THE WALL STREET JOURNAL: Renault Deal in Russia Shows Kremlin Tactics

A Nationalization
Precedes Pricey Sale
To Foreign Investors
By ANDREW OSBORN and DAVID GAUTHIER-VILLARS
March 21, 2008

TOGLIATTI, Russia — For Renault SA, a $1 billion investment last month in a struggling Russian auto giant is a bet on one of the world’s fastest-growing car markets. For Vladimir Putin, it’s a validation of Kremlin capitalism.
 
Most foreign investors long steered clear of Russian car maker OAO Avtovaz, a behemoth whose outdated models, inefficient plant and mafia-infested finances embodied everything wrong with post-Soviet industry. But in 2005, President Putin sent an old KGB colleague to clean the place up. By last year, top auto companies were lining up for a chance to bid for a stake. Renault Chief Executive Carlos Ghosn flew in personally to snag the contract.

The Avtovaz deal is just the latest example of the Kremlin’s strategy of re-nationalizing companies and sprucing them up, then selling minority stakes to foreigners at steep prices. In 2006, state oil giant OAO Rosneft, with assets taken from OAO Yukos, went public in a $10.7 billion offering in London. Gas monopoly OAO Gazprom has become a staple in Western investment portfolios even as the Kremlin has tightened control over the company.

The Kremlin, convinced it has hit on a winning formula, has plans to float stakes in a raft of companies it has taken over. That policy is set to continue under Mr. Putin’s anointed successor, Dmitry Medvedev, who takes office in May.

Results like the deal with Renault help explain why Western lectures on the evils of nationalization ring hollow in the Kremlin. Before the state’s takeover, “an investor would never have come to such a weak company” as Avtovaz (pronounced aft-OV-az), says Boris Alyoshin, its CEO and a former head of Russia’s state industrial agency. “We had to turn it into a business.”

In the 1990s, Western advisers pushed privatization as the key to fixing Russian industry; foreign investors stayed away. Today, foreigners are lining up to do deals with companies linked to the Kremlin’s state-run giants.

“The inflow of private capital into Russia in the past year amounted to about $80 billion,” Mr. Putin said last month. “Is this a reflection of the fact that investors are being deterred? Everyone wants to work with us.”

Indeed, foreign investment is surging at the same time as Russian government ownership of publicly traded companies has jumped. The government stake in companies is 40% now, versus 24% four years ago — an increase that comes amid the Kremlin’s farther-reaching consolidation of control over the press and politics in Russia.

Rising Car Demand

The latest deal boosts Renault to the head of a pack of growth-starved auto makers seeking to tap rising demand in emerging markets. Adding Avtovaz’s sales to those of its brands, the French company will have nearly 40% of a fast-growing Russian car market that is forecast to become Europe’s largest by 2010.

But the terms the Kremlin dictated make the deal risky. Renault has gained management control in previous investments it’s made in struggling auto makers, such as Nissan Motor Co. and Romania’s Automobile Dacia SA. The Kremlin wouldn’t allow that. Renault was able to buy just 25%. Control of Avtovaz’s board and management remains with a sprawling state industrial giant, called Rostekhnologii, created by Mr. Putin’s old KGB colleague, Sergei Chemezov.

Another risk: Avtovaz needs billions of dollars in new investment, yet most of the cash Renault is sending won’t go to the company itself. It will largely be devoted to a share restructuring that benefits the Kremlin.
 
Perhaps most important, while high-level connections made the deal possible, shifting political winds can make doing business in Russia perilous. General Motors Corp. thought it had lined up the right allies when it teamed with Avtovaz in 2002 in a joint venture to build small Chevys, but that deal nearly collapsed after the Kremlin team took over in 2005. (GM’s joint venture isn’t directly affected by the Renault deal.)

The hazards foreign investors can face were on display just this week as Russian police raided the offices of BP PLC and its joint venture TNK-BP, later accusing a joint-venture employee of industrial espionage, in what could be a sign of Kremlin pressure on the venture to sell out to Gazprom. Another Western oil giant, Royal Dutch Shell, is being forced out of a huge offshore gas field in favor of Gazprom.

Avtovaz, which provides a social safety net for its home region in south Russia, has been loath to cut its bloated staff. Its huge factory employs 104,000 people to make 736,000 cars a year; at Renault, 130,000 people produce 2.43 million vehicles.

Communist apparatchiks first had the idea of selling a stake in Avtovaz to foreigners. In 1991, as the Soviet Union began to crumble, the Kremlin prepared to sell a large stake to Italy’s Fiat SpA, which had helped Avtovaz build its plant in the 1960s. That plan collapsed when the U.S.S.R. did.

Privatized in 1993, Avtovaz barely survived as sales fell and lawlessness exploded. Local mafiosi used chalk to mark the windshields of cars they wanted, and criminals stole parts by the truckload, said local media reports at the time. Gangsters fought it out in factory-gate shootouts. Armed guards had to be brought in to secure the assembly line. Avtovaz had no money to invest in new models.

Foreign car makers came into the Russian market after the 1998 ruble devaluation, but they mostly avoided Avtovaz. In 2005, Renault began building its budget Logan model in an old Moscow car plant. Even as car sales in Russia rose — amid improving incomes and the novelty of consumer credit — Russian makers lost market share to newcomers that offered modern designs.

At Avtovaz, management was on the verge of losing control of the company to mafia groups by 2005, Mr. Alyoshin says. That’s when the Kremlin’s Mr. Chemezov came in.
 
An unlikely capitalist, he had served with Mr. Putin as a KGB spy in Dresden in East Germany. Once in power, Mr. Putin assigned his old friend to handle the lucrative arms-export business. Mr. Chemezov used his Kremlin ties to turn it into a sprawling industrial conglomerate.

With Mr. Putin’s blessing — and backed by prosecutors and hundreds of armed police — Mr. Chemezov ousted the Avtovaz management. He took the title of chairman and installed his own people. The government owned less than 2% percent of shares but was able to take the helm thanks to a tangled shareholding structure that gave management effective control.

The Chemezov team’s first instinct was to seek a government bailout. Mr. Alyoshin proposed injecting $5 billion into the auto industry. But he says the Kremlin didn’t want to create a state auto corporation. Instead, the Chemezov team set about polishing the company to attract a partner from among the foreign auto makers thronging the Russian market. They began to modernize production and squeeze out what they said were criminal gangs.

Looking to Expand

Renault was looking for a way to expand beyond its Moscow plant. The French company’s strategy director, Jacques Verdonck, met with Avtovaz management in Moscow in April 2006. Among the attractions Renault saw: well-trained but relatively low-paid Avtovaz engineers and a network of in-house parts affiliates.

While most Western car makers long ago shed their parts operations, Avtovaz’s vast factory in Togliatti, 600 miles south of Moscow, still has a foundry crisscrossed by trolleys carrying molten steel to forge engine blocks. That’s important because foreign auto makers that have built plants in Russia are scrambling to find parts suppliers to feed them. Renault saw that Avtovaz would offer instant capacity. For Western auto makers, building cars inside Russia is preferable to shipping vehicles in, because of stiff tariffs Russia imposes.

Renault’s Mr. Ghosn flew to St. Petersburg in mid-2006 to break ground on a new plant for Nissan, of which he is also CEO. He made an offer to Mr. Putin: Renault would buy a controlling stake in Avtovaz. Mr. Putin hedged, saying only that he was in favor of Avtovaz partnering with other firms if Avtovaz agreed.

Avtovaz’s response wasn’t long in coming. A company official told Russian journalists Renault’s offer was interesting, but unacceptable as it stood. “It was too early,” says Renault’s Mr. Verdonck. “It was impossible to hand the keys of Russia’s national car maker to a foreigner two years ahead of elections,” which were held last fall and early this year.

Renault kept lobbying. Mr. Verdonck invited Mr. Alyoshin to France and showed him Renault’s lineup of low-cost Logan models. But by a year ago, Renault officials were losing hope. Mr. Putin appeared to bless an Avtovaz deal with Canadian parts supplier Magna International Inc., which had the advantage of a powerful Russian oligarch as a major shareholder. Mr. Verdonck felt increasingly isolated at Renault, as Mr. Ghosn and members of the executive board began to lose patience.

Mr. Chemezov and his team, meanwhile, were backing up their physical takeover of Avtovaz with the complicated task of gaining formal equity control. They had hired Troika Dialog, a Moscow investment bank, to organize a buyout, financed by hundreds of millions of dollars in loans from state-owned banks.

By last September, with that process well under way, Troika Dialog invited bidders to look at Avtovaz’s financial data. Besides Renault and Magna, GM and Fiat sent delegations. Two Russian metals tycoons also were invited, as potential purchasers of an additional 25% of Avtovaz, but ultimately didn’t buy.

Factory workers say they lost count of the number of delegations from Fiat and Renault who toured the plant. “We were convinced it would be Fiat,” says a plant manager, Alexander Savin.

Frustrated by the mixed signals, Renault set a deadline of last Dec. 8 for the Russians to decide on its offer. Mr. Ghosn told his board he had signed Renault’s “final offer” for a 25% stake in Avtovaz. It included cash of up to $1 billion and pledges both to preserve the Russian company’s flagship Lada brand and to provide technology for new models. He warned the Renault board that “we may not win,” say people present.

‘An Appropriate Offer’

Other offers to Avtovaz also rolled in. Magna and its Russian partner wanted a controlling stake — a nonstarter. Fiat and GM were willing to take just a 25% interest, but offered less than Renault, says someone close to the talks. GM said it made “an appropriate offer”; Magna and Fiat declined to comment.

Serguei Skvortsov, a senior Troika official, says momentum for a deal had become inevitable: “Talks couldn’t last forever.”

The day before the deadline Renault had set, the chairman of Troika Dialog, Ruben Vardanian, called Mr. Ghosn to tell him Renault was close to victory, if it would only raise its bid. “I told him, ‘You win if you upgrade your offer,'” Mr. Vardanian says. In the last 24 hours, Renault did improve its bid, agreeing to speed the flow of part of its $1 billion investment.

The formal closing of the deal was Feb. 29. Even before then, Mr. Chemezov, meeting with Mr. Putin at an aircraft-testing center outside Moscow, was pitching plans for a similar overhaul of another Russian industry, in this case aviation.

KREMLIN CAPITALISM
 
•  The News: France’s Renault is investing $1 billion for a 25% stake in giant Russian auto maker Avtovaz.

•  Preliminary Step: Laying groundwork for the deal, the Kremlin took over the company and made it more attractive.

•  Expect More: The move illustrates a central Kremlin industrial strategy: nationalization followed by lucrative sales of minority stakes to foreigners.

Write to Andrew Osborn at [email protected] and David Gauthier-Villars at [email protected]

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