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Russia Markets: Why There Isn't a Next Yandex

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Russia shines momentarily with a tech IPO, but has few new companies in the pipeline.

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The IPO of Moscow-based search provider Yandex (YNDX) on Nasdaq last week was a fine moment for Russia. A country more famous for jailing its top oil man saw its leading internet company make a glittering global debut. Yandex raised $1.3 billion for an $8 billion valuation and a price-to-earnings multiple that was twice Google's (GOOG). Then its shares jumped 55% on the first day of trading, subsiding only slightly since.

Yandex is an attractive story in almost every way. CEO and majority shareholder Arkady Volozh is an honest geek originally from Kazakhstan who built the Russian-speaking world's most trafficked site without any Kremlin assistance or special favors. The biggest angel investor is Baring Vostok Capital Partners, run by American Michael Calvey, which has stuck obstinately with Russian private equity since the mid-1990s and finally made a big kill. Veteran U.S. tech guru Esther Dyson sits on the board.

Yandex was not a one-off event for Russia either. Mail.ru (MAIL), which offers the country's leading portal and stakes in its biggest social networking sites, raised $1 billion in a London IPO last November. Mail.ru founder Yuri Milner has earned international fame as an early-stage investor in smoking-hot Silicon Valley properties like Facebook and Groupon.

So now investors might expect a wave of baby Yandexes and baby Mails, a series of smaller Moscow or St. Petersburg software companies looking to monetize Russia's innovative genius while market conditions are so propitious. Except, no. There actually are no more tech companies waiting in the wings, with the possible exception of Kaspersky Lab, the anti-virus maker that has hinted at issuing shares in a low-key way for years.

That constitutes a big lost opportunity for Russia. In software and computer services, the country has essentially substituted imports effectively: Yandex and Mail.ru's networking site V'Kontaktye are soundly beating Google and Facebook on home turf. But it exports little. Annual Russian software exports come to about $3 billion by the optimistic calculations of the RUSSOFT trade association. That compares with more than $55 billion for global leader India.

Language is part of the problem, but a shrinking part, as more Russian managers learn English and more Russian-speaking techies spread across the globe. The real issue is Russia's political and regulatory environment. Whatever calculus produced Bangalore and other burgeoning Indian tech centers, the Kremlin has never seriously attempted to copy it. Official funds and attention have focused on "nostalgia" sectors that bureaucrats were used to managing from Soviet times: agriculture (where Moscow's policies have been something of an unheralded success), and military-industrial (where they have largely failed).

High-tech companies have been treated like other small businesses in Russia, which is to say miserably -- overtaxed, over-regulated, overly harassed by rent-seeking officials, highly challenged to find affordable financing. Small and medium-sized enterprises as a whole contribute just 20% of Russia's gross domestic product. That figure is about 60% in a more entrepreneurial developing economy like Poland's. Authorities also paid little attention until recently to software piracy, which runs more rampant in Russia even than in China and scares foreign tech partners away.

President Dmitry Medvedev is trying to make up for lost time, putting development of Russia's high-tech potential at the forefront of his campaign for "modernization." But his remedies are typically top-down. He puts great store in the brick-and-mortar construction of a would-be technology mecca at Skolkovo, a town just outside Moscow. The president also aims to set up a $10 billion private equity fund ("private" in quotation marks) under the aegis of state bank VEB.

Skolkovo has attracted commitments from an A-list of advanced multinationals, including Cisco Systems (CSCO) and Microsoft (MSFT). But the "Russian Silicon Valley" is a hardware solution, like installing a mainframe at corporate headquarters and expecting that somehow to increase productivity. What Russia needs is a software redesign, a shift in the whole environment surrounding tech and other start-ups from hostile and parasitic to nurturing and helpful. Investors need not hold their breath.
No positions in stocks mentioned.

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