• INTRODUCTION – GENERAL INVESTMENT PHILOSOPHY

The Focus is on Russia –
The Nikitsky Fund is focused on identification of deep value in the Russian small- and mid-cap market sectors – primarily assets privatized in the early 1990s, rather than the more recent wave of IPO’d assets. Nikitsky focuses primarily on “old-economy” type physical assets – mines, heavy industry, refining, chemistry, construction, etc.
The Russian market is evolving as the fundamental economic incentives change: macroeconomic stability and far greater predictability have incentivised company owners to invest in their firms and to show earnings, while enhanced access to capital markets and improving regulatory oversight and tax enforcement are leading to a steady improvement in transparency.
Careful consideration is given to the incentives of company management and – given the still-imperfect legal environment in Russia and the CIS – as a rule, the Fund will seek to align its interests with the interests of management.
While a catalyst is frequently required to trigger the revaluation of relatively illiquid assets, careful valuation must be carried out to ensure that, if the expected catalyst does not occur, the position will still be attractive in terms of fundamental indicators: cash flows, EV/EBIDTA, book value, etc.

…and on Small/Mid Caps
The last ten years have seen a steady pattern of sometimes-spectacular revaluation of sectors and companies initially ignored by the market due to mismanagement, illiquidity, inadequate size (in terms of reported financials) and flagrant corporate governance abuse. We think that there are many more waiting to be discovered.
Every Russian stock was once a small-cap, and even if you believe that all of the 50 stocks in the RTS have their full potential priced in (and we don’t), there are some 850 stocks still awaiting revaluation. While some of them are truly worthless, in many other cases, they are undervalued simply because the market hasn’t discovered the company, or because management is unwilling or unable to reveal the potential revenue growth.
As management incentives change, Russian market has shown time and again that good things come to those who wait, and who are willing to buy when others are selling. The managers at Nikitsky Fund have lived through several boom and bust cycles in Russia, and have learned that a steady hand, and a belief in fundamental principles, will win out in the end.

• FUND STRUCTURE

-What is the basic structure?
Standard hedge fund structure, Cayman Islands-registered, KPMG audit, tax-efficient Cyprus trading vehicle, independent valuation by the company administrator, Apex Fund Services Ltd.

-What if you do not reach your minimum?
The Fund documentation calls for launch only if a minimum amount of capital is raised.
This minimum was exceeded by the first value date – the fund is now irrevocably launched.
-Why two share classes?
Nikitsky is a series fund. Class 0 is the initial investor class, with slightly lower fees and no lock-in. It is currently still open for subscription.
-Class A is similar, but with a higher minimum investment and early redemption fees: 7.5% - year one, 5% - year two; 0% - subsequently.

-7.5% seems fairly stiff!
It was requested by our initial investors, whom it is designed to protect. Redemption fees are meant to protect the longer-term investors from the danger of Nikitsky being forced to liquidate positions during a cyclical bear market. The redemption fees are, of course, remitted back to the fund for the benefit of the remaining shareholders.

-Who values the Fund? On what basis?
To avoid any ambiguity, all positions in the Nikitsky Fund are valued at mid-market. Anyatta, the Fund advisors, prepare a preliminary valuation at the end of each month which is then submitted to Apex, the fund administrators, who independently check all prices, verifying cash positions and custodian reports. Results are published on (or about) the 10th of each month.

• WHO ARE YOUR CURRENT INVESTORS? WHO SHOULD INVEST?

The great majority of our early investors are market professionals with exposure to and experience in the Russian financial markets. All of our initial investors were readers of Eric Kraus’ market strategy publication, Truth and Beauty (…and Russian Finance) which can be downloaded from www.nikitskyfund.com.

-Why do you say it is not suitable for short-term trading?
We are selling alpha, not beta. The companies we identify generally have limited liquidity, and we await the triggers that will unlock their value. This is not a smooth, continuous process, and it often requires considerable patience. The Nikitsky Fund aims to attain high medium-/long-term returns from the Russian restructuring story. It is NOT a trading vehicle, and is thus not suitable for short-term trading of the Russian market – for which some of the long-only funds providing daily liquidity are more appropriate.

-But I am running a fund of funds…
Only investors willing and able to tolerate short-term volatility in return for above-par expected medium-term returns should consider investing. Funds of funds and other entities requiring substantial liquidity have taken positions in Nikitsky which are relatively small as regards their overall AUM – viewed as part of a value-enhancing, medium-term core position.

• INVESTMENT APPROACH

-What is your general investment approach?
Nikitsky fund is a deep-value, long-short investment vehicle with a medium/long-term time horizon, primarily trading the Russian small/mid-cap equity sector. We generally find the greatest value in the privatized Russian assets sold off by voucher privatization, management buy-outs, etc. in the early 1990s. Many of these companies will eventually do an international IPO – providing an exit strategy.

-I am a bit confused with your talking about IPOs as an exit strategy – I though you only did listed equity.
For those not familiar with the Russian market, it can be confusing. The great majority of Russian companies currently doing IPOs have RTS-traded “legacy” shares, i.e. domestic shares issued in the initial privatizations of the early 1990s. These companies tend to do their inaugural international IPOs at prices well above the local 6-month average equity price, offering substantial upside to the holders.
Furthermore, we will on occasion participate in pre-IPO placements managed by a reputable Russian broker, who undertakes to subsequently make a market in the securities.

-Are you heavily involved in Russian IPOs?
No. With a precious few exceptions, given the combined influence of greedy international investment bankers and overly-optimistic Russian company owners, we find them overpriced. In particular, we emphasise the importance of aligning our interests with those of management and we are wary of those IPOs in which the reference shareholders are seeking a partial cash-out.

-Any exceptions?
Yes, certainly. The RBC placement was reasonably priced, and the growth story was irresistible. Other business services start-ups not susceptible to rapid arrival of foreign competitors (e.g. IBS) may be worth a side-bet. These are, in general, start-ups, in sectors which are brand new for Russia. On the other hand, we are particularly wary of overpriced IPO’d shares of Russian retailers who may be highly susceptible to foreign competition.

-Do you engage in activist investment?
No. We consider it to be, even at best, an expensive waste of time – at worst it can be deeply counterproductive. We feel that our investors’ best interests are served by having the fund seek to align itself with the interests of management – not trying to force change on unwilling reference owner with interests radically different from our own.
Activist investing in Russia is suitable primarily for venture capital funds or others willing to take equity stakes of 25%+ in return for board representation. Nikitsky will not take management stakes in any company, though we will, of course, support activist investors with our votes.

-How do you feel about mixed state-public companies?
Strictly neutral. The fund aims to enhance value, not to advance any given ideology. Despite the obvious drawbacks of state ownership, companies in which the Russian government has a stake are often more stable than the fully privatized ones – and as the State seeks to enhance revenues from its portfolio, dividends may improve. While certain mixed state/private companies have done poorly, others (e.g. Gazprom, Transneft, Sberbank) have showed spectacular out-performance.

• INVESTMENT PROCESS

-How do you source your ideas?
A wide variety of sources. Research from the small Russian brokers is not to be scorned as a source of new ideas, especially as it gives some indication of where the liquidity and market interest lie. Regional business contacts and travel to the provinces provides useful information, as do a wide range of business contacts in Moscow; the local “buzz,” in particular among the Russian investment funds and brokers, is vitally necessary.

-Bottom up or top down?
Both, but more frequently top-down, i.e. we become interested in a given sector for macroeconomic reasons, then seek to screen the various companies in the sector.

By way of example, when the Ukraine gas crisis occurred, we sought to determine which of the Ukrainian industrial sectors would be most affected, and which were the competition for Russian industrials. While the fertilizers and chemicals would be most affected, in fact, they did not export to Russia, and their exports to the EU would likely enjoy compensatory tariff reductions.
We realized that the Ukrainian pipe-rollers provided tough price competition for the Russian mills and that their cost base was about to see a substantial increase. We thus purchased the Russian pipe-mills facing the greatest Ukrainian competition, in particular those providing high-quality, coated 1420mm pipe to Gazprom.
Similarly, in the short term, some of the main winners from the electricity sector reform will be neither the generators nor the distributors, but rather, companies building infrastructure or providing capital equipment to the new electricity companies. We are currently evaluating their ownership structures.
Of course, when we find an individual company with a potential value-driver, we will investigate further, even if it is not in one of our preferred sector.

-How do you conduct your due diligence?
Russia is not susceptible to “cookie-cutter” numerical screening. Each company must be treated as a separate case. RAS and (when available) IAS accounts are compared, and when possible, we seek to meet with management. Bond prospectuses are carefully compared with information on company websites and disclosure documents. Management structures are assessed to determine who the reference owners are, and what is their strategy.

In some cases, a key exercise is to find out how much a company physically produces, preferably from third-party sources. We then work out how much they might sell that for, and use that to estimate the company’s real revenues. Long term news searches often reveal a lot about how the asset was privatised, and who might be interested in acquiring it in the future.

-What are your exit strategies?
There is not an imperative need to have an exit for companies which are actively traded in the market, however, when companies in which we own privatized shares finally do an IPO, this is generally a cue for us to take profits, since they are then nearly- or fully-valued and heavily researched by the blue-chip investment community. Other potential exits include consolidations into holding companies, strategic investments, and simply emergence of the company as a more transparent and liquid mid-cap asset.

• GEOGRAPHIC SPREAD

-Do you have any Ukraine/Kazakhstan?
While this is allowed by our investment mandate, at the present time, we are solely invested in Russian equities. This for two main reasons:
→ First, many funds seem to be going into Ukraine and Kazakhstan simply because it is fashionable. This is particularly the case for Ukraine – far less transparent even than Russia, and suffering substantially greater political and macroeconomic risk, especially for a market which does not strike us as being particularly cheap.
→ Secondly, there are thousands of companies in Russia, hundreds of listed companies, and no shortage of opportunities far closer to our Moscow base.
Kazakhstan is seen as relatively stable, with a more beneficent hydrocarbons tax regime, and is an interesting resources play. Nevertheless, many of the purportedly high-growth companies are in fact “wild-caters” – by nature highly speculative, and frequently priced for perfection, in many cases due to hype from the local Russian brokerages who find that they can make more money in the outlying regions.
Finally, the idea of using the peripheral CIS markets as a risk-diversification tool is fundamentally flawed. In a general market correction, Ukraine in particular would likely become totally illiquid. Therefore, we see it as a candidate only for deep-value investing.
Needless to say, we are watching for compelling opportunities in both countries.

• RISK/VOLATILITY

-You warn that the fund is likely to be volatile - Isn’t this rather risky?
Please do not confuse “volatility” and “risk” – these are two totally distinct concepts!
Perhaps the fundamental problem is behavioural: there is no mathematical test to measure risk – while there are numerous and precise mathematical tests for the measurement of volatility.
Therefore, deprived of a simple means of measuring the all-important risk, many investors simply measure what they can, i.e. volatility, taking it to be a measure of “risk” – which it very clearly is not, at least for funds which do not claim to be market-neutral.
As just one example, in the first half of 1998 the Russian Rouble exchange rate had extremely low volatility – as subsequent events demonstrated, it was very clearly not low-risk!
Since 1999, on the other hand, the Russian equity market has been fairly volatile; we would argue that, given the excellent macroeconomic numbers, rapid and sustainable economic growth, and rapidly improving corporate risk profile, it has in fact been lower-risk than most of the emergings, and indeed, perhaps safer than one or two of the G7 economies.

-So, how do you manage risk?
Portfolio diversification is the main risk-management tool (see portfolio construction). Equity positions are rigorously risk-weighted.
Before entering into a position, we systematically pose the vital question: “and what if we are wrong?” No matter how attractive, the size of positions in the smallest illiquid growth opportunities is kept low (<2.5% total portfolio) due to their inherently higher risk. Positions in more liquid and transparent mid-cap stocks may account for up to 10% of the portfolio.
Equally, sectorial diversification is maintained, and we avoid becoming overly exposed to oil, metals, etc.
Tight stop-loss limits are placed on any short positions, which are generally held for relatively brief periods.
The fund positioning is evaluated regularly, and at least monthly, for assessment of risk.

• PERFORMANCE

-What was your performance during the May market downturn?
The Nikitsky fund was not invested. In preparation for the launch of the new fund we were in the process of winding down the managed account. While our initial intent had been to launch at the beginning of March, we encountered a series of administrative delays, causing us to put back the intended launch to April 1.
By the time we had our ducks in a row, the market appeared to be dangerously close to a near-term top; rather than either running a serious risk of seeing a substantial drawdown during our first few months, or having to go outside of our stated mandate by starting out predominantly short, we preferred to delay the launch by one quarter. Thus, our first month was July 2006.

-But how would your strategy have performed?
Quite frankly, not particularly well. The Nikitsky Fund is a deep-value fund, and the mark-to-market can be expected to suffer at times when the market-makers step away. Revaluation of illiquid assets is not a smooth, continuous process, and we would suggest that investors give limited credence to the monthly performance numbers – which can be affected by the widening/narrowing of dealing spreads and trading by retail funds, instead focusing on our medium-term results.

• PORTFOLIO CONSTRUCTION/COMPOSITION

-How many positions will you ordinarily have?
25 - 35 lines, i.e. about 30 signatures (in some cases, we have both ordinary and preferred shares of the same company).

-What is meant by a small/mid cap in Russia?
Russian “small caps” would be mid caps in most other markets. We would not look at any company with a fair market cap below $100M USD. Some of them will currently have market caps below this threshold, but that is an issue of valuation, transparency, and visibility of cash flows.

-So, how do you define them?
On the basis of trading criteria – i.e. when trading blue chips one can request a $5 X 5M market at any time. For the mid caps one can move one million or more during the day. Small caps trade less frequently, and considerable skill and diligence can be required in building and selling down positions (see chart, below).

-What is the average P/E of a company in your portfolio?
That, unfortunately, depends on how you define it! Defined by published numbers, some constituent companies will have relatively modest earnings. On the other hand, defined by what we think their real cash flows should be, most of the portfolio small caps have a P/E below 6.

-Do you participate in private equity transactions?
No. All assets must be priced on the RTS website, or, in the case of public pre-IPO financing rounds, by a reputable broker.
.
-What is your portfolio turnover, age of holdings?
Given the limited liquidity, portfolio turnover tends to be low. Nikitsky Fund will trade opportunistically in order to take advantage of market momentum, when a position becomes seriously overvalued, as well as top-slicing to prevent any one position from becoming too large; this trading will typically account for a small part of the total portfolio.

Tier	Description	Trading Criteria	Examples	Typical Mcap1	Proportion of Portfolio
1a	Most liquid Blue Chips	25 x 25 M markets	Lukoil, Gazprom	>25bn	None
1b	Smaller Blue Chips	5 x 5 M markets	Polyus, Novatek	>10bn	20 - 30%
2	Liquid Second Tier	daily trading, spreads < 5%	Fixed Line Telecoms, Pipe-rollers, TNK-BP	>2bn	40 - 50%
3	Illiquid Second Tier	Inside market generally available through IDBs	Refiners, mines, nuclear fuels	>1bn	20 - 25%
4/5	Virtual Private Equity	Occasional trades, largely off-screen	Construction companies	>500M	10 - 15%

¹ As recalculated by F.M. Note that market cap is a tricky number, which can be depressed by problems of transparency, liquidity, etc. Furthermore, some assets such as TNK-BP trade as second-tiers due to their very limited free floats, despite a market cap similar to that of the blue chips.

• SHORTING

-When/Why do you go short?
Shorting is generally carried out for profit, not as a hedging tool. The Fund will seek to short highly liquid assets (blue chips) which are fundamentally overpriced.

• CORPORATE GOVERNANCE ISSUES

-“Russian Corporate Governance” – isn’t that an Oxymoron?
That was certainly the case in the 1990s, but over the past 6 years we have seen huge strides. The regulators are forcing companies to improve their disclosure if they wish to raise finance in the bond market – these prospectuses and quarterly reports are freely available on the internet. The cumulative success of Russian IPOs in the West means that more and more managers see this as a realistic exit, which gives them an incentive to be more investor-friendly (of course, our plan is generally to sell ahead of the IPO…but we don’t tell them that!)
Russian corporate governance standards for the blue-chip companies range between best international standards (e.g. LUKoil, MTS) and fairly dire (e.g. Rosneft, Surgut). The best opportunities are often to be found not in those with the best current governance, but rather, where an ongoing improvement in practices is underway.

-Do you seek board representation in your portfolio companies?
NO. Nikitsky is not an activist investor. In Russia, it is far more advisable to align oneself with management; if company management is seeking access to international capital markets, consolidation, or simply to increase their own wealth via the equity market, then we want to find ourselves facing in the same direction. If they are attempting to squeeze out minorities, we would generally prefer to seek a good bid so as to leave before we are pushed.

-Isn’t Russian corporate governance even worse in the second-tier companies?
Yes (fortunately). Every Russian blue chip was once a small cap. As the economic incentives have changed, so has behaviour. Both carrots (the desire of the reference shareholders to increase their wealth in the stock market) and sticks (better tax enforcement with the threat of criminal penalties) are driving companies to enhance their governance standards. Best returns are to be had by buying them early on in this process.

• And what if Oil Prices were to take a Bath?

Since 1999, many people have found this to be a convenient reason not to invest in Russia… meanwhile, the market has surged 20-fold…There are two salient points:

-First, Russia now has the world’s 4th largest foreign reserves – some $280 bn, and counting, in addition to an oil reserve fund which is expected to hit $90bn by year end. Especially since a collapse in oil prices would be deflationary, this extraordinary fiscal situation would leave the government a free hand for aggressive pump-priming measures in the unlikely event that it were to become necessary.

-Secondly, it is simply not going to happen! The secular rise of China and India has permanently altered the global petroleum balance. Massive industrial growth in the developing countries is the primary driver subtending Russia’s economic resurgence, and is not likely to reverse in the coming decades…and a medium term sell off in oil will not abolish the European Winter!

Of course, markets are not fully rational places, and a short-term correction in oil prices cannot be excluded; the Russian market would not be a happy place during this hypothetical event. The Nikitsky Fund is heavily underweight oil by comparison with the RTS, not because we are concerned with a collapse in oil prices, but simply because we see better opportunities elsewhere.

While we see market risk, given the fiscal situation, no credible oil price scenario would imperil the underlying Russian growth story – the value basis for the Nikitsky Fund.