Bad politics and the end of spaghetti governance
\"Nice numbers, terrible politics.\"
That\'s the response Natalie Jaresko, managing partner of Horizon Capital, was getting from US investors when she was making the rounds in New York at the end of last year to raise money for Horizon\'s second Ukrainian private equity fund.
Since the winter of 2004, Ukraine has been in more or less constant political turmoil. The Orange Revolution carried Viktor Yushchenko into the president\'s office, but the hero of the barricades has proven to be a lot less effective sitting behind a desk.
By the start of this year, Yushchenko was on the back foot as his revolutionary nemesis, Prime Minister Viktor Yanukovych, made increasingly deep forays into his power base. In February, Yanukovych successfully rallied enough support in the Rada to override a presidential veto and rammed through the so-called \"Cabinet Law,\" which, if enforced, will effectively turn the president\'s job into little more than a title and a nice pension.
Yushchenko must be galled, as the passage of the Cabinet Law was only possible after his erstwhile Orange Revolution ally Yulia Tymoshenko joined Yanukovych in the vote.
Now a showdown in the constitutional court is on the cards and experts in Kyiv say the constitution is almost certain to be changed again, although no one is sure what will come out of the process.
However, Ukraine\'s businessmen have largely shrugged off these problems and the economy is ploughing ahead full steam. The likes of the World Bank were predicting GDP growth of between 2-3% at the start of 2006; Ukraine finished the year with an extraordinary 7% growth and growth was still accelerating in the first month of this year.
\"It\'s as if business has become immune to the politics,\" says Tomas Fiala, CEO of Dragon Capital in Kyiv.
The political problems look bad from the outside, says Fiala, but from the standpoint of Ukraine\'s leading businessmen things have improved dramatically. The two sides are intractably opposed, but they are also both so evenly balanced that neither side can do anything so radical as to tip the apple cart over.
Despite his short-comings, Yushchenko\'s biggest gift to the country has been to put Ukraine irrevocably on the path to closer ties with the rest of Europe – something that opinion polls show is popular with the whole population, including the Russophile eastern regions. At the same time, while corruption remains pervasive Yushchenko\'s government has also scored some bullseyes with his first attempt to clean up the system and make the rules a bit stickier.
For its part, the Kremlin managed to score an own-goal with its blatant attempt to manipulate the 2004 elections and install the establishment\'s pro-Russian candidate Yanukovych in the president\'s job.
The Kremlin\'s ham-handed manipulation led to a backlash against Russia amongst its traditional supporters in Kyiv; even Yanukovych, who is pro-Russia and draws his support from the Russophile eastern regions, has tempered his support for Moscow\'s advice with what he believes is in Ukraine\'s best interests.
\"Yanukovych today compared to Yanukovych a year ago is like night and day. He still believes that close relations with Russia is in the Ukraine\'s best interests but he is no longer going to slavishly follow the Russian line,\" says Andrei Shevchenko, a Rada deputy and chairman of the press committee.
End of transfer pricing
In business, the change has been more complete and reaches down to the roots of how business is done. The most noticeable transformation is the abrupt (but not complete) end to the transfer pricing scams that whisk profits offshore and out of the taxman\'s reach; a significant number of companies are trying to clean up their act ahead of deepening integration with Western Europe\'s economy.
\"In Ukraine everyone was transfer pricing all they could offshore until about 2005. Oligarchs and smaller businessmen were all making use of tax optimisation because they didn\'t want to show profits, as either the taxman or other businessmen would ask them to share these profits,\" says Dragon\'s Fiala.
The concentration of assets in Ukraine happened later than in Russia, where the oligarchs grabbed control of the main assets in the 1995-96 loans-for-shares deals. In Ukraine the process ran between 1998 and 2002.
\"Before this, most of the money was made by the traders who used the factories as a production base. It was not until [the 1998] crisis that the traders began to think about owning these factories,\" says Fiala.
By 1996, years of hyperinflation were nearly over the factories began to become more independent of the traders, who were forced to take them over to protect their trade businesses. Then as the economy bean to stabilise these assets began to become interesting in their own right as businesses.
\"By early 2000, the owners began to see the opportunities from investing and growing these businesses, but they were still afraid to show their profits or reveal the legal ownership,\" says Fiala.
The Orange Revolution in 2004-05 catalysed a change that was already happening. The change of regime showed the owners that Ukraine\'s future was further integration with the global markets and the EU in particular. Companies went looking for foreign investors, partly as a form of insurance against re-nationalisation by the state; it is much harder to renationalise a company with foreign investors in the shareholders equity, who can bring significant political pressure to bear and make a much bigger stink if their companies are threatened.
Despite the political instability and the largely stalled reform programme, Yushchenko\'s government has managed to push through two key reforms that have radically altered the business environment in Ukraine: a crackdown on tax avoidance and accession to the WTO.
The widely abused Special Economic Zones that were used by most oligarchs to avoid taxes completely were first abolished and then fixed, while the government cracked down on tax payments in general, significantly increasing budget revenues in the process.
The impetus to open up was given a push by Ukraine\'s imminent accession to the WTO; despite the ongoing bloody political battles that have stymied most reforms, Yushchenko has completed Ukraine\'s WTO negotiations, which is expected to enter the trade club sometime in the second half of 2007 or early 2008.
\"It has become clear to all Ukraine businessmen that the economy is about to be opened to international business when the WTO rules coming to force. And then the big boys arrive and anyone who is not prepared will be eaten alive. The race is on to grow as fast as possible in the meantime and for this they need capital – international capital,\" says Fiala.
As Ukrainian companies turn to international markets they need all see the need to open up, improve corporate governance and increase transparency.
End of Spaghetti governance
Maybe the clearest example of the depth of change these reforms caused was the dramatic swings in GDP growth over the first year of Yushchenko\'s administration. And the most dramatic example has been the complete volte-face that Ukraine\'s biggest conglomerate Systems Capital Management (SCM) has made in its attitude to corporate governance.
In the year before the elections in the winter of 2004, Ukraine\'s economy grew by 12% according to the official statistics. In the first half of the 2005 this growth fell to 2.5%. While commentators at the time blamed the fall on the street protests, a closer look at the statistics reveals that there was a massive restructuring of the way business was done in the midst of the revolution.
\"Wholesale trade turnover plummeted by 25% in 2005, while the retail trade turnover shot up by 25% in the same period. It\'s a nonsense result. What was really happening was cash flows were being switched out of the Special Economic Zones and made real so the official figures ceased to be meaningful while this restructuring was going on,\" says Fiala.
The diagram below show\'s SCM\'s corporate structure about three years ago. It was typical of Eastern Europe\'s Spaghetti governance – company structures were made so complicated that it was all but impossible for rival groups to find the shares of assets and so hinder an attempt at a hostile takeover. The side-effect was also useful: the taxman had an equally hard job and so profits could be transferred offshore with few difficulties.
However, that has all changed. The diagram below shows SCM\'s structure today; it is not complete, says Jock Mendoza-Wilson, the Scottish head of SCM\'s investor relations (his presence at the company alone is testament to the change in mentality at the company), but the company is committed to creating a modern transparent company that conforms to Western best practises.
\"Our mission is to create four clear areas of business covering metals, energy, banks/insurance and telecoms,\" says Mendoza-Wilson.
The groups is being split up into sectors that are being grouped under the various holding companies. Tantalisingly, SCM has said it is considering an IPO in the process; SCM itself will not IPO, but at least two of the holdings – Metinvest, which contains the metal assets, and DTEK, which holds all the power assets – could float.
\"We may IPO. We haven\'t said we will IPO. The point is to get everything ready so that we have the option of an IPO when the time comes if we decide that is the best thing to do,\" says Mendoza-Wilson.
If it comes, the SCM holdings will make a big splash on international capital markets, as they will surely float for several billion dollars apiece. Currently, there is no accurate estimates for these companies\' value, but the owner of SCM, Rynat Akhmetov, is reportedly worth $11.8bn, according to the Kyiv Post survey of oligarchs, making him by far Ukraine\'s richest man.
\"SCM is committed to the market. You have to look beyond the immediate industrial needs of the country to investing and building a post-industrial economy like that in the west,\" says Mendoza-Wilson. \"That\'s where we are going.\"