COMMENTARY: An admonition and overview about investment in Ukraine (03/12/06)

COMMENTARY

An admonition and overview about investment in Ukraine

by Richard A. Shepard

In Ukraine the period since December 2004 has generated emotions ranging from elation following the successful Orange Revolution, to frustration and huge disappointment among those who felt that the events at the end of 2004 signalled a complete break with the past.

Neither of these two conclusions, among many others, was or is reality-based.

The economic, social, legal and political structures, although shaken and modified, remain challenges to be addressed and are not susceptible to euphoric sloganeering, patriotic songs or fictional certitudes. Those who think that enacting new laws and regulations is enough to overturn attitudinal beliefs are simply not being practical.

Since independence Ukraine has put into place a vast number of new laws that should promote economic development and investment. The laws include a new Civil Code, Commercial Code, Economic Code, Land Code, Law on Financial Leasing and Law on Bankruptcy, to name but a few.

However, issues remain - not the least of which are the contradictory provisions among these laws and their implementing regulations. Hanging over the moves to implement a market economy through enactment of laws is the restraining influence of a culture of corruption that arose prior to independence and continues in various forms today - although far less than some believe or would like to believe. Further hindering faster investment, both local and foreign, is the regulatory bureaucracy that fosters rent seeking (the process by which an individual or firm seeks to profit by manipulation of the economic environment) and, above all, reflects a generational need for control.

The bad news, to be blunt, is that a generation that lived, learned and came into controlling positions at all levels of central and local government during the 1980s must fade away or, in some cases, be pushed out, before rapid change can take place. The good news is that the process is under way and with experienced assistance, investors can and do create successful businesses in Ukraine.

In the first six months of 2005, investment houses, law firms and businesses all witnessed a significant increase in investor interest in Ukraine relative to that which existed between 2001 and 2004. Nevertheless, many potential investors visiting during the past year were still extremely hesitant to commit funds, and planes that are filled flying to Prague, Budapest and Warsaw arrive half empty to Kyiv. The reasons are varied and include a perceived instability in the government and, incorrectly, an equally unstable business environment.

The perception was reinforced by the frequent prevarication by the competent but apparently leadership-challenged President Viktor Yushchenko and the sacking of Prime Minister Yulia Tymoshenko and the Cabinet. These same investors continued to point out that they would need to wait until the next election in March to see what government emerged.

It will make little difference. Power struggles in the government are not new and will continue - particularly if Our Ukraine does not win a majority and must form a minority government.

But, investors should be reminded that the strongest growth of the Ukrainian economy took place under the less than democratic rule of President Leonid Kuchma, a regime that was riddled with extreme corruption although seemingly stable. Furthermore, many successful investments - one need only look at Eric's Family of restaurants and clubs, Nestle, Coca-Cola and others - were started during far less appetizing times.

Real estate investments, executed properly, have been remarkably successful in the past two years, notwithstanding the recent scandal resulting in the loss of up to $100 million in a pyramid scheme involving apartment construction. In the case of the latter, investors must remember that the elaborate secondary and tertiary financing of these apartments combined with the probable lack of any serious due diligence, constituted an exceedingly perilous investment. It is not the norm, though the ripple effect will damage the industry.

However, waiting until "Ukraine is ready," as I have heard on numerous occasions lately, is to advocate a waiting game where the investor, not businesses looking for investment, is perpetually moving the goal posts. Ukraine is not for the risk-adverse. But, risks can be managed, pitfalls avoided and investments made profitable with hard work, a realistic understanding that money must be spent for lawyers and advisors, and not a little bit of patience. For those looking for high returns with no risk - well, such a world does not exist. Invest in U.S. government bonds or put your money in a CD.

For those willing to take a deep breath and take on the challenge, then the possibility of 25 percent or more return on investment is certainly do-able. Private equity investment, preceded by extensive due diligence, sound business relationships and proper documentation is much more likely to succeed for all involved.

Not all investments involve steel mills, mining operations or other multi-million dollar efforts. Investment opportunities exist in small and medium enterprises occupying niche markets, such as software development, small hotels, distribution centers and financial leasing and other consumer-oriented industries, which do not require high, eight- or nine- figure, investments.

In the future, I will discuss some of the smaller opportunities and the necessary steps that must be taken to secure investments. In the meantime, those who would like to invest amounts ranging from $1 million to $5 million should seriously consider investigating the market in Ukraine and not be too concerned about the spectacular horror stories of steel plant privatizations, housing construction scandals or the trials and tribulations of some smaller investors who have run afoul of the formulaic regulatory environment or less than savory partners largely due to their own unwillingness to strictly follow the rules, conduct proper due diligence or pay for either.

Postscript

Shortly after this article was written, the U.S. government awarded Ukraine market economy status. This designation is extremely important for Ukraine and indicates an acknowledgement of the successful legal and economic reforms that have been implemented by the government of Ukraine, as well as the moves to suppress corruption.

Richard A. Shepard is a director of Vesselka LLC, a Delaware limited liability company with an office in New Jersey and presence in Kyiv with over 30 years' senior management experience in multi-national companies and private consulting.

He has lived in Ukraine since 2001 and was regional director of the Eurasia Foundation through 2003. In that capacity he was responsible for managing a $4 million annual budget and providing funds to support non-governmental organizations in Ukraine, Belarus and Moldova for business development, civil society and regulatory reform.

From 1994 to 1997 he was senior legal advisor and then project director in the Russian Federation implementing the development of a real estate information system in six cities. Between 1998 and 2001 he also was project director for a real estate market reform and title registration project in Armenia. Armenia remains the only country in the CIS with a nationwide, electronic title registration and mapping system guaranteed by the government.

Mr. Shepard has also provided consulting services to the World Bank and the United States Agency for International Development in Macedonia, Uzbekistan, Georgia, Russia and Ghana. Vesselka LLC concentrates its activities on identifying, managing and consulting on a variety of investment opportunities in Ukraine with an emphasis on small and medium enterprises engaged in high-medium tech industries and the service sector.

He may be contacted at rshepard@justice.com.

| Home Page |