WORLD BANK TECHNICAL PAPER NO. 403

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The Case-bv-CaseApproach to Privatization

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WORLD BANK TECHNICAL PAPER NO. 403

The Case-by-CaseApproach to PrivatizationTechniques and Examples

Dick WelchOlivier Fremond

The World BankWashington, D.C.

Copyright © 1998The International Bank for Reconstructionand Development/THE WORLD BANK1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing March 1998

Technical Papers are published to communicate the results of the Bank's work to the development community withthe least possible delay. The typescript of this paper therefore has not been prepared in accordance with theprocedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sourcescited 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) andshould not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board ofExecutive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the dataincluded in this publication and accepts no responsibility for any consequence of their use. The boundaries, colors,denominations, and other information shown on any map in this volume do not imply on the part of the World BankGroup any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries.

The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sentto the Office of the Publisher at the address shown in the copyright notice above. The World Bank encouragesdissemination of its work and will normally give permission promptly and, when the reproduction is fornoncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through theCopyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A.

ISSN: 0253-7494

Dick Welch is a consultant and Olivier Fremond is a senior private sector development specialist in the EnterpriseUnit 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 0-8213-4196-01. Privatization-Case studies. I. Fremond, Olivier, 1955-

II. Title. III. Series.HD3850.W363 1998338.9-dc2l 98-12800

CIP

Contents

Foreword v

Abstract vii

Why case-by-case? 1Global experience 1Global lessons 1

First phase-getting ready 4Step one: Identifying privatization candidates 4Step two: Feasibility study 5

Second phase-moving to sale 8Step three: Privatization plan 8Step four: Obtaining approval 9Step five: Sale 9

Sales methods and special concerns 10Public offerings 10Secondary offerings 13Trade (third-party) sales 14Mixed sales-trade sales combined with share offerings 16Conditions attached to privatizations 17Role of foreign investors 17Privatizing natural monopolies 19

Organizing government for privatization 20Securing a central location and high-level support 20Setting clear objectives 20Developing institutional competence and experience 20Overcoming the commitment problem 21

Valuation methodology 22Value is in the eyes of the beholder 22Stages 22Methods 23

iv The Case-by-Case Approach to Privatization: Techniques and Examples

Hiring financial and other advisers 26Selecting financial advisers 26Selecting other advisers 27Should the same financial adviser be used for both phases of privatization? 27Foreign advisers 27Tenders for financial advisers 27

Foreword

Case-by-case privatization is of interest to all privatiza- agement, skills, capital, and marketing know-how totion 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 transitionused extensively in industrial countries as well as in Latin and developing economies, promote free markets, andAmerica 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 essentialvoucher (mass) privatization, are starting to privatize to economic reform. Moreover, it recognizes that thismedium-size and large state enterprises using case-by- approach can deliver significant financial resources tocase 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 experienceshare offerings, trade (third-party) sales, or mixed with case-by-case privatization. Dick Welch worked forsales. In the process the ownership and management many years as a senior executive in Canada's successfulof state firms are shifted to the private sector. The privatization program and has undertaken and advisedcase-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 inlabor concerns) surrounding privatization, lets merchant banking, where he participated in the sale ofgovernments 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 IskanderDirector

Private Sector Development DepartmentFinance 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 providesprivatization practitioners. Because it is the tech- practical guidance to government officials charged withnique 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 carryingin industrial countries and Latin America and, to a them out, and examines special conditions, such aslesser extent, Africa and Asia. And transition golden shares. It then outlines how governments shouldeconomies, having recently completed voucher undertake case-by-case privatization, identifying basic(mass) privatization, are starting to privatize medi- principles and common challenges, describing variousum-size and large enterprises and need to under- methods for valuing state enterprises, and explaining thestand, 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 areeconomies 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 andusually 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 andbination 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 beenment to pay close attention to the policy issues sur- implemented on a case-by-case basis. In general, theserounding 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, promoteket connections; and maximize the financial returns wider share ownership and entrepreneurship, reducefrom 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 reducelems. Selling state enterprises to the private sector can public and external debt.substantially reduce the flow of public funds to thesefirms. It also can generate significant revenue for gov-ernment in the form of sales proceeds and future tax Global lessonsrevenues 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" approachKingdom in 19 79. The U.K. program is still under way, Case-by-case privatization must be tailored to theand 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 andBritish 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 andadministration has embraced privatization. Other methods.OECD and developing countries have emulated theBritish model of case-by-case privatization, including Strong political support and leadership are vitalArgentina, Canada, Chile, France, Italy, Germany, New Privatization must receive support from the highestZealand, 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 vestedinterest in the status quo, and access to world-class Related structural reforms should keep pacetechnical expertise. The privatization agency should with privatizationreport 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 toLatin America, and Africa (Nigeria, Senegal) have taken restructure the economy.many by surprise. Analysts often underestimate theinformal savings and flight capital in developing and Pre-privatization restructuring should be brieftransition economies. With the right incentives, and defensivedomestic and international investors are eager to buy Pre-privatization restructuring should be limited toequities. To that end, governments must avoid setting balance sheet strengthening and organizationalunrealistic reserve prices. Instead, market-based valu- changes such as closures, workforce reductions, andations (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 fieldare essential Privatization programs should attractTransparency is crucial to successful case-by-case foreign investmentprivatization. Third-party financial advisers must Governments compete fiercely for foreign investmentcarry out asset valuations to ensure that prices are in privatized assets. To attract investment, foreignrealistic, fair, and consistent, as are procedures for investors should be treated the same as domesticcalling for bids and evaluating offers. Moreover, gov- investors. Without a conscious, consistent, andernments 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 revenueinvestors 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 usesirable changes during contract negotiations. its political power, residual shares, or golden share inFinally, 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 canSpecialist consultants-especially financial advisers- help m.aximize government receiptshave a clear role to play in case-by-case privatization. Emerging markets may be unable to absorb largeAlthough local experts can be used, governments packages of shares all at once. In such cases shareshould not hesitate to call on the growing body of sales should be broken into tranches and sold overforeign privatization experts. Investment banks, time following a preannounced schedule. Mixedconsulting firms, environmental experts, accountants, sales can boost domestic and foreign demand andand lawyers are essential players in case-by-case improve corporate governance by introducing aprograms. 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 programto privatization and establish and empower the institutions chargedElaborate 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-privatizethe deal. Governments should fix regulations, price con- without a privatization law, using specific legislationtrols, subsidies, and other problem areas before the sale. only where required. Countries with weaker institu-

tions and law enforcement, however, may not be ableGovernments should not adhere to an artificially to ensure the transparency of privatization. Such coun-fixed timetable tries should draft a privatization law that clearly definesAlthough 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 theseveral sales according to market conditions. Moreover, state's capacity to carry out structural reforms. Theygovernments should bear in mind that not all transac- also help make more transparent the transfer of statetions 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 tochange 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 crucialMost successful privatization programs have placed a Care should be taken in crafting a list ofheavy emphasis on educating the public and advertis- strategic industriesing 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, becausePrivate monopolies may be worse than they are deemed strategic). A positive list is usefulpublic monopolies because it has the full power of the law behind it.Before privatizing natural monopolies, governments Companies are committed to privatization within theshould restructure the industry to promote competi- deadline for the program, and can be privatized at anytion, accompanied by clear regulations and credible time by the institution in charge of executing theenforcement. transfers. Such arrangements make it harder-

though not impossible-for enterprise managers toThe desire to maximize sale proceeds should be stall privatization.balanced with other priorities Although a negative list may provide more optionsAlthough the privatization agency has a duty to sell for privatization, care should be taken in preparingstate assets for their fair market value, it must balance such a list. As many countries have learned, privateits desire to maximize sale proceeds with other priori- ownership does not necessarily imply a loss of stateties, such as broadening share ownership, deepening control over enterprises. Thus many state enterprisesdomestic capital markets, and promoting competition. that were once deemed strategic-oil and gas compa-

nies, telecommunications firms, other utilities-arePrivatization laws can be helpful but being privatized. Many governments have chosen notare 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 andprivatization 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 soease 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 steption 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 numberprocess-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 privatizationobjectives and legal framework. At a minimum, thesecriteria should include a policy test to establish what First phase Getting ready-steps one and twoshould 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, itbecomes a candidate for privatization or shutdown. Second phase Moving to sale-steps three, four, andfiveWorldwide, 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 athis 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 enterpriseto government

No-----------------------------------------rF----------------------------------------Step two: Financial advisers or

Feasibility study consortium of

advisers hired

Current and future _Iviability

Need for defensive commercial viability Not , Considerrestructuring? of enterprise evaluated viable wind-up

Need to corporatize? Viable

Valuation and possibleNeed 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 Lor conditions? Seller's due diligence from enterprise

Residual shares- managementmanagement and

future sale Move to approval No process for sale approval S

Trade sale- Approvalauction 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. Asnoted, 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 regulationtization (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 governmentworking, including an evaluation of whether a monop- appoint a competent official to manage these andoly should be broken up. If new regulations are required, future stages of privatization.the govemment and its advisers should identify them andset a timetable for implementing them. To avoid conflicts Identifying and resolving policy issuesof interest, the advisers who do the regulatory review The feasibility study should examine the policy issuesshould 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 thepotential 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 shouldpation is acceptable and what role employees will play examine the need for restrictions on sale (goldenin 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 enterprisevalue the firm and report on privatization options. This Valuation is of paramount importance because itreport 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 priceOrganization and to ensure that there is sufficient investor interest.Financial advisers may be useful during the identifica- In Western market economies valuation is based ontion 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 privatezation 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 not1984, New Zealand faced serious economic, finan- guarantee their debt.cial, and structural problems. Extensive government * Establish real balance sheets for state enterprises. (Mostregulations, 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 basedZealand 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 managereforms. The State-Owned Enterprises Act, passed in the newly corporatized firms, to boost their performance1986, established a framework for the operation of prior to privatization.government-owned businesses and provided for Corporatization was a successful tool in the financialtheir corporatization. Corporatization of state enter- and organizational restructuring of New Zealand's publicprises 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 byState 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 Easternronmental damage from industrial activities. Privatizing Europe try to control their financial exposure when theyindustries 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 posedcosts 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 buyerbuyer from unknown risks. Approaches that have been from the purchase agreement if the environmental auditused 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 specifiedPoland), 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 candidatesvalue may overstate value because firms are often sold for privatizationbelow replacement cost. In addition to the valuation, Governments are often concerned that the feasibilityfinancial 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 beentions prior to the closure of the transaction. incurred without identifying a viable privatization can-

didate. This risk can be reduced by dividing into twoOptionsfor sale and timing phases the financial advisery for the feasibility study. InIn most cases privatization officials submit a privatiza- the first phase the financial adviser quickly evaluates ation 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 valuingproposals 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 governmententerprise (figure 2). needs to put in place.

* An environmental statement identifying who willbear environmental liabilities (if any).

Step three: Privatization plan * Restrictions or conditions on foreign participation inthe sale.

Once a government decides to privatize a state enter- * The role of employees in the privatization-forprise, 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 thesale than it used to prepare for privatization, those Sales planadvisers (sales agents) should be hired at this point. The sales plan should state how the government

and its financial advisers or sales agents will carryCommunications plan out the sale. The plan should contain the steps andThe government should develop a communications timeline for the sale, covering the timing andplan 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 documentsprivatization 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 andprovide ministers, public officials, and company exec- underwriting syndicate (if an initial public offeringutives with question and answer material so that the is being used).government can provide coherent, coordinated, andaccurate information to the media and public on the Draft legislation or executive ordersaims, 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 decreesBefore the privatization can proceed to the sale phase, needed for the sale of the state enterprise should alsothe 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 Cregm

Environmental protection Policy issues resolvedregime Legislation orForeign 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 withSale restrictions _ potential investorsor conditions L

Residual shareholdings ISales plan prepared |management plan _ |(see below for options)|

Stepfour:vLegislation orexecutive order Legal regime needed

to allow saleput in place and policydecisions 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 togovernment 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 besales process becomes needlessly complex if legislation mature enough to absorb them.) Enterprises that dois pending when the company is brought to market. A not meet these requirements are sold through a tradecommunications exercise is needed to provide parlia- sale (third-party sale) of assets or shares using anmentarians with objective information on the aims of open bidding (auction) process. A negotiated sale tothe government and the reasons for privatization. a strategic buyer is another alternative, though in

most cases the government will receive less than itwould 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 methodsand special concerns

Case-by-case privatizations generally involve public Another variation, targeting small investors, is toofferings, secondary offerings, trade (third-party) sales, offer incentive schemes. France and the Unitedor mixed sales. In addition, attention must be paid to Kingdom, for example, have offered bonuses toany 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 everying 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 shareissue at once, governments should consider issuing

Public share offerings on stock markets can be used shares in several tranches. In Canada, for example, thefor large, profitable, relatively well-known state enter- government let state enterprises go to market with newprises. In addition to transferring ownership, share shares during the first tranche in order to establish aoffers often raise additional capital for an enterprise market for the shares. The government then offeredthrough 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 ofownership 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, forket 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 smallreceipts (GDRs). investors to increase (at the expense of institutional

Shares are offered to retail and institutional investors) when there is high demand. In France theinvestors, usually at a fixed price. In most cases shares subscriptions of small investors often receive priorityare sold by stockbrokers overseen by government reg- treatment and a 20 percent price discount for sharesulators. Public share offers are generally transparent held more than four years. In other countries, like Sribecause 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 offering of the offer price for the shares, which can be a fixed and on market capitalization in the countries where theprice offer, a tender offer, or both-as in the United issue is sold. Capital market imperfections, low marketKingdom, which pioneered an international and capitalization, and factors such as political risk candomestic 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 shareprice 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 morepeople can afford them)-can increase market capital- expensive but are less risky for government.ization, and thus ensure adequate prices for shareoffers. 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 agentswritten-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 Gasvatization in 1979. Since then it has privatized a vast num- The privatization of British Gas was the second divestitureber of state holdings worth more than $100 billion. Two of a public utility in the United Kingdom. The govemmentof the most successful offerings have been for British followed the same pattern of privatization as in the BritishTelecom and British Gas. Telecom privatization.

In 1985 the government announced its intention toBritish 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 indivestiture 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, andEmployee participation was also substantial. third to foreign investors.

The British government announced plans to deregulate In November 1986 the government offered 4 billionthe telecommunications industry in 1979 and in 1981 ordinary shares representing 97 percent of the ordinarypassed an act creating British Telecom and separating it capital stock. It retained 125 million shares to meet thefrom 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 publicconverted 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 domesticand abroad, was nearly nine times oversubscribed. Up to institutional investors in favor of individual investors. In10 percent of the offered shares (301 million) were the end 62 percent of shares went to the U.K. public, 23reserved for British Telecom employees and pensioners. percent to U.K. institutional investors, and 11 percent toThe 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 saletogether with the general public. The remaining 415 totaled $8.6 billion. In May 1997 shares of British Gasmillion shares were allocated to buyers in Canada, Japan, were trading at a premium of 138 percent over the initialand 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 shareBritish Telecom employees and pensioners, and the ownership, some critics argued that it sold British Gas tobalance to just over 2 million U.K. investors. The issue the private sector as a fully fledged monopoly and thatcreated 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 gas250,000 customers waiting to have a telephone installed, industry and the quality of service have been less thanNow it installs lines within two days. The government optimal. Given the uniqueness of the transaction, it iscontinues to regulate British Telecom and holds a special hardly surprising that increasing competition was not arights 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-ownedgovemments should hire foreign brokers to co-lead the oil company is described in box 5.issue (or at least the foreign component). Brokers shouldbe 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, andIncrease 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 issuewant to manage the sale. In this case the government will will be the choice of share instrument (usuallyneed 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 paymentmay, however, consist of a sale of government shares and over time.a company share issue. In such cases both the companyand 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 shareSteps in a public offering ownership plan can provide shares and often shareOfficials involved in privatizing an enterprise through financing for employees. A recent analysis of Europeanan 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), leadbrokers, 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 marketfinancial 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 whenThe 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 themanagement participation in the issue, management of prospectus for the share flotation. For example, thegovernment residual shareholdings (if any), and gov- government may decide to hold onto its residualemnment 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, installmentreceipts, convertible bonds, warrants, convertible pref- Pricing and distribution. Pricing and distribution areerence 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 institutionalny 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 beendistribution (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 orprepare prospectus government input secondary offer directly

to markets

Placement syndicateformed Placement syndicate

Government approves formedGovernment approves __ | employee and

prospectus management shares andresolves policy issues Road shows

Communication advisers State enterprise andnamed 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 buildingBook 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 ,ll 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 difficultagents must be able to provide the government with the because the shares are already trading and have atradeoff costs of changes to the sales structure (for market price. Brokers sell a secondary issue toexample, if the government wants to increase the share individuals and institutional investors in much theof retail shares or sell more shares domestically). same way as an initial public offering.

Officials involved in a secondary share issue mustoversee 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 salespublic 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 similarFiscales (YPF) as an integrated oil producer in the early activities and assets. The marketing of YPF's assets andpart of this century. By 1991 it was Argentina's largest activities included promotional events such as a series ofcompany, generating sales of more than $4 billion a year targeted investor presentations and a four-week investorand 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'soil industry. The government decided to privatize YPF to capital markets and persuaded international institutionalmake it an efficient, competitive, integrated oil and nat- investors to allocate funds to Argentina. Even skepticalural 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 theintroduced competition into the hydrocarbons industry, original investment for two years.lifting all restrictions on the exploration, development, When the multitranche global offering of YPFand sale of crude oil, gas, and petroleum products. After concluded. in July 1993, it represented the largestthe 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 sharescompanies, raising $1.4 billion by 1994. To compete in a sold, 40 million were in Argentina, 74 million were in thederegulated 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 didrestructuring. 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 timesand a cost reduction program that cut the number of oversubscribed, the government had to increase the issueemployees 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 investorgovernment 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 strategicYPF's assets. Independent consultants, whose decisions business unit's joint ventures, concessions, and saleswere 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 $99ers based on demand and supply conditions, financial and million in 1994. Dividends rose from $239 million inoperating data, dividends, sales, earnings, operatinginfor- 1992 to $587 million in 1994. Profitability more thanmation, 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 usuallyrevolve 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 thandirectly into markets, releasing small lots over a peri- negotiated sales. First, the financial advisers or salesod of time. The process, however, lacks transparen- agents, working with state enterprise managers andcy 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 issales 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 bidderssent to potential buyers signed withbuyerand gives them much more detailed, commercially

Expressions o confidential information on the state enterprise, accessExpressions 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 adviserschoose the best offer, and the sale closes with payment

Short list of bidders t for the shares (or in special cases, assets) of the statemoves 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 privatizedConfidential information Price and terms negotiated enterprises will continue to be going concerns. They are

memorandumsent 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 bebinding 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 oninvestors. 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 areor sales agents will have compiled a list of potential prequalified, final bids can be judged based solely oninvestors and will discuss it with the government prior price.to use.

Then, nonbinding expressions of interest are Negotiated salesreceived from interested buyers. Based on these expres- Negotiated sales are a variant of the open biddingsions 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 majorityto the buyer and protects the government's interests. (the strategic investor becomes principal shareholderNegotiated 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 theders 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. Thetransparent than open bidding (box 6). shares reserved for the stock market can be sold in sev-

eral tranches, depending on the absorption capacity ofdomestic 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 lowerthan 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 areThese 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 minimumsold to a strategic investor bringing capital, know-how, cumulative period of, say, five years. The sharesand 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 timethe requirements of potential investors, the level of of the initial public offering-provided the sharescontrol offered for sale may range from a supermajori- are not sold in the secondary market for, say, 18ty (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 plansuncompetitive and failed to keep pace with technological in Skoda as part of a general strategy to lower costs anddevelopments in the global automobile industry. One investment in Germany and abroad. Planned investmentstate-owned company, Skoda, accounted for almost all in Skoda was cut by more than half, from DM 8.2 billionproduction-about 200,000 cars a year. In 1990, howev- to DM 3.7 billion, through the end of the decade. Theer, Skoda reached an agreement with Volkswagen, the planned increase in production was also cut, fromGerman automaker, under which Volkswagen gradually 450,000 to 300,000. After prolonged negotiations, theassumed ownership of Skoda. Volkswagen's bid price and government agreed to these changes and allowedten-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 shareholdingcent after two subsequent capital injections of DM 350 was eventually sold as shares without voting rightsmillion 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 sellingtions of its shares. Finally, Volkswagen committed to state enterprises to strategic investors. Changing businessincreasing Skoda's annual production capacity from conditions mean that it is unrealistic for governments to200,000 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 aregovernment, in turn, agreed to manage its shares as an to be carried out over long periods. Thus governmentsinvestment and to refrain from interfering in the manage- should be prepared to renegotiate these commitments inment 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 toeral ways. However, experience from around the world give the government influence on company matters itsuggests 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 majoring or the negotiated sale to employees. Indeed, if the corporate actions such as the sale of the majority ofinitial 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, telecommunicationswere sold to retail investors at the time of the initial companies-in a number of countries, including Newoffering. 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 tothan the price offered to the public. Knowing this, the approve any participation exceeding 10 percent of astrategic investor might use the situation to obtain a privatized company's shares. As a rule, conditionsseries of concessions that the government otherwise attached to privatizations by government detract frommight 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 ofcountries with a nascent system of corporate gover- action (box 8).nance (box 7). Indeed, trade sales to strategic investorssafeguard the future of the privatized company by"'anchoring" its management with an international Role of foreign investorsoperator whose system of corporate governance can betransferred to the privatized entity. Where there is Governments in many transition economies encouragedomestic 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, newdomestic buyers to bid (as in the privatizations of technology, international links, and access to foreignArgentina's and Mexico's national telecommunications markets. Foreign participation in trade sales, mixedcompanies). If the foreign operator acquires only rela- sales, or public offerings ensures that government willtive 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 thatvatized 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 formergovernment can expect to maximize proceeds because state enterprises should not be underestimated. Thethe bidders will likely offer to pay a control premium world-class products and marketing that foreignfor the block of shares. Mixed sales also allow govern- investors bring are particularly valuable to former statements to broaden share ownership while ensuring that firms in transition economies that are manufacturingforeign 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 astelecommunications) where global competition is

Governments often attach special conditions to priva- strong and the costs of product development andtization sales, demanding a special or golden share to research and development are too high for a singleprotect 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 notlargest 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 toThe bank's 176 branches and 2,778 employees were domestic and foreign investors. Article 4 of the terms ofspread around the country. A minority interest was quot- reference stipulated that consortiums should include ated 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 nationalitychief 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 consortiumsinvestors. 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 thebining 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 endthe stock market (targeted at small investors and mutual of March 1995, and various alternatives were consideredfunds) for 14 percent, and a private placement with the to allow the transaction to close. Finally, instead of tryingbank's employees for 3 percent. The government retained to motivate foreign commercial banks to buy a stake in the7 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 ontem. The tender started in December 1994 and was due behalf of nominee accounts. Morgan Grenfell forged anto 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 Marchinterest in participating in the open tender. On the 1995. The winning consortium was led by a Moroccanstrength of this, the Ministry of Privatization launched and industrialist allied with Morgan Grenfell. The price paidclosed the secondary share offering before closing the for the 26 percent stake was at a 47 percent premium toopen 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 forattracted 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 givesimum price for the 26 percent of shares offered at open ten- privatization officials some discretion in responding toder 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 havereserved 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 thetranches. Half of the 26 percent stake, or 13 percent of the selection of the winning bidder are publicly disclosedbanks 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 ofcent or more of the capital of a Moroccan bank or that were potential bidders or on the use that they can make of theirowned 20 percent or more by a similar institution were investment does not enhance the transparency of theexcluded 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 FrenchFrance's state-owned automaker, Renault, announced in state would hold the rest. But the golden share would giveSeptember 1993 that it planned to merge with Sweden's the French govemment the power to limit anyVolvo. The merger was set for 1 January 1994. By shareholder-including Volvo-to just one-fifth of theNovember 1993, however, enough Swedish institution- voting rights in the company if Renault chose to dissolveal 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 governmentmeeting. 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 worriedRenault. The other was the golden share that the French that if Renault-Volvo ever had to cut costs-as Air France'sgovernment planned to retain in the merged group even boss had tried to-it would be Swedish rather thanafter privatization. Under the merger plan the French gov- French jobs that would go. But the French insisted thatemnment would directly hold 47 percent and Volvo 18 per- the golden share was a defensive weapon that would onlycent of the Renault-Volvo group. A holding company, be used if one of the big U.S. orJapanese automakers triedRVC, 51 percent owned by the French government, to take over the group. After protracted negotiations andwould 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 efficientpercent of the assets sold through 1994. provider. Examples include telephone companies,

Other countries have limited foreign equity partic- electric power systems, municipal water systems, andipation in privatized enterprises. Russia, despite municipal public transport. The opening of manydeclared intentions to the contrary, has not allowed countries to competition from abroad and changes inforeign 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 monopolycompany, 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 astake in the company The Russian banks were unable rate of return on capital employed-providing fewto 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 andment should be lifted and discrimination between for- unregulated, regulations must be put in place beforeeign and domestic investors eliminated. privatization. These regulations should encourage effi-

ciency and give investors a chance to earn a reasonablerate of return. Regulators should be as independent as

Privatizing natural monopolies possible from political interference. Capricious or

politically driven regulations detract from the value ofEconomists 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 governmentfor privatization

A successful privatization program must be located Setting clear objectivesat the center of government, receive support from thehighest levels of government, clearly define its Privatization programs should have clearly definedobjectives, develop institutional competence and objectives. The government can set these out in policyexperience, and overcome the commitment problem. statements, laws, or decrees or in instructions to the

officials administering the privatization program. Ifthese 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 madeMost 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 theseminister's office, the ministry of finance or treasury, or tradeoffs and to prevent privatization from beingsome other powerful central ministry or department. bogged down in a welter of unresolved issues. ForThere 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 policieschanges the status quo. By locating the group responsi- and authority than about the government's need toble for privatization near the center of government restructure the economy or raise revenue.power, bureaucratic opposition can be overcome andpolitical issues effectively managed.* Privatization programs are usually part of a structur- Developing institutional competenceal adjustment program or result from the government's and experienceneed to raise revenue. Central ministries are responsi-ble for such initiatives and so have the strongest incen- Government institutions responsible for privatizationtive 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 inthe enterprise being privatized, labor unions, national developing and transition economies do not have. Toand local politicians, and the employees, customers, develop this expertise, a single privatization bodyand 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 ofoften must intervene to resolve issues and move the institutions or ministries is a mistake, and will lead toprocess 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 obstructhave been mutually reinforcing. For example, Canada's cash sales of state enterprises. For example, privatizationmost successful privatization program was associated powers are often divided between the line ministrieswith 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 largelems 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 ofmitment problem because of the vast influence of state particular importance. Autonomy is the extent toenterprises-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 politiciansaddition, governments in transition economies-as else- or social groups. Rationality is the degree to whichwhere-have encountered public hostility toward the institutional procedures are based on uniform rulessale of a country's "crown jewels" to foreign investors. that must be followed.

Valuationmethodology

A company ultimately is worth what people are willing tender than if it chooses an initial public offering. Theto pay for it. Valuation is the process of estimating this political benefits of popular capitalism have financialvalue. 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 fundamentalimportance to both buyer and seller (in this case, the Stagesgovernment).

Buyers that overpay for an asset cannot meet their A valuation starts with a financial audit and a methodtarget 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. Theother hand, has a fiduciary responsibility to its citizens method of sale determines the weight and level of detailwhen it privatizes an asset. It is entrusted to sell priva- that should be applied to the valuation methods usedtizable 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 willAgreeing 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 termssometimes 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 soparency is crucial. Thus the size of the discount offered that the adviser can help prepare the terms of referenceshould 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 complementsthe 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, itsative concept. Valuation is more art than science. Buyers organization, its finances and balance sheet, its nationalwill value a company or set of assets differently, depend- and (if relevant) international standing, and any othering on the synergies they perceive between their own information that may be relevant to a valuation, such ascompany and a potential acquisition. The greater are a likely change in taxation or regulation. Past financialthe 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 existingselected 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 financialthings being equal, sale proceeds will likely be higher adviser will also work with the government to exploreif 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 incial adviser should be able to submit a first valuation the first place. Ultimately, however, productive assetsreport 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 economicsis. 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 oftenor the fixed price of the public offering. But the gov- prefer this valuation method. It gives them a sense ofernment's decision must be based on the objective data the price at which they should sell the assets in orderprovided 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 ofpared for the exclusive use of the seller (or buyer) and unreconcilable differences between buyers and sellers.under no circumstances should be disclosed to thirdparties. A leak to buyers could have adverse conse- Discounted cash-flow methodquences for the divestiture: insiders would become The discounted cash-flow method is best suited to a saleaware 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 inworking capital and future capital expenditures. A dis-

Methods count rate is then applied to these anticipated cashflows to calculate their present value. The discount rate

All valuation methods estimate market value. Some reflects the enterprise's weighted average cost of capitalmethods are appropriate if the company is to be divest- and the political risk of the country where its operationsed through an initial public offering; others if control is are based. Present values are then totaled. A terminalto be sold to a strategic investor. Whatever the method value is sometimes added to this number. Finally, theof sale, no valuation method is infallible. The market total funded debt on the enterprise's balance sheet at thevalue of a company is best estimated by combining, in time of the transaction is subtracted to arrive at the netdifferent 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 theserable 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 pricesmethods 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 areenterprise's fair market value by estimating the market most useful when they include variables that can bevalue of its assets (fixed assets and current assets) and modified to run sensitivity analysis. Such models canthen subtracting its balance sheet and off-balance prove especially useful during negotiations. A goodsheet 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 answersbecause it fails to take into account the assets' capaci- about the value of assets if certain conditions attachedty to generate revenues. It looks at the costs of pur- to the sale are modified-for example, the length of achasing them, then applies a depreciation factor to period of exclusivity or the level of taxation onaccount 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: theythe 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 estimateAn 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 acquisitionprice equals zero. Book building method

The book building method (also known as circling) isComparable companies and used in public offerings and private placements ofcomparable transactions methods quoted securities to determine the price they should beThe comparable companies and comparable transac- offered for at subscription. It differs from the methodstions methods are particularly appropriate when an described above in that it does not involve calculationsenterprise is being partly or entirely privatized through based on a set formula. Rather, the calculations takea 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 fromuation 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 offermultiple 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 $18price-earnings ratio). apiece, and how many if they were $20?

Valuation multiples are calculated by dividing the Each member of the placement syndicate constructsstock market capitalization of several companies in the an order book; every two days each book is transmittedsame 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 periodmultiples. 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 whichlow, and arithmetic mean) that is applied to the finan-cial results of the enterprise being valued. In addition, Fi 5 Bok buildin-de d filfor capital-intensive industries like cement or oil andgas, 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 -Day2be used to approximate market values. 1200 Day 8

As opposed to the multiples of operating income, - Day 10which estimate the market value of total assets, the 900multiple of net earnings estimates the market value of 600equity. To deduce the market value of equity, the netdebt on the enterprise's balance sheet is subtracted 300from the total assets estimate. The same operations arerepeated 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 fixedprice 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 vehiclescribed because investors typically request more than fleet). This valuation method often produces a muchthey want to receive, expecting their orders to be scaled higher value than the methods described above. Thisdown. It is important, however, that some unsatisfied is because the decision to form an industry may notdemand 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 beenshares reserved for global offerings to institutional equally important. For example, it may be politicallyinvestors. To be effective, this method requires a mini- desirable to build a medium-size petroleum refinerymum number of independent institutional investors in a small developing country, but from an economicthat are unlikely to collude with one another. In most standpoint it makes more sense to import refinedemerging markets institutional investors are too small products.to fulfill this condition; thus the book building method Investors almost never take the replacement valuecannot be used domestically Domestic issues are, how- method into account when valuing a company becauseever, 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 thisshares 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 beenReplacement value method discarded. Otherwise, critics of privatization may useThe replacement value method estimates how much it this method to argue that an enterprise is worth farwould cost to replace a company's assets if they were more or that it was sold for a fraction of its worth.

Hiring financialand other advisers

In the context of case-by-case privatization, financial contacting potential buyers, and enticing interestedadvisers are investment bankers or merchant bankers parties to bid for the companythat sell and advise on the sale of firms. The govern- If privatization involves a small enterprise that isment 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 anattract both domestic and foreign investors. international dimension, valuation should be done by

an investment bank or merchant bank. This is becausevaluation requires market awareness as well as techni-

Selecting financial advisers cal skills. Unless the financial adviser is involved inbuying and selling companies in the same sector as the

Governments need financial advisers in case-by-case privatization candidate, the results of the valuationprivatizations to value enterprises, advise on the tim- may not reflect what the market is willing to pay for theing 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 thatsale. 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 chargedny is salable, whether it should be sold now or later, with valuing assets responsible for also identifyingand what sorts of sales choices are feasible, and at potential buyers. This approach guarantees thatwhat 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 salein 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 ignoressyndicate of investment banks or merchant banks the fact that in most cases the structure of the placementwill be formed to sell the enterprise's shares. The mandate is such that the higher is the sale price, thegovernment must appoint a firm as the lead manager higher is the bank's compensation. Thus conflicts can befor the syndicate to manage the sale process. If a pri- avoided by properly structuring the compensation ofvatization takes the form of a trade sale, the sales agent financial adviers and ensuring that it is in their interestwill 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, theadviser 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 isvatization. Lawyers are required to manage due dili- not happy with the adviser's performance.gence activities, advise the government on the legalaspects of the privatization, draft and negotiate salescontracts and draw up confidentiality agreements. Foreign advisersAccountants and auditors may be needed to undertakeaudits prior to sale. Technical experts with specialized Governments in transition and developing economiesindustry 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 orhire them separately. injections of foreign capital, or if it plans to sell shares

on international markets. These advisers should workwith 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 advisersthe same financial adviser that helped the governmentduring the early stages of privatization should under- Governments should hire financial advisers through atake the sale of the enterprise. The argument against competitive bidding process. But given the specializedusing 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 andvatize an enterprise and helping with the sale of that marketing capacity needed for privatization. As a ruleenterprise. The best advisory firms, however, are often the list should include at least 10 companies to avoidreluctant 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 submititable. 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.

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