0bee28-b05a-11e3-8058-00144feab7de

2 commodity. In our assessment, the FIGURE 2: A Tale of Two Metals Companies bonds were slightly cheap at the time As of August 22, 2018 of the study (June 2018). 102 Latin American Co. Russian Co. By contrast, we concluded that the 100 bonds of Companies B and C were 98 not correctly pricing in sanctions risk. Both are more than 50% owned by 96 their sponsors. If the OFAC decides to classify the sponsors as SDNs, 94 all holdings in which they own more (100=2/28/2018)

Cumulative Price Return Cumulative 92 than 50% will automatically be 7 classified as SDN. 90 Feb-2018 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 For Company C, its sponsor’s connection with another firm that Past performance is not a reliable indicator of future returns. has been sanctioned adds an Source: Bloomberg—Bloomberg Finance L.P. Used with permission. additional layer of risk by being a potential target for OFAC sanctions. When the higher probability of being the governance risks. Comparing these two bouts of sanctions risk jitters and sanctioned was incorporated into the companies with peers in other regions underperforming the Latin American analysis, we didn’t believe investors (Latin America or Asia) at the time, we company by about four percentage points. were compensated for the risks found a number of firms with similar credit Today, despite the recent volatility and involved. At the time of the study we ratings and balance sheet fundamentals, negative news flow, we still believe that thought Company C was trading about offering similar yields, but without the Russian corporate bond valuations 13.5% higher than it should have been. corporate governance concerns. are underpricing sanctions risk. This is For example, the chart in Figure 2 largely due to technical support: Limited THE GLOBAL CONTEXT compares the price returns of the bonds new issuance means that supply has Building governance factors into relative of a Russian metals company with those been shrinking, with the result that tail valuations helps assess opportunities of a comparable Latin American peer risk is not being fully priced in. Against within Russia, but it also helps give since March this year. Both bonds are this backdrop, we are maintaining regional perspective. We concluded that rated BBB- and both mature in 2023. minimal exposure to corporate Russia. a number of the Russian companies Since March, the Russian company in our study were not fully pricing in has been far more volatile, suffering

7SDNs’ assets are blocked, and U.S. persons are generally prohibited from dealing with them.

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