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Dr. Gerd Lenga, CEO of KNAUF CIS Group in 2006–2014

Sooner or later, anyone who supplies goods to Russia asks themselves this question: do you want to continue engaging in trade only, or do you need to manufacture goods on this market? The decision depends on a number of conditions, the significance of which varies in practice. The reader may find some kind of advice in the following that will supplement their own thoughts on the matter.

Any production initiative goes through the typical project stages to establish a manufacturing facility, and begins with general considerations on the investment decision. This is followed by the planning stage, after which you have to ensure the necessary infrastructure is available. Then the construction itself begins. When it is completed, the questions arise of procuring machines and equipment for production, as well as finding personnel. Only after all of this can business activity really begin. This stage, i.e. the actual manufacturing activity itself, always lies in the realm of risk management, since it is essential to take into account the specifics of doing business in Russia and the particularities of working with your own (generally Russian) employees.

1. Any decision to invest in the Russian economy, i.e. to economically engage in capital investments, is both economic and political in nature: business people make their own decisions on expanding business abroad. Or, perhaps, the business has sufficient existing capacity and will continue to try to deliver a certain part of its products to Russia.

To limit yourself to trade alone is an understandable position to take, and one that does not require any particular entrepreneurial ambitions and keeps all expenses in view: the terms of import and export, receipt of possible certificates and permits, distribution channels and logistics, and finally issues of customs and currency legislation – all of them are part of the fairly long but still finite list of questions that have to be addressed. With ongoing operations, they need only to be updated from time to time.

If business doesn’t go as expected, there are no serious costs involved in leaving the market. Thus, on the one hand the risk is limited. However, you have also excluded the possibility of expanding the business, with increased turnover and profits, and sooner or later under the decisive heat of competition you will have to cede an attractive market with more than one hundred forty million consumers, and also – don’t forget! – lose a chance to enhance your business reputation.

Experience shows that with growing success on the market, the chances that appear are rated higher than risks. Based on this, the readiness for investment grows. Here the question should be raised of whether the entrepreneur has sufficient funds to finance the expansion of business abroad. If the desire to invest is stronger than the doubts, the entrepreneur’s chances of doing business on the new market may still be clouded by the financial risks involved: anticipated profits take second place; in first place is the question of the financial capability of the businessman faced with an investment decision.

Anyone who suddenly exceeds the bounds of their investment budget, regardless of the reasons, in the absence of sufficient funds to do so may lose out, sometimes losing everything, as many medium-sized enterprises did in the 1990s. Back then, real costs on organising a production facility were substantially underestimated, and this still applies today: Russia is an expensive country for investors, since setting up a production facility involves more than simply building the facilities. In the majority of cases, the necessary infrastructure must at a minimum be adapted to meet the needs of the facility, if not built outright from scratch.

2. In addition to financial risks, the investor must also attempt to assess the effect of the political situation. The question must be asked: is the current political situation in Russia stable and will the Russian sales market remain attractive for the foreseeable future?

At present, a relatively stable political situation prevails in Russia, which is not an obstacle to investment.

3. However, political stability alone does not justify investment – investors pay more attention to economic development. According to all forecasts, not just those of the Russian Ministry of Economic Development but also those of the International Monetary Fund, the World Bank, and European banks operating in Russia, despite all efforts to stop the development of the Russian economy through sanctions, it has begun, albeit slowly, to grow again: in comparison with our economy the rate of growth is low; however, for gross domestic product it is forecast at 2 % for the next few years, while inflation is expected to be at the unbelievable level of 3 % or even less.

Several sectors, such as agriculture or pharmaceuticals (unfortunately not yet the automobile industry) are already again showing positive trends. Even American investment banks recommend investing right now, and are themselves investing: after the recent difficult years, it is now profitable to acquire a company, all the more so since the contractions and restructuring needed in connection with the crisis have frequently already been completed. Local recruitment consultants recommend stopping staffing reductions gradually, in order to avoid a situation in two years’ time where you again have to compete with other companies for qualified employees.

4. Having established that neither the political nor economic conditions are an obstacle to setting up a manufacturing facility in Russia, the next question to come up is that of the legal framework, specifically: is the legal system that has taken shape over the last quarter century sufficiently stable, or can you expect substantial measures limiting investors’ rights? According to statements, including those recently made by senior officials to the captains of German industry, no restrictions whatsoever are planned, and there have never been any such changes over the period in question. The Russian state is interested as never before in attracting investors and establishing manufacturing enterprises, together with technology transfers in many sectors. The government is even offering financial incentives in this regard: the “special investment contracts” that have been advertised widely and concluded in large numbers in recent years offer various incentives, from tax concessions to subsidies. Limiting the rights of entrepreneurs would not only run counter to this economic policy, but would scare off investors and, of course, the politicians responsible for economic policy know that.

The conditions for doing business in Russia have actually improved according to investors talking about the business climate, as reflected in the review “Doing Business in Russia”, for example. Russia took 120th place out of 190 countries in this ranking in 2011, but since then, despite all the sanctions, it has gradually risen to 31st place by 2019. Although the goal of 20th place set by President Putin has not yet been achieved, Russia is ahead of France and Italy and one place behind Spain.

Complaints remain about corruption and discrimination against foreign enterprises in government purchasing. However, the businesspeople surveyed note significant progress in issues of respect for the law and relations with government agencies. In any case, the digitalization of administration in Russia has already begun, a fact that is not yet being taken seriously by the German authorities. No one disputes that Russia has a problem with corruption; however, there are only a few who will admit that a corrupt arrangement always involves a person who enables this phenomenon with their voluntary contribution. For this reason, it’s fairly simple to deal with corruption – don’t participate in it, and state this position whenever a hint is made. Experience shows that the position taken on this issue quickly becomes well known, and attempts to “sell” certain services are immediately reduced to zero.

Naturally, it should always be kept in mind that here we are talking about Russian law, which defines the legal framework for business activity. Despite the fact that in many respects Russian law took shape under the influence of our legal system, and is therefore even similar to it in certain respects, nonetheless it they cannot be equated. The Russian “tax inspectorate” is not the same thing as the German tax inspectorate speaking Russian, and Russian law still differs in many aspects from German law. All the same, these differences do not mean that we are talking about “bad” law for business people and their activity. It means only that you must work more intensely with the law of the country in which you intend to do business. There are competent consultants for these purposes.

Those who have heard horror stories of business failures (and of course they do happen) should follow the advice of re-examining the situation with a more critical eye, and studying the reasons for the failure: poor choice of a partner, change in personal relationships, inappropriate work with employees, negligence in risk management. These are not the fault of the Russian legal system or tax system, but are on the shoulders of the investor, even when entrepreneurs attempt to locate the reason for their failures in everything but their own actions. Entrepreneurs take a very self-critical attitude when researching the reasons for unsuccessful projects, however in case of failures in Russia this analysis is apparently prematurely abandoned. In this regard, you can only protect yourself from the unexpected consequences of emotional decisions by factoring in a possible “out” from the project and setting aside the required expenses. These expenses are almost never considered in practice.

5. When an investor finally decides to organise production facilities in Russia, with due account of its available financing, the current political and economic environment, and the existing legal framework, this still does not mean that it is ready to implement its plans as quickly as in, say, Germany. The following practical examples show the problems that an investor might face when implementing its plans. There is no need to be frightened, as all the given situations were ultimately resolved in line with all compliance rules, and all the corresponding investments ended up being successful. Some solutions were not found as quickly as the investor might have hoped, however, and in some cases previously unknown individual paths had to be found. In any case, what was left was unplanned time, and time is money for an investor (in this case, losses). Therefore, reserves must be stipulated in the investment budget for these types of unforeseen situations.

The existing legislation on construction offers a compelling and important example when it comes to the placement of production facilities: roof structures in Russia must by law be able to withstand a higher snow load than in Germany. The standards on fire resistance of construction materials and soundproofing also differ from German requirements. For this reason, it is recommended that a local design bureau be engaged in a timely manner for design work, instead of trying to adapt finished projects to meet Russian standards as is often the case. After all, the design projects of foreign architects and construction engineers cannot receive the consent of the state authorities without being reviewed by a Russian design bureau.

The developer’s risks do not depend on construction legislation. They depend on how carefully it checks the site to be developed, on which, for example, the floor of a workshop with heavy installations will be placed together with the imposed additional load from presses and machine tools. The same applies to the expansion joints in a roof with a large surface area, where it is necessary to take into account the extreme variations in temperature in Siberia between daytime in the sun and sub-zero temperatures at night. So, there are reasons why an expansion joint in Siberia must look different than in the Rhine valley.

Those who entrust these tasks exclusively to their construction division that has made a name for itself in Germany or their own engineering firm, and believe that local specialists do not need to be engaged, may repeatedly observe how the floor of their 205-meter workshop gets flooded by a centimeter of water or wonder how and if they can use an additional foundation or rebar to maintain their heavy presses in a horizontal position on a workshop floor that is covered in cracks. Again, the country in which the production facilities are to be placed cannot be blamed for this problem, the real problem is insufficient investment planning and, in many cases, a certain degree of disregard for local expertise.

6. Not only the construction itself, but the installation of infrastructure also involves certain specifics that need to be managed: those who, for example, do not have experience with Russian utilities companies and believe that the latter are deeply interested in acquiring each new client and, therefore, will bring the utilities at least up to the boundaries of the land plot, cannot even imagine how long this might take or the costs that will have to be incurred before they receive, for instance, natural gas at their production facility. And they certainly do not think that the gas supply company’s network expansion plans may change without the entrepreneur having any say whatsoever: sometimes so much time goes by between the selection of the site, design, and receipt of approvals to the start of construction, that the utilities company may no longer consider the territory previously stipulated for connection to the grid as a priority, and for this reason may put off the corresponding plans for decades.

Those forced in this way to switch from natural gas to liquified gas unexpectedly find themselves in a completely new situation that presupposes certain expenses: another utilities company, at triple the price, with completely different logistical requirements due to transportation being performed by railway in tank cars instead of by pipeline, with the entirely unplanned need to create reserves, for which a special storage facility with enhanced safety features must be built.

Many entrepreneurs have had to admit that a power supply company cannot be forced to connect transformer substations and cabin substations to its grid, even if they meet all Western standards: the assumption of the utilities company that this equipment could lead to a short circuit or to a power outage throughout the entire existing grid in the region for which the utilities company is responsible would be enough for the investor to be left without electricity. It can take a long time to overcome these assumptions. Sometime so long that it is easier to switch to the equipment offered by the utilities company. So, those who inquire not about what they need for production, but about the technical requirements and conditions for connection established by the power supply company, come out ahead in the end.

The installation of infrastructure is not always a question of money: as we have seen in our practice, even those who are ready to build unloading stations for a large production facility with 12 railway lines using their own money do not receive the right to use them. In Russia this is a strategic issue, and for this reason cannot be handed over to a private foreign enterprise for resolution. Another reason is that the responsible corporate division of the state railway company will have to put this unloading station on its balance sheet and pay taxes on it. However, the indicated corporate division understands full well that its equity will predictably and naturally be reduced, while its expenses will increase due to the resultant servicing costs. For these two reasons, the director of this corporate division will not appreciate this initiative by the holding company.

7. Many investors believe that close personal contacts (for example, with the head of the region in which they plan to invest) will help them avoid a similar experience. Regardless of how pleasant the display of support by the regional heads, it must be admitted that even the governor can only offer limited assistance. There are very few who can assume the obligation to provide (guarantee the provision of) gas or electricity through one of the major utilities companies, to say nothing of the impossibility to legally force through supplies. This is due not only to political pressure, or, as Russians say, the “administrative resource”, being incompatible with compliance standards. And not only with the fact that Russian governors can be changed often and without warning. It is simply because many utilities companies today are “private” companies, which the state can no longer influence like it did in the past or which it simply does not want to influence. This is why even an agreement signed publicly with a highly placed regional official must be checked from a legal standpoint for enforceability, or even better should be concluded with the participation of the utilities companies.

8. Many of the indicated problems can be avoided by organising the production facility as a Brownfield project, under which the existing infrastructure can be used, and by agreeing on long-term supplies of power, gas, water, etc. (so-called “limits”). Unlike placing a production facility based on a Greenfield project, in which case the planned placement of federal high-voltage lines or an obsolete railway bed that could be legally considered a strategic railway line must be taken into account, a production facility created on the basis of an already existing enterprise can guard against such surprises.

Nevertheless, Greenfield projects, in which there is no risk of “old baggage” that could lead to unpredictable risks, are the most common. This, of course, is true, but one should not forget that such problems can be resolved through the performance of due diligence procedures by qualified specialists in relation to such an “inheritance”. This procedure can rule out the corresponding risk, as is the case on the performance of mandatory legal and tax due diligence. One should also not forget that here we are always talking about lower costs compared to the creation of infrastructure from scratch.

We no longer say that the investor, in the case of a going concern, may generate an income, however small, from the very first day. When creating a production facility from scratch, it will only incur expenses during the first one or two years. This fact triggers thoughts on taxes. In view of frequently unsubstantiated skepticism, certain investors also underestimate the advantages of experienced employees compared to new employees if the former have been trained and motivated for new production facilities.

9. However banal it may sound, German entrepreneurs nevertheless fail to adequately factor in that Russian employees not only have a different mindset compared to their German colleagues, but also a different level of social participation and a different education. Meanwhile the mindset and social participation depend to a large extent on the personal and social setting in which the individual develops, and that is subsequently hard to influence when it comes to education; in our opinion here the educational system, with its differently oriented curriculum, is primarily responsible.

In Russia, unfortunately, the educational system does not have “dual learning” when people receive training on practical, professional skills in addition to theoretical knowledge. Numerous German entrepreneurs accordingly decided to independently train employees so that they satisfy the requirements of their workplace. Moreover, this is happening more and more in cooperation with other enterprises as a model experiment, with a focus on dual education.

The issue being addressed here therefore does not concern only the lack of knowledge or skills, as these can always be acquired. More serious problems relate to differences in mentality and social participation. For example, it is extremely hard to explain what a German manager means when he uses the word “Mitdenken” (“thinking together”). It is worth noting that there is no comparable concept in the Russian language: this could become a serious challenge to be communicated to the Russian employee that he should in his activity always “think together”, in other words, constantly think not only about his activity and certain processes, but about the possible development and consequences of his activity. This can only be achieved in instances when such “thinking together” is communicated to employees through explanations and even for clarity through their own example, that is, “exemplify”, a word for which Russian has no direct equivalent.

Comparable efforts will be required in order to compel the Russian employee to assume responsibility. If German entrepreneurs agree with each other about anything, it is that the most complex task in Russia is to find a manager who is ready to make decisions independently and to assume responsibility for these decisions. The issue here is not that entrepreneurs want to foist their responsibility on others (that issue is governed by legal regulations), and not that they want to have a scapegoat in case of doubts, but simply that they want management personnel to take decisions independently and quickly, without searching for a safety net. And this can only be driven home based on personal experience that includes acknowledgment of errors that the individual can make.

Efforts to select the right workforce and with the help of exemplary actions to transfer to them your views on how the production process should be and what are the anticipated results are part of the process of organising production facilities, on a par with the assembly of equipment and machinery, and this needs to be recognized. However, this does not replace the need for constant technical and financial oversight. Whoever feels tired or lets their guard down should not be surprised that everything does not go as planned. Furthermore, in the production area it does not cost that much to benchmark your company against other production platforms when it comes to consumption and output in such a way that an deviations that require an explanation can be determined. Experience shows that such comparisons, if conducted regularly and popularized, can motivate employees to outperform their colleagues at the company: In Russia there are production enterprises that rank first even in terms of technical productivity globally within the framework of a group of companies. Consequently, successful examples of the set-up of production facilities show that there are no longer differences between Germany and Russia on product quality issues.

10. As regards financial indicators, then the Russian subsidiaries more often rank first in ratings as part of a concern, even if this is not always spoken of with pleasure, either for reasons of competition, or to avoid internal discussions. It must be admitted that this happened, admittedly at a time when the state of the market was different, oil prices were high and there were no sanctions. Nevertheless, regular benchmarking with the performance of other companies in one group is entirely justified. In any case, this means objective benchmarking, net of expenses that cannot be influenced by the Russian subsidiary, as they are attributable to the decisions of the head office. Every company doing business in Russia knows about transfer pricing issues. Consequently the difference in the level of prices of supplies and also when related companies provide services should be regulated by the market, and not by using excessive prices to accumulate profits in Germany where it was not in fact generated. Such practices are already under the control of the Russian tax authorities.

It is also interesting to consider performance that has not been reduced by current EBITDA or EBITDA, but instead income net of capital expenditure, with due account of the invested capital, in other words the performance of Russian production facilities based on economic value added. Here you can see even more clearly whether the investments, in other words, the setup of production facilities in Russia, are actually worth it.

In each country managers exchange opinions regarding the market, their business and problems, when they live so to speak in a diaspora as in Russia. And for this purpose, you have not only such institutions as foreign chambers of commerce or trade missions or European Business Associations, but also independent platforms unrelated to the external (economic) policy of the country of origin. The leaders of multinationals doing business in Russia can be encountered in Moscow on a regular basis in the biggest network of such “business groups”, which naturally must not be named for the purposes of retaining anonymity not only for the purpose of exchanging opinions, but also in order to learn anonymously, on the basis of their own experience and therefore with a certain degree of reliability, how colleagues from the same industry assess the development of the market and its results. Knowledge of the market and the opportunity to benchmark a company’s performance in Russia against that of the other subsidiaries of the other concerns, are therefore at times more extensive than business people in Germany often think. Therefore it is currently held that it is quite possible in Russia to engage in production and demonstrate results that turn out to be justifiable compared to the other participants of the group.

11. In conclusion it is worth noting that you have all the prerequisites for successful production. For this purpose, a real estimate of the facts and legal framework, careful financing and technical planning, and also a great deal of patience are required.

Anyone, who has any doubts on this matter, should simply talk to people who already have experience of working in Russia.

You have also to ask what is of interest to investors in Russia’s current economic policy. It is worth highlighting first and foremost the attempt to localize production capacities in Russia and within this framework proposing the creation of added value in the country, and accordingly attracting technologies to the country. However, this approach is not unique and characteristic only of Russia. If we look at the example of American economic policy, then compared to American import duties on goods, which are set in prohibitive amounts and to an unimaginable extent, it would be virtually impossible to characterize Russian tax concessions for the setup of the production facility as actual pressure. Especially if concessions are granted only to parties that conclude transactions with the Russian state as a client.

For the first time in the English language this publication covers the relevant legislative provisions extensively, including industry rules that are applied when setting up production facilities so that the investor is able to avail itself of the benefits of localizing products in Russia. The materials contained therein extend far beyond only the topic of localisation – they highlight the economic and political conditions under which it is possible to work in Russia.