The Real Estate M&A and Private Equity Review: Russia
Overview of the market
In the boom years, Russia was one of Europe's largest property markets, with investment volumes of US$8 billion–US$10 billion annually; the figure briefly decreased during the 2008–2009 financial crisis.
However, a downward trend on the property market began in 2014 in sync with the political challenges that Russia is facing as a result of continuing Western sanctions and low oil prices (on average), which has brought about a weakening of the Russian currency.
However, in recent years the Russian economy has stabilised, showing a record-low 3 per cent inflation figure for 2019. The Ministry of Economic Development and Trade expects the same 3 per cent inflation in 2020, which, however seems optimistic in light of covid-19 (the Central Bank of Russia has since updated its forecast, anticipating 4 per cent inflation in 2020).2
The reports of JLL, Knight Frank and Colliers for 2019 suggest that the Russian real estate market remained relatively stable. The volume of investment transactions into commercial real estate in 2019 reached almost US$2.5 billion, which is slightly higher than the results of the previous year (US$ 2.4 billion). A major part of the investments (58 per cent) was attributed to the fourth quarter of 2019, when several high-value investment deals were closed.3
On the other hand, the share of foreign investors has drastically decreased, now amounting to nearly 12 per cent compared to 20 per cent in 2019.4
Continuing the trend started in 2018, the office segment again outperformed other segments and accounted for 44 per cent of investments in 2019 (US$1.1 billion); retail reached 34 per cent (US$842 million); and the warehouse and hotel market segments attracted 10 per cent and 9 per cent of the total investment, respectively.
Saint Petersburg, which was very attractive for investors in 2018 (it had a 29 per cent share) lost more than 20 per cent, with only a 9 per cent share on the Russian market. Moscow remains the biggest and most active real estate market with a share of 58 per cent of the total transaction value (US$1.5 billion).
The average transaction amount in 2019 increased by a third compared to the previous year – US$46.2 million as opposed to US$33.3 million in 2018. The median values of the transaction remain around US$16–18 million.5
As of Q1 2020, the cumulative volume of investments amounted to 56 billion rubles (about US$800 million), which is 6 per cent lower than a year earlier. The effects of the current economic and social situation will undoubtedly influence all segments of the real estate market; however, no substantial structural changes on the market are expected.6
The Russian commercial real estate market remains fairly diverse and institutionalised, with about 30 major players, including seven foreign companies (e.g., Ingka Centres, (formerly IKEA), Raven Property Group, Hines, Morgan Stanley Real Estate Investing and Malltech), with annual rental revenue ranging from US$1.6 billion (Kiyevskaya Square group companies owned by Zarah Iliev and God Nisanov) to US$50 million (Ingeokom) in 2019.7 The Russian real estate market lacks any substantial public real estate companies, except for several residential developers listed on the Moscow Stock Exchange (e.g., PIK Group and LSR), as well as the major warehouse owner – Raven Property Group – listed on the London Stock Exchange, so deals are more often structured through non-public sale and purchase agreements of shares in a company holding the desired properties.
Real estate investment trusts (REITs) are not present on the Russian real estate market, although a common way of investing in real estate is through investment funds, especially those that possess certain analogous characteristics to REITs (Section III). The most common investment fund in the Russian real estate market is a closed-ended investment fund (CEMIF).
As of 2019, the net asset value of real estate CEMIFs amounted to US$6.3 billion, representing a 9 per cent share in the Russian mutual investment funds market. This share has, however, been decreasing starting from 2016 largely as a result of a continuing fall in profit of CEMIFs. For 2019, real estate CEMIFs showed a positive yield (3.9 per cent per annum).8
Recent market activity
i M&A transactions
As mentioned above, the Russian real estate market does not have a significant public sector, therefore we have selected the following transactions involving sophisticated market players that focus on real estate investments, as well as major corporate real estate transactions:9
- Mubadala Investment Company purchased a 49 per cent share in the Gallery shopping mall in Saint Petersburg: the estimated deal value is US$600–650 million;10
- Ingrad acquired several land plots for brownfield development: the estimated deal value is US$160 million;11
- a subsidiary of O1 Properties (which is allegedly affiliated with Russian oil giant Rosneft) acquired the historic building of Moscow Central Telegraph: the estimated deal value is US$55 million;12 and
- a major Russian bank (name was not disclosed) purchased Akvamarin III office center in Moscow: the estimated deal value is US$65 million.13
ii Private equity transactions
We have selected the following significant private equity transactions involving, inter alia, foreign real estate private equity (PE) firms:
- Sindika (a company operating a hotel chain in Russia) purchased the Bridge Resort hotel located in Sochi: the estimated deal value is US$73 million;14
- Metrika Investments purchased the office part of Neva Towers in Moscow: the deal value was not publicly disclosed;15
- Sberbank Asset Management purchased the Rechnoy mall in Moscow: the deal value was not publicly disclosed;16
- IHI Plc and Lizar Holdings acquired a historic building on Tverskaya Street, Moscow for its further redevelopment into a luxury hotel operated under Corinthia brand: the deal value was not publicly disclosed;17 and
- Accent Capital purchased the Valishevo Park warehouse: the deal value was not publicly disclosed.18
Real estate companies and firms
i Publicly traded REITs and REOCs – structure and role in the market
As mentioned above, Russian law has not yet incorporated the concepts of REITs and real estate operating companies (REOCs). However, mutual investments in Russian real estate are permitted through an investment fund, which is an asset portfolio consisting of assets placed under the management of an asset management company. There are different types of investment funds, though only two types of such funds may invest in real estate: CEMIFs and joint stock investment funds. We note that real estate joint stock investment funds are not particularly widespread and their market share is insignificant in comparison to CEMIFs.
The assets that comprise the CEMIFs and joint stock investment funds must be managed by an asset management company (AMC). Investment shares under management must be accounted for with a special depository. A special depository is a licensed entity that controls the compliance of an AMC's activities with regard to abiding by legal requirements and trust management agreements. The specialised depository is responsible for the safekeeping and accounting of the investment funds' assets.
The investment funds may pay dividends (in the case of joint stock investment funds) and may, if the investment policy permits distributions to investors, distribute income from management (in the case of CEMIFs).
Only 'qualified investors' may invest in these specific funds that invest in real estate (see the section below for more details).
Joint stock investment funds
A joint stock investment fund is a joint stock company that has a licence from the Central Bank of Russia for the purpose of investing in assets in accordance with its investment policy. It may invest in real estate and be listed on the stock exchange.
Shareholders may pay for shares of a joint stock investment fund in cash or in any other asset permitted by the fund's investment policy. As opposed to CEMIFs, joint stock investment funds can exist for an indefinite term. Shareholders of a joint stock investment fund generally do not have the right to demand redemption of their shares.
The main difference between joint stock investment funds and CEMIFs is that the former is a legal entity and its shareholders do not directly own the assets comprising the fund. On the other hand, a CEMIF is an asset portfolio rather than a legal entity, therefore its participants have direct ownership rights to the underlying asset, which is deemed to be the common property of the CEMIF's participants. This is one of the reasons, along with certain administrative complications and low liquidity, why joint stock investment funds are very rare in the Russian market.19
Similarly to joint stock investment funds, a CEMIF is placed under the management of an AMC and can be funded by cash or by any other asset permitted by the fund's investment policy. Each fund investor agrees to the fund management rules with which the AMC has to comply. The assets of all fund investors create a pool. A participation unit from the AMC evidences a share in the funds' property. Generally, bankruptcy of the AMC does not affect a CEMIF's assets as they are legally separated.
CEMIFs distribute to the investors a fixed number of units, only redeemable on expiry of a trust agreement or on the occurrence of certain other events specified by applicable law. However, the unitholders are not restricted in their right to sell their units to third parties or, if the fund is designated as such, to 'qualified investors'.20
CEMIFs cannot be established for a period longer than 15 years. CEMIFs can be listed on a stock exchange but its units do not have the same liquidity as shares. To dispose of the units on a stock exchange, a unitholder has to involve the AMC, which significantly prolongs the sale process.
The capital markets legislation imposes special requirements on the assets that may comprise a real estate CEMIFs and, if such CEMIF's assets do not meet the requirement, only 'qualified investors' may acquire the units. In particular, the general public may acquire the units of a real estate CEMIFs if its assets consist of only:
- residential properties;
- non-residential properties in a condominium;
- certain other non-residential properties meeting specific criteria;
- residential properties in non-residential buildings;
- unified real estate complexes;
- engineering infrastructure related to other funds' assets;
- land related to other funds' assets;
- leasehold related to other funds' assets;
- common construction schemes;
- money-market instruments; and
- properties related to management or payment for management of the funds' assets.
However, there is a further condition that makes CEMIFs less attractive to the general public – only qualified investors may acquire units of a real estate CEMIFs if:
- the minimum tranche for the units is less than 300,000 roubles (approximately US$4,600)21 (including any units that an investor may acquire in addition to the units it already owns); and
- the managing company has the right to split the units.
In practice, most real estate CEMIFs are either controlled by the major Russian banks (e.g., Sberbank, VTB) or property developers. However, the largest real estate CEMIF (Dom.RF) is controlled by the Moscow government and its main purpose is to provide residential financing to individuals. Standard portfolios of real estate CEMIF comprise residential property.
Compared to REITs, real estate CEMIFs have the following unique characteristics:
- CEMIFs are not legal entities;
- CEMIFs can only be closed-ended;
- usually CEMIFs are not listed; however, this is not legally restricted;
- CEMIF's lifespan is limited to 15 years; and
- investments in CEMIFs are less affordable for the general public.
ii Real estate PE firms – footprint and structure
Owing to economic instability and currency volatility in Russia over the past few years, PE firms have been less active in the real estate sector. Significant drops in rent revenues and change of fixed rent rates from US$ to roubles have made the formerly lucrative market less profitable, especially taking into account challenging market conditions. Pure private equity deals in Russian real estate have become quite rare.
PE companies in the Russian market are acting mainly through offshore vehicles. The choice of jurisdiction will largely be driven by tax issues and corporate considerations (Cyprus and BVI remain the most popular jurisdictions).
In Russia it is more common for PE investors to take minority stake investments. Where control is acquired, these investments tend to be carried out by way of a consortium deal. One of the main drivers for this is financing. As with any jurisdiction, investors can access larger deals by clubbing together, but this increased financial resource is particularly relevant in the Russian Federation where deals tend either to involve limited debt financing or none at all.
Finance is just one reason why foreign investors often seek out locals to partner with; Russia also has a reputation as a jurisdiction in which it is desirable to have a strong local partner to achieve a successful business operation. A local partner brings local knowledge and connections that can be indispensable for foreign investors who are unfamiliar with the Russian regulatory system and lack relations with the Russian authorities. Partnering with a local PE house may make obtaining investment committee consent easier, as reassurance is taken from the experience, expertise and influence of the domestic partner. For the Russian investor, involving an international partner may provide access to funding from banks based in the same overseas jurisdiction as the foreign investor and carries with it a certain cachet that can be of particular leverage when trying to negotiate an exit. In addition to funding, international investors can bring a greater depth of deal experience and sector knowledge to what is still a relatively immature PE market.
i Legal frameworks and deal structures
There are two main structures for the acquisition of real property: asset purchase (acquisition of real property directly from its owner) or share purchase (acquisition of a holding company that owns relevant real property).
Where a deal is structured as an asset transfer, the target's liabilities, including tax liabilities and penalties, should not (subject to careful structuring) transfer to the purchaser.
An asset purchase is not, however, a perfect solution for the following reasons:
- there remains a risk that the Russian tax authorities could recharacterise the asset transfer as a 'sale of an enterprise' under which historic liabilities would be treated as transferring to the purchaser; and
- the authorities may attempt to establish that an asset transfer constitutes a fraud against creditors if it is proved that it was designed to evade historic liabilities.
In addition to the risks described, the key disadvantages of a sale of assets are as follows:
- administratively, they are more cumbersome than an acquisition of shares;
- the acquisition may require obtaining new licences and permits, or the novation or assignment of contracts; and
- the acquisition may lead to Russian VAT being payable.
A typical sale and purchase transaction is a two-stage process involving the execution of a sale and purchase agreement and registration of the transfer of title onto the Unified State Register of Real Estate. The sale and purchase agreement must be a single written document.
The handover of the property is effected by completing a document that formally conveys the property from the seller to the buyer (an act of transfer and acceptance).
As a general rule, if a building or other immovable facility and the underlying land are owned by the same person, a sale of the building without the underlying land (and vice versa) is not allowed. If the land is owned by someone other than the owner of the building, the building can still be sold, and the new owner will enjoy the same rights to use the respective part of the land plot underlying the building as the previous owner of the building.
Share purchases are a very popular way to acquire real property in Russia. The major risk of a share acquisition is, of course, that a buyer will also assume all of the target's existing liabilities (subject to any contractual apportionment and post-acquisition risk mitigation strategies). This means that thorough due diligence of the historic activities of the target is crucial.
There are, nevertheless, numerous advantages in a share purchase structure, chief among which are avoiding the need to reapply for licences and permits, a less complex and burdensome acquisition process, no Russian VAT (although please see below certain new developments in relation to application of Russian VAT to share deals) and the avoidance of business interruption.
If the target company does not have a dedicated offshore holding company, it may be advisable to set up a holding company to make the acquisition or, in the case of an asset transfer, to create an offshore holding company with a wholly owned Russian subsidiary (the latter subsidiary being the recipient of the transferred assets). The choice of jurisdiction will largely be driven by tax issues and corporate considerations.
CEMIFs, not being a legal entity, do not participate in any kind of M&A activity.
ii Acquisition agreement terms
Proper PE or M&A transactions traditionally start with the due diligence exercise. There is no standard approach to performing due diligence on Russian assets. Some buyers take the exhaustive, forensic approach normally associated with foreign strategic bidders, whereas others are happy to 'kick the tyres' and place more heavy reliance on the deal protections offered by way of warranties and indemnities (see further below). The approach of PE sponsors in Russia sits perhaps halfway between these two extremes – PE sponsors are acutely aware of customary risks in a particular sector or asset class and are therefore keen to avoid the costs and delays associated with compiling lengthy confirmatory diligence reports.
Since Russian law provides for a strict rule that any transaction involving real property is subject to Russian law, effectively applying the principle of lex rei sitae, the asset deals are documented as Russian law sale and purchase agreements. In recent years, Russian law has implemented several English law concepts such as warranties and indemnities. Therefore, if for certain commercial reasons sophisticated market players decide to acquisition property as an asset deal, Russian law acquisition agreement are drafted in very similar terms as a standard English law share purchase agreement. However, as mentioned above, sophisticated players still prefer to structure their investments in Russian real estate under English law share purchase or framework agreements.
Warranty packages are usually the most negotiated area in real estate acquisition agreements. The exact set of warranties heavily depends on the type of the real property acquired but usually includes title and no encumbrances warranties, property condition, compliance with building laws warranties and warranties in relation to the leases (usually in relation to commercial property). PE investors typically expect more detailed and longer-form warranties than other bidders, but as warranty packages expand in the market in general, PE investors are less likely to be considered out of tune with competing bidders for an asset. As warranties have expanded, so too has the scope for indemnities. Tax and title to group companies and real property are now, more often than not, accepted as a starting point for a discussion of indemnities, with further requests being made on the basis of due diligence findings.
In terms of consideration, payment under real property acquisition agreements in the highly competitive Russian real estate market encourages cash deals.
Another important and heavily discussed term of the real property acquisition agreement is price adjustment. For many years, post-closing adjustments in Russian private M&A and PE transactions took the form of traditional completion accounts; accounts drawn up as of the completion date and delivered by a reporting accountant after closing. This would often involve crucial negotiations regarding the security for any clawbacks or downward price adjustments (typically in the form of deferred consideration or escrows).
However, as parties have sought to simplify deal making, and International Financial Reporting Standards (IFRS) have become increasingly applied in recent years, there has been a marked shift towards the use of some form of locked-box mechanism – whereby the seller warrants the financial position on an accounts date and undertakes not to permit any unforeseen leakage from the date of the locked-box accounts until closing. Dealmakers seek to avoid the uncertainty, cost, inconvenience, delay and adversarial discussion that a completion accounts mechanism often brings.
One of the most important differences between asset deal acquisition agreements and share deal acquisition agreements is the approach to signing and completion. With share purchase agreements, the market tends to favour simultaneous signing and completion or at least a very short period between signing and completion, and no, or limited, post-completion obligations. On the other hand, with asset deal acquisition agreements, signing and completion are always separated due to title registration requirements, unless the parties agree on a different concept of 'closing' (e.g., actual transfer of property versus consideration instead of registration of title versus consideration). This, in turn, influences the payment structure, which may consist of pre-completion, completion and post-completion payments.
iii Hostile transactions
Owing to the lack of a public M&A market in the Russian real estate sector, there are no hostile takeovers in this area.
iv Financing considerations
Acquisition finance to leverage M&A or PE transactions in the real estate market is not a prevalent feature of real estate investment in Russia. The significant majority of deals are equity only and, with increasing restraints on access to international finance markets, the ability to 'self-fund' is more important than ever. That said, there are examples of state banks providing debt financing for acquisitions. Domestic financial institutions and funds such as VTB Capital, Sberbank CIB and RDIF can at times offer the ability to refinance post-investment, which gives them a competitive advantage over other PE sponsors, for example.
The most common security in relation to real property is mortgage, which may be established over real property, lease rights and certain rights to property that are at present primarily reserved for state institutions.
A mortgage as an encumbrance becomes effective upon its state registration and, in the absence of such a registration, is considered to be null and void. The parties may enforce a mortgage without recourse to the courts (a limited number of exceptions apply).
The enforcement options for mortgagees include a public sale and taking possession of the secured asset (this option is not available if the mortgage is granted by an individual).
Where a land plot is mortgaged, all buildings and structures erected or to be erected on the land plot and owned by the mortgagor will be mortgaged by operation of law in favour of the mortgagee. Similarly, if a building or structure is mortgaged, the underlying land plot (if owned by the mortgagor) will be automatically mortgaged by operation of law in favour of the mortgagee.
v Tax considerations
Generally, both Russian tax resident and non-resident companies are subject to corporate profits tax on capital gains on any disposal of Russian real estate, at a general rate of 20 per cent. In addition, the sale of real property (except for residential property and land) is subject to Russian VAT at the rate of 20 per cent.
As mentioned above, it has been common for Russian real estate owners to structure real estate sales through a share deal, often by selling offshore vehicles. The reason for that was that share deals were not subject to VAT in Russia, and in some cases, profits tax could be eliminated via the application of a double tax treaty relief on the disposal of shares. However, Russian tax authorities have started scrutinising the share deals concealing the virtual sale of real estate in order to avoid VAT. Furthermore, during the past few years, many treaties Russia is a party to have been amended to tax disposals of shares of real estate companies (i.e., the assets of which directly or indirectly consist, by more than 50 per cent, of real estate located in Russia) in the same manner as the sale of real estate.
Real property owners, irrespective of tax residence, are also subject to property tax and – in respect of land – to land tax (rates vary depending on the region and type of asset).
As noted above, CEMIFs are not legal entities and are not consequently taxpayers; the management company of the fund pays property tax and land tax, as applicable; it also pays VAT in the case of disposal of real property. However, the management company pays profit tax on its remuneration only, and it is not taxable on income from the disposal or rent of real property, which basically allows a CEMIF to reinvest its income without losing its profit due to tax.
The unit holders only pay their profit tax or personal income tax at the moment of disposal or redemption of the unit, and distribution of the fund's profit to them. For this reason, real estate unit investment funds are presently a popular tool, allowing for legitimate income tax deferral. Russia has started reconsidering its double tax treaties to apply profits tax to the capital gains realised by foreign participants in the real estate unit investment funds.
vi Cross-border complications and solutions
Most PE deals relate to Russian targets and given the current political, economic and regulatory conditions in Russia and the novelty of Russia as a jurisdiction attracting PE investment in the real estate sector, foreign investors are still in the minority. The bulk of the M&A and PE transactions, therefore, involve the acquisition of Russian real estate by Russian bidders. Nonetheless, these deals have traditionally had a strong cross-border element since, as a result of various tax, regulatory and legal considerations, the deals still tend to be structured using offshore acquisition vehicles.
Typical challenges to be dealt with on cross-border transactions in Russia include the increasingly complex regulatory landscape and marrying the applicable requirements of the Russian legal system with those of the chosen governing law of the transaction; sanctions issues; the rapidly evolving taxation regime; the lack of established market practice and relatively few precedent deals against which to benchmark transactions; the related lack of experience of PE deal-making among the business community; and managing relations with the Russian regulators and government.
Russian legislation dealing with controlled foreign corporations (CFCs), which came into force in 2015, has continued to develop in 2016–2017. Although broadly consistent with the OECD and EU approach, these rules remain widely untested in the Russian legal framework and have already started heavily influencing the choice of investment structures.
The Russian CFC legislation sets out rules in the following four areas of tax structuring. First, it addresses the taxation of profits received by the controlled foreign companies of Russian residents but not yet received by the Russian residents themselves. Second, it requires Russian residents holding shares in, or controlling, foreign companies or non-corporate entities to notify the Russian tax authorities of such shareholding or control. Third, it lays down the test for determining the tax residency of legal entities, and lastly, it introduces the concept of beneficial ownership of income for the purposes of double tax treaties.
It is clear from the new law and recent court practice that the aim of the Russian government is to restrict the availability of double tax treaty benefits for recipients of Russian-source passive income where offshore structures are deliberately established to obtain tax treaty benefits for the ultimate beneficial owners of such income. This focus of the government's recent reforms is of key importance to the private equity sector.
Corporate real estate
Since there is no specific incentive (tax or otherwise) to separate corporate real estate from operating companies, such transactions are not common in the Russian market.
As mentioned, market conditions have dampened the enthusiasm of many international investors (with the notable exception of Chinese funds) to invest in Russia and have made fundraising more challenging. That said, existing capital is being deployed by opportunistic foreign investors with higher risk appetites and local players with deep experience. Among this number are Chinese state-owned funds and companies that have shown some interest in Russian commercial real estate, and it is anticipated that they will continue searching for lucrative investment opportunities in the coming 12 months, in line with the Chinese government's policy to focus investment along the old 'Silk Road'.
The continuing development of the Russian government's de-offshorisation programme has had an impact on overall investment activity. This, together with changes to the Russian Civil Code aimed at creating a more flexible onshore legal environment, may put further pressure on Russian investors to return capital to Russia and to invest directly in Russian companies. The traditional approach of structuring deals using overseas intermediaries noted above, may now be in question as a result of this de-offshorisation drive.
How the major players in the Russian real estate market respond to these economic, political and regulatory challenges will be a key factor in determining whether Russia can develop a PE real estate market with substantial scale, depth and liquidity.
Traditional share deal approaches used for selling and acquiring Russian real property may also significantly change owing to major reform in Russian civil law, which started in 2012. It was expected that the whole section of the Russian Civil Code regarding real property would be completely redrafted by introducing new in rem rights. However, this reform was postponed for an indefinite term.
1 Sergey Kolobov is a senior associate at Herbert Smith Freehills CIS LLP.
2 Knight Frank – Investment Market Research, Russia Q3 2019; https://content.knightfrank.com/research/599/documents/en/moscow-investment-market-q3-2019-6835.pdf.
3 Colliers International – Investment Market Year-End Review 2019; https://www2.colliers.com/en-RU/Research/Moscow/annual-Investment-2019.
4 See footnote 2.
5 See footnote 3.
6 Knight Frank – Investment Market Research, Russia Q1 2020; https://content.knightfrank.com/research/599/documents/en/moscow-investment-market-q1-2020-7212.pdf.
7 Forbes Russia – Kings of Russian Real Estate 2020; https://www.forbes.ru/biznes-photogallery/391673-koroli-rossiyskoy-nedvizhimosti-2020-reyting-forbes.
8 Central Bank of Russia – Review of Key Indicators of Mutual and Joint Stock Investment Funds 2019; http://www.cbr.ru/collection/collection/file/27853/review_paif_19q4.pdf.
9 Since the parties are not required to disclose terms and conditions of the listed transaction we refer to credible press coverage and assume that the transactions were structured as private share deals (which is mostly the case for such type of properties).
19 According to Central Bank of Russia, now there are only two such funds in Russia.
20 'Qualified investors' are individuals or legal entities meeting certain criteria provided in the legislation and generally considered as sufficiently experienced participants of the market.
21 The rouble/US dollar exchange rate is 65 roubles to US$1.