2007 is expected to be a busy year for mergers and acquisitions in the Russian power generation sector, as the RAO Unified Energy System moves forward with the sale of stakes in its generation subsidiaries.

The aim is to bring some needed capital into the Russian electricity sector, with perhaps $80 billion required over the next five years. A large proportion of this will be foreign money, so the deals will include the sale of majority and minority stakes to both foreign and domestic investors.

RAO is state controlled, with the government holding a 52.6% stake. The company owns over 70% of Russia's installed electricity generation capacity, 96% of the high voltage grid, and 77% of the distribution network. Generators include regional vertically integrated utilities as well as 44 federal power plants, of which eight are under construction.

The regional generation companies and wholesale federal generation companies are coming up for sale by RAO at a time of unprecedented interest in power and infrastructure assets on the part of investors globally.

The first Initial Public Offering (IPO), in OGK-5, was successfully completed in November, with a 14% stake being sold for $459 million. RAO now controls 75% of OGK-5. Investors in the IPO included strategic foreign investors such as energy companies, Russian financial and energy company investors and the European Bank for Reconstruction and Development. Overall, no single investor was allotted more than 1.1% of the capital of OGK-5.
Once an IPO is completed there will typically be a six-month moratorium on further share sales, after which there can be another public offering or a sale of a stake to a strategic investor.

New lending opportunities

These newly independent generating companies are going to be a major source of business for bank lenders, though initially bankers do not anticipate much project debt, but rather balance sheet borrowing.

Bankers are looking for new lending opportunities in Russia, since during 2006 pricing on loans to big oil and gas companies like Gazprom and Rosneft fell to an all time low.

The result has been a move down into second tier corporates by banks looking for new business. The buyers of the generating companies, whether Russian or foreign, can expect fierce competition for mandates on their acquisition facilities. And given the vast amount of new investment needed in the power sector, the generating companies will soon be looking for large loans to fund capital expenditure.

"There is likely to be a high level of interest from foreign as well as domestic investors in acquiring stakes in the OGKs," says Vladimir Karpounin, Manger in Corporate Finance at KPMG in Moscow.

"European utilities are bulking up to meet the challenges of competition, rigorous investment requirements and the need to enhance purchasing power in a world thirsty for fuel," comments Mark Hughes, European Utilities Leader, Corporate Finance and Advisory Services at PricewaterhouseCoopers. "Looking ahead, the courtship of Russia and Europe presents some intriguing possibilities," says Hughes. "The interdependency of Russian fuel sources and western European end markets, combined with the need for investment, points to a strong likelihood of key players striking deals to secure both supply and markets."

"The equity disposal/privatisation programme has been considered from inception to be an integral part of the restructuring of the power industry in Russia," says David Griston, CEE Head of Energy and Projects at CMS Cameron McKenna in Moscow. "Much investment is needed to upgrade and to supplement the existing asset base to alleviate capacity constraints and improve security of supply," Griston adds. "It is expected that sourcing this investment form third parties – both domestic and international – will be cost effective, will result in competitively priced energy, and will ensure the success of the market reform process."

Energy privatisation picks up

There has already been some activity during 2006. In addition to the OGK-5 IPO, in October Fortum of Finland bought a 12.5% stake in Russian St Petersburg Generating Company (PGK). The plan is that Fortum will now exchange its shares for a 7.2% stake in Territorial Generating Company 1 (TGK-1) that is being created to hold the power generating companies in North West Russia. This will raise Fortum's total stake in TGK-1 to 25%.

The national grid itself will remain state owned as a strategic piece of infrastructure. Already there is substantial investment, helped by both bank loans and bond offerings.

In December S&P assigned its ruA+ national scale rating to a Rb5 billion ($191 million) senior unsecured bond offering from Federal Grid Co (FGC), itself part of the Unified Energy System.

According to Eugene Korovin, credit analyst at Standard & Poor's in Moscow, this ruA+ rating was placed on CreditWatch with positive implications, in line with other ratings of FGC. "FGC plans to use the proceeds to partially fund its investment programme," says Korovin.

Very sizeable capital investment is needed to avoid future electricity shortages – and there have already been warnings of blackouts this winter in the event of unusually cold weather.

The restructured generating companies should have access to plentiful bank debt, since lenders in Russia are looking for new business with second tier companies – partly because the big oil and gas companies have driven margins steadily down to very tight levels.

The improving sovereign credit environment, with Russia moving up from BB minus in 2003 to investment grade BBB today, has benefited a wide range of Russian borrowers. GDP growth is estimated at 7% for 2006 and 7% for 2007, profitability is up, and corporates have room to further leverage their balance sheets.

Many issuers have taken advantage of market conditions to extend tenor and reduce margins, creating many refinancing deals where no new money is added, which leads to repricing bidding. In 2003 Rosneft was paying 350bp over Mosprime for three year loans, but this had come down to under 100bp by the first quarter of 2006.

A few big borrowers do secured loans in order to get the finest pricing, but most have been content to borrow unsecured, taking advantage of the many banks fighting it out for mandates. Margins on syndicated loans reached historic lows in 2006, and the market swung towards unsecured loans on the back of fierce competition for mandates, with the price differential between secured and unsecured closing.

Unsecured syndicated loans have also become accessible for second tier corporates in Russia, as bankers have sought new business outside the giant oil and gas companies. As one banker puts it, "too many banks are chasing the same borrowers."

IPP project market long way off

The arrival of newly independent generating companies during 2007 will provide some welcome new lending opportunities. RAO has specifically included limited recourse project finance schemes as one way to attract private capital into the power generation sector, but in reality project finance is likely to remain on the back burner in the short term.

"New power generation companies are being formed, though it is unlikely that many deals will be done via project finance," comments Maarten van den Belt at WestLB in Moscow.

And in the oil and gas sector, lending is also still mainly done on balance sheet. "Many Russian borrowers in the oil and gas sector have seen margins on syndicated loans drop significantly, and they can live with the balance sheet implications of taking on more debt, since many companies have been underleveraged," van den Belt adds.

"It will be hard for regular power deals to be done via project finance," agrees another Moscow based banker. "There may be some ring fenced co-generation facilities, and those could be project financed based on strong take or pay contracts with big industrial groups, but in terms of selling to the grid, you are not going to see any merchant deals in the near future. With uncertainty about tariffs and regulatory changes you won't get the banks taking project risk."

Certainly, given worries about power blackouts in Russia in the coming years, there are big industrial projects that have a power generating element in order to ensure electricity supply.

In November oil company TNK-BP and generating company OGK-1 established a joint stock company to construct a power unit at Nizhnevartovskaya GRES. The power project will cost around Rb19 billion, and is expected to come onstream in 2010.

Meanwhile, the Boguchanskaya energy and metals complex project includes the construction of a 3000MW Hydro Power Plant on the Angara River, and a 600,000 tonnes per annum aluminium smelter, which will be one of the major consumers of the electricity generated.

This project should be up and running in 2009, at a cost of $3.6 billion. Rusal and HydroOGK will each contribute 30%, with the rest debt financed. Associated roads and a reservoir will be financed by the government, as part of a government/private sector partnership to spur regional development, with a pulp and paper mill, iron ore mining and railways also planned.

Rusal is the world's third largest primary aluminium producer. HydroOGK is a wholly owned subsidiary of RAO UES, and is one of the largest hydro generating companies in the world. Development banks such as the EBRD may also get involved, particularly on the hydro side, given the commitment of the bank to help countries reduce their carbon emissions.

Last June, European Bank for Reconstruction and Development signed a Rb6.3 billion loan to help HydroOGK refurbish hydropower units. The A loan had a 14-year tenor, the longest yet seen for a Russian. Around Rb4 billion was syndicated as a B Loan, with eight and ten year tenors. Co-arrangers were Bank Austria Creditanstalt, Standard Bank and ING, who were joined as lead managers and co-leads by Calyon, Fortis, Raiffeisenbank Austria, Citigroup, Credit Suisse, and Societe Generale.

Oil and gas political leverage

In the oil and gas sector, bankers are still lending into an environment where there is great political uncertainty about the precise intentions of the Kremlin in terms of state control of oil production assets.

In December, Shell was in the news, as talks with the Russian government proceeded about a restructuring of Sakhalin 2 and Gazprom became the controlling shareholder. Environmental breaches were cited by the government in slowing down progress at Sakhalin 2.

And BP has also been under pressure with regard to its TNK-BP joint venture. The company is 50% owned by BP, 25% by Mikhail Fridman's Alfa Group, 12.5% by Viktor Vekselberg's Renova, and 12.5% by Len Blavatnik's Access Industries.

After the government blocked licences for TNK-BP subsidiary Rospan, citing violations of environmental agreements and licensing rules, there was speculation that state controlled Gazprom was looking to move in to TNK-BP as a shareholder. Rospan was owned by Yukos, but Yukos sold it to TNK-BP as a way to raise cash to pay off the massive back taxes demanded by the government, which eventually pushed Yukos into bankruptcy.

Analysts say that this atmosphere of political uncertainty, alongside aggressive pricing, was a factor behind the poor market reception given in December to the syndication of a new $1 billion loan to TNK-BP, featuring Bank of Tokyo Mitsubishi UFJ, Barclays Capital and BNP Paribas and Mizuho as bookrunners. But the endgame was being reached in December, and bankers hope that during 2007 the future shape of the Russian oil and gas sector will become clearer.