WORLD BANK TECHNICAL PAPER NO. 403 WvTPL403 Work in progress \dTPYOS for public discussion Aotco> c O The Case-bv-Case Approach to Privatization 1)1't11St1ts k//t II- 't2XI/h I)i,k Il,/,/, (,,/i ,, i, ,,,, RECENT WORLD BANK TECHNICAL PAPERS No. 326 Colletta, Balachander, and Liang, The Condition of Young Children in Sub-Saharan Africa: The Convergence v,f Health, Nutrition, and Early Education No. 327 Valdes and Schaeffer in collaboration with Martin, Surveillance of Agricultural Price and TErade Policies: A Handbookfor Paraguay No. 328 De Geyndt, Social Development and Absolute Poverty in Asia and Latin America No. 329 Mohan, editor, Bibliography of Publications: Technical Department, Africa Region, July 1987 to April 1996 No. 330 Echeverria, Trigo, and Byer]ee, Institutional Change and Effective Financing of Agricultural Research in Latin America No. 331 Sharma, Damhaug, Gilgan-Hunt, Grey, Okaru, and Rothberg, African Water Resources: Challenges and Opportunities for Sustainable Development No. 332 Pohl, Djankov, and Anderson, Restructuring Large Industrial F'irms in Central and Eastern Europe An Empirical Analysis No. 333 Jha, Ranson, and Bobadilla, Measuring the Burden of Disease and the Cost-Effectiveness of Health Interventions: A Case Study in Guinea No. 334 Mosse and Sontheimer, Performance Monitoring Indicators Handbook No. 335 Kirmani and Le Moigne, Fostering Riparian Cooperation in International River Basins: The World Bank at Its Best in Development Diplomacy No. 336 Francis, with Akinwumi, Ngwu, Nkom, Odihi, Olomajeye; Okunmadewa, and Shehu, State, Community, and Local Development in Nigeria No. 337 Kerf and Smith, Privatizing Africa's Infrastructure: Pviom-ise and Change No. 338 'foung, Measuring Economic Benefits for Water Investments and Policies No. 339 Andrews and Rashid, The Financing of Pension Systemts in Central and Eastern Europe: An Overview of Major Tren.ds and Their Determinants, 1990-1993 No. 340 Rutkowski, Changes in the Woge Structure during Economic Transition in Central and Eastern Europe No. 341 Goldstein, Preker, Adeyi, and Chellaraj, Trends in Health Status, Services, and Finance: The 'Transition in Central and Eastern Europe, Volume I No. 342 Webster and Fidler, editors, Le secteur informel et les inst'itutions de microfinancement en Afrique de l'Ouest No. 343 Kottelat and Whitten, Freshwater Biodiversity in Asia, with Special Reference to Fish No. 344 Klugman and Scnieber witn Heleniak and Hon, A Survey of Health Reform in Central Asia No. 345 Industry and Mining Division, Industry and Energy Departmrrent, A Mining Strategy for Latin America and the Caribbean No. 346 Psacharopoulos and Nguyen, The Role of Government and the Private Sector in Fighting Poverty No. 347 Stock and de Veen, Expanding Labor-based Methodsfor Road Wcrks in Africa No. 348 Goldstein, Preker, Adeyi, and Chellaraj, Trends in Health Status, Services, and Finance: The Transition in Central and Eastern Europe, Volume II, Statistical Annex No. 349 Cummings, Dinar, and Olson, New Evaluation Procedures for a New Generation of Water-Related Projects No. 350 Buscaglia and Dakolias, Judicial Reform in Latin American Courts: The Experience in Argentina and Ecuador No. 351 Psacharopoulos, Morley, Fiszbein, Lee, and Wood, Poverty and Income Distribution in Latin America: The Story of the 1980s No. 352 Allison and Ringold, Labor Markets in Transition in Central and Eastern Europe, 1989-1995 No. 353 Ingco, Mitchell, and McCalla, Global Food Supply Prospects, A Background Paper Preparedfor the World Food Summit, Rome, November 1996 No. 354 Subramanian, Jagannathan, and Meinzen-Dick, User Organizations for Sustainable Water Services No. 355 Lambert, Srivastava, and Vietmeyer, Medicinal Plants: Rescuing a Global Heritage No. 356 Aryeetey, Hettige, Nissanke, and Steel, Financial Market Fragmentation and Reforms in Sub-Saharan Africa No. 357 Adamolekun, de Lusignan, and Atomate, editors, Civil Service Reform in Francophone Africa: Proceedings of a Workshop Abidjan, January 23-26, 1996 (List continues on the inside back cover) WORLD BANK TECHNICAL PAPER NO. 403 The Case-by-Case Approach to Privatization Techniques and Examples Dick Welch Olivier Fremond The World Bank Washington, D.C. Copyright © 1998 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing March 1998 Technical Papers are published to communicate the results of the Bank's work to the development community with the least possible delay. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. 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ISSN: 0253-7494 Dick Welch is a consultant and Olivier Fremond is a senior private sector development specialist in the Enterprise Unit of the Private Sector Development Department of the World Bank. Library of Congress Cataloging-in-Publication Data Welch, Dick, 1936- The case-by-case approach to privatization: techniques and examples / Dick Welch, Olivier Fremond. p. cm. - (World Bank technical paper; no. 403) ISBN 0-8213-4196-0 1. Privatization-Case studies. I. Fremond, Olivier, 1955- II. Title. III. Series. HD3850.W363 1998 338.9-dc2l 98-12800 CIP Contents Foreword v Abstract vii Why case-by-case? 1 Global experience 1 Global lessons 1 First phase-getting ready 4 Step one: Identifying privatization candidates 4 Step two: Feasibility study 5 Second phase-moving to sale 8 Step three: Privatization plan 8 Step four: Obtaining approval 9 Step five: Sale 9 Sales methods and special concerns 10 Public offerings 10 Secondary offerings 13 Trade (third-party) sales 14 Mixed sales-trade sales combined with share offerings 16 Conditions attached to privatizations 17 Role of foreign investors 17 Privatizing natural monopolies 19 Organizing government for privatization 20 Securing a central location and high-level support 20 Setting clear objectives 20 Developing institutional competence and experience 20 Overcoming the commitment problem 21 Valuation methodology 22 Value is in the eyes of the beholder 22 Stages 22 Methods 23 iv The Case-by-Case Approach to Privatization: Techniques and Examples Hiring financial and other advisers 26 Selecting financial advisers 26 Selecting other advisers 27 Should the same financial adviser be used for both phases of privatization? 27 Foreign advisers 27 Tenders for financial advisers 27 Foreword Case-by-case privatization is of interest to all privatiza- agement, skills, capital, and marketing know-how to tion practitioners. As the technique best suited to priva- the privatized firm. tizing medium-size and large enterprises, it forms the The World Bank maintains a strong interest in fos- basis of privatization programs worldwide. It has been tering privatization as a way to restructure transition used extensively in industrial countries as well as in Latin and developing economies, promote free markets, and America and, to a lesser extent, Africa and Asia. And tran- increase economic efficiency The Bank considers case- sition economies, most of whom recently completed by-case privatization of large state enterprises essential voucher (mass) privatization, are starting to privatize to economic reform. Moreover, it recognizes that this medium-size and large state enterprises using case-by- approach can deliver significant financial resources to case privatization. governments while reducing the economic and finan- Case-by-case privatization involves selling gov- cial risks posed by these firms. ernment shares in state-owned firms through public The authors of this paper have extensive experience share offerings, trade (third-party) sales, or mixed with case-by-case privatization. Dick Welch worked for sales. In the process the ownership and management many years as a senior executive in Canada's successful of state firms are shifted to the private sector. The privatization program and has undertaken and advised case-by-case approach allows governments to a large number and wide range of privatization trans- resolve the policy issues (such as regulation and actions. Olivier Fremond has extensive experience in labor concerns) surrounding privatization, lets merchant banking, where he participated in the sale of governments sell firms for their fair market value, a number of state enterprises. He also was senior advis- provides a transparent sales process, can improve er to Morocco's privatization program during 1993-96. corporate governance and attenuate insider influ- This paper is a practical guide for privatization practi- ence, and, where required, can bring foreign man- tioners based on the authors' hands-on experience. Magdi Iskander Director Private Sector Development Department Finance and Private Sector Development The World Bank v Abstract Case-by-case privatization is of great interest to all Drawing on global experience, this paper provides privatization practitioners. Because it is the tech- practical guidance to government officials charged with nique best suited to privatizing medium-size and managing case-by-case privatization programs. It iden- large enterprises, it forms the basis of privatization tifies the five key steps in case-by-case privatization, programs worldwide, and has been used extensively describes sale options and the processes for carrying in industrial countries and Latin America and, to a them out, and examines special conditions, such as lesser extent, Africa and Asia. And transition golden shares. It then outlines how governments should economies, having recently completed voucher undertake case-by-case privatization, identifying basic (mass) privatization, are starting to privatize medi- principles and common challenges, describing various um-size and large enterprises and need to under- methods for valuing state enterprises, and explaining the stand, design, and launch case-by-case privatization role of financial advisers and sales agents in valuing pri- programs. vatization candidates and developing options for sale. vii Why case-by-case? Most privatization programs outside the transition Many Central and Eastern European countries are economies take a case-by-case approach. Governments starting to move beyond their initial privatization pro- move control of state enterprises to the private sector, grams, which focused on small-scale privatization and usually one at a time, using domestic and internation- mass (voucher) privatization. Thus case-by-case priva- al public offerings, trade (third-party) sales, or a com- tization of major infrastructure and medium-size and bination of the two (a mixed sale). The case-by-case large (strategic) enterprises is taking hold there as well. approach offers several advantages, allowing govern- Most of the world's privatization programs have been ment to pay close attention to the policy issues sur- implemented on a case-by-case basis. In general, these rounding privatization; structure privatizations to programs seek to increase efficiency, expose state enter- bring in needed foreign capital, knowledge, and mar- prises to market discipline and best practices, promote ket connections; and maximize the financial returns wider share ownership and entrepreneurship, reduce from privatization. government interference in the economy, strengthen Many countries adopt privatization programs as competition and weaken monopolies, develop domes- part of structural reforms and to alleviate budget prob- tic capital markets, cut budget deficits, and reduce lems. Selling state enterprises to the private sector can public and external debt. substantially reduce the flow of public funds to these firms. It also can generate significant revenue for gov- ernment in the form of sales proceeds and future tax Global lessons revenues from the newly privatized firms. Considerable experience has been gained with case-by- case privatization, and consensus is emerging about Global experience the main requirements for successful programs. The global wave of privatization started in the United There is no "right" approach Kingdom in 19 79. The U.K. program is still under way, Case-by-case privatization must be tailored to the and has generated almost $100 billion in revenue from circumstances of the country and the enterprise. the privatization of such major state enterprises as Although there are a number of best practices and British Telecom (the first large British privatization), generally accepted privatization methods, only care- British Gas, British Airways, British Petroleum, the ful packaging, timing, and sequencing can guaran- electricity system, the water companies, and, most tee success. The focus should be on pragmatism, recently, the railways. Even the recently elected Labor flexibility, and willingness to try new solutions and administration has embraced privatization. Other methods. OECD and developing countries have emulated the British model of case-by-case privatization, including Strong political support and leadership are vital Argentina, Canada, Chile, France, Italy, Germany, New Privatization must receive support from the highest Zealand, and Spain. levels of government to overcome inertia and resis- 1 2 The Case-by-Case Approach to Privatization: Techniques and Examples tance from the bureaucracy and special interests. because governments, lacking qualified personnel, Implementation should be the responsibility of prag- could not manage the process. matic individuals with political clout, no vested interest in the status quo, and access to world-class Related structural reforms should keep pace technical expertise. The privatization agency should with privatization report to a senior minister. Governments should implement privatization pro- grams within a framework of mutually reinforcing eco- Investors will respond to a well-prepared transaction nomic reforms, including macroeconomic stabilization, Naysayers often claim that investors-both domestic trade liberalization, financial sector reform, public sec- and foreign-have little interest in privatization. Yet tor reform, and regulatory reform. If other reforms lag, heavy oversubscription of share offerings in Britain, privatization will be unsustainable and unable to Latin America, and Africa (Nigeria, Senegal) have taken restructure the economy. many by surprise. Analysts often underestimate the informal savings and flight capital in developing and Pre-privatization restructuring should be brief transition economies. With the right incentives, and defensive domestic and international investors are eager to buy Pre-privatization restructuring should be limited to equities. To that end, governments must avoid setting balance sheet strengthening and organizational unrealistic reserve prices. Instead, market-based valu- changes such as closures, workforce reductions, and ations (rather than replacement or book values) should transfers of social services. Technology changes, be used. capital investment, and major purchases should be left to the new owners, not to government officials. Transparency, fairness, and a level playing field are essential Privatization programs should attract Transparency is crucial to successful case-by-case foreign investment privatization. Third-party financial advisers must Governments compete fiercely for foreign investment carry out asset valuations to ensure that prices are in privatized assets. To attract investment, foreign realistic, fair, and consistent, as are procedures for investors should be treated the same as domestic calling for bids and evaluating offers. Moreover, gov- investors. Without a conscious, consistent, and ernments must carefully plan and execute privatiza- aggressive policy to attract foreign investors, privatiza- tion. Publicity campaigns help make potential tion programs may fail to generate sufficient revenue investors aware of investment opportunities. In or could discourage investors who could provide mar- trade sales the contract terms should be included in ket access, new technology, and management exper- investment bidding documents to discourage unde- tise. The state must assure investors that it will not use sirable changes during contract negotiations. its political power, residual shares, or golden share in Finally, the privatization award process must be a way that jeopardizes the company's ability to maxi- transparent to avoid corruption and controversy. mize profits and efficiency Outside expertise should be sought Privatization in tranches or through a mixed sale can Specialist consultants-especially financial advisers- help m.aximize government receipts have a clear role to play in case-by-case privatization. Emerging markets may be unable to absorb large Although local experts can be used, governments packages of shares all at once. In such cases share should not hesitate to call on the growing body of sales should be broken into tranches and sold over foreign privatization experts. Investment banks, time following a preannounced schedule. Mixed consulting firms, environmental experts, accountants, sales can boost domestic and foreign demand and and lawyers are essential players in case-by-case improve corporate governance by introducing a programs. Many privatization programs have suffered strong, controlling shareholder. Why case-by-case? 3 Governments should minimize the conditions attached Such laws define the rules of the privatization program to privatization and establish and empower the institutions charged Elaborate conditions for sale will detract from the value with executing it. Canada and the United Kingdom- and attractiveness of an enterprise and may undermine countries with a common law tradition-privatize the deal. Governments should fix regulations, price con- without a privatization law, using specific legislation trols, subsidies, and other problem areas before the sale. only where required. Countries with weaker institu- tions and law enforcement, however, may not be able Governments should not adhere to an artificially to ensure the transparency of privatization. Such coun- fixed timetable tries should draft a privatization law that clearly defines Although constant pressure is needed for case-by-case privatization procedures. privatization to proceed, unrealistic time constraints Privatization laws offer both advantages and disad- serve little purpose. One useful approach is to sequence vantages. When carefully drafted, they strengthen the several sales according to market conditions. Moreover, state's capacity to carry out structural reforms. They governments should bear in mind that not all transac- also help make more transparent the transfer of state tions will be successful, and that it might be necessary property to the private sector. Once ratified, however, to reject all bids and start the bidding process anew or a law cannot easily be changed. If procedures need to change the method of divestiture. be revised in response to market conditions, an amend- ed law or new regulations may be required. Public information campaigns are crucial Most successful privatization programs have placed a Care should be taken in crafting a list of heavy emphasis on educating the public and advertis- strategic industries ing expected sales. Special efforts to inform institu- In selecting companies for privatization, many coun- tional investors have encouraged them to participate in tries have drafted a positive list (containing enter- many privatizations. prises that can be privatized) or a negative list (con- taining enterprises that cannot be privatized, because Private monopolies may be worse than they are deemed strategic). A positive list is useful public monopolies because it has the full power of the law behind it. Before privatizing natural monopolies, governments Companies are committed to privatization within the should restructure the industry to promote competi- deadline for the program, and can be privatized at any tion, accompanied by clear regulations and credible time by the institution in charge of executing the enforcement. transfers. Such arrangements make it harder- though not impossible-for enterprise managers to The desire to maximize sale proceeds should be stall privatization. balanced with other priorities Although a negative list may provide more options Although the privatization agency has a duty to sell for privatization, care should be taken in preparing state assets for their fair market value, it must balance such a list. As many countries have learned, private its desire to maximize sale proceeds with other priori- ownership does not necessarily imply a loss of state ties, such as broadening share ownership, deepening control over enterprises. Thus many state enterprises domestic capital markets, and promoting competition. that were once deemed strategic-oil and gas compa- nies, telecommunications firms, other utilities-are Privatization laws can be helpful but being privatized. Many governments have chosen not are not always essential to have a positive or a negative list, preferring to pri- Countries with a civil law tradition tend to approach vatize state enterprises without restriction, as and privatization by preparing a general privatization law when market conditions appear favorable. First phase- getting ready Case-by-case privatization is a five-step process. Many dates once the analysis is complete. Moreover, govern- case-by-case practitioners separate these steps into two ments should avoid making a list of "strategic" indus- phases (box 1)-both for conceptual reasons and for tries that are exempted from privatization. Doing so ease of contracting when designing terms of reference only provides an opportunity for firms that are reluc- and hiring financial advisers and sales agents. tant to privatize to lobby for inclusion on the list. This section deals with the first phase of case-by- Once the government has compiled a list of candi- case privatization-getting ready This phase begins dates, it should decide, with ministers and senior offi- with the government identifying potential privatiza- cials, which enterprises will proceed to the second step tion candidates. It ends with the completion of a feasi- of the process, the feasibility study As it identifies can- bility study and the government's decision on the pri- didates, the government will find that some state enter- vatization option and sale. The second phase of the prises have excellent commercial potential, a number process-moving to sale-is examined in the next are attractive, and some will be difficult to privatize. section. Governments should choose more candidates than are needed over the short term-all privatizations are dif- ficult, and having a number of good candidates in the Step one: Identifying privatization candidates pipeline increases the likelihood of success. Moreover, the government should be trying to build an inventory Identification and selection of privatization candidates of privatization candidates. is the first step in case-by-case privatization (figure 1). Selection criteria depend on a country's privatization Box 1. The five steps in case-by-case privatization objectives and legal framework. At a minimum, these criteria should include a policy test to establish what First phase Getting ready-steps one and two should be privatized and what should remain in gov- Step one: Identification and selection, where the gov- ernment hands. For example, in Canada the policy test emient chooses its candidates for privatization. is whether a state enterprise's activities are core to gov- Step two: The feasibility study, where the government identifies policy issues and develops options for resolv- eminent-that is, whethermthere isaneedforgovern- ing them and financial advisers value the enterprise and ment ownership or delivery of the enterprise's services provide options on timing and method of sale. or products. If an enterprise does not pass this test, it becomes a candidate for privatization or shutdown. Second phase Moving to sale-steps three, four, andfive Worldwide, many governments are narrowing their Step three: Privatization planning, where the govern- definition of what is considered a core government ser- ment resolves policy issues and, with its financial advis- vice ad broaening he tyes of nter'rses an ser- ers, plans the sale. vice and broadening the types of enterprises and ser- Stepfour: If required, the legislative or approval phase. vices eligible for privatization. Step five: Implementation or transaction, where the Governments should consider all state enterprises in government and its advisers make the sale through a this initial analysis. Those that clearly perform core bidding or public offering. government functions will not be privatization candi- 4 First phase-getting ready 5 Figure 1. First phase-getting ready Step one: Identification of privatization Test to determine if Keep as state candidates enterprise is central Yes enterprise to government No -----------------------------------------rF---------------------------------------- Step two: Financial advisers or Feasibility study consortium of advisers hired Current and future _I viability Need for defensive commercial viability Not , Consider restructuring? of enterprise evaluated viable wind-up Need to corporatize? Viable Valuation and possible Need for methods and timing monopoly regulation? of sale determined Environmental issues Level of foTeign > Policy issues and options ownership? for resolving them Employee issues identified Need for sale restrictions L or conditions? Seller's due diligence from enterprise Residual shares- management management and future sale Move to approval No process for sale approval S Trade sale- Approval auction Sales option approved Trade sale- negotiated Share flotation New financial adviser _ ~~~~~~~or sales agent or step Mixed sale two advisers reconfirmed Step two: Feasibility study * The need for restructuring and rationalization. As noted, governments should limit pre-privatization During the second step the government and its finan- restructuring to legal, accounting (balance sheet), cial advisers analyze the feasibility of and options for and organizational changes. Any workforce reduc- privatizing the enterprises identified in step one (see tions should take place before an enterprise is sold. figure 1). This analysis should examine: Technology changes, capital investments, and major * The enterprise's economic performance, efficiency, purchases should be left to the new owners. profitability, and earning potential. * The environmental aspects of the privatization, * The enterprise's internal structure and management. including past and future pollution and the need * The need to corporatize the enterprise before priva- to establish environmental legislation or regulation tization (box 2). (box 3). 6 The Case-by-Case Approach to Privatization: Techniques and Examples * The market situation in which the enterprise should be the same time, it is essential that the government working, including an evaluation of whether a monop- appoint a competent official to manage these and oly should be broken up. If new regulations are required, future stages of privatization. the govemment and its advisers should identify them and set a timetable for implementing them. To avoid conflicts Identifying and resolving policy issues of interest, the advisers who do the regulatory review The feasibility study should examine the policy issues should not be the same ones selling the enterprise. surrounding the possible privatization and propose * The characteristics, concerns, and requirements of solutions that are compatible with the sale of the potential buyers and investors. enterprise. It should, for example, address regulation * The policy issues that need to be resolved before pri- and competition and, if necessary, employee issues- vatization-for example, what level of foreign partici- particularly downsizing and buyouts. It also should pation is acceptable and what role employees will play examine the need for restrictions on sale (golden in the privatization. share) and study the management of any residual * Any restrictions on sale-for example, government shareholding. shares, golden shares, or special terms and conditions. For marketable enterprises, the financial advisers will Valuing the enterprise value the firm and report on privatization options. This Valuation is of paramount importance because it report will help the government decide whether and establishes a market price range for the enterprise. how to proceed. Valuations based on market principles are essential to stifle criticisms that the state is not receiving a fair price Organization and to ensure that there is sufficient investor interest. Financial advisers may be useful during the identifica- In Western market economies valuation is based on tion stage, but they are essential for the feasibility study discounted cash-flow projections of future earnings (See the section on hiring financial advisers, below.) At and comparisons of similar firms' market prices (when Box 2. Corporatization in New Zealand Corporatization reduces government control over a state activities, while the government would fund noncom- enterprise by giving it the organizational form and man- mercial activities. agement structures characteristic of a commercial private * Make state enterprises more market-oriented. Corp- business. New Zealand's experience shows that corporati- oratized state enterprises are treated the same as private zation can be a prelude to privatization. businesses. They pay taxes, receive no subsidies, and must When a labor government was elected in mid- operate at a profit. Moreover, the government will not 1984, New Zealand faced serious economic, finan- guarantee their debt. cial, and structural problems. Extensive government * Establish real balance sheets for state enterprises. (Most regulations, intervention, and subsidies hobbled the state enterprises receive their capital through direct gov- economy. In response, the new government imple- emient transfers, subsidies, or debt injection.) A debt- mented economic and social reforms to move New equity ratio was established for each balance sheet based Zealand toward a free market economy. Corp- on the experience of similar firms in the industry. oratization and privatization were part of these * Bring in executives from around the world to manage reforms. The State-Owned Enterprises Act, passed in the newly corporatized firms, to boost their performance 1986, established a framework for the operation of prior to privatization. government-owned businesses and provided for Corporatization was a successful tool in the financial their corporatization. Corporatization of state enter- and organizational restructuring of New Zealand's public prises sought to: sector. It also facilitated the later sale of assets to the pri- * Separate commercial and noncommercial activities. vate sector: about half of the entities privatized by State enterprises would continue to engage in commercial December 1995 had first been corporatized. Source: World Bank staff. First phase-getting ready 7 Box 3. Environmental aspects of privatization Many transition economies have suffered significant envi- Investors in OECD countries and Central and Eastern ronmental damage from industrial activities. Privatizing Europe try to control their financial exposure when they industries that cause damaging pollution will require acquire environmentally problematic enterprises. addressing environmental issues in order to reduce Measures include: uncertainty for investors and the state. Failure to do so * Environmental audits, to help identify an enterprise's envi- has delayed and even derailed many privatization romnental liabilities and reduce the uncertainty of valuation. transactions. * Environmental and risk assessments, to determine the The government should develop transparent and pre- environmental consequences of a proposed development. dictable regulations and incentives to reduce the risk and * Remedial actions, depending on the health risks posed costs associated with environmental problems. In most by environmental problems. cases this means the govemment will have to assume * Contractual arrangements. some known environmental risks and indemnify the * Pre-closing conditions (government can release a buyer buyer from unknown risks. Approaches that have been from the purchase agreement if the environmental audit used include allowing private owners to set aside part of identifies serious problems). the purchase price for cleanup (the Czech Republic, * Indemnification (for costs incurred fixing specified Poland), indernnifying private owners for costs incurred problems). during cleanup (Bulgaria, Germany), and lowering the * Warranties (a type of indemnification if defects are dis- purchase price but making the buyer responsible for covered only after ownership). cleanup (Argentina). * Private insurance. Source: World Bank staff. sold through trade or negotiated sales) or stock market of the firm, the options for sale (trade sale, public offer- valuations (if publicly traded). ing of shares), and the timing options (immediate sale, Replacement value and book value are not measures sale after restructuring). of market value. Book value may understate real value because it is based on historical costs, and replacement Minimizing the risk of choosing poor candidates value may overstate value because firms are often sold for privatization below replacement cost. In addition to the valuation, Governments are often concerned that the feasibility financial advisers often prepare a sensitivity analysis study will find that a state enterprise is not suited to pri- that models the purchase price under changing condi- vatization, and that significant costs will have been tions prior to the closure of the transaction. incurred without identifying a viable privatization can- didate. This risk can be reduced by dividing into two Optionsfor sale and timing phases the financial advisery for the feasibility study. In In most cases privatization officials submit a privatiza- the first phase the financial adviser quickly evaluates a tion proposal to the political authorities at the end of state enterprise's potential for privatization. If the poten- the feasibility study. In case-by-case privatizations such tial is low, the adviser can be terminated before valuing proposals contain the valuation (usually a price range) the enterprise and developing options for privatization. Second phase- moving to sale As noted, the second phase of privatization involves the privatization raises. These may be wide-ranging, three steps: preparing a privatization plan, obtaining but common ones include: legislative approval (if needed), and selling the * The regulatory regime, if any, that the government enterprise (figure 2). needs to put in place. * An environmental statement identifying who will bear environmental liabilities (if any). Step three: Privatization plan * Restrictions or conditions on foreign participation in the sale. Once a government decides to privatize a state enter- * The role of employees in the privatization-for prise, it should prepare a privatization plan with its example, participation in an initial public offering, advisers. This plan should include a communications preferential subscription rights, discounts to sale price, plan (to build public support and attract investors); a and so on. plan to resolve the public policy issues surrounding the * Restrictions or conditions on the sale-for example, privatization; a plan outlining the method of sale, the golden shares. steps required to reach sale, and a timeline; and draft * The government's plan for managing residual share- legislation or executive orders. In addition, if the holdings. government is using different financial advisers for the sale than it used to prepare for privatization, those Sales plan advisers (sales agents) should be hired at this point. The sales plan should state how the government and its financial advisers or sales agents will carry Communications plan out the sale. The plan should contain the steps and The government should develop a communications timeline for the sale, covering the timing and plan before it starts the sale process. This plan should method of sale, responsibilities of government offi- be designed to build public support for the cials and advisers, production of sale documents privatization and teach the public about features of the (for example, information memorandums prospec- privatization that require public participation (for tuses), legal tasks and timeline, and the composi- example, how to purchase shares). The plan also should tion and hierarchy of the placement syndicate and provide ministers, public officials, and company exec- underwriting syndicate (if an initial public offering utives with question and answer material so that the is being used). government can provide coherent, coordinated, and accurate information to the media and public on the Draft legislation or executive orders aims, rationale, and progress of the privatization. If legislation is required for the privatization, includ ing for matters such as regulation, it should be draft- Public policy issues ed at this point. Any executive orders or decrees Before the privatization can proceed to the sale phase, needed for the sale of the state enterprise should also the government must resolve any public policy issues be prepared. 8 Second phase-moving to sale g Figure 2. Second phase-moving to sale Step three: Privatization plan Monopoly regulation C regm Environmental protection Policy issues resolved regime Legislation or Foreign executive order prepared ownership levels (if needed) Employee issues (pensions, share -T Communications to | ownership plans, I Communic ations plan | |pbuild public support a buyut, ndsoon prepared Icommunications with Sale restrictions _ potential investors or conditions L Residual shareholdings ISales plan prepared | management plan _ |(see below for options)| Stepfour:v Legislation or executive order Legal regime needed to allow sale put in place and policy decisions implemented Stepfive: Sale, T-hird-party (trade) sale | Mret Flotation Mixed .Step four: Obtaining approval lic offering, trade sale, negotiated sale, or mixed sale. An initial public offering requires the enterprise If legislative or government approval is required, the being privatized to be of sufficient size and quality to government should obtain it at this stage. Legislation justify a public sale of shares. (In addition, the mar- should be passed before the sales transaction starts; the kets in which the shares are being sold must be sales process becomes needlessly complex if legislation mature enough to absorb them.) Enterprises that do is pending when the company is brought to market. A not meet these requirements are sold through a trade communications exercise is needed to provide parlia- sale (third-party sale) of assets or shares using an mentarians with objective information on the aims of open bidding (auction) process. A negotiated sale to the government and the reasons for privatization. a strategic buyer is another alternative, though in most cases the government will receive less than it would through an active, open bidding process. Step five: Sale Finally, governments can use a mixed sale, combin- ing a trade sale with a public share offering, particu- The issues that arise during the sales transaction will larly if a strategic buyer is being sought for a signifi- vary according to whether the privatization is a pub- cant block of shares. Sales methods and special concerns Case-by-case privatizations generally involve public Another variation, targeting small investors, is to offerings, secondary offerings, trade (third-party) sales, offer incentive schemes. France and the United or mixed sales. In addition, attention must be paid to Kingdom, for example, have offered bonuses to any conditions attached to privatizations, to the role of encourage small investors to hold onto shares. foreign investors, and to the steps involved in privatiz- Investors typically were given one free share for every ing natural monopolies. ten shares bought and held for three years. Other schemes have allowed shares to be paid for in install- ments so that small investors can participate. Public offerings If domestic markets cannot absorb the entire share issue at once, governments should consider issuing Public share offerings on stock markets can be used shares in several tranches. In Canada, for example, the for large, profitable, relatively well-known state enter- government let state enterprises go to market with new prises. In addition to transferring ownership, share shares during the first tranche in order to establish a offers often raise additional capital for an enterprise market for the shares. The government then offered through the issue of new shares. Share offers can also some or all of its remaining shares at a later date. meet a government's objective of broadening share There are also variations involving the treatment of ownership by allocating a portion of shares to small small investors relative to institutional or "core" investors. Shares can be offered on the domestic mar- investors. In France and the United Kingdom, for ket as well as in international markets using American example, some offerings use the "claw back" method, depository receipts (ADRs) or global depository which allows the number of shares allocated to small receipts (GDRs). investors to increase (at the expense of institutional Shares are offered to retail and institutional investors) when there is high demand. In France the investors, usually at a fixed price. In most cases shares subscriptions of small investors often receive priority are sold by stockbrokers overseen by government reg- treatment and a 20 percent price discount for shares ulators. Public share offers are generally transparent held more than four years. In other countries, like Sri because of advertising (if permitted) and disclosure Lanka, the allocation to small investors is a fixed per- requirements. This approach is especially suitable if the centage of the public offering. size of the sale justifies the costs involved. The success of a share issue and the share prices Variations on this form of divestiture relate to the fix- obtained partly depend on the size of the share offer ing of the offer price for the shares, which can be a fixed and on market capitalization in the countries where the price offer, a tender offer, or both-as in the United issue is sold. Capital market imperfections, low market Kingdom, which pioneered an international and capitalization, and factors such as political risk can domestic pricing arrangement when it sold shares of depress asset values below the level indicated by stan- British Telecom (box 4). Shares were sold at a fixed dard valuation techniques. Measures to broaden share price to domestic retail investors but were auctioned to ownership-including targeting groups of investors, foreign and domestic institutional investors. selling in both domestic and foreign markets, and 10 Sales methods and special concems 11 offering shares in small denominations (so that more assume the risk of sale. Underwritten sales are more people can afford them)-can increase market capital- expensive but are less risky for government. ization, and thus ensure adequate prices for share offers. Governments should also consider whether Financial advisers and sales agents they want their public share flotations to be under- Govemments must hire financial advisers or sales agents written-that is, whether to have the sales agents (brokers) to underwrite (if required) and sell shares. The Box 4. Privatizing British Telecom and British Gas The United Kingdom kick-started the global wave of pri- Brtish Gas vatization in 1979. Since then it has privatized a vast num- The privatization of British Gas was the second divestiture ber of state holdings worth more than $100 billion. Two of a public utility in the United Kingdom. The govemment of the most successful offerings have been for British followed the same pattern of privatization as in the British Telecom and British Gas. Telecom privatization. In 1985 the government announced its intention to British Telecom privatize British Gas and in 1986 passed the necessary leg- The privatization of British Telecom was the first large islation. The Cabinet considered selling British Gas in divestiture of a public utility in the United Kingdom and tranches, starting with a 51 percent offer. Eventually, how- was among the most successful in the world, maximizing ever, it decided to offer all shares at once. It gave first pri- sales proceeds and achieving widespread share ownership. ority to U.K. individuals, second to U.K. institutions, and Employee participation was also substantial. third to foreign investors. The British government announced plans to deregulate In November 1986 the government offered 4 billion the telecommunications industry in 1979 and in 1981 ordinary shares representing 97 percent of the ordinary passed an act creating British Telecom and separating it capital stock. It retained 125 million shares to meet the from the General Post Office. During 1981-84 British requirements for bonus shares, employees, and pension- Telecom cut staff, improved it ratio of debt to equity, and ers. The offer allocated 1.6 billion shares to U.K. institu- improved service levels. In 1984 the government tional investors, 1.6 billion shares to the British public converted British Telecom into a public limited company (including British Gas customers, employees, and pen- and sold 51 percent of its shares in an initial sioners), and 800 million shares internationally. public offering. Because the offer was four times oversubscribed, the The $4.8 billion share flotation, offered domestically government reduced allocations to foreign and domestic and abroad, was nearly nine times oversubscribed. Up to institutional investors in favor of individual investors. In 10 percent of the offered shares (301 million) were the end 62 percent of shares went to the U.K. public, 23 reserved for British Telecom employees and pensioners. percent to U.K. institutional investors, and 11 percent to The government allowed 2,000 U.K. institutional foreign investors. The government retained the remain- investors to apply for 2.6 billion shares on a priority basis ing 4 percent. Total adjusted proceeds from the sale together with the general public. The remaining 415 totaled $8.6 billion. In May 1997 shares of British Gas million shares were allocated to buyers in Canada, Japan, were trading at a premium of 138 percent over the initial and the United States. All told, 47 percent of the shares offering price. went to U.K. and Swiss institutional investors, 14 percent Although the government achieved its fiscal goals, to Canadian, Japanese, and U.S. investors, 5 percent to increased short-term efficiency, and broadened share British Telecom employees and pensioners, and the ownership, some critics argued that it sold British Gas to balance to just over 2 million U.K. investors. The issue the private sector as a fully fledged monopoly and that created 2.2 million new shareholders in the United the regulatory agency, Ofgas, had insufficient powers. Kingdom. Before privatization, British Telecom had Thus some believe that the efficiency of the British gas 250,000 customers waiting to have a telephone installed, industry and the quality of service have been less than Now it installs lines within two days. The government optimal. Given the uniqueness of the transaction, it is continues to regulate British Telecom and holds a special hardly surprising that increasing competition was not a rights preference share (golden share) in the company high priority Source: Privatisation International, various issues; Euromoney, various issues. 12 The Case-by-Case Approach to Privatization: Techniques and Examples lead broker will lead the syndicate of brokers involved in * Closing, payment, and share delivery. the offer. For issues with a significant foreign component, Argentina's successful public offering of its state-owned govemments should hire foreign brokers to co-lead the oil company is described in box 5. issue (or at least the foreign component). Brokers should be selected through competitive tender so that the com- Prospectus, share instrument, and timing. The govern- parative strengths of competing firms can be evaluated. ment should work closely with the lead broker on issues relating to the prospectus, its contents, and Increase in capital contributions from the enterprise being privatized. If there is an increase in capital, the state enterprise will Of particular importance to the success of the issue want to manage the sale. In this case the government will will be the choice of share instrument (usually need independent advisers-preferably some who are common shares) and the timing of sale and payment. not involved in any aspect of the sale. A privatization Installment receipts, for example, can spread payment may, however, consist of a sale of government shares and over time. a company share issue. In such cases both the company and the government will need financial advisers. The Management and employee participation. Public offer- sales agents will normally work for the government. ings offer an opportunity for managers and employees to buy stock in their enterprise. An employee share Steps in a public offering ownership plan can provide shares and often share Officials involved in privatizing an enterprise through financing for employees. A recent analysis of European an initial public offering must oversee a number of flotations found that these plans account for 3-5 per- steps (figure 3): cent of the shares sold in initial public offerings. * Choosing sales agents (brokers or underwriters), lead brokers, and placement syndicate members. Residual shareholdings. if a public offering leaves the * Drafting of the prospectus, which is done by the government with a residual shareholding, the market financial advisers or sales agents in cooperation with will want to know how the government plans to man- state enterprise managers and government officials. age its shares (actively or passively) and how and when The prospectus must address dividend policy, envi- the government plans to divest its remaining holdings. ronmental issues, the regulatory regime, employee and The government should address this concem in the management participation in the issue, management of prospectus for the share flotation. For example, the government residual shareholdings (if any), and gov- government may decide to hold onto its residual emnment intentions toward the firm and industry. shares as an investment but not exercise its voting * Selecting shares and, the share instrument-for rights. example, common or preference shares, installment receipts, convertible bonds, warrants, convertible pref- Pricing and distribution. Pricing and distribution are erence shares, and so on. two of the hardest issues to manage in a share flotation. * Resolving policy issues. The government may want to maximize price; brokers * Implementing the public sales campaign. may want a lower price to make the issue easier to sell. * Organizing "road shows" where company officials Moreover, the government may want a wide retail dis- and sales agents travel to key securities markets (New tribution of shares for policy and political reasons; bro- York, London, Zurich, Tokyo) to showcase the compa- kers may find it more efficient to sell to institutional ny and share issue. investors. The government and its brokers should agree * Setting the subscription period (and book building, early in the sales process on how pricing will be man- where appropriate). aged. Because pricing is usually set late in the sale- * Determining pricing (retail and institutional) and after book building or other sales processes have been distribution (domestic and foreign), with government completed and the sale of shares is about to begin-offi- approval. cials must be able to react quickly and obtain senior Sales methods and special concerns 13 Figure 3. Case-by-case process-market flotations Initial public offerings Secondary offerings Financial advisers State enterprise and Short prospectus or prepare prospectus government input secondary offer directly to markets Placement syndicate formed Placement syndicate Government approves formed Government approves __ | employee and prospectus management shares and resolves policy issues Road shows Communication advisers State enterprise and named and public possible govemment Communication advisers sales campaign launched participation named and public sales campaign launched Road shows ; | ~~~~~~~~~~~~~~~~~~~~~~~Open offer for sale | Price range approved l l Open offer for sale < by govermnent Book building Book building (where appropriate) (where appropriate) 1~ Minimum subscription No Extend offer Pnce (usually reached L, Stop close to market); government approves | Price set | No pX Stop ,l l govemment approves I | Close | Close = ] No Underwritten . > Not underwritten Sell at market approval. Meanwhile, the financial advisers or sales offering. Setting a price for shares is less difficult agents must be able to provide the government with the because the shares are already trading and have a tradeoff costs of changes to the sales structure (for market price. Brokers sell a secondary issue to example, if the government wants to increase the share individuals and institutional investors in much the of retail shares or sell more shares domestically). same way as an initial public offering. Officials involved in a secondary share issue must oversee a number of steps (see figure 3): Secondary offerings * Preparing a prospectus, although it may be short- er and simpler than a prospectus for an initial offer- The sales process for a secondary offer-that is, a ing. Working with their financial advisers or sales public offering of shares already traded on domestic or agents, the government and the former state enter- foreign markets-is less complex than, but shares a prise should help draft the prospectus. number of steps with, the process for an initial public * Organizing road shows. 14 The Case-by-Case Approach to Privatization: Techniques and Examples Box 5. A public offering for Argentina's oil company The Argentine government set up Yacimientos Petroliferos market price of shares of foreign companies with similar Fiscales (YPF) as an integrated oil producer in the early activities and assets. The marketing of YPF's assets and part of this century. By 1991 it was Argentina's largest activities included promotional events such as a series of company, generating sales of more than $4 billion a year targeted investor presentations and a four-week investor and accounting for 13 percent of public employment. road show in twenty-nine of the world's financial centers. Until 1989 YPF had an almost absolute monopoly in the This campaign helped build confidence in Argentina's oil industry. The government decided to privatize YPF to capital markets and persuaded international institutional make it an efficient, competitive, integrated oil and nat- investors to allocate funds to Argentina. Even skeptical ural gas producer. Argentine retail investors were moved by a major adver- During 1989-91 the government deregulated and tising campaign, as well as by bonus shares for holding the introduced competition into the hydrocarbons industry, original investment for two years. lifting all restrictions on the exploration, development, When the multitranche global offering of YPF and sale of crude oil, gas, and petroleum products. After concluded. in July 1993, it represented the largest the Privatization Law was passed in 1992, many of YPF's privatization to emerge from Latin America to that date. assets were sold or given (under concessions) to private Cash proceeds exceeded $3 billion. Of 160 million shares companies, raising $1.4 billion by 1994. To compete in a sold, 40 million were in Argentina, 74 million were in the deregulated environment and prepare for privatization, United States, and 46 million were in the rest of the world. YPF's new management, appointed in 1990, initiated The final two tranches were in the form of American depos- comprehensive organizational, workforce, and financial itory receipts (ADRs) because international regulations did restructuring. This included significant additional sales of not permit a direct promotion of the initial public offering. noncore assets, the creation of two strategic business units The structure of the initial public offering was extreme- (one for upstream operations and one for downstream), ly effective. Because all tranches were four to five times and a cost reduction program that cut the number of oversubscribed, the government had to increase the issue employees from 51,000 in 1990 to 8,000 in 1993. size to 160 million shares from the original 110 million. Financial restructuring included clearing YPF's balance Within three months YPF shares traded at $27-50 per- sheet-writing off accumulated losses and having the cent more than the initial price-strengthening investor government assume company liabilities. To make its interest in Argentine privatization and stocks. shares more attractive, YPF paid special dividends. YPF's privatization generated $5.1 billion in cash and The sale was preceded by a valuation and marketing of incurred $13.5 million in costs. The upstream strategic YPF's assets. Independent consultants, whose decisions business unit's joint ventures, concessions, and sales were binding on the bidders, carried out the valuations. brought $1.8 billion, and the downstream strategic busi- The initial $19 a share public offering price was set by the ness unit's direct sale brought $272 million. In addition, Ministry of Economy, YPF's managers, and the underwrit- the new YPF paid $109 million in taxes in 1993 and $99 ers based on demand and supply conditions, financial and million in 1994. Dividends rose from $239 million in operating data, dividends, sales, earnings, operatinginfor- 1992 to $587 million in 1994. Profitability more than mation, price-earnings and price-cash flow ratios, and the doubled, and productivity improved. Source: Privatisation International, various issues; World Bank staff. * Book building. Trade (third-party) sales * Setting the share price. Price setting will usually revolve around the discount from the market price There are two types of trade sales for privatizations: auc- required to sell the shares. tions (open bidding) and negotiated sales (figure 4). Once the government approves the price, the bro- kers will sell the shares and the deal will close. In Auctions or open bidding some jurisdictions it may be possible to sell shares Auctions are more common and more transparent than directly into markets, releasing small lots over a peri- negotiated sales. First, the financial advisers or sales od of time. The process, however, lacks transparen- agents, working with state enterprise managers and cy and may depress share prices. government officials, prepare an information memo- Sales methods and special concerns 15 Figure 4. Case-by-case process-trade (third-party) of potential bidders, a short list of potential buyers is sales selected. These bidders then move to the second stage Auctions Negotiated sales of the process. Infrmo mDuring the second stage the government signs con- sent to potential buyers signed with buyer fidentiality agreements with the short-listed bidders sent to potential buyers signed withbuyerand gives them much more detailed, commercially Expressions o confidential information on the state enterprise, access Expressions of interest to management, and a draft sales agreement. Bidders received containing Confidential information that wish to proceed then submit a binding offer (bid) nonbinding price memorandum sent to buyer and a deposit. Finally, the government and its advisers choose the best offer, and the sale closes with payment Short list of bidders t for the shares (or in special cases, assets) of the state moves to next step etris - L l ~~~~~~Buyer's dues diligence | enterprise. Buyers due diligence Open bidding procedures have evolved in response Confidentiality agreement to government concerns about the buyers of privatized signed with bidders assets. Governments often try to ensure that privatized Confidential information Price and terms negotiated enterprises will continue to be going concerns. They are memorandum sent to bidders wary of asset strippers, and concerned that new own- Bidders visit state ers may lay off large numbers of employees. Thus gov- enterprise and Price and terms agreed and ernments seek buyers with sufficient resources to invest confidential data room approved by government in the enterprise, transfer know-how, and increase Bidders receive draft employment. sales agreement To achieve these objectives, some governments have Final buyer's due diligence used two-part open bidding procedures: a technical Bidders submit Reps and any warranties bid and a financial bid. The financial bid cannot be binding offers evaluated unless the technical bid meets the require- Payment and closing ments of the tender. The terms of reference for the tech- Open bidding process nical bid often require bidders to commit to investing (auction) capital in the enterprise over five years, and to describe their plans for the workforce. If the technical bid is sat- Buyer chosen isfactory, a weighted average of the technical and finan- cial bids of all retained bidders is calculated to deter- Buyer's due diligence mine the winning bid. Buyer's due dligence Worldwide, many buyers of privatized enterprises have failed to fulfill their contractual commitments. Payment and closing When that happens, a government's options are limit- ed and the risks of pursuing them are significant. It is randum containing general information for potential better to carefully screen potential buyers-based on investors. The memorandum is sent to potentially reputation, financial capacity, and technical compe- interested parties. In most cases the financial advisers tence-before starting final bidding. Once firms are or sales agents will have compiled a list of potential prequalified, final bids can be judged based solely on investors and will discuss it with the government prior price. to use. Then, nonbinding expressions of interest are Negotiated sales received from interested buyers. Based on these expres- Negotiated sales are a variant of the open bidding sions of interest and a review of the financial capacity process (see figure 4). Once the government has cho- 16 The Case-by-Case Approach to Privatization: Techniques and Examples sen a buyer, it negotiates an agreement that is attractive ty (51 percent of voting rights), to a relative majority to the buyer and protects the government's interests. (the strategic investor becomes principal shareholder Negotiated sales are used when there is only one bid- with, say, 35 percent of shares). der or a bidder has a marked advantage over other bid- Initial public offerings are often used to allow the ders in the government's eyes. It is difficult to get the public, together with domestic and international insti- highest price in such sales, however, and they are less tutional investors, to participate in privatization. The transparent than open bidding (box 6). shares reserved for the stock market can be sold in sev- eral tranches, depending on the absorption capacity of domestic and international markets at the time of the Mixed sales-trade sales combined with offering. In addition, in developed markets the share share offerings price offered to retail investors is often slightly lower than the price offered to institutional investors, which Mixed sales combine two or three sale methods to is lower than the price paid by the strategic investor. transfer the state's shareholdings to the private sector. Finally, negotiated sales or private placements are These sales allow several types of investors to partici- used to transfer shares to the employees of the pri- pate in the privatization transaction. vatized entity, including retirees and former employ- Trade sales are usually used when an enterprise is ees who worked for the company for a minimum sold to a strategic investor bringing capital, know-how, cumulative period of, say, five years. The shares and market connections to the privatized firm. reserved for employees are generally sold at a dis- Depending on the objectives of the government and count to the offer price for retail investors at the time the requirements of potential investors, the level of of the initial public offering-provided the shares control offered for sale may range from a supermajori- are not sold in the secondary market for, say, 18 ty (66 percent of voting rights), to an absolute majori- months to three years. Box 6. Selling the Skoda Automobile Company to a strategic buyer Until 1990 Czechoslovakia's automobile industry was In 1993 Volkswagen scaled back its investment plans uncompetitive and failed to keep pace with technological in Skoda as part of a general strategy to lower costs and developments in the global automobile industry. One investment in Germany and abroad. Planned investment state-owned company, Skoda, accounted for almost all in Skoda was cut by more than half, from DM 8.2 billion production-about 200,000 cars a year. In 1990, howev- to DM 3.7 billion, through the end of the decade. The er, Skoda reached an agreement with Volkswagen, the planned increase in production was also cut, from German automaker, under which Volkswagen gradually 450,000 to 300,000. After prolonged negotiations, the assumed ownership of Skoda. Volkswagen's bid price and government agreed to these changes and allowed ten-year investment plan for Skoda totaled $6.5 billion. Volkswagen to increase its stake in Skoda to 60 percent in Volkswagen's initially offered DM 500 million ($340 1994. A year later, Volkswagen raised its stake to 70 per- million) for 31 percent of Skoda (later increased to 70 per- cent. The government's 30 percent residual shareholding cent after two subsequent capital injections of DM 350 was eventually sold as shares without voting rights million apiece in 1993 and 1995). Volkswagen also agreed through a coupon scheme and initial public offering. to pay DM 200 million to the Czech government for por- Skoda's experience offers a key lesson about selling tions of its shares. Finally, Volkswagen committed to state enterprises to strategic investors. Changing business increasing Skoda's annual production capacity from conditions mean that it is unrealistic for governments to 200,000 to 450,000 by 2000 and to managing Skoda sep- expect buyers, however reputable, to keep all their invest- arately as one of Volkswagen's family of automakers. The ment and restructuring promises-particularly if these are government, in turn, agreed to manage its shares as an to be carried out over long periods. Thus governments investment and to refrain from interfering in the manage- should be prepared to renegotiate these commitments in ment of the company. a firm but realistic manner. Source: Raj M. Desai, 'Organizing Markets,' Ph.D. dissertation, Harvard University, 1996. Sales methods and special concerns 17 These three sales methods can be combined in sev- (usually aimed at preventing a foreign takeover) or to eral ways. However, experience from around the world give the government influence on company matters it suggests that the trade sale for the strategic investor considers of national importance. Golden shares nor- should come first, followed by the initial public offer- mally involve the government's right to approve major ing or the negotiated sale to employees. Indeed, if the corporate actions such as the sale of the majority of initial offering comes first the market value of the shares to a third party, sale of major assets, and liqui- shares in the secondary market may exceed the price dation or reorganization. that strategic investors are willing to pay to take con- Governments also have used golden shares to pri- trol of the enterprise. Even worse, the strategic investor vatize strategic enterprises that provide essential ser- may be unwilling to pay the price at which the shares vices to the public-for example, telecommunications were sold to retail investors at the time of the initial companies-in a number of countries, including New offering. It would be politically difficult for the gov- Zealand and the United Kingdom. In France the gov- ernment to sell a control stake for a lower unit price ernment can hold a golden share giving it the right to than the price offered to the public. Knowing this, the approve any participation exceeding 10 percent of a strategic investor might use the situation to obtain a privatized company's shares. As a rule, conditions series of concessions that the government otherwise attached to privatizations by government detract from might not have had to concede. an enterprise's value because they increase uncertainty Mixed sales are particularly useful for developing or restrain privatized firms' commercial freedom of countries with a nascent system of corporate gover- action (box 8). nance (box 7). Indeed, trade sales to strategic investors safeguard the future of the privatized company by "'anchoring" its management with an international Role of foreign investors operator whose system of corporate governance can be transferred to the privatized entity. Where there is Governments in many transition economies encourage domestic sensitivity to foreign buyers, some govern- foreign participation in privatization, relying on for- ments have arranged consortiums of foreign and eign investors to bring capital, management skills, new domestic buyers to bid (as in the privatizations of technology, international links, and access to foreign Argentina's and Mexico's national telecommunications markets. Foreign participation in trade sales, mixed companies). If the foreign operator acquires only rela- sales, or public offerings ensures that government will tive control of the company, the core shareholding can receive a better price because of the increased compe- be syndicated with domestic institutional investors, tition for assets or shares. It also means that the com- further improving the corporate governance of the pri- pany will move into the hands of a strong owner that vatized entity. In addition, if the shareholdings sold in can restructure the company. this manner exceed 51 percent of voting rights, the The role of foreign investors in restructuring former government can expect to maximize proceeds because state enterprises should not be underestimated. The the bidders will likely offer to pay a control premium world-class products and marketing that foreign for the block of shares. Mixed sales also allow govern- investors bring are particularly valuable to former state ments to broaden share ownership while ensuring that firms in transition economies that are manufacturing foreign investors do not take control of privatization. products that do not meet international standards, are outdated or technically obsolescent, and have no inter- national brand awareness. Strategic alliances are also Conditions attached to privatizations important in high-technology industries (such as telecommunications) where global competition is Governments often attach special conditions to priva- strong and the costs of product development and tization sales, demanding a special or golden share to research and development are too high for a single protect the enterprise from an unwelcome takeover national carrier. 18 The Case-by-Case Approach to Privatization: Techniques and Examples Box 7. Privatizing Banque Marocaine du Commerce Exterieur through a mixed sale At the time of its privatization Banque Marocaine du Moroccan insurance company was allowed in each consor- Commerce Exterieur (BMCE) was Morocco's second tium-and even then only insurance companies that did not largest bank, with a balance sheet representing 19 percent own shares in the BMCE prior to the tender were allowed. of the country's banking credit and 17 percent of deposits. The remaining 13 percent of shares were open to The bank's 176 branches and 2,778 employees were domestic and foreign investors. Article 4 of the terms of spread around the country. A minority interest was quot- reference stipulated that consortiums should include at ed on the Casablanca stock exchange. The government least one foreign bank committed to buying at least 5 per- owned 50.01 percent of the bank, and its chairman and cent of the BMCE's share capital, and that the nationality chief executive officer was a civil servant. Foreign com- of at least one such bank should not already be repre- mercial banks owned 12.55 percent of the BMCE; the rest sented in the BMCE's share capital. (37.44 percent) was owned by private Moroccan By the end of February 1995 two main consortiums investors. Net profits for 1994 totaled $29.5 million. were in competition. Both were having trouble finding a The privatization took the form of a mixed sale, com- foreign commercial bank not already represented in the bining an open tender for 26 percent of the bank's share BMCE's share capital and willing to buy a 5 percent stake. capital and management control, a secondary offering on As a result the tender period was extended until the end the stock market (targeted at small investors and mutual of March 1995, and various alternatives were considered funds) for 14 percent, and a private placement with the to allow the transaction to close. Finally, instead of trying bank's employees for 3 percent. The government retained to motivate foreign commercial banks to buy a stake in the 7 percent through the Caisse de Depot et de Gestion, a BMCE, investment banks were approached with propos- public agency overseeing Morocco's social security sys- als to buy the 5 percent stake, either for themselves or on tem. The tender started in December 1994 and was due behalf of nominee accounts. Morgan Grenfell forged an to close at the end of February 1995. alliance with one consortium and Citibank with the other, Domestic institutional investors had showed strong and the tender was successfully closed at the end of March interest in participating in the open tender. On the 1995. The winning consortium was led by a Moroccan strength of this, the Ministry of Privatization launched and industrialist allied with Morgan Grenfell. The price paid closed the secondary share offering before closing the for the 26 percent stake was at a 47 percent premium to open tender. Between 16January and 20January 1995 the the price of the secondary offering-or 19 times antici- shares were offered to the public at $38.35 per share. The pated earnings for 1994. offering was more than 6.1 times oversubscribed and The BMCE's experience offers an important lesson for attracted more than 51,000 subscribers. countries contemplating mixed sales. Privatization offi- The closed private placement to the bank's employees cials should be wary of overengineering the terms of ref- offered shares at a 15 percent discount. The BMCE also pro- erence of their tenders. Simplicity is always preferable- vided loans to help its employees buy these shares. The min- it allows the market to speak for itself, and it gives imum price for the 26 percent of shares offered at open ten- privatization officials some discretion in responding to der was the issue price of the public offer. The terms of market signals. It is misguided to assume that trans- reference for the open tender stipulated that the stake was parency will be compromised if privatization officials have reserved for bidders organized in consortiums of at least four some discretion in finalizing privatization transactions. parties. The shares offered for sale were structured in two Transparency is safe as long as the rules regarding the tranches. Half of the 26 percent stake, or 13 percent of the selection of the winning bidder are publicly disclosed banks share capital, was reserved for Moroccan investors- from the outset and scrupulously observed by govern- with two caveats. Banks and investors that owned 20 per- ment officials. Imposing restrictions on the identity of cent or more of the capital of a Moroccan bank or that were potential bidders or on the use that they can make of their owned 20 percent or more by a similar institution were investment does not enhance the transparency of the excluded from the tender. In addition, no more than one selection process. In fact, it may hinder it. Source: World Bank staff. Privatization projects can be attractive to foreign ness or new manufacturing capacity in order to acquire investors who prefer buying an existing business with market share. In some cases foreign investors have par- an established market share to setting up a new busi- ticipated in a large portion of state enterprise sales. In Sales methods and special concerns 19 Box 8. Golden share in action: The planned merger of Renault and Volvo After three years during which they shared components, would own 35 percent-of the new automaker. The French France's state-owned automaker, Renault, announced in state would hold the rest. But the golden share would give September 1993 that it planned to merge with Sweden's the French govemment the power to limit any Volvo. The merger was set for 1 January 1994. By shareholder-including Volvo-to just one-fifth of the November 1993, however, enough Swedish institution- voting rights in the company if Renault chose to dissolve al shareholders had declared their intention to vote the shareholder pact. There were fears in Sweden that, against the deal to postpone a general shareholders under such an arrangement, the French government meeting. would always put French interests first. The French gov- The Swedish rebels had two main complaints. One was emnment's reversal on workforce reductions at state- France's failure to set a date for the privatization of owned Air France hardly helped. Some Swedes worried Renault. The other was the golden share that the French that if Renault-Volvo ever had to cut costs-as Air France's government planned to retain in the merged group even boss had tried to-it would be Swedish rather than after privatization. Under the merger plan the French gov- French jobs that would go. But the French insisted that emnment would directly hold 47 percent and Volvo 18 per- the golden share was a defensive weapon that would only cent of the Renault-Volvo group. A holding company, be used if one of the big U.S. orJapanese automakers tried RVC, 51 percent owned by the French government, to take over the group. After protracted negotiations and would control the remaining 35 percent. with France's refusal tc relinquish the golden share, the What this meant was that, directly and indirectly, Volvo merger fell through. Source: Privatisation International, various issues. Argentina, for example, foreign investors bought 60 scale are such that a single firm is the most efficient percent of the assets sold through 1994. provider. Examples include telephone companies, Other countries have limited foreign equity partic- electric power systems, municipal water systems, and ipation in privatized enterprises. Russia, despite municipal public transport. The opening of many declared intentions to the contrary, has not allowed countries to competition from abroad and changes in foreign strategic investors to participate in sales of technology, however-for example, in telecommuni- strategic holdings in the state's major oil companies. cations-have narrowed the definition of what is con- The sale of Svyazinvest, the state telecommunications sidered a monopoly company, was a breakthrough in that foreign investors Governments often own or regulate natural monop- bid with large Russian banks to acquire a 25 percent olies. In the past most such regulation guaranteed a stake in the company The Russian banks were unable rate of return on capital employed-providing few to meet the minimum bid price without these incentives for efficient performance. Modern regula- investors. tion is moving toward a price cap-based system that Macroeconomic stability and a favorable business ties changes in rates to a predetermined percentage of environment are required to attract foreign investment. basic rates or to a price index. In economies where nat- Moreover, unnecessary restrictions on foreign invest- ural monopolies have been government owned and ment should be lifted and discrimination between for- unregulated, regulations must be put in place before eign and domestic investors eliminated. privatization. These regulations should encourage effi- ciency and give investors a chance to earn a reasonable rate of return. Regulators should be as independent as Privatizing natural monopolies possible from political interference. Capricious or politically driven regulations detract from the value of Economists generally consider economic functions or an enterprise being privatized and, in extrerne cases, services to be natural monopolies if the economies of can make privatization impossible. Organizing government for privatization A successful privatization program must be located Setting clear objectives at the center of government, receive support from the highest levels of government, clearly define its Privatization programs should have clearly defined objectives, develop institutional competence and objectives. The government can set these out in policy experience, and overcome the commitment problem. statements, laws, or decrees or in instructions to the officials administering the privatization program. If these objectives are missing, confusion will develop Securing a central location and about why privatization is being pursued. high-level support Given the wide range of interests affected by any sig- nificant privatization, tradeoffs will need to be made Most privatization programs are at the center of between stakeholder and government wins and losses. government, attached to the president's or prime Clearly defined objectives are required to make these minister's office, the ministry of finance or treasury, or tradeoffs and to prevent privatization from being some other powerful central ministry or department. bogged down in a welter of unresolved issues. For There are a number of reasons for this: example, governments must make tradeoffs between * Privatization inevitably encounters bureaucratic oppo- the interests of line ministries, which may be more con- sition and political resistance-because privatization cerned about how privatization will affect their policies changes the status quo. By locating the group responsi- and authority than about the government's need to ble for privatization near the center of government restructure the economy or raise revenue. power, bureaucratic opposition can be overcome and political issues effectively managed. * Privatization programs are usually part of a structur- Developing institutional competence al adjustment program or result from the government's and experience need to raise revenue. Central ministries are responsi- ble for such initiatives and so have the strongest incen- Government institutions responsible for privatization tive to make privatization succeed. must gain experience and develop competence with * Because privatizations affect so many parties inside the process. Privatizing state enterprises is difficult, and outside government-including line ministries, and often requires commercial skills that officials in the enterprise being privatized, labor unions, national developing and transition economies do not have. To and local politicians, and the employees, customers, develop this expertise, a single privatization body and suppliers of the enterprise being privatized-they should be established to gain experience over time. can be extremely contentious. Thus senior officials Spreading the privatization effort over a number of often must intervene to resolve issues and move the institutions or ministries is a mistake, and will lead to process forward. conflicts and undermine the institutional capacity 20 Organizing government for privatization 21 needed in privatization. Moreover, the privatization In some countries the commitment problem is exac- agency should be adequately funded so that it can hire erbated by two features of the institutional and legal financial, legal, and other advisers, as required. framework: overlapping jurisdictions and excessive dis- In many countries efforts to centralize power, secure cretionary authority. Many countries have a proliferation high-level support, and focus institutional capacity of veto-holding agencies, each with the power to obstruct have been mutually reinforcing. For example, Canada's cash sales of state enterprises. For example, privatization most successful privatization program was associated powers are often divided between the line ministries with the Department of Finance. Argentina and Mexico responsible for an enterprise and the agencies responsi- also relied on their ministries of finance. New Zealand ble for the mechanics of the sale and (possibly in anoth- and the United Kingdom centered their programs in er body) the oversight of privatization programs and sales. the treasury. There are good reasons for policymakers to prefer discretion to rules if governments are fragmented. Discretion is flexible; rules are not. With discretionary Overcoming the commitment problem powers, enterprises can be sheltered in friendly min- istries or municipalities, offering useful leverage for The commitment problem arises because governments parties or factions with uncertain political futures. may be tempted to deviate from or reverse economic poli- Moreover, discretion is opaque, not subject to the over- cies over time, and because institutions are not strong sight of regulators, courts, and the like. enough to prevent such reversals. Commitment prob- Although good institutions cannot eliminate a large lems increase the perceived risk of expropriation and number of veto holders and an inclination toward dis- drive out investment. In postcommunist economies, for cretionary policymaking, they can ameliorate them. example, governments face a particularly severe com- Autonomy and rationality in institutional design are of mitment problem because of the vast influence of state particular importance. Autonomy is the extent to enterprises-the linchpin of a powerful coalition of ben- which an institution is insulated from outside interfer- eficiaries with privileged access to public resources. In ence, and thus from the veto power held by politicians addition, governments in transition economies-as else- or social groups. Rationality is the degree to which where-have encountered public hostility toward the institutional procedures are based on uniform rules sale of a country's "crown jewels" to foreign investors. that must be followed. Valuation methodology A company ultimately is worth what people are willing tender than if it chooses an initial public offering. The to pay for it. Valuation is the process of estimating this political benefits of popular capitalism have financial value. Unlike in mass privatization, where the precise costs. value of assets is not known and is not a crucial factor, in case-by-case privatization value is of fundamental importance to both buyer and seller (in this case, the Stages government). Buyers that overpay for an asset cannot meet their A valuation starts with a financial audit and a method target rate of return from the acquisition, and share- of sale. The audit is important because certain valua- holder value will decrease. The government, on the tion calculations cannot be completed without it. The other hand, has a fiduciary responsibility to its citizens method of sale determines the weight and level of detail when it privatizes an asset. It is entrusted to sell priva- that should be applied to the valuation methods used tizable assets at or above their fair market value, and to estimate the assets' fair market value. must take every precaution to ensure that this happens. Next is the selection of the financial adviser who will Agreeing to sell state assets below their market value is carry out the valuation. The adviser should be select- tantamount to favoring a buyer, and it deprives the ed by competitive tender from among several inde- state of needed financial resources. While this may pendent and reputable companies based on their terms sometimes be politically desirable-for example, in the of reference for various valuation methods. The finan- case of employees of privatized companies-trans- cial adviser should be selected before the auditor so parency is crucial. Thus the size of the discount offered that the adviser can help prepare the terms of reference should be determined and publicly disclosed. for the audit, which besides a financial review normal- ly includes an operational and legal review. Once appointed, the financial adviser undertakes due Value is in the eyes of the beholder diligence-an exercise that differs from but complements the audit. Due diligence consists of gathering and verify- Value may be a paramount concern, but it is also a rel- ing information about the privatization candidate, its ative concept. Valuation is more art than science. Buyers organization, its finances and balance sheet, its national will value a company or set of assets differently, depend- and (if relevant) international standing, and any other ing on the synergies they perceive between their own information that may be relevant to a valuation, such as company and a potential acquisition. The greater are a likely change in taxation or regulation. Past financial the synergies, the more they will be willing to pay. performance must be explained and projections made Similarly, depending on the divestiture method under several scenarios in cooperation with the existing selected by the government, the value of privatizable management team. Future investments should be iden- assets may differ significantly For example, all other tified and estimated. During this period the financial things being equal, sale proceeds will likely be higher adviser will also work with the government to explore if the government chooses to sell an enterprise by open options for privatization. 22 Valuation methodology 23 At the end of the due diligence process, the finan- that the seller may have paid too much for the assets in cial adviser should be able to submit a first valuation the first place. Ultimately, however, productive assets report to the government. After reviewing the report, must pay for themselves and generate extra earnings; the government can request further sensitivity analy- otherwise their purchase does not make economic sis. In the end the government-and no one else-is sense. responsible for setting the reserve price of the tender Conversely, it is easy to understand why sellers often or the fixed price of the public offering. But the gov- prefer this valuation method. It gives them a sense of ernment's decision must be based on the objective data the price at which they should sell the assets in order provided in the valuation report. to "get their money back," after taking into account A valuation report is highly confidential. It is pre- their use of them. This approach is often the cause of pared for the exclusive use of the seller (or buyer) and unreconcilable differences between buyers and sellers. under no circumstances should be disclosed to third parties. A leak to buyers could have adverse conse- Discounted cash-flow method quences for the divestiture: insiders would become The discounted cash-flow method is best suited to a sale aware of the most sensitive valuation parameters in the to a strategic investor who will gain control of an enter- eyes of the seller, and would be able to use such infor- prise's management and cash flows. It consists of esti- mation to lower the sale price. mating the company's free cash flows over a medium- to long-term horizon, taking into account variations in working capital and future capital expenditures. A dis- Methods count rate is then applied to these anticipated cash flows to calculate their present value. The discount rate All valuation methods estimate market value. Some reflects the enterprise's weighted average cost of capital methods are appropriate if the company is to be divest- and the political risk of the country where its operations ed through an initial public offering; others if control is are based. Present values are then totaled. A terminal to be sold to a strategic investor. Whatever the method value is sometimes added to this number. Finally, the of sale, no valuation method is infallible. The market total funded debt on the enterprise's balance sheet at the value of a company is best estimated by combining, in time of the transaction is subtracted to arrive at the net different proportions, six methods of valuation: the present value of the company's equity. adjusted net assets method, the discounted cash-flow Potential strategic investors tend to prefer the dis- method, the comparable companies method, the compa- counted cash-flow valuation method. They verify these rable transactions method, the book building method, calculations by comparing them with the market val- and the replacement value method. Combining these ues of comparable quoted companies, and with prices methods allows a range of probable values to be estab- paid by other buyers in recent comparable transac- lished, a process known as triangulation. tions. Their discounted cash-flow valuation is general- ly a significant component of their offer. Adjusted net assets method Discounted cash-flow valuations require the con- The adjusted net assets method tries to ascertain an struction of a spreadsheet model. These models are enterprise's fair market value by estimating the market most useful when they include variables that can be value of its assets (fixed assets and current assets) and modified to run sensitivity analysis. Such models can then subtracting its balance sheet and off-balance prove especially useful during negotiations. A good sheet liabilities. model can anticipate arguments or concerns that may Buyers do not have much faith in this method be raised by potential buyers and can provide answers because it fails to take into account the assets' capaci- about the value of assets if certain conditions attached ty to generate revenues. It looks at the costs of pur- to the sale are modified-for example, the length of a chasing them, then applies a depreciation factor to period of exclusivity or the level of taxation on account for their obsolescence. Thus it ignores the fact imported goods. 24 The Case-by-Case Approach to Privatization: Techniques and Examples Investors often have a "hurdle" rate of return on cap- Of course, each company has its own idiosyncrasies, ital to help them decide whether to pursue an invest- and markets differ from one country to the next. ment. The potential acquisition is actively pursued if Valuation multiples should not be applied blindly: they the anticipated return is above the hurdle rate; other- often require a great deal of interpretation. But if car- wise it is discarded. Some investors calculate an inter- ried out carefully, the comparable companies and com- nal rate of return to help value a potential acquisition. parable transactions methods provide a useful estimate An enterprise's internal rate of return is the rate at of an enterprise's market value. which the sum of its future cash flows and acquisition price equals zero. Book building method The book building method (also known as circling) is Comparable companies and used in public offerings and private placements of comparable transactions methods quoted securities to determine the price they should be The comparable companies and comparable transac- offered for at subscription. It differs from the methods tions methods are particularly appropriate when an described above in that it does not involve calculations enterprise is being partly or entirely privatized through based on a set formula. Rather, the calculations take a stock exchange. The principle underlying both meth- place before the book building operation. ods is that companies' market values can be deter- The method involves pricing the shares of a forth- mined by applying a series of empirically derived val- coming issue by constructing a book of orders from uation multiples to their latest (or normalized) institutional investors based on different issue prices. financial results. The most commonly used multiples In most cases the book is opened for about two weeks. are the multiple of turnover, multiples of operating During this period members of the placement syndi- income (either the multiple of earnings before interest cate contact their institutional clients and request non- payments, tax, depreciation, and amortization or the binding orders of shares that are linked to various offer multiple of earnings before interest payments and tax), prices. For example, how many shares would the insti- and the multiple of net earnings (also known as the tutional investor want to buy if they were priced at $18 price-earnings ratio). apiece, and how many if they were $20? Valuation multiples are calculated by dividing the Each member of the placement syndicate constructs stock market capitalization of several companies in the an order book; every two days each book is transmitted same sector, of a similar size, and from various regions to the lead manager of the issue, who constructs a con- by their turnover, operating income, and net earnings solidated book. By the end of the book building period multiples. Thus a series of multiples are derived, sort- the trends in the consolidated book resemble figure 5. ed, and treated mathematically to obtain a range (high, The issuer is then able to determine the price at which low, and arithmetic mean) that is applied to the finan- cial results of the enterprise being valued. In addition, Fi 5 Bok buildin-de d fil for capital-intensive industries like cement or oil and gas, operational ratios (such as dollars per ton of capac- Demand (millions of shares) ity or dollars per barrel of reserves in the ground) can 1,500 -Day2 be used to approximate market values. 1200 Day 8 As opposed to the multiples of operating income, - Day 10 which estimate the market value of total assets, the 900 multiple of net earnings estimates the market value of 600 equity. To deduce the market value of equity, the net debt on the enterprise's balance sheet is subtracted 300 from the total assets estimate. The same operations are repeated using recent corporate transactions in the sec- 017 18 19 20 21 22 tor involving companies of similar size. Limit price (U.S. dollars) Valuation methodology 25 the market will absorb the issue. In figure 5 the issuer will destroyed by an act of God. This mainly includes fixed price the issue at between $19.4 and $20.0 per share. assets (plants, machinery) but also covers startup costs Order books are usually several times oversub- and certain current assets (for example, a vehicle scribed because investors typically request more than fleet). This valuation method often produces a much they want to receive, expecting their orders to be scaled higher value than the methods described above. This down. It is important, however, that some unsatisfied is because the decision to form an industry may not demand remains in the secondary market to ensure have been motivated solely by economic considera- that the share price continues to rise. tions, particularly if it was made by government. Book building operations are generally used to price Social or political considerations may have been shares reserved for global offerings to institutional equally important. For example, it may be politically investors. To be effective, this method requires a mini- desirable to build a medium-size petroleum refinery mum number of independent institutional investors in a small developing country, but from an economic that are unlikely to collude with one another. In most standpoint it makes more sense to import refined emerging markets institutional investors are too small products. to fulfill this condition; thus the book building method Investors almost never take the replacement value cannot be used domestically Domestic issues are, how- method into account when valuing a company because ever, sometimes priced relative to their global institu- it does not measure the expected return from the pro- tional offering. Governments often choose to price the posed investment. Thus sellers should not use this shares reserved for domestic subscription at a discount method to determine the market value of assets. Still, to the price paid by international institutional investors. the replacement value should be calculated and argu- ments should be prepared to explain why it has been Replacement value method discarded. Otherwise, critics of privatization may use The replacement value method estimates how much it this method to argue that an enterprise is worth far would cost to replace a company's assets if they were more or that it was sold for a fraction of its worth. Hiring financial and other advisers In the context of case-by-case privatization, financial contacting potential buyers, and enticing interested advisers are investment bankers or merchant bankers parties to bid for the company that sell and advise on the sale of firms. The govern- If privatization involves a small enterprise that is ment may use a single financial adviser or a consortium unlikely to attract much international interest, account- of financial and other advisers. A foreign and a domes- ing firms and financial consultants may suffice as finan- tic adviser should be used if the government wants to cial advisers. But if the enterprise is larger or has an attract both domestic and foreign investors. international dimension, valuation should be done by an investment bank or merchant bank. This is because valuation requires market awareness as well as techni- Selecting financial advisers cal skills. Unless the financial adviser is involved in buying and selling companies in the same sector as the Governments need financial advisers in case-by-case privatization candidate, the results of the valuation privatizations to value enterprises, advise on the tim- may not reflect what the market is willing to pay for the ing and method of sale, and contact potential buyers. assets. Furthermore, an investment bank is more like- Advisers will suggest the price (usually within a ly to provide the government with timely market infor- range) that the government could receive for the mation on the corporate strategy of potential buyers. enterprise. Advisers may provide several valuations Accounting firms, by contrast, may not have a corpo- based on different sales methods-for example, rate relationship with potential buyers. whether sale is through a stock flotation or a trade For the same reason, many analysts believe that sale. Advisers will also suggest sales options. This valuation mandates should be combined with place- advice will cover such issues as whether the compa- ment mandates-making the investment bank charged ny is salable, whether it should be sold now or later, with valuing assets responsible for also identifying and what sorts of sales choices are feasible, and at potential buyers. This approach guarantees that what cost. valuation reports are grounded in market reality. Others Once the government has decided when and how believe that valuation mandates and placement man- to privatize, it will require a financial adviser (sales dates should be dissociated because of the potential con- agent) to undertake the sale. The sales agent will flict of interest between the two tasks. Indeed, the invest- help design the sales plan and will undertake the sale ment bank charged with placing assets may want the sale in cooperation with government officials. If a priva- price to be low to facilitate its task. Thus it may be tempt- tization takes the form of an initial public offering, a ed to undervalue the assets. Still, this argument ignores syndicate of investment banks or merchant banks the fact that in most cases the structure of the placement will be formed to sell the enterprise's shares. The mandate is such that the higher is the sale price, the government must appoint a firm as the lead manager higher is the bank's compensation. Thus conflicts can be for the syndicate to manage the sale process. If a pri- avoided by properly structuring the compensation of vatization takes the form of a trade sale, the sales agent financial adviers and ensuring that it is in their interest will be responsible for preparing the sale documents, to maximize proceeds. 26 Hinngfinancial and other advisers 27 Selecting other advisers participating in or winning the second. Alternatively, the adviser could be hired for both phases, but the govern- Other professional advisers are also needed during pri- ment could be allowed to exit after the first phase if it is vatization. Lawyers are required to manage due dili- not happy with the adviser's performance. gence activities, advise the government on the legal aspects of the privatization, draft and negotiate sales contracts and draw up confidentiality agreements. Foreign advisers Accountants and auditors may be needed to undertake audits prior to sale. Technical experts with specialized Governments in transition and developing economies industry skill and knowledge may be required as well. should probably use both domestic and foreign advis- The government may find it convenient to tender for ers. Foreign financial advisers are essential if the gov- these advisers as a single consortium or may prefer to emient expects participation by foreign investors or hire them separately. injections of foreign capital, or if it plans to sell shares on international markets. These advisers should work with domestic advisers, who should address more local Should the same financial adviser be used for issues. both phases of privatization? The literature on privatization often questions whether Tenders for financial advisers the same financial adviser that helped the government during the early stages of privatization should under- Governments should hire financial advisers through a take the sale of the enterprise. The argument against competitive bidding process. But given the specialized using the same adviser is that there is an inherent con- nature of financial advice, officials may want to devel- flict of interest in advising on whether and how to pri- op a "short list" of firms that have the experience and vatize an enterprise and helping with the sale of that marketing capacity needed for privatization. As a rule enterprise. The best advisory firms, however, are often the list should include at least 10 companies to avoid reluctant to participate in the first phase if they cannot too few bidders if companies combine to bid or if sev- participate in the second, which is usually more prof- eral are uninterested. Interested firms should submit itable. written proposals against broad terms of reference One way to manage this issue is to tender for advice for drawn up by the government. Interviews with key offi- both phases but not to restrict the winner of the first from cials of the best firms should follow. Distributors of COLOMBIA GERMANY ISRAEL NEPAL PORTUGAL SWEDEN Inloenlace Lida. UNO-Vedag Yozmot Lderature LId. Everest Media Intemational Services (P) Ltd. Livraia Podugal Wennergren-Williams AB W orld Bank Carrera6 No. 51-21 PoppelsdorferAllee 55 PO. Box 56055 GPO Box 5443 Apartado 2681, Rua Do Carmo 70-74 P.O. Box 1305 Apartado Aereo 34270 53115 Bonn 3Yohanan Hasandlar Street Kathmandu 1200 Lisbon S-17125 Solna Publications SantatddeBogota, D.C. Tel: (49228) 949020 Tel Aviv 61560 Tel: (977 1)472 152 Tel: (1)347-4982 Tel: (46 8) 705-97-50 Prices and credit terms varyfrom Tel: (57 1) 285-2798 Fax: (49 228) 217492 Tel: (972 3) 5285-397 Fax: (977 1) 224 431 Fax: (1) 347-0264 Fax: (46 8) 27-00-71 cotintrrt.0'lr'E-mail: mail@wwi.se country to cotntry. Constlt your Fax: (571) 285-2798 URL: http://www.uno-verag.de Fax: (972 3) 5285-397 local distributor before placing art E-mail: unoverag@aol.com NETHERLANDS ROMANIA order. COTE D'IVOIRE R.O.Y Intemational De LindeboooVinOr-Publikaties Compani De Librarii Bucouresti S.A. SWITZERLAND order. Center dEdition et de Dflusion Atricaines GREECE PO Box 13056 PO. Box 202,7480 AE Haaksbergen Str. Lipscani no. 26, sector 3 Librairie Payot Service lnstitutionnel ARGENTINA (CEDA) Papasotiriou S.A. Tel Aviv 61130 Tel: (31 53) 574-0004 Bucharest Cotes-de-Montbenon 30 Oficia de Libo lnemaconal04 8.2 541 35, Stoumara SIr Tel: (972 3(5461423 Fan: (31 53) 572-9206 Tel: (40 1( 613 9645 1002 Laosanne Otcnade Libol ntemacional Abidjan 04 10682 Athens Fax: (9723)5461442 E-mail: lindc bo@3 wor7 dnlise9nl Fey: (401(3124000 Tel: (41 21) 341-3229 1120 Buenos Aires Tel: (225) 24 6510;24 6511 Tel: (30 1)364-1826 E-mail: royil@netvision.net.il URL: htp://www.woddonline.nV-lindeboo Fax: (41 21) 341-3235 Tel: (54 1) 815-8354 Fax: (225) 25 0567 Fax: (30 1) 364-8254 RUSSIAN FEDERATION Fax: (541) 815-8156 Palestinian Authority/Middle East NEW ZEALAND Isdatelstvo Forrm i2tirtg Policy Strategies No. 392 Felker, Chaurdhuri; Gi ;. gy, and Goldman, The Pharmaceutical Industry in Tnhza and Hunga.y: Poiicics, s>iu:ions, and Technological DeovelObm '.e No. 393 Mohan, ed., Bioliograph, of Publications: Africa Region, 1990-97 No. 394 Hill and Shields, fncen tives fr Joint Forest Management in India: Analyti ca[' Ietfhods and Case Studie` No. 395 Saleth and Dinar, Satisfying Urban Thirst: Water Supply Augmentation and Pricin7g Poliicy in Hyderabad Cus, Indiat No. 396 Kikeri, Privatization and Labor: TWhat Happens to Workers When Governm.n.s Divest? No. 397 Lovei, Phasing Out Lead from Gasoline: Worldwide Experience and Policy Implications No. 399 Kerf, Gray, Irwin, Levesaue, Taylor, and Klein, Concessions for Infrastructure: A Guide to Their Design and Award No. 401 Benson and Clay, The Impact of Drought on Sub-Saharan African Economies: A Pre/iminary Examinatio7a THE WORLD BAN K I S I SI I, .\. \\isliiigt tn, ID.(. 204.33 S \ I.clcponcl,: 2(02-47, 1-.34 IF.i.imil.: 21 2-417-0(}. I IcIc\: \I(.I 64145 \\ )I{I.)I \V k N I CI 24S423 i \N () R , 1 I)I \.\ \\I,-ld \\ i.lC \NC 11 II I])l: NN \\ \\ .\% ,,,-1.11 II,.III,, A..l I-a diI: hb Wrl LIh',III ), r ISBN 0-8213-4196-0