The Role of Buy-outs in Restructuring Central and Eastern

Europe: Theory and Practice Mike Wright, Igor Filatotchev and Trevor Buck

Centre for Management Buy-out Research, CJni\versity of Nottingham, UK

After the excesses of the “wild privatisations” which marked much of the early stages of the transformation to market economies in Eastern Europe, management and employee buy-outs are slowly working themselves back on to the agenda, especially for small- to medium-sized firms and spin-offs from large state enterprises. The widespread ability of managers associated with the ancierts rQinw.s to acquire their firms in an uncontrolled manner, so-called “nomenklatura buy-outs”, produced considerable resistance to the buy-out phenomenon. Particular concern arose that “red directors” would steal away the country’s assets and be the unwelcome bcncficiarics of market reforms. However, it has come to be rccogniscd that in many casts such managers arc the only available cntrcprcnours (Kornni. 1992; Filatotchcv et (II., 1992b). Morcovcr, it is becoming clear that a key clcmcnt in the privatisation process in Central and Eastern Europe (CEE) has to bc the cstablishmcnt of cffcctivc corporate govcrnuncc structures if cfticicncy is to bc incrcascd (Corbctt and Mayer. 1991). Buy-outs rcprcscnt an innovative form of corporate govcrnancc, with ownership and control closely held bctwccn incumbent munagcmcnt and funding institutions (Thompson et trl., 1992). Such buy-outs have been the most I’rcqucnt form of privatisation in the UK (Thompson et d., 1990). The applicability of thcsc terms of priv:ltisihti<)n to the transformation of CEE is a core aspect of the paper, although it would bc naive to argue that buy-outs prcscnt the only viable form of privatisation.

This paper analyses the issues involved in the application of the buy-out concept as used in the West to the transformation of the economics of CEE. The second section briefly summariscs privatisation buy-out trends internationally. The third section outlines general buy-out principles and the fourth section analysts their application in diffcrcnt contexts which have arisen both in privatisation buy-outs in the West and which arc relevant to CEE. The fifth section presents some conclusions.

Privatisation Buy-out Trends The most widespread USC of buy-outs as a form of privatisation in the West has been in the UK. To the end of the second quarter of 1992, 166 such cases

Buy-outs in Central/Eastern

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Financial support for CIMROR from Barclays Dcvclopmcnt Capital Limircd and Touchc Ross Corporarc Finance is gratefully acknowlrdgrd.

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have been identified since 198 1. This figure represents 4.6% of all buy-outs completed in the UK. and compares with 4-l privatisations by stock market flotation and at least 100 sales to third parties. The peak year for privatisation buy-outs was 1987 when some 35 were completed, mainly from the break-up of National Bus. In the eighteen months ending in June 1992, 19 privatisation buy-outs were completed, principally involving local-authority activities as the privatisation of state enterprises was nearing completion. Buy-outs on privatisation in the UK have occurred in four main ways: complete enterprise buy-outs (National Freight and BTG); multiple buy-outs on the break-up of a state firm (39 from National Bus, five from Scottish Bus, and 12 from British Shipbuilders); buy-outs on divestment of “non-core” activities (43, principally from Austin Rover, British Steel and BTG); buy-outs of previously non-commercial governmental or quasi-governmental activities including local authority services, ancillary health services and government agencies (65).

Elsewhere in the West, modest numbers of such transactions have been identified in France, Austria. Spain. Italy, Sweden, The Netherlands, Portugal. Norway. New Zealand. USA and Canada (Wright and Buck, 1992). In less- developed countries privatisation buy-outs have also been identified, principally in Bangladesh, Chile, C0te d’lvoire, Gambia. Jamaica, Mexico, Nigeria and Tunisia (see Vuylesteke, 1988; Bouin and Michalet, 199 I ).

Information on the actual level of buy-out activity in Eastern Europe is difficult to obtain. Besides an unknown number of nornenklatura buy-outs, several hundred buy-outs of retail premises and small workshops have been complctcd in several countrics. In Russia, half of these smaller sales, an estimated 6,500 transactions, have involved managcmcnt and employee buy- outs. Similarly, in Romania, 270 out of 1,100 smaller activities sold up to October 1992 were to cmployccs. But, apart from in the former GDR, buy- outs of sizeable cntcrpriscs have at the time of writing been limited. By June 1992, of the total 8, I75 privatisations by the Treuhandanstalt (THA), the German state privatisati0n agency, some 1,475 (or 18%) were management buy-outs and an cstitnatcd 250 (or 3%) were management buy-ins. The Privatisation Law in Poland allows for a procedure of “liquidation”. whereby a buy-out occurs when incumbent management and employees create a private entcrprisc IO least state assets. The original state-owned enterprise is subsequently wound-up. By October 1992, more than 450 out of a total of about 800 sales were buy-outs. In Hungary, around 20 buy-outs have so far estimated to have been completed under the recently introduced self- privatisation rules, with emphasis particularly on foreign trading companies and services. In Romania, four companies have been selected to be sold as buy-outs as part of a pilot privatisation project, three of which have so far been completed. In Estonia, two of the first seven pilot privatisations (Sami and Mareta) were full buy-outs and four others (Baltika, Valga, Voit and Talleks) were buy-outs where management and employees were obliged to leave minority stakes with the state or sell them to the general public. Slovenia, which under its initial Draft Privatisation Law gave pre-eminence to

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buy-outs, has seen buy-outs completed via several routes. Seven have been Buy-outs in completed in the last 18 months where workers’ councils transfer ownership Central/Eastern to the privatisation trust which then sells the shares back to the employees. a further 17 have involved privatisation through the internal acquisition of

Europe

shares using the old Yugoslavian legislation, but with most occurring through the “drop-down” method whereby a newly created company owned by management and employees buys or leases the assets required from the old company.

Buy-out Principles A buy-out is a generic term covering a variety of closely-related organizational forms. In the US the “taking private” of firms quoted on a stock exchange has emphasised very large buy-outs of quoted companies, generally effected by external leveraged buy-out (LBO) Associations, with the possibility of some internal management equity ownership and with high leverage consisting of various layers of senior secured and subordinated/mezzanine debt (Jensen. 1989). In the UK, the vast majority of buy-outs are completed for transaction prices below the equivalent of $20 million and in two-thirds of cases involve divestments of divisions (Chiplin et nf.. 1992): Typically a group of between four and six senior managers will take the initiative and obtain a majority of the equity, with funding being provided by a combination of debt providers and venture capitalists. In a number of cases it may be considered appropriate to include managers below the very senior level in share ownership, where to do so is seen as important in gaining their commitment to the transaction.

In principle, buy-outs provide a means for dealing with the problems raised by the divorce between ownership and control in a firm with diffuse or “absentee” shareholders, such as in firms quoted on a stock market or state- owned firms (Jensen, 1989; Wright rt (II., 1989). Managers, as agents of shareholders in such firms, make decisions on behalf of the beneficial owners or shareholder principals. The diluted or even non-existent equity involvement of managers may bring the pursuit of non-profit maximising bchaviour to the detriment of shareholders (Fama and Jensen, 1983; Jensen, !989), especially in the absence of active investors who take a direct role in the monitoring of quoted companies. These governance problems can also be extended to divisions as a second-tier agency problem. Monitors in large complex organisations with diffuse shareholdings may also be less willing and able to monitor divisions effectively (Wright, 1986).

Management and leveraged buy-outs introduce the possibility for dealing with these problems through the following: the introduction of higher managerial ownership which should increase incentives to perform; closer monitoring by a small group of institutional shareholders; and the use of high levels of debt which introduce a commitment to perform in order to meet

‘Such dcnls also occur in the US but have generally received little attention (but see Malone.

1989).

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interest payments which, unlike dividends, cannot be waived. Besides straightforward debt a number of other financial instruments are available to finance buy-outs which embody control instruments. For example quasi-debt (or dequity) instruments such as redeemable preference shares carry obligations and incentives to perform in order that the shares may be repurchased on favourable terms. Such instruments may offer more flexibility than debt, and be appropriate in circumstances where cash flow is less predictable. The incentive and control effect of buy-out structures is frequently enhanced where management’s shareholdings are themselves dependent upon the medium-term performance of the firm and may be adjusted up, and sometimes down, by means of a ratchet mechanism (Thompson and Wright. 1991). Governance structures in buy-outs also embrace requirements to keep within debt covenants, board representation, and regular detailed reports and meetings which involve a greater amount of information than the outside market would typically receive. The essence of these mechanisms is that they provide a range of flexible techniques for the direct control of buy-outs in different situations (Wright et trl., l992b). The extension of shareholdings to the wider body of employees may also help to reduce lower level agency cost problems. By becoming sharcholdcrs. employees may bc cncouragcd to en,, b v ‘e in horizontal and self-monitoring to reinforce traditional vertical monitoring. Where thcrc is a rationale for divesting activities with a trading rclotionship, a buy-out may offer attractions to the vendor in prcfcrcncc to salt to a competitor. cspccially where the former subsidiary is heavily dcpcndcnt on its crstwhilc parent (Wright. 19%).

Examination of the buy-out process indicates that for each individual transaction the intcrcsts of the partics involved have to bc satisfied bcforc it can bc complctcd - the vendor, the mana~cmcnt, financial institutions and the company itself (Wright rf (il., 109 I, chap. 7). This suggests that the SCOPC

for buy-out type transactions can bc broiidcncd considerably by matching govcrniulce and finaricin, 17 structures to the individual circumstimccs of each transaction and provides a means by which buy-outs CM bc extended to the CEE context.

Application of Iluy-outs in Differing Contexts The experience of buy-outs in the West, particularly in privntisation from the public sector, rcvcids a number of circumstances that arc broadly comparable to CEE and which require adaptation of the general buy-out procedure.

Uncertcrin Market Codilions cud klutition Sales involving incumbent managers and others with connections with the former regime carry the threat of illicit transfers at nominal prices, based on inside information and bolstered by various forms of corruption’. The problems for enterprise valuation which are thus raised art: not, however, entirely unique to the CEE. The whole valuation process for privatisation in

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any context may be affected by an interrelated set of factors which may be Buy-outs in grouped under the headings of accounting; presentational; institutional: and Central/Eastern economic. Nearly all valuation methods rely heavily upon accounting data

and may therefore be intluenced by the techniques that firms may use in Europe

preparation of their accounts (Wright, 1937). Presentational factors concern

action taken by government to help ensure that a privatisation is seen to be

successful; institutional factors concern the influence on valuation of the

ability of institutions to absorb a given level and type of sale; and economic

factors concern both the performance of the company to be sold and the

intluence of post-privatisation market factors.

In addition to these general problems. valuation of firms in CEE is vexed

by a series of particular problems (Valentiny et (II., 1992). The absence of

appropriate accounting policies and capital markets in CEE limits the

application of standard valuation techniques. Uncertain market environments

may mean that income streams are uncertain. Valuation problems also arise

from the sporadic and arbitrary treatment. if not exclusion, of land and

buildings from enterprise accounts. As markets in land and buildings develop

as part of the transformation process many firms may be able to release on to

the market a good deal of unrccordcd assets. A further key valuation problem

in CEE concerns enterprise d&t. especially inter-firm credit which may not

always be legally enforceable. high levels of obsolctc inventory and hidden

liahilitics in the form of the social infrastructure which frcqucntly surrounds

firms. Thcsc issues also have implications for financing, to which we return

b&w.

Scvcral mechanisms arc available for dealing with undervaluation. A

number of countries aIs0 now insist on an auction, but outsiders may bc

unwilling to bid against incumbents, who in any case may bc able to take

iltlV~lIltil~C of inside information. Rctcntion of an equity stake is oric means of

dealing with l~nticrvaluation, anti cnablcs the vendor to cxcrt sonic continued

influence. A third option is to USC the taxation regime to recoup

undervaluation tither on the basis of accrued or realiscd gains. although there

are possible dctrimcntal cffccts OII incentives and the cash tlow available for

invcstmcnt. Firms may bc sold minus certain assets, although there may be

difficulties in accurately dctcrmining which assets belong to the firm. Finally.

contingent price clauses rclatin, (r to protits or clawback mechanisms related to

the gains on the sale of real estate can be used, but require a reliable formula

to be dctcrmincd. Independent investigations of the privatisution process in

the UK by parliamentary audit bodies such as the National Audit Office and

the Committee of Public Accounts have consistently stressed that more use

could have been made of clawback mechanisms and sale excluding real estate ilSSCtS (see Valcntiny rl ~11.. 1992 for a review).

Attempts to deal with the problem of undervaluation in the privatisation of

former GDR assets include purchase-price adjustment clauses and clawback

clauses which rcquirc capital gains to be repaid to the THA on a sliding scale

if the enterprise is sold within a relatively short period. The THA is also able

to sell tirms without the accompanying property, which may be Icascd on a

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long-term basis but with the granting of an option to buy the property. The pilot privatisation buy-outs in Romania have also made use of clawback arrangements whereby purchasers are not allowed to sell land and buildings within a IO- to 20-year period. If they do, all the proceeds above the inflation- adjusted figures in the initial buy-out contract are clawed back by the state.

The development of decentralised privatisation as a means of freeing up the transformation process in CEE has attempted to minimise valuation difficulties. Privatisation agencies can retain some regulation of the process by selecting major consultancy firms with reputations to protect. to carry out the detailed aspects of the process as well as a reserve right of approval of transactions.* Whilst reputation and the threat of removal from the approved list gives consultants an incentive to make a fair valuation, this may be difficult in an uncertain environment, where incumbent managers may be in a strong position to influence the apparent true value of a business.

Fnilirlg Firms

The buy-out concept can also be applied to failing firms. Indeed, in the recession of the early 1990s a fifth of buy-outs in the UK involved firms in receivership. The problem in CEE is particularly acute, given the large number of firms which are “value subtractors” when world prices are applied to their activities, an estimated 30% of firms in Hungary and Poland alone (Hate and Hughes, 1991). In CEE, pure management buy-outs (MBOs) without a Western industrial partner face severe problems of neither immcdiatc access to market contacts in the West, nor the capital and human resources that such a partner can bring to aid the restructuring process. However. many partners may be unwillin, ~7 to buy unless they can obtain majority control, which managcmcnt may be unwilling or unable to concede. Many MBOs in CEE in any case arise as rcactivc job-saving attempts when no industrial investor can be found to acquire the company and may only stand a good chance of success if they involve viable and separable units of failed groups which also possess a well-known brand name or other competitive advantage, have skilled managers and can attract the support of local and regional governments.

Wider employee share ownership may be considered a desirable aspect of privatisation buy-outs in both the West and CEE for two principal reasons. First, the support of incumbent workforces who hold strong positions within enterprises to be privatised may be necessary if privatisation is to be effected and worker attitudes towards productivity improvements are to be changed for the better. Second, employee shareholdings may be seen as important to encourage horizontal and self-monitoring among employees in addition to

That the SPAS xc taking this issue very seriously is indicntcd by reports that the Hungarian SPA was threatening to drop BZW as an advisor because of allegations that it had ncglccted the state’s interests, N. Dcnton (1992) BZW lows Hungarian Sell-Off Role. Finn~icrl Ti~ws, November 4. p. 27, although subscqucnt reports said that the comp;lny had been rcinstatcd.

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vertical monitoring by management hierarchies. From a corporate governance Buy-outs in viewpoint the former are most effective where monitors in a vertical hierarchy Central/Eastern have difficulties in observing the behaviour of employee agents, that is. where tasks are non-routine and require judgement by individuals. .Rewarding

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individuals for such behaviour is difficult because of the impossibility of writing employment contracts which incorporate incentives to maximise performance in such conditions. Employee shares can overcome this problem partly by providing incentives to perform (although this is subject to free-rider problems) but more effectively through encouraging employees to monitor each others’ compliance.

Employee shares can be distributed through the establishment of an Employee Share Ownership Plan (ESOP) in which an employee share ownership trust is created whose beneficiaries are the company’s employees. These so-called leveraged ESOPs are typically funded by a loan which also helps in the funding of the buy-out (Bruner. 1988). The company uses the cash from the trust together with other finance to buy the business, and shares are subsequently distributed to employees following the earning of profits and contributions to the share-ownership trust in return for shares in the company. The employee share-ownership trust operates the ncccssary internal market which allows employees to buy and sell shares. With a workforce which is relatively stable in size and with little staff turnover, there is a danger that the internal market of an cmployec buy-out would soon run out of sufficient liquidity to opcratc cffcctivcly (Ben-Ncr. 198X). Also the inccntivc cffcct of employee share ownership may bc crodcd as employees become unwilling to hold such shares in the long term bccausc of concern about the undivcrsificd nature of their asset portfolios and dcpcndcncc upon their employer for both investment income and salary.’

The so-called self-managcmcnt system in what was Yugoslavia. and similar systems in Hungary and Poland at the end of the I9YOs. raise particular issues concerning the involvcmcnt of the wider body of cmployccs in the ownership and control of bought-out firms. Such involvcmcnt was a key element in gaining acceptance of privatisation, but at the same time it was necessary to avoid the w&-known problem that self-managed entities with an egalitarian ethic tend towards short-tern&m in the form of cxccssivc pay-outs of profits in the form of enhanced remuneration rather than retaining profits for reinvestment. The initial Draft Privatisation Law in Slovenia introduced a specific buy-out provision in addition to other privatisation methods (Ellerman rt ctl., 1991).

Remaining key issues in buy-outs with wider sham ownership concern the selection process regarding who is to participate in equity ownership and the ultimate locus of control. The incentive effect and acceptability of ESOP schemes may depend significantly on selection procedures being seen to be open and fair. Where ultimate control rests with the wider body of employees,

‘Even though employee control was maintained after the flotation of NFC through the creation of instruments which give employee sharcholdors special voting rights in the event of a hostile takeover bid, there was a sharp fall in the percentage of shares h&l by employees.

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there may be a danger that truncated time-horizons are introduced with the well-known problems which may result.

High tm~estment Needs The ideal subject of a highly leveraged buy-out has low investment needs, so that cash flow can be focused on paying-down debt. However, buy-outs can also be applicable in situations where significant levels of investment are required. Indeed, there is extensive evidence from both general and privatisation buy-outs in the West that the buy-out structure permits higher levels of investment than was possible under the restrictive control of former owners, particularly state-owned groups experiencing substantial losses (Wright et al.. 1991). In order for financing needs to be met. initial financing structures can be adjusted to include more equity and quasi-equity instruments rather than straightforward debt. as well as the negotiation of a lower purchase price which takes account of the expected investment required. Alternatively, a joint bid with an industrial partner may be preferred where there are scale and expertise justifications for so doing. But again, as already noted. industrial partners may be reluctant to undertake such deals if they do not have control. A further possibility is to structure the buy-out with a view to a subsequent sale to an industrial partner within a short period. This last point raises the issue of the life-cycle of buy-out structures, which we address in more detail below.

High Ir~tercl~~~~ctrtlcrl~~~ l3cmwn flu?-out Ttrr,qet crrltl Otkr Firms Where trading relationships exist bctwccn parts of a stat+owned firm, divestment of a subsidiary may help resolve monitoring problems. A buy-out may offer attractions in prcfcrcncc to salt to a competitor or to a supplier, cspccially whore the former subsidiary is heavily dcpcndcnt on its crstwhilc parent (Wright, l98h). Hence, internal control is replaced by control through a quasi-market rclalionship. Such an arrangement may have important financial structure implications, since an elcmcnt of retained ownership may both enable the buy-out price LO be funded and help the state-owned parent :IS

trading partner to influence post buy-out behaviour. In order to ensure sufficient viability to attract external finance, it may also be necessary for the vendor to guarantee to maintain a certain level of trading for a specified period of time after the buy-out. Bought-out firms tend subsequently to reduce their dependence upon their former parents in order to avoid being squeezed by their more powerful trading partners. A further problem in divestment cases has implications for valuation and obtaining financial support, and concerns the difficulty of establishing a sufficiently accurate assessment of trading performance. This issue is particularly acute in those cases which were formerly subsidiaries of larger state firms and which did not have a separately identifiable track record of independent trading as they were cost centres rather than profit centres (see c.g. the case of RFS Industries in Wright et ~1.. I99 I). Divested firms of this type may also require intense managerial effort to build up certain functions previously undertaken by the

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parent. Where a straightforward buy-out is not feasible or viable, but where the contribution of employees’ specific skills is important, a joint sale to a buy-out team and a third party may be a preferred route.

This issue is of particular importance in restructuring and improving efficiency in CEE given the highly vertically integrated nature of many industries. The disintegration of the CMEA, and of the highly integrated industrial organisation in the former USSR in particular, may pose serious problems for the maintenance of trading relationships. The case of the Moscow Ventilator Factory (MOVEN) buy-out illustrates how such problems might be dealt with. MOVEN, one of the biggest producers of industrial fans in the Moscow region, is a so-called “All-Union” enterprise, i.e. it was owned by the former Ministry of Light Engineering. Being an All-Union enterprise, MOVEN receives its input from different enterprises all over the ex-USSR - for example, from Tallin’s Electrical Engines Factory in Estonia (engines), from the Ukraine (metal), etc. In an attempt to deal with the potential interruption to supplies which might occur as the newly independent republics seek to restructure their economies through reducing dependence on other republics, MOVEN sought to tie-in its suppliers to a continuing trading relationship. Besides personal savings, the buy-out team, led by the incumbent director, decided to acquire the company by borrowing from its customers - mainly from the “Svetlana” association. This loan represents an interest-free credit repayable within 10 years. In exchange, the customer was promised a reliable supply of fans at a low price (see Filatotchev et aZ., 1992a).

Buy-outs in Central/Eastern

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Managerial Skills A key aspect of buy-outs in the West is the necessity for incumbent management to demonstrate sufficient entrepreneurial skills to be able to manage an independent business if they are to obtain the financial support of institutions. In CEE, buy-outs represent an important mechanism in addition to the creation of new firms, for meeting Komai’s (1992) view that there is a need to develop private sector management. Although not all managers of firms in CEE are likely to possess the necessary skills to run an independent business, many are likely to do so particularly in countries such as Hungary, where market reforms have been developed for some time prior to 1989.

The requisite skills to run an independent business may not be fully present in incumbent management, especially in the case of subsidiaries of both private- and public-sector firms which were little more than cost centres and/or where head office provided central financial activities. In such situations institutions will typically insist that managers to fill key positions (notably finance and marketing) are recruited as a condition of finance being extended and are likely to monitor closely the firm’s post buy-out evolution (Wright et al., 1992a). Alternatively, where incumbent management do not pass institutional screening processes, but the context of the firm indicates the feasibility of a buy-out type transaction, an external team of entrepreneurs may be recruited to acquire the company, producing a management buy-in (Robbie et al., 1992). In practice, many such transactions are hybrid buy-

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out/buy-ins, with joint bids with industrial partners also occurring. Management buy-in (MBI) managers who have senior management experience in finance and marketing in a Western company and some experience in the East, so that he goes into an MB1 or MBO/MBI with realistic expectations as to the scope of the turnaround job at hand, brings the necessary skills as well as the ability to invest significant personal wealth.

Finding appropriate management with the requisite skills and matching them to firms is problematic, however, even in the West (Robbie et al., 1992). The THA launched a program in January of this year to find highly qualified MB1 candidates and to match them with suitable companies in the East. However, although over 3,000 enquiries from interested Western managers were received, these were reduced by the THA to about 350 who met most of the required criteria. Of this group, little more than a tenth are expected to progress to identifying a suitable target, preparing an acceptable turnaround plan, and acquiring and financing a deal in competition with bids from industrial groups. There have, however, been a small number of buy-ins by Western managers.*

Buy-out Life-cycles Many buy-outs may only be a staging post on the way to other organisational forms. Evidence suggest that whilst the majority of buy-outs in the West do keep their original structures for five years or more, a significant minority change very soon after buy-out (Wright et al., 1994). Indeed, privatisation buy-outs are twice as likely to need to exit than other forms of buy-out.+ Such exits from one part of a firm’s life-cycle to another may be deemed necessary from the point of view of the strategic development of the business. The need for exit in privatisation buy-outs is indicated by the available evidence showing the significant growth and development which occurs after privatisationt (see e.g. the case of Victaulic in Wright and Coyne, 1985; NFC in Bradley and Nejad, 1989). A number of danger signals are also apparent, which suggests that some buy-outs may need to become part of a larger group in order to survive, for example: diversification which has been too rapid and outside areas of core skills and has consequently been unsuccessful; erosion of market as a result of new entry; loss of core contracts in some local

*An example of an MB1 involves two Berlin electronic companies, Elpro AG and TGA acquired by a partnership of three ex-McKinsey consultants and three industrialists. The deals, worth an estimated DM 409 million and involving employment guarantees for 1600 workers, constitutes the largest known MB1 in the eastern states and possible in Germany as a whole. Comag AD Pumpen und Verdichter was also sold by the Treuhand as an MB1 to two entrepreneurs previously involved in running Dutch and German companies. Again the new owners provided employment guarantees for the 860 employees as well as planning a major investment programme. +Some 36% of UK privatisation buy-outs have exited compared to 17% of all buy-outs. $A considerable number of studies have examined the effect of buy-outs in general on performance and organisational change (see Palepu, 1990 for a review of US evidence and Wright et al., 199 1 for UK evidence) and consistently found improvements, at least in the short term.

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authority buy-outs; and problems with commercially inexperienced managers (see e.g. Paddon, 1991 and Wright, 1991 in respect of local authorities; and the case of Coated Electrodes in Wright et al., 1991).

In a broad way the structure adopted for a buy-out should take account of size and market conditions in which a firm is operating, managerial preferences and contribution of specific skills to the firm, and the preferences of financing institutions. The actual life-cycle will depend on the extent to which various environmental factors change, and managerial and institutional behaviour in responding to them. In the rapidly changing and uncertain environment across CEE, such life-cycle factors seem likely to assume considerable importance, but will also be heavily influenced by the development of market institutions and a market in corporate assets.

Buy-outs in CentraVEastem

Europe

Finance and Financial Institutions Finance may be a particular problem in completing buy-outs in Eastern Europe, both in enabling transactions to be funded and in terms of the monitoring role that institutions can play. Moreover, the accounting and valuation problems noted above raise problems over the ability of institutions to identify sufficient collateral against which to make loans.

Typically, legislation has come to require management and employees in CEE who wish to undertake a buy-out to fund a pre-determined percentage of the buy-out price from their own resources and, given the potential problems of undervaluation, the ability of incumbents to buy shares at a discount has been limited. In Hungary it is possible to obtain loans for buy-outs on favourable terms, the so-called E-credit, guaranteed by the National Bank. In order to obtain the credit, management must pay at least 10% of the purchase price from their own resources. The new ESOP law in Hungary does allow a 5% discount on shares. Elsewhere, down payments range from 15% in Slovenia, through 20% in Poland and Estonia to 30% in Romania. In the former GDR, in order to help resolve the problem of limited personal finance, a Programme of Eigenkapitalhilfe (equity support) of loans up to DM 1 million was introduced in the former GDR for managers wishing to acquire at least 20% of a firm’s equity, as long as this amounted to less than 40% of the total amount invested.

The Draft Slovenian privatisation schemes are able to make use of redeemable preference shares (RPS). The company has the right to repurchase the RPS at any time within 10 years, and at the end of the first year the Fund has the right to sell and the company has the obligation to buy 10% of the RPS at face value. A key condition attached to the RPS is that if the company is unable to repurchase its due portion of them, then the Fund can force the conversion of the RPS into ordinary shares with full voting rights. Besides having an important control function this also enables adaptation to circumstances and allows the company to continue in adverse conditions, whereas bank debt could have provoked bankruptcy. The newly revised privatisation legislation proposed at the end of October 1992 to introduce a special 25% discount on the shares available for employee purchase, up to a

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maximum of 40% of the company’s shares. Similarly, in Croatia, there is the possibility of a 50% discount to employees, but the proportion of shares to which this applies is limited.

A similar scheme is proposed by the “first type” of privatisation in Russia. The managers and employees of the state-owned enterprise have a right to obtain 25% of its shares free in the course of the privatisation programme. Managers and administration of the enterprise may buy 5% of the shares at their face value. After this, workers of the enterprise can obtain another 10% of shares at a 30% discount on their face value and pay for them in instalments over a three-year period (with an initial 15% deposit). The rest of the shares will be kept in the State Property Fund.

In Romania, the four pilot buy-outs have made use of deferred payments, although management are obliged to maintain employment for two years. In Slovenia, the first buy-out to use an ESOP, the Pecivo bakery, was able to select the assets it required using the “asset drop-down model” to create a new company into which these assets were transferred from the old company. Loans for the purchase were provided by the old company.

Despite these developments, the capabilities of institutions in terms of monitoring investments, a crucial aspect of the buy-out argument, remain weak. Moreover, the political attractiveness of voucher-based mass privatisation schemes for some segments of the population has frequently caused problems for the advocates of buy-outs. Both sche,mes can, however, co-exist for different sizes of companies, and recent developments indicate that it may be possible to include both elements in the privatisation of a particular firm. Hence a minority of shares in a company may be acquired through vouchers, including the possibility for employees to exchange vouchers for shares in their company, with the majority of the shares being sold in auction to incumbent management and employees.

Conclusions This paper has analysed the applicability of the buy-out concept to the CEE context. The buy-out concept can be adapted to the circumstances prevailing in CEE. Although problems will be encountered, they can be resolved by building on the experience with privatisation buy-outs in the UK in particular. Financing structures are available which enable buy-outs to be completed in contexts where the nature of a firm’s cash flow might mean that it would be unable to service interest payments on high amounts of debt or fund much needed investment. Similarly, mechanisms are also available to deal with uncertainties in the valuation of assets and future profit streams. Buy-outs may not be a once-for-all transfer of ownership. Rather they may be only one stage within the general life-cycle of a firm. This point has particular relevance for the rapidly changing and uncertain economies of CEE. The initial ownership and governance structures present in buy-outs need to be sensitive to the particular conditions and context of each buy-out and to take a view on the expected longevity of the buy-out structure.

Increasingly, decentralised privatisation appears necessary to free-up the

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privatisation process, but despite the important role to be played by advisers with reputations to protect, there is a need for safeguards to help avoid the worst abuses which may arise when incumbents are the purchasers. Such regulations would be difficult to enforce and may deter many buy-out bids. They would also encourage the “capture” of regulators by the enterprises, but this is likely to occur in any case, as managers and their financial supporters attempt to buy-out in conditions which are most favourable to them. Where clawback and other mechanisms are imposed, great care is needed to ensure that they do not remove the incentive on managers to bid.

Buy-outs in Central/Eastern

Europe

A further note of caution, however, arises in relating developments back to buy-out principles in that, whilst management and employees may obtain significant incentives from equity ownership, the monitoring by financial institutions and competition in product and capital markets may continue to be weak. It is well-known that there is no guarantee that management and employees will pursue profit- and efficiency-maximising objectives in the absence of such mechanisms.

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Received December 1992