I was an investment banker in London when the Berlin Wall fell in November of 1989. Over the next two years, Russias already weak economy accelerated its steep descent into a state of total dysfunction. By 1992, the centrally planned apparatchik economy no longer functioned. Companies paid their employees in worthless currency. Goods, if they were produced at all, were left abandoned in warehouses because nobody wanted them. Vital products were in short supply and could only be procured with hard currency on the black market controlled by murky criminals. In Moscow, there were very few cars on the roads and shop windows were bare. People walked the streets with their heads held low, and the only public excitement seemed to be at the McDonalds restaurant off Tverskaya Street, where throngs of people lined up to pay a weeks wages for a happy meal for their children.
Over the next few years, Western nations sought to aid their former Cold War enemy in transitioning to the new world order. By mid-1993, with the assistance of the International Monetary Fund (IMF) and the European Bank for Reconstruction and Development (EBRD), there slowly began an almost unnoticeable transformation. The green sprouts of the private sector were beginning to grow. The new economic norm, in which you could buy anything you wanted, had previously been the illegal black market just a few months earlier. Factories that had been producing goods no one wanted were retooling to make everything from titanium bike frames to U.S. replica shotguns. Aluminum smelters with cheap hydroelectric power were suddenly the worlds low-cost producers, exporting every ingot they could make. The old Russian command economy had no choice but to adapt to free market forces, and its workers and consumers were beginning to respond.
By early 1994, Western investors noticed this change. A palpable excitement was building in Moscow: existing hotels were filling with foreign investors, and just as quickly, new infrastructure was being built. The streets were bustling with activity, and everyone was in a hurry to meet someone about a new deal or job opportunity. Amidst this awakening, the government began plans to privatize the entire economy with the help of the IMF and EBRD under a plan designed by Harvard economists. This voucher auction process had already been implemented successfully in Poland, Hungary, and the Czech Republicbut a key difference was that Russias companies were of staggering size in what had been the largest economy in the Soviet bloc.
To a few intrepid investors, it seemed like a once-in-a-lifetime opportunity. Russias entire stock of industrial companies, local and long-distance phone companies, nascent mobile phone franchises, the monopoly electric utility, its cement, forestry, steel, and fertilizer industries, and even its oil and gas complex, which held as much as 40% of the worlds oil and gas reserves, would be transferred to private investors and company management in the course of just one year.
To Russians, it seemed like an odd thing that foreigners were so keenly interested. Virtually all these businesses were bankrupt and didnt have the basic working capital to operate. Russians believed that these assets were worthless and that owning them had little or no value because of the perceived burden of the social responsibility businesses historically had to their workers.
Foreign investors who remembered the lessons of historythat former world powers can recover and reconstruct themselvesknew that this was the time to buy Russian assets. It had happened before. In Germany after World War II, a controlling stake in BMW was sold for the price equal to 50 of its cars. In Japan, when the stock market began a few years after the war, its entire market capitalization was equal to the cost of building two New York City skyscrapers. Flash forward 40 years, and the land under the Tokyo Imperial Palace was worth more than all the real estate in California.
History told a few bold investors that they were going to get rich buying assets for 1-2% of their intrinsic value, which would be realized once the Russian economy was back on its feet and its stock market began functioning akin to those in the rest of the modern world. Russia was one of the largest oil producers on the planet. Their scientists and industrialists had beaten the U.S. to space and given us a good fight in the nuclear arms race. The logic said that after the Cold War, the surplus of human capital and natural wealth would blossom under a free-market ideology and efficient markets would value Russias assets with the expectation that it would become a normal market economy and democratic system like Germany and Japan.
I remember the raw excitement and energy leading up to Russias voucher privatization in 1994. The expectation of getting rich is a visceral feeling. People get very excited about the prospect of making money. Hotel lobbies were brimming with eager foreigners. International banks and brokerage companies were establishing offices and paying staggering wages, even by Wall Streets exorbitant standards. I remember hearing from a banker that a Boeing 747 cargo jet was leaving JFK for Moscow every week full of pallets of U.S. currency that Russian banks were buying as they received wired funds into their accounts from investors positioning to buy these once-in-a-lifetime assets.
As a middle-class kid in the early stages of my career, the things I saw in Moscow were intoxicating and almost unbelievable. Investors were laser-focused and worked tirelessly throughout the day. In the evenings, they lined up in front of Moscows brand-new nightclubs and restaurants. The minute I landed back in the U.S. after two weeks in Moscow, I was already planning my next trip.
Information was the most valuable commodity during the voucher auctions in 1994. Many of the most attractive assets were being auctioned off in unpublicized proceedings and often in remote areas that most investors wouldnt travel to or couldnt access. The small hedge fund where I worked invested nearly $25 million in these auctions from March to September 1994. Many of these auctions involved the largest state-owned companies including RAO UES, Lukoil, and Gazprom. Some auctions were unique, in particular the third-largest cigarette company and second-largest chocolate company in Russia. Within six months, our collective investment was worth almost 10 times our initial capital as the worlds largest investors flocked to get a position in the newest free enterprise economy, which instead of trading at a 99% discount, was trading at merely a 90% discount to Western markets.
I didnt stick around Russia too much longer after the initial surge in asset values, and I had sold out completely by 1997 to finance my own new fund which had a global investment mandate. I survived the Russian meltdown in 1998 when then-Secretary of the Treasury Bob Rubin saw that money flowing to Russia from the IMF bailout was quickly going into the Swiss bank accounts of Russian leaders. He immediately halted emergency funding to Russia, which led to its defaulting on local currency obligations, a banking collapse, renewed hyperinflation, and a second economic meltdown in under 10 years.
In mid-1999, with my own new investment partnership, I began buying back the same Russian stocks I had sold a few years earlier and bought Russias defaulted loans held by Japanese banks just before Boris Yeltsin resigned and replaced himself with an unknown leadera former KGB officer from St. Petersburg named Vladimir Putin.
Historians will argue for the next 100 years about why Putin turned so viciously on the West and its free market and democratic principles. I would just point out that in his first few years in office, Putin was an absolute Eagle Scout, pushing the economy toward Western practices and reform. The stock market responded magnificentlyit was up almost 20-fold from the lows immediately after Yeltsins resignation until 2008. Putin was also the first world leader to visit the World Trade Center site after the 9/11 tragedy with then-President George W. Bush.
I am not sure why Putin became so decidedly anti-Western, seemingly sometime in 2003 or 2004. I have heard many explanations (NATO expansion, the Orange Revolution, being slighted by the Clinton Administration, high oil prices) but none are all that convincing. But I do recall my first inkling that Putin might be a bad guy.
I was in a discussion with the investment committee running the Rothschild family office, which was the largest investor in my fund at the time. Sitting in a NYC hotel high above Central Park, I was explaining how my fund had made so much money in Russia for the second time in my career. They said, Thats great that you are making money and then told me their network of investors believed that Putin had gone to the dark side and that I should be careful. Putin had recently ordered the arrest of Mikhail Khodorkovsky, who was planning to run for president of Russia.
A few months later, I was still making money when Russian immigration authorities at Sheremetyevo Airport blocked Bill Browder, who at the time was the largest foreign investor in Russia, from entering the country. I remember thinking to myself, if I were Putin, why would I prevent a large investor from doing his job? I knew Bill well. We had been friends as young bankers in London when the Berlin Wall fell, and he was an upstanding guy with strong business ties in Russia. And then I remembered my earlier conversation with the Rothschild representative and thought to myself, maybe there was a good reason the family stayed so wealthy for 200 years! By 2006, my fund was no longer invested in Russia.
Most totalitarian regimes never prosper for more than a generation or two. The parasitic behavior of such governments and their bureaucracies eventually drain the economy of its human capital and vitality. But out of this inevitable political failure and economic collapse, there will again come an opportunity to invest in Russia.
John Kleinheinz is a former investment manager with over 30 years of experience in the financial sector. He graduated with an economics degree from Stanford in 1984 and remains involved with the University in various capacities, including his current role as Chairman of the Board of Overseers for the Hoover Institution. He and his wife Marsha live in Texas and are actively involved in numerous business ventures and philanthropic activities through the Kleinheinz Family Foundation. After the fall of the Soviet Union in the 90s, John and other intrepid investors traveled to Russia to invest in state-owned companies. His wild adventures are captured in a new novel, The Siberia Job, out in June.
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