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Privatization: Slovakia

Peter Green

Not long after they took control of the Slovnaft oil refinery in the Slovak capital Bratislava in 1995, the company's top managers hung their portraits from a wall in the plant's reception area. It was not a welcoming sight: the dour faced managers looked like a prize bunch of sourpusses. But they had cut themselves a sweetheart of a deal.

In the political sweepstakes that marked the privatization of Slovak industry under the regime of nationalist strongman Vladimir Meciar, the Slovnaft managers were adept players, and they came up winners, acquiring control of a 16.4 billion Koruny ($529 billion at the time) company for free.

The way that Slovnaft's managers swung their deal was indicative of the politically motivated privatization of Slovak industry as Mr. Meciar sought to reward his political supporters, punish his foes and find fast cash to keep his voters sitting on a soft cushion of social benefits while the Slovak economy struggled a painful transition towards the free market.

The Company

The Slovnaft refinery, on the outskirts of the Slovak capital Bratislava, was designed to refine oil from the Soviet Union and other Communist states. It went into service in 1959, with a capacity to refine 122,000 tons of oil per year, but in a prime example of the problems with Communist central planning, the Druzba (Friendship) pipeline that was to supply Soviet oil only reached Bratislava in 1962. By 1970, Slovnaft had production lines for 62 different products and a capacity of 6 million tons of oil annually. In fact, right up to the fall of Communism, in 1989, the Czechoslovak government continued to invest in new capacity at Slovnaft, and the company entered the post-Communist privatization process as one of the most modern refineries in the former Soviet bloc.

The Plan

Lined up behind their then-CEO, Slavomir Hatina, the managers formed a limited partnership called Slovintegra, and in 1995 acquired a 39 percent stake in Slovnaft for what should have been the reasonable price of 6.4 billion Koruny (about $206 million at the time). The firm's fair market value was never really in doubt. Post-Communist privatizations were often difficult to value – usually firms were assigned a book value based on a rough estimate of the worth of its fixed assets minus debts plus a smalll multiple of annual earnings. But with no market forces affecting these valuations, most were at best guesswork. Slovnaft was more fortunate. Only a few weeks earlier, the European Bank for Reconstruction and Development had paid $56 million for 10.5 percent of the company, to salvage Slovnaft's foundering initial public offering. That valued the entire company at a hefty $533 million.

The sale of effective control of the firm to its technically competent managers was scheduled alongside the IPO as an integral part of Slovnaft's privatization. And the firm, the largest single employer in the capital and one of the country's largest enterprises was to serve as an example for the privatization of the rest of Slovakia's state-owned industry. But when the smoke had cleared, Slovnaft's privatization was an example of nothing more than how pervasive and deep rooted was the crony capitalism that ravaged Slovakia's economy and kept Mr. Meciar and his party in power for eight of Slovakia's 12 years of post-Communist rule. The Scam On August 10, 1995, Slovakia's National Property Fund, the government agency charged with selling off state-owned businesses, declared Slovintegra the winner of a 39 percent stake in the refinery. The stake was valued by a government privatization audit at 6.4 billion koruny, which Slovintegra was to pay in installments, with a down payment of 100 Million Koruny.

So far so good. The sale price could be reduced by up to 3 Billion Koruny if the managers invested that amount in upgrading the company's aging refineries. A further 2.4 Billion Koruny would be knocked off the purchase price if the factory met profit targets set out in the purchase agreement. In ordinary times such wording might be considered a reasonable incentive to secure the development of the factory, by giving its shareholders an interest in developing the refinery for long-term growth, and not simply running the outdated, Soviet-era plant into the ground, pocketing the profits and leaving the government to pick up the tab several years down the road.

At least until you read the fine print. The 3 billion Koruny investment did not have to come from the managers' firm, Slovintegra, or from outside financing which they arranged and for which they took the risk. Instead it could be invested by the company itself. Since Slovnaft already had in place a modernization plan in excess of 3 billion Koruny, partially financed by bank loans and bonds and partially by the money it had just raised from floating certificates of deposit on the London Stock Exchange, the managers in fact were not investing an additional penny - or haller as the smallest unit of Slovak currency is called - of their own money. And no incentive was needed for Slovnaft to reach its target profits. The firm was already Slovakia's most profitable heavy industry, as favorable tariff barriers protected its wide margins on the domestic market. In other words, for a stake in Slovnaft with a market value of 6.4 billion Koruny, the managers' firm, Slovintegra, was only asked to pay 1 billion Koruny. That alone would be enough to make the Slovnaft privatization one of the most profitable deals of the 20th Century.

But the spirit of Christmas was still firmly alive at the National Property Fund: The remaining 1 billion Koruny was payable in interest-free installments of 100 Million Koruny a year over ten years. Still a considerable sum for a group of 19 post-Communist managers to pay by themselves. Until you take a look at Slovnaft's financial results. The firm was so profitable that the dividends due to the Slovintegra managers for their 39 percent stake would be significantly greater than 100 million Koruny a year. At that point it was not difficult for the Slovintegra management to secure a 100 million Koruny loan for the first installment from the state-owned Bank, Polnobanka.

The bottom line: Slovnaft's managers, who were appointed by the National Property Fund, actually paid the Fund nothing from their own pockets. In addition the fund lost 5.4 billion Koruny by lowering the purchase price, and an additional sum of perhaps 450 million Koruny on the interest free installments.

But the giveaway didn't end there: One reason Slovnaft was for sale at all was that the Slovak government had cancelled a second wave of voucher privatization which was set to distribute shares in state-owned enterprises to Slovak citizens. In fact, dozens of investment funds had already been set up to manage the citizen's privatization vouchers and the funds themselves had spent hundreds of millions of crowns on everything from staff and computers to in depth analyses of target companies and on advertising campaigns.

After winning parliamentary elections in September 1994, Mr. Meciar's coalition put the privatization funds out of business, invalidated the coupons and declared companies would now be directly sold by his government or floated on the Bratislava bourse. It also shifted privatization to the National Property Fund, an agency not under scrutiny by parliament or the opposition. Mr. Meciar's government defended the system. "We want to create a strong class of domestic entrepreneurs. We do not want control of strategic companies sold to foreigners," said Ota Balogh, spokesman for Slovakia's National Property Fund, said in an interview at the time

In exchange for their cancelled privatization vouchers, the government issued citizens bonds with a face value of 10,000 Koruny - the average book value of a privatization voucher - redeemable in ten years.

But if Slovak voters can be sometimes gullible - after all they voted Mr. Meciar's cabinet into office - they can also be realistic. No one believed the government's pledge to redeem the bonds at full value in a decade, and the market was flooded with bonds, trading for as little as 30 percent of their face value - a 70 percent discount.

The only people to maintain any illusion about the bonds appeared to be the National Property Fund. It informed large privatization purchasers, including the clever financiers at Slovintegra, that they could meet their payments to the fund in bonds, rather than cash. In the looking-glass world of Slovak privatization, the Slovintegra managers then used their 100 Million Koruny a year dividend to buy bonds for as little as 30 million Koruny, making an additional profit of 70 million Koruny.

Total up the cost to the managers: they were paid more than 70 million Koruny a year from the state to accept ownership of a 16.4 billion Koruny refinery company. The loss to the state was close to the total 6.4 billion Koruny that the state never received. Curiously there was no outcry from the state. The only scream came from a private shareholder, the EBRD.

The Regulators

In a developed market economy, such shenanigans would have been blocked by a host of regulatory agencies and parliamentary commissions. But in Slovakia’s emerging market democracy, the regulators, the administrators of the privatization and most of the parliament were all in the hands of the same party, Mr. Meciar’s HZDS. And despite sharp attacks in the media, the government and its cronies simply ignored any objections to its actions. After all, they had won the last election, and had the support of both the population and the powerful elites.

As for the banks, well, who could blame them for lending to Slovintegra. If the owners of a company have a government guarantee giving them title to the firm, and the dividends they receive from their share in the company more than covers the loans payments, then those owners would appear to any bank as a low risk, high return borrower.

The Effect on the Firm

Besides Mr. Hatina, who was a financial backer of Mr. Meciar's Movement for a Democratic Slovakia (HZDS), other privatization winners included former finance minister Julius Toth and former transportation minister Alexander Rezes who controlled Slovakia's largest export earner, East Slovakia Steelworks (VSZ Kosice). VSZ was eventually driven into bankruptcy by Mr. Rezes, but not before he escaped with a hefty payout when the firm was sold to American steel giant US Steel. The wife of Meciar associate Vitazoslav Moric won control of rail builder ZOS Vrutky, and Stefan Rosina, a close associate of finance minister Jan Ducky, led a management buyout of tiremaker Matador Puchov.

Not everyone was blinded by Mr. Meciar's smoke and mirrors. "The privatization was a very cheap sale of the country's assets to those who are loyal to the government," says Brigita Schmoegnerova, a reform-minded opposition parliamentarian who later served as finance minister. Schmoegnerova said Meciar was distributing public property to his friends as he built a warchest for the 1998 parliamentary elections. "It's old-fashioned political patronage to grab the levers of power," a Western diplomat in Bratislava said at the time. Nor did the Slovnaft sale - and others like it - encourage outside investors to believe Slovakia had a future as a market economy. Management buyouts like the Slovnaft deal "do not set a precedent for a market-oriented economy," said Jiri Heubner, chief banker for the Czech and Slovak Republics at the EBRD.

Economist Kenneth Murphy says the government's plan had done little to create or spread the wealth. In an academic study he wrote at the time, Mr. Murphy noted that in its first six months in office, the Meciar government sold companies valued at 20 billion Crowns while the Property Fund received only 3 billion Crowns. "Because these sales are conducted in secret and the terms are unknown, it is impossible to verify whether or not they are contributing much - if anything - to the government's coffers," wrote Mr. Murphy, who worked for the Central European University's Privatization Project.

The EBRD's Mr. Huebner says the Slovak government has conducted "basically privatization on credit," to domestic management with that credit provided by the Government. "Generally, there are no tenders, no announcements and the price isn't the market price. Even the financing is subsidized," he said.

Slovnaft's Vlado Kassovic defended Slovintegra's terms. "It's cheap, but I would like to underline that there are additional conditions that are very strict," he said in an interview, referring to the Property Fund's ability to seize back the company if detailed investment targets were not met.

The easy terms also worried institutional investors like Josef Oravkin, then a manager of the VUB Invest fund. He warned that by placing politics over market sense, many of the newly privatized firms would go bust. "The too easy terms are not an incentive for good management," said Mr. Oravkin.

Others argued that with little domestic capital available, Slovakia's privatization scheme was a valid option. "It's the transition from Monopoly money capitalism to real capitalism. You don't have people with real money but you want to privatize fast," said a Bratislava banker.

The Lesson

From shoemakers to heavy machine manufacturers, many of the firms that were privatized in Slovakia’s special style went bankrupt. But others, like Slovnaft, with a strong grip on their home markets, and run by competent if not brilliant managers, survived. What was lost was the opportunity for the state – and for the Slovak people – to profit from the transition to capitalism. The government lost billions of dollars in revenue that could have been used to invest in infrastructure, education, health care and other prerequisites of a modern economy. The result was to leave Slovakia to become one of the most impoverished candidates for membership in the European Union, a position from which it will take decades to recover.

It seems clear now, that despite a few reluctant successes such as Slovnaft, privatization would have been more successful for the Slovak economy as a whole if several key steps had been taken. First, the banks should have been privatized to foreign banks. With expertise in lending to a capitalist economy, a reputation to protect, and a desire for profit, the banks would have made capital available to those entrepreneurs with skill and a reasonable expectation of success.

Secondly, with a proper, transparent and apolitical regulatory process, the privatization would have spread the wealth to more citizens than the politically connected ex-communist elite.

Thirdly, the direct entry of foreign strategic partners into key large businesses would have moved them far more swiftly to a profitable footing. Hungary and Estonia have both followed this path with tremendous success. The objection most often heard, that control of the nation’s economy would be in the hands of those with no long term interest in that economy could easily have been dealt with by intelligent regulatory action and taxes that would have assured that a reasonable share of revenues remained in Slovakia.

The proof, in fact, that Slovakia’s special style of privatization was merely a long and costly detour from the path of market reality, is that six years later, few of the companies privatized to "Slovak capital" are still in Slovak hands, Mr. Meciar is out of power. Slovnaft is controlled by Hungarian oil firm MOL, and VSZ went bankrupt before being repossessed by the state and sold to U.S. Steel. "The market genie may not be so easy to reimprison in the bottle," wrote Mr. Murphy at the time. Presciently, he noted that "If Meciar's erstwhile cronies like Slavomir Hatina are to reap maximum profits from their new holdings, they will need the foreign shareholders and capital markets that his government suppresses."

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