Foreign Assistance: U.S. Russia Fund Is Following Its Investment
Selection Process and Criteria (Letter Report, 10/02/2000, GAO/GAO-01-2).

This report summarizes GAO's findings on the United States Russia Fund
and its investment selection process and criteria. The United States
established enterprise funds to support private sector development in
selected countries of Central and Eastern Europe and the former Soviet
Union as they transform from centrally planned to market-oriented
economies. Enterprise funds are private, nonprofit United States
corporations which are supposed to make loans to, or investments in,
small, medium, and large sized businesses in which other financial
institutions are reluctant to invest. The Fund is authorized to receive
$440 million through the Agency for International Development. As of
March 2000, the Fund had invested $114.4 million in 30 projects through
its direct investment program which provides loans and equity capital to
businesses in Russia. GAO's analysis showed the Fund followed its review
process and criteria for selecting direct investments.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GAO-01-2
     TITLE:  Foreign Assistance: U.S. Russia Fund Is Following Its
	     Investment Selection Process and Criteria
      DATE:  10/02/2000
   SUBJECT:  Investments abroad
	     Foreign economic assistance
	     Private sector practices
	     Foreign aid programs
	     International economic relations
	     Funds management
	     Private sector
	     Nonprofit organizations
IDENTIFIER:  Russian-American Enterprise Fund
	     U.S. Russia Investment Fund
	     Russia
	     Fund for Large Enterprises in Russia

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GAO-01-2

A Report to Congressional Requesters

October 2000 FOREIGN ASSISTANCE

U. S. Russia Fund Is Following Its Investment Selection Process and Criteria

GAO- 01- 2

Lett er

October 2, 2000 The Honorable Ted Stevens Chairman, Committee on
Appropriations United States Senate

The Honorable Mitch McConnell Chairman, Subcommittee on Foreign Operations
Committee on Appropriations United States Senate

The United States established enterprise funds to support private sector
development in selected countries of Central and Eastern Europe and the
former Soviet Union as they transition from centrally planned to market-
oriented economies. Currently, 10 funds cover 19 countries in these regions
with authorized funding of about $1.3 billion. Enterprise funds are

private, nonprofit U. S. corporations that are supposed to make loans to, or
investments in, small-, medium-, and large- sized businesses in which other
financial institutions are reluctant to invest. 1 In 1995, the United States
established the U. S. Russia Investment Fund by merging two earlier Russian
funds- the Russian- American Enterprise Fund and the Fund for Large
Enterprises in Russia. 2 The Fund is authorized to receive $440 million
through the U. S. Agency for International Development (USAID). Although
USAID has primary responsibility for monitoring the Fund's operations, it
does not have a direct role in the Fund's investment review and selection

process. As of March 2000, the Fund had invested $114.4 million in 30
projects through its direct investment program which provides loans and
equity capital to businesses in Russia.

1 See our prior reports entitled Foreign Assistance: Enterprise Funds'
Contributions to Private Sector Development Vary (GAO/ NSIAD- 99- 221, Sept.
14, 1999) and Enterprise Funds: Evolving Models for Private Sector
Development in Central and Eastern Europe (GAO/ NSIAD- 94- 77, Mar. 9,
1994). 2 The two original funds were established in 1993 and 1994,
respectively, under the FREEDOM Support Act of 1992 (P. L. 102- 511).

The uniqueness of Russia's economic, regulatory, and legal environments
required the Fund to establish an investment selection process and criteria
tailored to the Russian market. You expressed concern about the Fund's

selection of projects for its direct investment portfolio; in particular,
whether it was following an established process for making its investment
decisions. At your request, we determined whether (1) the Fund adhered to
its process and criteria for selecting direct investments and (2) its
selection process and criteria were comparable to those used by other
investment organizations operating in Russia. In conducting our review, we
examined

the files for the Fund's 30 direct investments and a random sample of other
direct investment proposals the Fund had not approved since 1994. 3 We
designed our sample so that the statistics generated can be projected to the
total population of proposals. (See scope and methodology for more details.)
In addition, in response to your specific interest concerning the Russian

Far East, we briefly discuss the views of officials from the Fund and other
investment organizations in Russia on investment conditions in that region.
This information is presented in appendix I. Results in Brief Our analysis
showed the Fund followed its review process and criteria for

selecting direct investments. For approved investments, the selection
process included an initial review by the investment team in Russia, a
review of the organization's finances and management, and a final review

by the Fund's Investment Committee in the United States. For declined
proposals, each was reviewed by at least two investment officers and the
review often involved the Moscow- based investment team. In addition,
although the Fund is not required to document the proposals it does not
approve, over 80 percent of the case files contained at least some
documentation about the Fund's decision. 4 As shown in its case files, the

Fund followed its stated investment criteria in making investment decisions.
When specific reasons for decline were cited, the Fund most often cited two
reasons- the quality of the proposal's management was 3 We examined some
proposals that had been received by the two enterprise funds that were
combined to form the U. S. Russia Investment Fund. 4 We reviewed 330 case
files of the 1,578 proposals the Fund said it had received in 1994- 2000 and
did not approve; 62 files did not have sufficient documentation to determine
why the

proposal was not approved.

deemed insufficient or the proposal was not believed to be commercially
viable. The Fund's review process and investment criteria are similar to
those used by the five other investment organizations that we visited that
were operating in Russia. The Fund and the other investment organizations
used a multistep review process involving an investment officer or
investment team, a review of the proposing organization's finances and
management,

and upper- level management or board review prior to approval. These
organizations also used similar criteria for selecting investments. USAID,
the State Department, and the U. S. Russia Investment Fund agreed with the
contents of this report. Background The Fund's mandate is to encourage
private sector development while

assisting the long- term growth and profitability of businesses throughout
Russia. Since its creation in 1995, the Fund has drawn $174. 5 million from
the U. S. government 5 to support two programs- direct investments and
financial services. The Fund's direct investment program provides loans,
equity investments, and technical assistance to small-, medium-, and large-
sized businesses in Russia. The Fund's financial services program (formerly
known as Bank Partner and Small Business Lending Program) provides technical
assistance to banks and loans, mortgages, and leasing services to small
businesses, micro- enterprises, and individuals through the Fund's
subsidiary financial institutions and partner banks.

The Fund has invested $114.4 million in 30 direct investments and has
recovered $31.1 million in returns on these investments. The Fund values its
current investments at $60.3 million. 6 The Fund's smallest investment
through this program is $75,000 and the largest is $15.5 million, with an
average investment value of $3.8 million. The Fund's 30 investments
represent a variety of sectors throughout Russia- from communications to

consumer products. 5 Based on statistics provided by the Fund as of December
31, 1999. 6 This figure is difficult to determine. According to Fund and
other private venture capital officials, markets for the Fund's investments-
and a way to determine their fair market value- often do not exist in
Russia.

The Fund Followed Its Our review of approved investments and proposals not
approved showed

Investment Review that the Fund followed its review process. The Fund uses a
multistep

process to review and select its investments, as illustrated in figure 1.
Process and Criteria According to Fund officials, the steps in this process
can and often do overlap. For example, the Fund's President often involves
individual Investment Committee members, who also serve on the Fund's Board
of

Directors, early in the review process both to provide them with information
and to make use of their particular area of expertise. The Fund continues
discussions with the proposing organization throughout the financial,
management, and Investment Committee reviews. Further, the investment team
periodically briefs board members on the status of potential investments.

Figure 1: The Fund's Investment Review Process

Fund receives proposal and assigns it to an

Investment investment

team officer

conducts initial review

Investment of proposal

team talks with company

Investment Investment

team begins approved

reviews of

Declined/

management Fund submits and finances

proposal to Investment Committee

Investment Committee conducts final

review

Retired Source: GAO analysis of Fund documents.

Our file review of the Fund's 30 approved direct investments showed that the
Fund followed its review process from the initial review by the investment
team to the final review by the Investment Committee. Where documentation
was sufficient to make a judgment, our file review indicated that the Fund
followed its review process for its declined proposals by having at least
two investment officers review each proposal. In many of the declined
proposal files, we also found documentation showing that the

entire Moscow- based investment team reviewed the proposal. Our review of
approved investments and declined proposals showed that the Fund considered
its criteria (see table 1) in judging the merits of proposals and making
investment decisions. According to Fund officials, the most important factor
in any investment decision is the quality of management. The Fund looks for
managers who have operational experience in the venture they are proposing,
business experience in Russia, and a willingness to cooperate with the Fund.
According to Fund officials, the second most important criteria for
investment is the

commercial viability of the proposal. The Fund's objective is to make a
profitable investment, and it will not take on projects that have a poor
chance of succeeding.

Table 1: The Fund's Investment Criteria Criteria Description

Management The Fund seeks managers who have experience in the sector; have
overseas experience, especially in Russia; and exhibit competence,
integrity, and a willingness to cooperate with investors.

Commercial viability The Fund reviews the proposing organization's current
and potential revenue growth and market share and the proposal's viability,
regulatory risks, civil liabilities, and potential return.

Sector focus The Fund seeks a diverse portfolio consisting of businesses
from many sectors; however, it generally discourages investments in natural
resources, construction, agricultural production, and livestock production.
USAID terms The Fund's grant agreement with USAID stipulates that the Fund
may not invest in companies that sell abortion equipment or munitions;
violate international labor, environmental, or human rights standards; or

seriously impact the U. S. economy, employment, or national interests.
Location The proposed investment must be in Russia. Start- up/ concept stage
Historically, the Fund has avoided start- up companies. a Proposal terms The
Fund and the proposing organization must agree on the proposal's terms,
including an exit strategy.

a One Fund official told us that in the past the Fund only considered
proposals that were already generating revenue, thus eliminating start- up
proposals or proposals that were in the concept stage. The official added
that the Fund would now consider start- up proposals if a Russian
entrepreneur with a proven track record in start- ups led the proposing
organization.

Our review of documents in the Fund's direct investment files showed that
the Fund considered its criteria during the course of its review process. 7
Our file review also indicated that the Fund declined proposals on the basis
of its criteria. Although the Fund is not required to keep documentation on
the proposals it does not approve, we found at least some documentation
about the Fund's decision in over 80 percent of the case files we examined.
We reviewed 330 case files of the 1,578 proposals the Fund had received in
the years 1994- 2000 and did not approve; 62 files did not have sufficient
documentation to determine why the proposal was not approved, 7 were retired
because the proposing organization withdrew or did not reply to Fund
inquiries, and 2 were transferred to another enterprise fund. Of the

remaining 259 case files, file documentation indicated that the Fund
formally declined the proposal; 179 had one or more detailed reasons for
decline, 72 had only a form letter to the proposing organization stating
that the proposal was declined because it did not fit into the Fund's
current

investment strategy, and 8 were declined with no specific reasons indicated.
As shown in table 2, when specific reasons for decline were given, poor
commercial viability and poor management were cited most often. See appendix
II for more information on the results of our file review.

7 One file did not contain a standard form documenting that the proposal met
the USAID grant agreement terms, but we found no evidence to indicate the
USAID terms were not met.

Table 2: Frequency of Reasons Given for Declining Proposals Reason for
proposal decline Percent a

Not commercially viable 37 Management not acceptable 22 Outside sector
emphasis 14 Terms not acceptable 13 A start-up company 10 Did not meet USAID
grant terms 4 Investment not in Russia 2 Did not fit in Fund's current
strategy (form letter only) 28 No specific reason for decline 3 Note:
Percentages add to over 100 because some proposals were declined for more
than one reason. a We found at least some documentation about the Fund's
decision to decline the proposal in 259 of the

330 case files we reviewed. Our statistics project that we would find
similar documentation in 1,238 of the total 1,578 case files for proposals
not approved. The percentages above can be applied to this subpopulation of
1,238 with a 95- percent confidence level, plus or minus 5 percentage
points.

Other Organizations The Fund's review process and investment criteria are
similar to what five other investment organizations use in Russia. 8 Like
the Fund, investment Use Similar Processes

officers at each organization review a proposal and, if warranted, present
it and Criteria to an investment team. The team negotiates with the
proposing company on the terms of the proposal. During the negotiations, the
investment team reviews the management and finances of the company in which
it might invest. The organizations contract much of this review to local law
firms, public accounting firms, and security service organizations. After
the

parties agree to the terms of the proposal, final approval is required by a
higher- level investment committee. The investment criteria used by these
other investment organizations were similar to the Fund's criteria. Like the
Fund, the two most important criteria were the quality of management and
commercial viability of the

proposing organization and its proposal. The officials we met with
emphasized that they must have confidence in the integrity and 8 We met with
officials from the International Finance Corporation, the European Bank for
Reconstruction and Development, AIG Brunswick Millenium Fund, Agribusiness
Partners International, and Russia Partners Fund.

competence of the management, and in assessing the proposal's commercial
viability, they look at both the current and future profitability of the
venture and its current and projected market share. They also stressed that
each proposal should contain an exit strategy that provides for an
acceptable rate of return on the investment when it is sold.

Agency Comments USAID, the State Department, and the U. S. Russia Investment
Fund commented on a draft of this report. USAID provided written comments
(see app. III), which said the report was thorough, balanced, and accurate.

Both State's Coordinator of Assistance to the New Independent States and the
Fund's President characterized the report as fair and balanced. The Fund
also provided technical comments, which we incorporated as appropriate.

Scope and To determine whether the Fund adhered to its review process and
Methodology

investment criteria, we reviewed related documentation, interviewed
cognizant Fund and USAID officials, and reviewed the files for the Fund's
investments and investment proposals. We reviewed documents provided to us
by USAID and the Fund on the process and criteria the Fund uses to review
and select direct investment projects. We interviewed the Fund's

President, Chief Financial Officer, Investment Committee Chair, Board of
Directors, and Chairman of the Board; other Fund investment officers; and
USAID officials responsible for oversight of the Fund's activities. At the
Fund's New York and Moscow offices, we reviewed (1) files for the 30
investment proposals the Fund approved and (2) a random sample (330) of the
1,578 proposals the Fund received and did not approve during the years 1994-
2000 (to date). We designed our sample so that the statistics can be
projected to the population of 1,578 proposals with a 95- percent confidence
level, plus or minus 5 percentage points. To determine whether the Fund's
review process and investment criteria

were comparable to other investment organizations operating in Russia, we
interviewed officials from the Fund in Washington, D. C., New York, and
Moscow; USAID; the State Department; the Overseas Private Investment
Corporation; the International Finance Corporation; the European Bank for

Reconstruction and Development; AIG Brunswick Millenium Fund; Agribusiness
Partners International; and Russia Partners Fund.

We performed our work from May through August 2000 in accordance with
generally accepted government auditing standards. As agreed with your
office, unless you publicly announce its contents earlier, we plan no
further distribution of this report until 30 days from the date of this
letter. We are sending copies of this report to the Honorable Madeleine K.
Albright, the Secretary of State; the Honorable J. Brady

Anderson, the Administrator of USAID; and interested congressional
committees. We also are providing copies to the President and Board of
Directors of the U. S. Russia Investment Fund. We will also make copies
available to others upon request. Please contact me at (202) 512- 4128 if
you or your staff have any questions about this report. An additional GAO
contact and staff acknowledgments are listed in appendix IV.

Jess Ford, Director International Affairs and Trade

Appendi Appendi xes x I

Investments in the Russian Far East The Fund's grant agreement with the U.
S. Agency for International Development (USAID) requires the Fund to
allocate at least $40 million of its $440 million in authorized capital to
activities in the Russian Far East. As of March 2000, the Fund had devoted
$17.5 million to the region- $11.4 through its direct investment program and
$6.1 million through its financial services program. Of the $11.4 million
for direct investments, the Fund invested $3 million in a supermarket chain,
$0.2 million in an ice cream company, and $8. 2 million in a seafood/ marine
equipment supplier. Of the three, only the seafood/ marine equipment
supplier has enjoyed any

success. Fund officials told us that because of the poor investment climate,
risks involved with direct investments in the Russian Far East, and limited
success to date of their three investments in the region, leasing equipment
offers a better financial opportunity to fulfill their $40 million
requirement. As a result, the Fund is expanding its financial services
program to target fishing and logging companies in the Russian Far East
through an equipment- leasing program. Officials at all of the organizations
we spoke with, including the Fund, cited several limitations to investing in
the Russian Far East.

Markets are limited because of the region's low population density and low
purchasing power per capita, making the potential commercial viability of
ventures poor.

The predominant industries in the Russian Far East- natural resources,
construction, and fishing- are unattractive to foreign investors due to
their escalating costs and susceptibility to corruption.

Corruption is widespread both within regional government institutions and
within the private sector. Companies operating in the Russian Far East have
little transparency in their operations and management and often avoid
relationships that would force them to become more transparent.

The remote location of the Russian Far East (eight to nine time zones from
Moscow) makes management from western Russia, where most of the Russian
economy is based, difficult. In comparison, close proximity gives China,
Japan, and Korea a competitive advantage in the Russian Far East markets.
Besides the Fund, of the five other investment organizations we met with,

only the European Bank for Reconstruction and Development had made equity
investments in the Russian Far East. The Bank has two distinct, separate
operations in the region- its Regional Venture Fund for the Russian Far East
and Western Siberia, managed from London, and its

primary country operation, managed from Moscow. The Bank's Regional Venture
Fund set aside $30 million for equity investments in the Russian Far East
and Western Siberia. However, it has invested only $12.2 million and,
because of the limitations of investing in the region, has decided not to
make any new equity investments at this time. In addition, for similar

reasons, the Bank's primary country operation has not made any equity
investments in the region.

Appendi x II

Summary Information on Proposals During our file review, we gathered
statistical information on the proposals received and investments made by
the Fund since 1994. As table 3 illustrates, the Fund received most of the
proposals and made most of its investments prior to 1997. Fund officials
stated that the number of proposals they received decreased after 1996 due
to changes in investors' outlooks, better dissemination of information about
the Fund, and the

relocation of the Fund's New York direct investment office to Moscow.
Primarily because of the August 1998 Russian financial crisis, the Fund made
no new investments until January 2000 and instead concentrated on
strengthening its existing portfolio.

Table 3: Proposals Approved and Not Approved (1994- 2000) Calendar year
Proposals approved Proposals not approved

Number Percent Number Percent

1994 3 10 158 10 1995 10 33 521 33 1996 3 10 363 23 1997 10 33 126 8 1998 3
10 63 4 1999 0 0 47 3 2000 1 3 32 2 Could not determine year a a 268 17

Total 30 100 1,578 100

Note: Percentages may not add to 100 due to rounding. a Not applicable.

The Fund received the most proposals from organizations in Russia and
invested most often in proposals based in the northwest and Moscow/ central
regions of western Russia. Fifty- six percent of all investments the Fund
made and 64 percent of all proposals it received but

did not approve were proposed by organizations in Russia; 30 percent of
investments and 23 percent of proposals came from the United States; the
rest came from organizations in other countries. Figure 2 illustrates the
location of the proposed venture; the location of the Fund's 30 investments;
and the value of its investments, by region. 1 1 Percentages for the 1,578
proposals not approved were estimated at the 95 percent confidence level,
with plus or minus 5 percentage points. The numbers in figure 2 are
estimated based on these percentages.

Figure 2: Proposals Not Approved and Approved and Funds Disbursed, by Region

Siberia

Not approved: 106

Northwest Russia

Approved: 0 Not approved: 215

Disbursed: 0 Approved: 5 Disbursed: $21 million

Moscow region

Not approved: 507 Approved: 9 Disbursed: $27 million

Russian Far East

Not approved: 129

Southwest Russia Urals

Approved: 3 Not approved: 105

Not approved: 86 Disbursed: $11.4 million

Approved: 1 Approved: 1

Disbursed: $0.1 million Disbursed: $3 million

Location Not approved Approved Disbursed (Estimated) (Actual) (Actual)

Total from above 1,148 19 $62. 5 million Multiple regions in Russia 134 11
51. 9 Outside Russia 19 0 0 Could not determine 277 0

Total 1, 578 30 $114. 4 million

Source: GAO analysis.

Comments From the U. S. Agency for

Appendi x II I International Development

Appendi x I V

GAO Contact and Staff Acknowledgments GAO Contact A. H. Huntington, III
(202) 512- 4140 Acknowledgments In addition to the contact named above, Jody
L. Woods, Jim Strus, and

Jack E. Edwards also made key contributions to this report. (711566) Lett er

GAO United States General Accounting Office

Page 1 GAO- 01- 2 Foreign Assistance

Contents Letter 3 Appendixes Appendix I: Investments in the Russian Far East
12

Appendix II: Summary Information on Proposals 14 Appendix III: Comments From
the U. S. Agency for International Development 16

Appendix IV: GAO Contact and Staff Acknowledgments 17 Tables Table 1: The
Fund's Investment Criteria 7

Table 2: Frequency of Reasons Given for Declining Proposals 9 Table 3:
Proposals Approved and Not Approved (1994- 2000) 14

Figures Figure 1: The Fund's Investment Review Process 6 Figure 2: Proposals
Not Approved and Approved and Funds

Disbursed, by Region 15

Abbreviations

USAID U. S. Agency for International Development

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Appendix I

Appendix I Investments in the Russian Far East

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Appendix II

Appendix II Summary Information on Proposals

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Appendix III

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Appendix IV

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