Construction of the new Moscow financial city on the Moskva River - investors who have poured money into Moscow's expensive real estate market may be looking to diversify their portfolios

Investing in Technology Versus Other Growth Sectors in Russia

Here are som additional salient points about the Russian direct and venture capital investment market:

• New big funds are emerging

• The government is implementing a policy of rapidly improving infrastructure and is keenly interested in IPOs.

• In 2005, there was an estimated $247 billion invested in Russian companies.

• There are about 50 venture and direct investments funds in Russia; most of them have been established with the participation of foreign investors.

As of 2006, only 10 of the 50 funds were focused on directing investment towards Russian technology companies. The majority of investors, both Russian and foreign, have continued to favor companies that are already in later stages of development and are not involved in developing new technologies. However, this was once true for the IT-sector as well. Until recently, the companies favored by the market were nearly all mature with an extensive market history. Investors remain cautious, but now their interests are shifting towards new technology start-ups.

The Birth of the Modern IT Sector in Russia

The Russian IT sector is growing phenomenally – starting from 2000 with the annual growth rate of 25-30%, overstepping all other industries. After the collapse of the Soviet Union this industry suffered drastic losses. While Russia in the early Nineties did not lack educated specialists in the fields of mathematics, computer science, and information theory, the IT equipment leftover from the Soviet era was almost useless, and many scientific institutes were shut down.

Quite naturally, the first steps for the post-Soviet Russian IT industry were associated with importing a variety of hardware. These patterns established in the 1990s have led to the current market structure, where the hardware rather than software commands 58% of the IT sector market. The other factor that differentiates the Russian IT sector from more mature IT markets is that most of the companies exercise all-round approach to business as opposed to concentrating on individual new products.

General Trends Driving IT Development in Russia

• The legacy of underinvestment in Russia’s IT infrastructure is now changing. Installed hardware increases the demand for IT applications that can be used on the servers. Current projections call for increasing of the share of software and IT services to 52.4% of the total market.

• The organizational challenges of a modern, globalized economy dictate the need for advanced IT products.

• A booming economy has given Russian companies ample cash to spend on IT projects, especially companies in the natural resources, financial, and telecommunications sectors.

• Russia is emerging as a key partner in the outsourcing of software development – (including for companies like Boeing and Microsoft).

• The growing complexity of modern IT systems means that they can no longer be supplied, maintained and run by in-house teams.

• The Russian government and major corporations are currently the principal buyers of IT goods and services. This was extremely positive for initial development of the sector: it created the necessary volume of orders for the infant industry to develop. However, this situation has now changed with the emergence of small and medium-sized enterprises (SMEs) and even Russian entrepreneurs working out of small offices/home offices (SOHOs) with their growing demand for IT products and services. Increasing the rapid penetration of Russian cities by competing telecommunications companies offering high-speed Internet services will accelerate this development.

Logo of APKIT, the Russian Information & Computer Technologies Industry Association

FINAM's Approach to the Russian IT Industry

At the FINAM Investment Company, we have accumulated substantial experience in dealing with Russian IT and telecommunications companies. FINAM has invested in a number of existing and established players in the market as well as some new ones. Analyzing the market trends, we have distinguished the following priority areas for investment in Russian information technology:

• Development of software, its applications and services

• Outsourcing of IT services

• Services and software targeted towards SMEs, SOHO and individuals

Robust Growth in the Booming .Ru-Net

• Online advertising - the advertising segment is one of the most promising in terms of growth tempo and revenues. Publicly available data shows that in 2006 media advertising sales in Russia topped $100 million – a 1.6-fold increase compared with 2005. At the same time sales of contextual advertising reached $ 110 million – this is historic maximum – for the first time contextual advertising overshadows media ads. Online advertising in Russia has massive growth potential stemming from the fact that it currently constitutes only 1-2% of the total advertising market, compared with 5% in the EU countries and 8-10% in the U.S. Further development of Russian e-commerce and online gaming services will boost the Internet market as well.

• Russia is experiencing explosive growth in the number of Internet users: since 2000 to 2005 Internet penetration has increased from 2.1% to 15.5%; projections show that the number of Russians online will double over the next decade. One of the key driving factors is a government program to provide Internet access to each school in Russia – this would give half the population the opportunity to access the Internet by 2012. (Russia's IT and Communications Ministry will provide broadband Internet access for 95% of Russian schools).

• Penetration growth leads to increased Internet usage. Both SMEs and SOHOs, plus individuals will require more and more services. To present one example, by the end of 2006 there were 718,236 domain names registered in Russia, with an annual growth rate of over 60%. When we look at the popular “Goods & Services” part of the Russian Internet (or the .ru-net) it is easy to notice its dramatic expansion – 30-40% per annum (over 50,000 projects in 2006). As the result of this the demand for website design and contextual advertising services is immense. The market of media (banner) advertising is growing at the rate of 60-70% per annum.

• This overflow of information needs its own instrument to deal with. Here the role of the search engines is becoming more and more prominent. It is interesting to note that the market for search engine optimization (SEO) shows tremendous growth rates – 200-300% per annum. Development of Internet mass media adds more to momentum – all these news feeds and publications need to be found, managed, and syndicated by content. Many Westerners are aware that one of the co-founders of Google, Sergey Brin, is from Moscow, but they are probably not familiar with the Russian counterparts to Google and Yahoo, Yandex.ru and Rambler.ru.

• 2005-2006 were boom years for the emergence of broadband Internet access in Russia. And this in turn increased e-commerce, online gaming, and interactive services. More and more personal services are in demand. Online dating services were the biggest earners among Russian web-sites in 2006 with $34 million in profits for 2006. The figure is expected to double in 2007.

General Recommendations and Analysis

Within the scope of specific drivers, FINAM thinks that the most promising directions for IT investment in Russia are the following:

• Companies that exploit opportunities for online advertising segment, specifically contextual advertising.

• Companies that provide comprehensive services to users: support e-commerce, provide interactive services (specifically, on-line dating), help create and maintain Web-sites, develop and implement search engines; utilize creative potential of Internet users.

Prospects for Expanding Western Investment in Russian Information Technology

Western investors have understood some of the challenges facing the Russian IT sector for some time. This is well supported by statistics on foreign investment in Russia’s IT sector. Analyzing publicly available investment information, it is easy to understand why the bulk of these investments were in mature and well-established companies that have a relatively lengthy market history. This may be explained by the effectiveness of the profitability/risk ratio and by the recent availability of companies from this group that have not yet received foreign capital.

With the possibility of an IPO in 2008, Russian software producer Kaspersky Labs is already on international investors radar

According to a number of experts, investors are really interested in acquisition of Russian technology businesses, but at the same time are cautious, carefully evaluating the market and waiting for the right moment when Russian IT companies will be mature enough.

Potential investors currently receive a positive signal when a company’s turnover is in the $5-$10 million range; thus acquisition of equity coincides with the rapid capitalization of growth. The best example of this phenomenon is the recent acquisition by Martinson Trigon, a Scandinavian venture capital company based in Estonia, of a minority (25-20%) stake in the REKSOFT Company in 2005 for $2 million. Given the Russian IT sector’s state of development, the big multinational investment banks cannot yet be considered a likely source of capital for Russian start-ups. Thus the major part of investments in start-ups comes from domestic investors, who are more familiar with the marketplace.

There are definitely several hurdles Russian technology start-ups have to clear before they receive strong interest from the major industry players, which are international venture capital funds. As was previously stated, these funds look for mature mid caps with an average turnover of several million USD per year. However, the number of such candidates – the ones that have been selected from the market and adhere to all criteria – is limited; and the “maturity” period for them requires about 3-4 years. Thus the funds’ interests are slowly shifting towards early stages companies.

New $100 Million Venture Capital Fund for Russian IT

To that end, OpenView Venture Partners of Boston and ABRT Venture Fund of Moscow have announced their new "Partnership for Russia" investment program. The goal of this joint effort is to identify and invest in the best software and IT companies in Russia and Eastern/Central Europe. "Partnership for Russia" will jointly focus on fast-growing software companies and other IT start-ups that are looking to expand their sales and marketing operations in the U.S. and Europe. The combined capital available for investments between both firms exceeds $100 million.

Information Technology Likely to Outpace Telecoms in Russia

In conclusion, we can confidently make one more general recommendation – Russia’s IT sector is a strong, viable alternative to Investing in Russian telecommunications companies This is supported by experts’ projections - the Russian IT sector is set to grow much faster in the nearest years than the telecommunications sector (20-25% for telecoms versus 25-27% for IT).

You can read the original post at Vladimir Kuznetsov's blog, Equity Financing in Russia. The views expressed in this post and on his blog are the personal opinions of Vladimir Kuznetsov, and are reproduced here solely for educational purposes. To read more Russia Blog posts about Russian capital markets, click on the finance section or type www.russiablog.org/finance in your web browser.