Case Study:

Transformation of Traditional Russian State Owned Enterprise into Modern Business Group

 ZEIM Group

Russia's Hard Road to Capitalism

Background paper

In the early 1990s political and economic reforms in Russia concentrated on transformation of the macro­economic environment and privatization of enterprises. It was believed that the new owners would take care of enterprise restructuring and renewal. However, this was not the case and now the delay in large-­scale enterprise restructuring threatens the future of these reforms. To appreciate the slow pace of enterprise restructuring in Russia, it is important to understand the national context, particularly the nature of Russian enterprises and the factors constraining their rapid transformation.

Legacy of a centrally planned economy. Russian enterprises and industrial structures are the product of the Soviet form of industrialization and a centrally planned economic system. The goals pursued and the nature of the Soviet economic system strongly determined the organizational design, management systems and practices of enterprises. The table below illustrates how fundamentally different Soviet enterprises were from their Western counterparts in market-oriented economies.

A parallel influence that shaped the structure and management of Soviet enterprises was the dominance of the defense industrial complex. The economy was oriented towards fulfilling military needs and defense production. All the best "brains" and "hands" were mobilized in military research, development centres and enterprises. Since the defense sector was able to obtain funds and resources without any justification, management paid little attention to the economic side of the enterprise.

The absence of change agents. The average age of top enterprise managers is over 50 and, being mentally grounded in the Communist past, they rarely perceive a need for radical organizational change. Besides, the majority lack the skills needed to initiate and conduct restructuring. The new generation of young managers, many of whom have been educated abroad, are not interested in working in traditional industrial enterprises and prefer employment with the new private trading companies, banks, brokers' firms or small businesses.

Lack of motivation and pressure for change. Why should managers devote effort and resources to restructuring if, in the words of Mr. Iasin, former Minister of the Economy, "It is still not profitable to produce" (Iasin, 1996)? Why submit to the pain and risk of restructuring production systems when one can make a profit faster by investing in speculative financial operations? Another reason why there is no real pressure for enterprise managers to change is that bankruptcy laws are not enforced. Companies continue to operate though creditors, and employees and taxes are not paid. As Mr. Kirienko, former Prime Minister, writes "How can one talk about reforms if for the past seven years there were fewer cases of bankruptcy (in Russia) than in the US in the course of one week?" (Kirienko, 1999).

Lack of stability. Russian managers face constantly changing laws and regulations. Every day brings changes in legislation (often introduced retroactively), new restrictions, sudden arbitrary decisions by local authorities, new taxes, drastic price increases in energy and basic raw materials, or devaluation of the national currency. Moreover, the rules of the game are not only unstable but often unfair. Until recently, almost half the products on the market were brought into the country with reduced or no import tax by the holders of "special" permits or illegally.

Unsettled corporate governance. In the course of privatization, the majority of enterprises have chosen the option, which allows insiders to obtain a controlling share in the company (51 per cent). This created opportunities for many enterprise directors to gain personal control of the company by purchasing shares from the workers. It was in the interest of such persons and their entourage to keep the company down, often for years, before seizing control of the enterprise at very depressed share prices.

Shortage of investments. Any serious restructuring requires investment. It is estimated that the renovation of basic production facilities in Russia would cost about US$800-900 billion over a 10-year period (Iasin, 1996). However, Russian banks have not provided funds for enterprise development, their activities being limited to providing short-term loans to meet working capital needs. In any case, the majority of enterprises would not be acceptable credit risks due to low liquidity and high indebtedness.

Shortage of outside professional help. In Russia, where problems are more severe and management is less experienced in organizational matters than in the West, consultancy services are practically unknown. What are the reasons for such a paradox? First of all, Russian managers lack experience in making use of professional help from outside, and second, there is an inherent distrust of advisers. Efforts made by the Russian government and international donor organizations to change this traditional attitude have been to no avail. A recent attempt of the World Bank to introduce special loan schemes for consultancy assistance failed to be implemented. The Russian Training Foundation is also experiencing serious problems in promoting a loan scheme to cover special costs for training services.

Response of government and non-governmental institutions

The Russian government. As mentioned before, the Russian government did not play an active role in enterprise restructuring and renovation. Priority was deliberately given to accelerating privatization in the hope that this would drive the restructuring process. The need for government intervention became evident and in 1997 the basic concept of enterprise restructuring was adopted in the framework of the (1997­2000) programme called "Structural adjustment and economic growth".

 The document was drawn up on the assumption that restructuring would be undertaken by the enterprises themselves with minimum support from the government. The government was to provide a more conducive environment to stimulate development and endorse sanctions against proprietors holding back the renovation process. The government planned to co-fund management training in the area of enterprise restructuring. Specific legislation and bankruptcy procedures were included in the programme, and special measures were foreseen to improve the effectiveness of the portfolio management system and government representation on company boards of directors.

The frequent changes in government, the new economic crises and other political and economic emergencies did not facilitate implementation of these measures and a severe budget deficit did not allow funds to "fuel" the programme. Yet, with the support of international donors many activities have been partially implemented.

Russian Privatization Centre (RPC). Originally privatization-oriented, the Centre now focuses more on enterprise restructuring. The RPC has recently provided direct support to the restructuring of more than 150 privatized companies. About 1,500 enterprises (out of 80,000) have benefited through participation in tailor-made training courses and seminars. The Centre has also initiated publication of a management series.

Presidential programme. In response to the challenge, a national management education programme was launched at the initiative of President Yeltsin. The presidential programme aimed at training 5,000 carefully selected young managers over a two-year period (1998-1999). This initiative won the support of international development institutions and leading Western governments.

Lower Volga Regional Venture Fund (LVRVF). Established in May 1995 with the support of the European Bank for Reconstruction and Development, the fund has a total of US$33 million in investment capital and is supported by a USAID $20 million technical assistance grant for a period of 19 years. The investments are to facilitate the restructuring and development of companies with good potential for growth. Apparently the fund is having difficulty finding companies, which meet the criteria, and in achieving a good rapport with Russian enterprise managers (Montgomery, 1997).

International development agencies. Russia receives technical assistance for restructuring from several leading international and bilateral donors including development agencies and funds, but mainly from the World Bank and the European Bank for Reconstruction and Development. Major international consultancy companies and management development institutions are involved in implementing technical collaboration programmes. Following a request from the Russian Union of Industrialists and Entrepreneurs, the ILO has developed, in close cooperation with Russian counterparts, some innovative tools to facilitate enterprise restructuring. The unique feature of the ILO approach is its emphasis on reducing the social costs of organizational change. Workshops and training seminars using the approach have taken place in the Chuvash and Tatar Republics, and in Nizni Novgorod and Riazan.

Recent developments

There are indications that the "gestation period" is now coming to an end and a new class of effective owners is emerging. The financial crisis of 17 August 1998 had a positive "awakening" impact on some Russian industries. This "awakening" led to notable growth in the number of spin-offs, mergers and acquisitions, adoption of new forms of production structure, and the development of strategic alliances and flexible networks among companies. A prevalent approach to enterprise restructuring in Russia is to "downscope" by means of separating the "core" company structure from certain production and service units. In fact, large enterprises have become the prime source of new small businesses. ZEIM in Cheboksary is an example of a company, which transformed itself from the traditional vertically integrated mono-product enterprise into a flexible business system of 37 semi- and fully independent business units.

ZEIM Group

There are few survivors of the Russian instrument-building industry. Among them is ''ZEIM''. In the early 1990s this company was one of the first in Russia to dismantle its old production structure. Its restructuring success was due to its ability to distinguish and retain "core" activities inside the mother enterprise and to provide autonomy or full independence to the rest of the units. Ignoring this approach was the main cause of failure in many similar Russian enterprises.

Another approach to restructuring has been through mergers and acquisitions among Russian companies. Three leading military aircraft producers recently appealed to the President for permission to merge; two of the largest automobile tyre producers "Interchimprom" and "Roshshinainvest" are in the process of aggressively acquiring smaller competitors. A similar trend is occurring in the telecommunications and financial sectors as well as in oil and gas (Grigoriev, 1998). Active restructuring through the acquisition of milk-processing factories and building close relations with milk producers have enabled the food producing group "Winn Bill Don" to become absolute leader in the Russian milk market. The history of this Russian multiproduct group goes back to the privatization in 1992 of the Leanozovski milk combinat. Since August 1998, WBD increased its market share in Moscow and Saint Petersburg by more than 15 per cent by driving out foreign competitors. Now, the group controls 80 per cent of the milk market and 40 per cent of the juice market in Moscow. The company is spreading across Russia through active acquisition. Besides Moscow and Saint Petersburg, it is present in six major regions of Russia as well as in Kiev, Ukraine. The company's vision is to build up production and distribution networks covering all of Russia from Smolensk to Vladivostok.

Another common trend is the development of "flexible businesses". These businesses are usually driven by private entrepreneurs with money and innovative ideas, and they are quickly replacing foreign suppliers who left Russia in August 1998. Some of them are building their business by using the unique know-how developed in military laboratories. A successful case is a small group of Russian scientists and entrepreneurs who began the industrial production of very light bicycle frames made of magnesium alloys. The company "Litech" now competes with leading bicycle producers worldwide thanks to its unique use of alloys, special laser welding technology and patented methods of surface treatment techniques which they borrowed from defense research and development laboratories.

Litech Group

"Litech " is a network of small companies and informal task groups engaged in the design and production of bicycle frames made from magnesium alloys. Commercial production began in 1997 and the group is now a recognized supplier to leading producers of racing bikes in the United States and Europe. The group's success is due to the ability of the key partners to build up and keep developing a "virtual" production structure, which includes formal and informal development and production groups in Russia, Ukraine and Hungary. Some of these units belong to large defense enterprises and the work is coordinated by three formally independent small companies in Moscow, Budapest and New York.

The crisis of August 1998 forced many foreign companies to leave Russia, with the exception of those already engaged in production in the country. All foreign producers in Russia are experiencing lower profits or losses which they are now overcoming by cutting costs, reducing personnel, reducing salaries and re-engineering work processes. Nevertheless, some are planning additional investment, hoping to take over the market left by retreating competitors.

There are some success stories of foreign companies in Russia. Among them are the Swedish concern VVN which bought out Baltika Beer Company and has grown to become the number one beer producer in Russia; Nestlé which became a leading producer of Russian chocolate; and ABB which managed to become a key supplier of equipment to Russia's power industry. In all these cases, the foreign companies took full control of local enterprises, redesigned and re-equipped the production facilities and retrained the personnel.

Nestlé in Russia

Nestlé started production operations in Russia in 1995 when it bought the first confectionery factory in Samara. Since then, Nestlé has acquired a number of other plants in Samara, Barnaul, Perm and Zhukovsk. Now it employs 5000 people in Russia. Nestlé captured about 11 to 15 per cent of the chocolate market in Moscow and Saint Petersburg. Turnover grew to US$500 million and the company is gaining market share in all its major areas, including coffee. Nestlé's policy is to retain the local management but to bring in an international team to train staff in new technologies, management techniques and finance.

Final observations and conclusions

Enterprise restructuring is vitally important for Russia's economic reforms and internationalization. To achieve this will require a fundamental transformation of companies in an organically different socio-economic system. Postponing restructuring and transformation can only prolong suffering and reduce the chances of revival.

With hindsight, it was unrealistic to expect a rapid transformation of Russian industries. Factors such as the traditional way of thinking of managers, the unsettled issues of ownership, the lack of financial resources and necessary management skills, the lack of legislation, bankruptcy laws and property laws have all held back restructuring. No less important was the lack of motivation to change caused in part by the failure of the government to establish a favourable macro-economic environment for investors.

This prolonged stagnation of industry, the downsizing of the workforce, and the slow development of small and medium-sized enterprises have led to a rapid loss of human capital - the only competitive advantage of most Russian companies.

The successful cases of restructuring in Russia have followed the same pattern as in highly industrialized counties: mergers, acquisitions, spin-offs, process re-engineering, downsizing, building alliances and networking. At the same time, the actual scope and depth of change has been more dramatic and fundamental in Russia. This has made restructuring an even more risky and painful undertaking. The shortage of professional assistance in this area remains a serious problem.

Yet there are encouraging signs of an "awakening" of Russian industry. An acceleration in enterprise restructuring gives hope that this period of "incubation" may be coming to an end. Many Russian managers have gained the necessary experience and knowledge to restructure and run enterprises efficiently under new conditions. The recent devaluation of the national currency offers more favourable conditions for local producers. Other practical steps to support local producers and attract foreign investment have to be taken in order to take advantage of this positive trend.