Privatization

Deidre Sheehan

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Since the late eighties when Thatcher and Reagan were elected there has been a changing in thinking about the state owning businesses and governments around the world have decided to stop running businesses and let the private sector take over. The main way of accomplishing this is for the government to sell the companies it owns, a process known as privatization.

All but a few countries - Cuba and North Korea are among the minority - have carried out at least some privatizations in recent years, and more are sure to follow. They are driven by the promised rewards of privatization: higher economic growth, elimination of fiscally costly subsidies, and better companies that deliver cheaper and more efficient service to the people.

However, because privatizations often result in greater "efficiency," they also cause job loss, so it is important to look at whether the government has a safety net for those workers who are put out on the street.

Furthermore, the promised rewards don't always materialize. For developing countries in particular, without a clear legal or regulatory framework to encourage competition in the marketplace, the dangers are acute. In Russia, for example, many companies went from being badly run government-owned enterprises to being badly run privately owned enterprises. The new private sector companies, often still run as monopolies, were no more efficient, didn't deliver better services or products, and didn't cut prices or even create jobs.

To follow what can be a complicated and often politically fraught process, it is vital to know not just how companies are privatized but also why they can fail.

THE PROCESS:

What Gets Sold?

A government may choose to sell 100% of its ownership in a firm (full divestiture). Or it may choose to keep a stake in the firm (partial divestiture). In order to qualify as a true privatization, the government must sell at least 51% of the company and give up control of the management. A government may choose to keep a stake to reassure the public that it is still closely monitoring the country's strategic interests.

How is it sold?

1. Vouchers: In a mass privatization through vouchers, citizens of the country are given vouchers, which they can exchange for shares in the company when it is sold off. This method was widely used in Central and Eastern Europe in the mid-1990s, but with only limited success.

  • Advantages: Vouchers can be a politically popular way of giving a typically alienated public a stake in the ownership of the company. The method is also seen as equitable in that it confers ownership across the board rather than restricting it to the monied elite. Vouchers have also been seen as a good way to develop budding stock markets by automatically turning members of the public into stockholders.

  • Disadvantages: Vouchers cut down on the amount of money received by the government for the sale of a company. Also, because the company is ultimately owned by thousands of individuals, there is a risk that old managers at the company may carry on as before, with no single investor to force the changes needed to make the company more efficient.
  • Another problem was seen when the Czech Republic used vouchers in a mass privatization program in 1992-95. Investment funds bought up many of the vouchers. Large, domestic government-owned banks controlled those funds. Those same banks often held debt owed by the privatized companies too. In effect, the bank became the ultimate owner of the company. As a result, the funds wouldn't punish a badly run company by pulling out of it, because then the bank would have to write down the loans it had extended to the company. Of course this problem, while important, is not restricted to the voucher method. Banks could, and often do, become owners of enterprises in other ways as well.

2. Direct Sales: The government sells the company directly to large investors. These strategic investors, usually a private company or group of companies, bid against each other to buy the firm. They may bid in an open process with the highest offer accepted, or the government may choose to review potential buyers on a case-by-case basis. This process was used to privatize Kenya Airways in 1996. The government sold 77% of its shares in the airlines in a series of competitive auctions. KLM Royal Dutch Airlines bought 26% of the carrier, local investors bought the remainder.

  • Advantages: Competitive bidding is likely to bring the government the most revenue from the sale. In addition, the method typically brings along a "strategic investor" who, in addition to capital, provides technological and managerial expertise. Direct sale is also cheaper than offering the company for sale on the stock exchange, which often involves marketing and other costs.

  • Disadvantages: Direct sales may be politically unpopular since the general public has no opportunity to get a stake in the company. And since shares aren't issued or sold, this method does nothing to help develop the stock market.

3. Public offerings: Where the company is sold to the public on the stock exchange through an intitial public offer (IPO) of shares.

Advantages: It helps to develop the stock market. It is also easier to make this a transparent process, where the public can see exactly who buys what and for how much. It is also used to phase in a sale rather with a first tranche used for "price discovery" purposes. And it prevents a single politically powerful investor from snapping up all the shares. For these reasons, this process is also more likely to attract foreign investors.

4. Mixed Sales: This is a mix of a direct sale to strategic investors, followed by a public offering, often held six to 12 months later. In the 1990 privatization of Telmex, the government sold 20% of the company's shares to a strategic investor, then sold another 31% through public offerings in 1991 and 1992.

  • Advantages: The big investors can carry out the changes needed to make the company more efficient and profitable by the time it is offered publicly. This often raises significantly the company's value benefiting both the government and the new partial owner. It also helps develop the stock market.

  • Disadvantages: There is a cost to carrying out one type of sale, then another type, including fees to the investment banks that help organize the sales etc. Because of this, this method is normally used on large companies that are attractive to investors.

5. Concessions: Sometimes the government may not give up its ownership of the company, particularly in the case of natural monopolies such as water, electricity, or infrastructure development. Instead it will sell the rights to operate the company for a specific period of time. This method aims to give the investors the freedom they need to make money, while still protecting consumers from exorbitant price rises. It can also be seen as a way of keeping ownership of a vital national asset. In 1997, Gabon used this method to privatize its water and electricity company, Societe d'Energie et d'Eau du Gabon (SEEG). Interested companies bid by offering the biggest cut in water and electricity rates that they could implement if they won the concession. France's Vivendi, in a consortium with the Electricity Supply Board of Ireland, won with a proposed cut of 17.25% and an investment requirement of at least $200 million. A successful IPO was carried out afterwards.

What should happen next?

Ideally, after privatization, the company should become more competitive and productive. Ultimately, if it is successful, it should create more jobs, and deliver better goods and services to the people of the country at a cheaper price. In addition, the government should be able to save the money it previously used to subsidize an inefficient company and spend it on things the country needs instead, such as health care, education, or roads.

To figure out if this will happen, ask these questions:

  • Who bought the company?
  • What are they doing to make it work better?
  • Is the government doing what it must to create the right kind of economic environment for the company to succeed?

First, even before the privatization has been held, you should be asking: What has the government done to prepare for this?

Things To Watch For:

  • Large amounts of debt. Few investors will want to take over a government company that is deeply in debt. The government must usually assume the company's debt and promise to pay it off separately, in order to sell the company free of debt. The alternative is to sell the company at a very low price to tempt investors to take on the debt, too. (See privatization of Philippine electricity generator, Napocor.)
  • Competition policies. Just turning a government-owned telecommunications monopoly over to a private investor won't bring down prices or help the consumer without a new competitive environment. Has the government issued licenses to anyone else who wants to start up telecom companies? Is there a watchdog agency that will make sure the monopoly will allow those competitors to use its infrastructure for a reasonable fee? What about the fees charged to consumers in rural areas where there is no competition? Prices need to be high enough for the investor to make money, but low enough to give access to a large number of consumers.
  • Property rights. There must be a functioning system of legal property rights. There will be no buyers for a company if the ownership of the land or assets it owns is in dispute. Are there any hidden disputes over ownership before the sale? Are the country's courts strong enough to enforce contracts if there is a dispute after the sale?
  • A weak financial and economic environment. Once the company is privatized, are interest rates too high for it to borrow the money? Is there a viable stock market or bond market where the company can raise money? Is the banking system strong, or is it carrying a lot of bad debt? The success of a privatization if also related to the function of the overall macro economy-including the health of the banking sector. But it's important to look at whether the new owner's plans for financing are credible and well planned. The new owners will need to restructure the company in the short-term, while in the medium to long-term they will hopefully want to expand. It will be difficult to do either if they haven't the access to the funding they need.

Next, after the privatization, you should ask: What is the government doing to make sure the transition is as smooth and beneficial as possible?

Things To Watch For:

  • Lay offs. In the short to medium term, there are likely to be job losses both before and after a company is privatized. Jobs may be cut before the sell-off as the new owners won't want a company with excessive employees and many state-owned enterprises are over staffed. A company is usually privatized because the government hasn't been running it efficiently. Often the new owners will find that they have too many clerical and administrative workers. Laying off large numbers of white collar workers may be necessary for the company, but it could have harmful effects for the country's economy and political stability. Is the government making plans to soften the blow? Did the government take into account the new owners' layoff plans when it negotiated the sale? Some countries (Benin, Zambia) insert five year "no layoff" clauses into their sale contracts. Others, (Pakistan, Madagascar) require the buyer to provide severance packages to the workers it lays off. In many cases, the country receives low-interest loans from the international development agencies for this purpose. These severance packages, varying from a few months' to more than a year's salary, give the worker support while he or she is looking for a new job, or provide seed capital for a new business.
  • Shortages of skilled workers. While there are often too many administrative workers at a state-owned company, there may also be too few skilled technical employees available in the work force. Has the government set up any education and training programs to make sure the country is producing enough skilled workers? Has the new owner developed and implemented a training program? What about new hiring?
  • Benefits. Many government companies include housing, education, health and child care as part of their employees' package. Has the government set up any safety net of benefits to replace the ones these workers will lose? This issue, particularly acute in the former Soviet Union, extends beyond the divestiture of the enterprise and involves myriad issues of fiscal decentralization and institutional building of local governments. The fiscal implications of these programs are extremely important and need to be carefully examined.
  • Poor tax collection and big budget deficits. When a government privatizes a company it receives a big influx of cash. But, that is just a one-time effect. Over the long-run, the government will be losing out on the profits the company may have been earning while it was state-owned. To make up for that lost revenue, tax reform is often needed that introduces market-based tax systems that replaces old-style transfers into corporate taxation of the newly privatized company.
  • Government interference. Once the government has given up management control of the company, it should not interfere with the running of the firm. Independent regulatory boards should be the ones to monitor price and competition policy (see Ukraine electricity experience).

THE NEW OWNERS:

The government isn't the only one to watch. The new owners are now responsible for the running of the company. Will they make it a healthy part of the economy and create jobs for the country?
There are generally three types of new owners:

  • Foreigners. Foreign investors pay for companies with foreign exchange. This is attractive for governments, who can use that money to pay off their foreign debt. Foreigners also bring in expertise and technology. In poorer nations, there may not be a local investor with enough money to buy the company. A committed foreign owner will reinvest profits in the company to ensure its long-term prosperity. WATCH FOR: foreign owners who whisk future profits out of the country instead of reinvesting them. This will spur political opposition to the whole privatization process.
  • Insiders. Inside owners are generally the managers and employees already at the firm. On the one hand, these kinds of owners could be seen as having the most experience at running the company and having the most interest in seeing it succeed. On the other, though, selling a company to existing managers risks them continuing with the same inefficient practices behind the initial problems. WATCH FOR: inside owners who are reluctant to make any change in the way the company is run, or who keep relying on the government for financial support and bailouts.
  • Outsiders. These owners tend to be local entrepreneurs and businessmen. In their favor, they will have a good understanding of the domestic marketplace, sufficient capital for expansion and technological improvements, and a proven track record in business. WATCH FOR: Outside owners with political influence who force the government to protect the company from competition.

What should the new owners be doing?

Things to Watch For:

  • Incentives and training for workers. In the short-term the new owners may have to bring in executives from their old businesses with the experience they need. But are they spotting workers with managerial talent and developing those employees? They will need to do this if they want to ensure stability and profits in the long run.
  • Strategy. Are the new owners identifying and terminating products or services that the company provided for purely political reasons? Are they focusing on improving those areas where the company does have a competitive advantage? Are they updating technology and labor skills? If the company isn't making money in the beginning, how will it gain access to short-term cash flow? Can it sell bonds or borrow from the banks? Does the new owner have the cash to invest in the company?
  • Reporting requirements. Is the newly privatized company transparent – is there reasonable public access to information regarding the financial health of the firm? If it is listed on the stock exchange, is it filing reports in line with international accounting standards with the Securities Regulator? If it is a monopoly, is it submitting accounting reports to the government or watchdog body? Is the company training its managers and accountants in the new accounting procedures?
  • Profitability and efficiency. The company should tell you not just what profit it made, but some measure of its efficiency. Ask for the rate of return on total net assets, the rate of return on sales revenue, or the rate of return on equity. Ask what is the level of debt to assets, or leverage. Do these ratios improve or worsen in the first year following privatization?

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