Ben Aris in Moscow -

The World Bank's commercial arm, the International Financial Corporation (IFC), is getting into the Russian fund business. In June, it launched the third fund focused on the country's banks, the Russian Banking Opportunity Fund, which it hopes will tap into the potential growth of the financial sector and help drive its consolidation at the same time.

There are already two private equity funds focused on banks in Russia. The pioneer was what is now called the East Capital Financials Fund that miraculously opened its doors in 2006 just ahead of the mega-wave of banking acquisitions that swept the region. However, more recently the fund has suffered: while East Capital was an early investor in the Bank of Georgia story - probably the best rags-to-riches tale in the entire Commonwealth of Independent States - it got burned on its investments into Nadra Bank in Ukraine and BTA Bank in Kazakhstan during the recent crisis and the fund is down 11.24% this year.

Then there's the Renaissance Capital Financial Institutions fund that came into being shortly after in 2007. Both funds have a similar strategy: take minority stakes of about 10-15% to boost the bank's capital and provide technical help on managing the business to allow the bank to grow.

The performance of both these funds highlight how volatile investing in Russian banks can be. The long-term growth of the country's financial sector over the last 15 years has been phenomenal and on an assets/per-capita basis Russia remains at the bottom of the league in Europe. By launching its bank fund during the tail end of this crisis, the IFC is hoping to offer great returns to investors during what it hopes is a protracted recovery. "In all the years I have been in Russia, the one thing I have learned is that the Russian banking sector is cyclical," says Timothy Krause, the fund's manager, who first arrived in Russia in the mid-1990s. "The Russian banking sector remains one of the fastest growing in the world and the crisis means this is a great time to be investing."

When Krause first arrived in Russia, Russian banks were going for up to 4.5x book value - quadruple the valuations that countries in Central Europe got for their banks when they were privatised in the 1990s. But the prices have come off since: the mid-tier commercial bank Nomos bank floated earlier this year with a valuation of 1.5x book value and investors' favourite Sberbank was trading at 1.2x book value in the middle of October.

Right time, right place

The fund comes at just the right time, as the Russian government is keen to pull in more investors. And it has put its money where its mouth is: the fund has been seeded with a $250m contribution by the IFC, matched by $250m from Vnesheconombank (VEB), the state-owned development bank, and another $50m from the Russian Finance Ministry. Krause is now on the road trying to raise at least another $500m from private investors, pension funds, sovereign wealth funds and institutional investors.

Indeed, at first the IFC was not very keen on the idea of the fund, floated by the Russian banking association, which was looking for ways to finance smaller banks as the tsunami from the global debt crisis broke on Russia's shores. But during the International Monetary Fund's annual meeting in Turkey in 2008, the then-Russian finance minister Alexei Kudrin cornered Lars Thunell, IFC's executive vice president and CEO, and badgered him into the idea.

The IFC is already long in the tooth when it comes to investing in Russia and has made several banking investments off its own bat. The idea with the fund is to leverage this experience and tap international capital. And as an international financial institution, Krause believes the IFC's development mandate is actually an advantage, as the fund continues to invest even when the investment climate is poor. "All these private equity funds are chasing the sweet deals, but they chase sweet deals with the wrong people, which regularly blow up in their faces," says Krause. "There is a positive relationship between investments and the development impact: if something is to make a development impact, it has to create something that wasn't there before and this is usually good business."

The fund's strategy is two-fold. First, it is targeting 10-15% stakes in mid-sized banks ripe for growth, which can in turn acquire smaller banks. These will be groomed and then either sold or floated on the stock market. "Currently, the state banks dominate and both Sberbank and VTB are listed. At the other end of the scale, there are a handful of listed private banks with a tiny free float," says Krause. "The IPO of Nomos Bank earlier this year is somewhere in the middle, but it is only one bank. It is very hard for investors to get exposure of the burgeoning banking sector."

The second plank is to buy up to 40% in niche players and knock them into shape. Krause says the "sweet spot" investment is to take a 25%-plus-one-share stake and maybe co-invest with other funds to control 50% plus one share of the whole bank. "We don't want to manage the banks, but if we feel that it needs a new CFO or major change in strategy, we need the ability to impose these decisions via the board," says Krause, who has already done a deal like this in partnership with Barings Vostok Capital to jointly own a controlling stake in Orient Bank, which has been buying up smaller competitors all year.

The partnership with the Russian state organs should give investors some comfort and is a model that the state is actively pushing. In the summer, VEB also made the first $2bn investment of a $10bn total in the newly established Russian Direct Investment Fund (RDIF), which is supposed to partner with foreign private equity investors into everything - except banks.

But the key will be if Krause can attract some serious international investment. No one doubts that big institutional investors are interested in Russia, but so far they have invested next to nothing. "I am confident they will come. It is a question of education, but international investors remain nervous of Russia - despite its good returns," says Krause. "But that is our job: to convince them it is a good deal and now is the time.