\. ' -- - - -"- . - -· - - ·-- --··· .. - • - - - I:TERN:TIO~A·: · FIN~:C-E CORP. · LIBRARY . I 1111111111111111111111111111111111111111111111111111111 IFC006871 Selling State Con1panies to Strategic Investors Trade Sale Privatizations in Poland) Hungary) the Czech Republic) and the Slovak Republic VOLUME ONE Analysis of Issues Susan L. Rutledge Cofinancing and Financial Advisory Services (Privatization Gro~p) . , IFC with the participation of the Legal Departmeflt (Private Sector Developm·ent Unit) HD The World Bank 4140.7 S355 . ~anuary 1995 1995 I V .1 Copyright© 1995 The World Bank 1818 H Street, NW Washington, D.C. 20433, U.S.A. All rights reserv~d Manufactured and printed in the United States of America First printing, January 1995 The findings, interpretations, and conclusions expressed herein are entirely those of the authors and should not be attributed in ariy manner to CFS, the Legal Department, the World Bank, or to members of the Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication, •::- and accepts no responsibility whatsoever for any consequence of their use. The paper and any part thereof may not be cited or quoted without the author's expressed written consent. CFS Discussion ·Paper Series, No. 106 .J,' • ' .:_ • 1: I :to Selling ~tate Cotnpanies~ Strategic Investors . Trade Sale Privatizations in Poland} Hungqry} the Czech Republic} and the Slovak Repubti•c VOLUME ONE Analysis of Issues Susan L. Rutledge . r TABLE OF CONTENTS Acknowledgments iv Foreword v Executive Summary 1 Introduction 9 Methodology 9 Case Study Findings 11 The Problems 13 .Initial Approvals from State Enterprises 13 Weak (and Deteriorating) Financial Position of the Enterprises 14 Poor Disclosure of Financial Information 16 Unclear Property Title • 17 Transfer or Sale of Land Rights 17 Local Governments 18 Restitution 18 Other Property Issues 20 Open-ended Liabilities for Environmental Cleanup 20 Termination Fees on Prior Legal Agreements 23 Need for Enterprise Restructuring 24 Pre~privatization Restructuring 24 Post-privatization Restructuring 26 Restructuring as Part of Privatization 27 Government Retention of Equity Shares 28 Employee Shares . 28 Shares for Vouchers and Capital Investment 29 Shares for Restitution Programs 29 Shares for Environmental Cleanup 30 Shares for Local Governments 30 Shares held by a State Holding Company 30 Reliance on Valuations in Setting Sale Prices 31 Boxes and Tables Box 1. A Checklist of Recommendations 3 Table 1. The Companies in the Case Studies 7 Table 2. Privatization Statistics 10 Table 3. Key Findings from the Case Studies 11 Table 4. Sharing of Environmental Liability 21 Table 5. Enterprise Restructuring in the Case Studies 25 ACKNOWLEDGMENTS There were many contributors to this paper. Our thanks go to the government officials who made this project possible: Jerzy Strzele~ki, then Undersecretary of the Ministry of Privatization of Poland, and Michal Mrozek, Minister's Plenipo- tentiary for Foreign Relations, Lajos Csepi, Chief Executive Officer of the Hungarian State Holding Company, and Erzsebet Lukacs, Director,of the Company, Roman Ceska, First Deputy Minister of the Ministry of Privatization and Administration of National Property of the Czech Republic, and Jan Porvaznik, Director of Economics of the Ministry of Privatization of the Slovak Republic. Our thanks are also due to Michael Gold of the advisory group funded by the United States Agency for International Development (USAID), who provided comments on the privatization process in the Czech Republic. Our deep thanks go also to the many company managers, investors, and legal and financial advisers who found time to · meet with the research teams and search their memories and their files for the details of the stories in the case studies. Our thanks go also to the labor union leaders who provided their perspective on trade sales. We also are grateful for the support of Marko Sirnoneti of the Central and Eastern European Privatization Network. The concept for the paper was developed by Kevin Young, Chief of the Private Sector Development and Privatization Groul' of Cofinancing and Financial Advisory Services (CFS), who supervised the development of the paper until its publication. Susan L. Rutledge of CFS wrote the analysis of issues found in trade sales, supervised the team that prepared the case studies, and acted as project manager for the paper. The case studies were prepared by a Bank research team of Christina Kappaz and Maziar Minovi of C:fS and Martin C. Stewart-Smith of the Legal Department's Private Sector Development Unit. They designed the format of the case studies, visited the companies in the survey, wrote copious notes and commented on the many drafts that followed. Douglas Webb, Peter Kyle, and Zoe Kolovou of the Legal Department contributed to the conceptual design of the paper. Les Andrew Nemethy of CFS (and formerly of the Hungarian State Property Agency) and Hafeez Shaikh, also of CFS, provided helpful comments and suggestions. Thanks also to Ilham Zurayk and .Apil Sood of the World Bank who supported the project from its earliest conception, and to the Bank staff who provided useful comments on the drafts. Valuable background research on the companies was prepared by Andrew .Alexandrowicz .of lTCA in Warsaw, by Ladislav Veny~ of the Anglo-American Business Institute of Prague, and by Joan Stein ofCentralEurope Trust in Budapest. All supervised teams of researchers who diligently worked with the companies in the survey to provide a first draft of the case studies, and later to find the answers to our follow-up questions. Andrew G. • Berg, then of th~ .Harvard Institute for International Development, assisted in reviewing the trade sale process. Roger Leeds ofKPMG Peat Marwick provided valuable advice at all stages of the paper. Invaluable assistance also came from our !!difors, Bruce Ross-Larson of American Writing Corporation, and especially Emily Evershed, who patiently worked through the complex details of the case studies. Christian Perez typed the many changes to the text, Gerry Quinn designed the layout of the paper and John Swepston completed the desktop preparation for printing. Sµbstanti1.1l funding for the paper was provided by the Government of Japan. iv SELLING STATE CoMPANIES TO STRATEGIC INvESTORS, V0LUMB ONli FOREWORD This paper looks at the experience of four countries in Central Europe - Poland, Hungary, the Czech Republic, and the Slovak Republic - and reviews their experience in trade sales. Selling state companies to strategic investors (or "trade sales") is an important form of privatization and one that could generate substantial benefits for the national economy. Yet trade sales were used only for a limited number of companies. The paper reviews the experience of 1990-92 and looks at the problems encountered by governments in Central Europe - and the solutions they found. As background to the paper, 22 case studies were prepared on companies that had been privatized. The paper takes the solutions that worked, and presents them as a list of recommendations for trade sales. However, the paper does not attempt to address other important issues in privatization. It does not assess the relative merits of different methods of privatization. Nor does it discuss the governments' institutional structures or their funding needs; The recommendations in the paper are intended to make trade sales more efficient and the process more effective. But the recommendations must be tailored to fit the circumstances of each country. Many readers will browse only the Executive Summary and selected chapters of Volume One (Analysis of Issues). However, for those readers interested in the dynamics of selling (or buying) state companies -in the ups and downs of the process- Volume Two (Case Studies) will also provide interesting insights. This paper was prepared as part of the CFS Discussion Paper Series on privatization in developing and transition economies. Other papers in the same series have covered privatization programs in Argentina, the legal and regulatory frameworks in the countries of the former Soviet Union, and, most recently, privatization of the retail sector (or "small- scale privatization") in Hungary, Poland, and the Czech Republic. The purpose of the Discussion Paper Series is to dis- seminate current practices and the "lessons" learned in privatization. As a Department that covers all the World Bank's borrowing countries, Cofinancing and Financial Advisory Services (CFS) endeavors to share with outside readers some of its cross-country experience in privatization. We are pleased to present this review of trade sale privatizations in Poland, Hungary, the Czech Republic, and the Slovak Republic. Inder Sud Kevin Young Director Manager Cofinancing and Financial Private Sector Development Advisory Services (CFS) and Privatization Group (CFSPS) ANALYSIS OF ISSUES V EXECUTIVE SUMMARY In 1989-90, the governments of Central Europe faced the 2 were financial institutions that had other investments in task of rapidly transforming from a centrally - planned the same industry and took an active role in the manage- economy to a market economy, in large part through ment of their investments. • privatization of the state sector. Sales to strategic investors The state enterprises were medium-size or large com- (or trade sales) were an important part of privatization in panies. Their work force ranged from 100 to 7,700, with an Hungary, Poland, and, to a lesser degree, the Czech and average size of almost 2,200. All companies were engaged Slovak Republics. Yet three years later not many trade sales in competitive markets, two-thirds in consumer goods and had been completed. Out of a total of nearly 6,000 large one-third in industrial sectors. Their annual revenues ranged and medium-size state enterprises that had been privatized, from US$4 million to nearly US$300 million. about 1,300 were privatized through trade sales (including The companies in the case studies were selected on a large number of sales to domestic strategic investors). the basis of several criteria: they were enterprises sold to Why have there not been more trade sales? Is the trade strategic investors; the transactions had been completed and sale process flawed? Or are there ways to improve the pro- the state companies had been sold; and the companies were cess to make it more workable? willing to participate in the survey. As a result of the selec- 'frade sales are sales of controlling blocks of shares to tion criteria, the case studies may not be fully representa- strategic investors, often multinational companies in the tive of all trade sales in Central Europe. Nevertheless, they same trade or business as their investment. Critics com- provide useful insights into the issues and practical prob- plain that trade sales are cumbersome, slow, and resource- lems often seen in trade sales. .intensive. Such sales, however, are an important method of The survey covers a limited period of time. All but two ensuring the financial strength of the enterprise after companies were privatized between February 1991 and De- privatization, as well as of contributing cash to the state cember 1992. This represented an initial phase of treasury. Other privatization methods (issuance of vouch- privatization. The State Property Agency in Hungary was . ers to be exchanged for shares, initial public offerings on created only in March 1990. The privatization law in Po- • domestic stock exchanges, employee and management land was enacted in July 1990, and it was not until February buyouts, and so on) also have strengths and weaknesses. 1991 that the privatization law for large enterprises was However,for large and medium-size enterprises, trade sales enacted in the Czech and Slovak Republics. In the period are a valuable method of attracting strategic investors .to . follqwing this initial phase, some government privatization generate revenues for the state treasury and to invest capi- .•pc;,licies have been amended - in part to address the issues .tal to restructure and.reorient state enterprises. raised by the trade sale process - and some of the paper's To provide a better understanding of trade sales, case recommendations have already been incorporated into gov- studies were undertaken of 22 companies privatized as trade ernment policies and regulations. With these caveats in sales - 6 in Poland, 7 in Hungary, 6 in the Czech Republic, mind, the case studies nevertheless provide interesting in- 2 in the Slovak Republic, and 1 that spanned the Czech sights into the trade sale process and into some of the prob- and Slovak Republics (Table 1). The cases included three • lems that arise in selling state companies to strategic inves- forms of trade sales: the sale of operating companies to stra- tors ..They also suggest ways in which similar problems could tegic investors, the divestiture of selected assets from the be avoided, or minimized, in other countries. companies, and the sale initially to management, who in- The case studies confirmed the commonly held view tended to later merge with a strategic investor. In about of trade sales. An average of 15 months was needed to pre- two-thirds of the cases the state enterprises were sold in pare and negotiate each transaction, with more than 30 their entirety as operating companies, and in one-third of person-months of consultant time for each sale. Each sale the cases selected assets (such as factories) were either sold raised an average of US$32 million in cash or shares for the directly or contributed to a joint venture with private inves- state treasury and another US$23 million in minimum capi- tors. Eighteen companies were sold to foreign investors, tal investment for the enterprise. The cases also reflected and 4 were sold to domestic entrepreneurs. Of the foreign the prevalence of post-privatization restructuring, with more investors, 16 were multinational industrial companies and than 70 percent of the companies in Poland and Hungary incurring major organizational restructuring after the sale. What, then, were these problems? And what steps could In the Czech and Slovak Republics, the investors could bid governments take to avoid them? for bits of companies. Thus, some restructuring took place as part of the privatization process. Even so, after 1. Need for initial approvals by the state enterprises privatization more than half of the Czech and Slovak com- Often the first step toward privatization had to be approved panies were further restructured. by enterprises. Only in the Czech and Slovak Republics was One unexpected finding in the case studies was the no approval needed. But in Poland a nod from the work- low level of competitive bidding from investors. In more ers' council was required to begin the privatization process. than half of the case studies, the terms of sale were directly In Hungary initial approval had to come from the enter- negotiated with a single buyer, and only in 4 cases was there prise council. Both Poland and Hungary provided financial vigorous competitive bidding among investors. Indeed, in incentives to encourage enterprises to support privatization, 15 out of 22 cases, the final investor was the same company but in the case studies, the incentives had little impact. For initially identified by enterprise management as the preferred example, in Poland employees had the right to buy equity investor. The information in the cases came from several shares in the privatized company at one-half the nominal sources, including the final investor and enterprise man- price. However, employees bought shares in only two of agement, and they may not have been aware of any govern- the six Polish case studies, and only where the investor of- ment discussions with other potential investors. Even when fered to immediately buy back the shares at full price. this is taken into consideration, however, the cases reflect a This suggests that financial measures cannot be relied surprisingly low level of competition among potential in- upon to gain enterprise support for privatization. Indeed, vestors. at the end of 1992, thousands of Polish enterprises and The issue is not academic. In all the countries in the hundreds of Hungarian enterprises had not given their ini- study, legislation or government policies (or both) required tial approval. The enterprises could not be privatized - competitive tenders for trade sales. Moreover, the govern- even if an investor were interested in buying. ments needed competition to establish market-determined The governments of Poland and Hungary have since prices for state enterprises, to increase transparency in the taken measures to address this problem. New legislation trade sale process, and to provide leverage in negotiating required that all Hungarian state enterprises initiate their the final details of .sales contracts. The universe ~f possible transformation. As a result, by the end of 1993 there re- strategic investors for a large (or even a medium-size) state mained fewer than 200 state enterprises (out of an original enterprise is admittedly limited by several factors: the num- list of 1,848) that had been neither transformed into com- ber of companies engaged in the industry, their different mercial form, and thus made available for sale, nor liqui- • market strategies, their views of "greenfield" investments dated. However, as of September 1994, similar draft legis- as opposed to mergers and acquisitions, and their confi- lation had not been approved by the Polish Parliament and dence in the government's macroeconomic policies. How- the problem remained outstanding. ever, there may be actions governments could take to To gain initial approval of the privatization legislation, heighten investor competition for large and medium-size a political compromise may be necessary, and the law may state enterprises. require the approval of individual state enterprises before From the case studies, nine specific problems emerged. their privatization can begin. However, such approvals can Resolution of all nine problems may not preempt the need reduce the number of state enterprises available for sale. for other methods of privatization - in addition to trade Where possible, the initial privatization legislation should sales. However, by addressing the nine problems govern- give state enterprises a voice in determining the form of ments could make the trade sale process more effective. their privatization, but it should not give enterprises the Resolution of these problems would increase the number right to veto their sale. of state enterprises available for sale to strategic investors, would reduce undefined risks for investors, and would mini- 2. Weak (and deteriorating) financial position of the mize the need for extended negotiations over the terms of enterprises sale. Not all nine problems applied to all companies in the Many enterprises faced a "barrier of demand" because they case studies, or to every country in the survey. Nor were all could not sell all their production. They had difficulty mov- nine unique to trade sales. However, all had a material im- ing from a centrally planned economy to a market economy, pact on some companies sold as trade sales. Thus, the prob- as goals changed from meeting production targets to reach- • lems provide a checklist for review by a country proposing ing earnings goals. At the same time, the Soviet Bloc was to embark on a trade sale program, or hoping to accelerate disintegrating and enterprises lost some of their best mar- the pace of trade sales. kets. Furthermore, the controls placed on enterprise man- 2 SELLING STATE COMPANIES TO STRATEGIC INvEST0RS, VOLUME ONE Box 1. A Checklist of Recommendations Establish a preparation process that does not require approvals from state enterprises. ✓ Do not give enterprise management or employees the power of veto over privatization of the enterprise . ✓ Do not rely on financial incentives alone to ensure employee or managemenrsupport for privatization. Place a high priority on speed in trade sales. ✓ Allow state enterprises to be sold at market-clearing prices. Favor rapid conclusion of sale over obtaining the highest- possible price. ✓ Simplify the process of negotiating the details of individual sales contracts by establishing clear policies on sensitive issues, such as environmental liabilities. ✓ Include other privatization methods (such as voucher sales) to provide alternatives to trade sales, and to put pressure on government and investor negotiators to come to agreement. Improve financial information available on state enterprises. ✓ Revise domestic accounting legislation and regulation to reflect international accounting _ standards, particularly treatment of reserves for bad debts, unusable inventory, and disclosure of third party liabilities. ✓ For any company expected to be sold to foreign corporate investors, hire an international auditing firm to restate the company's financial statements in accordance with international standards. ✓ For all trade sales, provide a warranty that all known third-party claims have been disclosed. Clarify property rights. ✓ Favor financial restitution over restitution-in-kind to former property owners. ✓ Clarify the basis on which any compensation to local governments should be calculated. ✓ As policy , give investors a warranty that title to properties held by privatized companies is free and clear of third party liens. Establish clear policies on assignment of environmental risk. ✓ Assign to privatized companies responsibility for mitigating air pollution. ✓ Retain liability for cleanup costs for prior environmental damage to subsoil and groundwater basins, but estimate the amount of the government's liability through an environmental audit. Set aside funds (for example, from the proceeds of privatization sales) to reimburse privatized companies for costs of cleanup. ✓ Assign privatized companies responsibility for implementing cleanup programs. ✓ Avoid using equity as compensation for assuming environmental liability. ✓ Avoid resetting the final sale price for a transaction on the basis of actual cleanup costs. Minimize Impact of existing licensing or franchise agreements. ✓ Examine options for defining (and reducing ) the legal liability on licensing or franchising agreements. ✓ Assume responsibility for payment of any liquidated damages, and use the proceeds of sale to pay amounts due. Leave major enterprise restructuring to private investors. ✓ Avoid major restructuring of state enterprises before privatization. ✓ Where no investor interest exists for state enterprises, encourage investors to submit bids for parts of state enterprises. Minimize government retention of equity shares in privatized companies. ✓ Permit investors (particularly trade investors) to buy majority control in state enterprises. ✓ Minimize all government holdings of shares in privatized companies. ✓ Where requested by investors, sell 100 percent of the shares of state companies to private investors. Give investors the option of making cash payments for restitution programs, environmental cleanup, and shares for local governments. Minimize reliance on valuations. ✓ Use competition among investors to set the price for sale of state enterprises, and avoid complex valuations . ANALYSIS OF ISSUES 3 agement to restrict asset disposals and purchases limited 4, Unclear property title to land and buildings the managers' ability to restructure their enterprises in re- Legislative changes in 1989-90 were intended to return full sponse to changing markets. property rights to the private sector, but they sometimes In all 22 companies the financial position deteriorated left issues unresolved. Two in particular affected trade sales: during sale negotiations, and 6 companies were almost in- the transfer of state property to local governments and claims solvent at the time of privatization. The enterprises' weak for payments; and the return (or restitution) to private in- financial condition reduced their value to investors. While dividuals of property illegally seized by socialist governments. strong enterprises were valuable to investors for their mar- Particularly in Hungary, claims by local governments ket share and ability to generate earnings, weak companies were thought to slow down the trade sale process. How- were often worth only the market value of their physical ever for the companies in the case studies, local govern- assets, With firms bordering on insolvency, their value could ment claims were rarely a major issue. In only one Hungar- be limited to the cash that could be generated from the ian case a municipality initially questioned the land valua- liquidation sale (or auction) of the individual assets. tion, and in one Polish case the local government disputed Thus, governments should emphasize speed in conclud- the amount of compensation due. ing trade sales. To accomplish this, governments should sell By contrast, restitution - particularly return of prop- companies at market-clearing prices, which may be lower erties to original owners - was a bigger problem. Issues than the government had originally anticipated. Moreover, related to restitution arose in only seven companies, but, in governments should simplify preparation and sale processes each, they were important que~tions. In three case studies, by adopting clear policies on sensitive issues (such as envi- claims for restitution-in-kind by former property owners re- ronmental liability) and leaving fewer issues open to nego- moved properties from possible privatization and reduced tiation. In addition, governments should include other the assets being privatized. In another case, the restitution privatization methods (such as voucher sales) that provide claims remained outstanding and were the subject of fu. alternatives to trade sales and put pressure on investor and ture court action and decisions. However, restitution in the government negotiators to come to agreement. form of financial compensation (such as transfer of equity shares in the privatized company) raised fewer issues for 3, Poor disclosure of financial information trade sales. In socialist economies, information was generated to en- To avoid property title issues, financial restitution should sure that production targets were met, without regard to be preferred to restitution-in-kind. Financial restitution profitability. Even under the revised accounting laws of could be paid as shares of privatized companies. Alterna- 1990-92, important financial information was not disclosed tively, trade investors could have the option of making cash concerning bad debts, unusable inventory and third party payments to a restitution fund in lieu of setting aside shares. claims. Thus, revision of companies' financial statements Governments should also clarify the basis for calculating in accordance with international accounting standards of- any obligations to local governments. In addition, to increase ten resulted in a substantial reduction in the book value, or investor confidence, governments should provide a warranty net worth, of the companies. to investors indicating that title to all properties held by In every case study where the potential buyer was a state companies is free and clear of third party liens. multinational company, the investor insisted on a restate- ment of the company's financial position under international ;, Open-ended liabilities for environmental cleanup accounting standards, thus slowing preparation of the trade After years of inadequate environmental legislation in sale. This could be avoided by revising domestic account- Central Europe, most companies engaged in manufactur- ing legislation and regulations to reflect international stan- ing were polluters, The governments recognized their need dards, especially on treatment of bad debts and unusable to assume responsibilityfor pest environmental damage, but inventory and disclosure of third party claims. For trade used different approaches to implement cleanup programs, sales, particularly of large enterprises likely to be sold to Air pollution generally resulted from ongoing operations and multinational investors, international auditors should be was therefore considered to be the responsibility of the used for restatement of the financial position. Furthermore, privatized company. But many state enterprises had con- to increase investor confidence in the quality of financial taminated the subsoil and ground~ater basins of the land disclosure and to simplify negotiations between governments they used, and governments had limited funds for cleaning and investors, governments should provide a warranty to up prior damage. Several formulas were adopted, but most investors that all known third party claims have been dis- left the risk of open-ended liability for environmental closed. For this, governments could rely on enterprise man- cleanup shared between the investor and the government. agement to identify and disclose any known liabilities. In almost half the case studies environmental issues 4 SBLLING STATE COMPANIES TO STRATEGIC INVBSToas, VoLUMB ONB were a major concern for investor~, and in at ~east six cases 7. Need for enterprise restructuring these issues had a material impact on the final terms of sale. Many state enterprises in Central Europe had long needed Although agreement was eventually reached, assignment of capital to improve their manufacturing facilities. The enter- envirmµnental risk was one o( the most controversial and prises were often uneconomical conglomerates with unre- time-~onsuming issues in the negotiations - •and in one lated business units, where the constituent parts were more case was subject to lat~r court disputes. valuable to investors than enterprises maintained as single Environmental liabilities for state enterprises may be units. They had social obligations, including loss-making em- broad and complex in scope and may differ from one situ- ployee housing, and were often overstaffed and burdened ation to another. In the case studies tailor-made solutions by ineffective management and organizational structures. were the rule, but where the government adopted a clear In some cases, the enterprises also had heavy debts, having policy, there was less need for protracted negotiations. In borrowed in the past for expansion and modernization. general, governments should pay the costs of cleaning up In the case studies, governments left most restructur- past environmental damage from state enterprises. If the ing to private investors. In half the companies there was damage is caused by ongoing operations such as air pollu- some restructuring before privatization, but it was limited tion, the cost of avoiding future deterioration should be to reducing the work force through attrition and spinning paid by the privatized company. However, cleanup of prior off some employee services. In the two cases in which the contamination (of subsoil and groundwater basins, for ex- government undertook debt restructµring before ample) should be paid by government- either directly by privatization, the process was flawed. It either increased indemnifying the company, or indirectly by reducing the sale the difficulties in privatizing or left open issues to be re- price to the investor. The preferred solution is that the solved in court. privatized company implement the cleanup program and In virtually every case study, there was substantial (of- the government indemnify the company for the cleanup ten fondamental) restructuring by investors after costs. The amount of the government's liability should be privatization. In half the companies there was new capital estimated through an environmental audit prepared in ac- investment to modernize or simpl;J repair existing facilities cordance with government guidelines, and eligible expenses and complete deferred mainten~nce. In 11 cases restruc- should be limited to those identified in an agreed-upon turing was also used to "rationalize" product lines or im- cleanup plan. The government should also set aside funds prove the organizational structure; The minimum employ- (some of the proceeds of.privatization, perhaps) to cover ment commitments, or collective bargaining agreements, the costs. However, investor commitment to do the cleanup limited the number of workers that could be laid off, and also results from the goodwill established between the gov- companies in the survey reduced work forces by only 12 ernment and the investor, and should not be ignored in ne- • . percent on. average. Most companies spun off employee gotiations over trade sales. apartments and other "social. assets" after privatization. However, despite the clear need for restructuring, all the 6. Termination provisions on prior legal agreements companies in the survey were privatized to strategic inves- In the 1960s.and 1970s, many state enterprises in Poland tors. and Hungary entered into licensing (or franchise) agree- Although it is too early to judge, it appears that in 19 of ments. These agreements included provisions for liquidated 22 cases (or 86 percent) the companies had benefited from damages that, for any bidder except a signatory to the agree- the capital investments, changes in internal management ment, would increase the costs of buying the company. Other systetns,·access to new financing, opening of new markets, bidders thus appeared at a competitive disaqvantage. Such and other "restructuring" that occurred after privatization. issues were seen in only four cases, but in two cases this However, two companies appeared no stronger after was, perhaps, the dominant privatization issue. Govern- privatization than before, and in a third case, the plant closed • ments should examine options for defining (and reducing) within a year of privatization. In addition, in four cases, the the legal liability on licensing agreements. To achieve a level acceptance of investor proposals for parts of state enter- playing field, the government could also assume responsi- prises left the government with unproductive assets (such bility for payment of any fees for early termination of agree- as depleted rock quarries) that could not easily be sold. ments and use some privatization proceeds to pay any The case studies confirm that, although enterprise re- amounts owed under. the contract. With the gov~rnment structuring .was needed and may have discouraged some assuming direct responsibility for payments of liquidated investors, restructuring could (and should) be left to pri- damages, no one bidder (such as the licensing company) vate investors. At a minimum, restructuring should be un- would appear to have a competitive advantage. dertaken in response to investor proposals. Where possible, ANALYSIS OF ISSUES 5 governments should sell state enterprises as single entities, nority stake, the strategic investor had strong incentives to with the necessary restructuring occurring after privatization. complete the capital investment program and thus obtain a But where there is no investor interest in a state enterprise, majority position in the company. However, in two Czech the government should accept bids for bits of the enter- case studies strategic investors claimed that if they had not prise. This may be a "second-best" solution, but it would been permitted to buy 100 percent of the shares, they would be preferable to not privatizing the enterprise at all. have declined to buy any shareholding in the company. Furthermore, the use of employee shares in Poland may 8. Government retention of equity in privatized companies not have been particularly successful. In the six Polish stud- Trade investors generally :want to buy sufficient equity to ies, workers bought company shares only when promised obtain a controlling interest in the acquired companies - an immediate resale to the strategic investor- at full nomi- and enough to gain freedom from government interference. nal value. In addition, the use of shares as financial com- Some strategic investors insisted on buying 100 percent of pensation for restitution claims created fewer problems for the equity. They argued that they needed full control of the trade sales than restitution-in-kind, but it still reduced the companies to restructure them, and holdings by other share- number of shares available for sale to investors. holders diluted the effectiveness of the strategic investor. To encourage investor demand in state companies, stra- On the other hand, many governments were concerned over tegic investors should be given the option of buying at least the appearance of selling their state enterprises to foreign- a majority shareholding in the companies (either at the time ers (who represented a substantial portion of strategic in- of sale, or soon thereafter) and possibly up to 100 percent vestors). As a compromise, governments generally sold a of the equity. Government holdings of shares should be mini- majority share, but not 100 percent, of the equity. mized. Rather than being obliged to set aside shares for Governments also retained shares in privatized com- government programs, where possible, investors should be pani~s for other purposes - to set aside shares for the mass given the option of making cash payments instead. privatization (voucher) programs, to sell equity to employ- ees at reduced prices, to cover restitution claims, to pay for 9. Reliance on valuations in setting sale prices future environmental cleanup or even to provide a future In the case studies, valuations played an important role in source of revenue for other government obligations. For determining the sale price of state enterprises. Among the example, in the Czech and Slovak Republics, often more 19 companies in which information was available, the sale than half the shares of a privatized company were set aside price was on average about 1.20 times the company's book for vouchers. In Poland 20 percent of the state company's value. The sale price was within the range of valuations, shares was set aside for employee purchase at discounted and it appeared that the valuations (particularly book value) prices, a measure intended to encourage worker support had been important in setting the sale price. for the privatization of their employers. In Hungary, 25 or The apparent reliance on valuations in setting sale prices 50 percent of the shares of certain "strategic" state compa- was probably due, in part, to a lack of vigorous competition nies was given to a state holding company. Smaller amounts among investors. Several factors may have contributed to were transferred to local governments to generate additional this, including the risks to investors described above. In ad- sources of revenue, or were allocated to the restitution fund. dition, some investors may have declined to bid once enter- However, all programs to set aside shares reduced the per- prise management had selected one preferred investor. In centage of equity available to strategic investors. at least half the case studies, there was only one investor In 5 of the 22 cases, investors bought 100 percent of active in the final rounds of bidding, and thus the sale prices the state company- and in 3 cases investors threatened to (and other terms and conditions) were set by negotiations walk away if they were not permitted to buy all the shares. between the government and the investors. In such situa- In every case where the investor was a multinational corpo- tions government officials were forced to rely on valuations rate investor (and limited to less than 100 percent at the to assist in the negotiations, and to ensure that the state time of sale), the investor took immediate steps after the enterprises were not sold below their "value." sale to increase its shareholding. This was through the issu- The difficulty in forecasting corporate earnings in a tran- ance of new capital (in the Czech and Slovak Republics), sitional economy made reliable business valuations diffi- the purchase of employee shares (in Poland), or the pur- cult to prepare. Yet much time and energy were spent pre- chase of shares issued on the stock exchange (in Hungary). paring such valuations. While the issue was important for For some programs - such as vouchers in the Czech all forms of privatization, it was heightened by trade sales: and Slovak Republics - the set-aside of shares was impor- government officials were under pressure not to sell state tant in establishing a rapid method of privatizing thousands enterprises to strategic investors (who were often foreign of state enterprises and in gaining popular support for corporations) below the "value" of the companies. In spite privatization. In addition, by being limited to an initial mi- of the difficulties in estimating future cash flow, investors 6 SELLING STATE COMPANIES TO STRATEGIC INVESTORS, VOLUME ONE Table 1. The Companies In the Case Studies Approximate Employment Date or Annual (at time of Privatization Sector Revenues privatization) Poland Fampa February 1991 Papermaklng $10 million 840 machinery Norblln Aprll 1991 Copper and brass billets, $9 million 858 bars, rods, and wire Polkolor May 1991 Color television tubes $44 million 4,500 Polam PIia May 1991 Lamps and lighting $59 million 3,290 components Kwldzyn August 1992 Pulp and paper $150 million 3,620 Porcelana August1992 Porcelain ware $8 million 841 Hungary OrosMza November 1988 Float glass $42 million 600 (Hunguard) Gardenia February 1991 Textiles $16 million 600 Lehel Aprll 1991 Durable household $134 million 4,800 appliances Zalakeremla May 1991 Ceramic tiles and $15 million 840 building materials Csemage July 1991 Food and beverage $198 million 3,873 retalllng Szolnokl December 1991 Paper $4 million 690 Dune March 1993 Hotel $11 million 400 Czech Republlc Cokoladovny February 1992 Confectionery products $287 milllon 7,696 Kyje Aprll 1992 Soft drinks not available 100 ssz July 1992 Engineering bridges, $197 million 3,977 and construction of roads, bridges, railways, end airports Severokemen August 1992 Crushed stone for $10 mllllon 1,100 construction Centropen October 1992 Writing Instruments $9 mllllon 600 Elektroslgnal December 1992 Alrfleld lighting $5.5 million 350 devices, traffic signals, and audio equipment Slovak Republic Tatramat May & July 1992 Washing machines, $23 million 1,300 water heaters, vending machines, and small electrlcal appliances Figaro August 1992 Chocolates and $27 million 619 confectionery products Czech & Slovak Republics Prior Stores May-August 1992 Department stores not aval1able 6,000 ANALYSIS OF ISSUES 7 prepared valuations to determine .i range of bid prices, de-·· tion of state enterprises, need for enterprise restructuring, pending on their own guesses for the future and their appe- and reliance on valuations - the problems are noted, but tite for risk. Different corporate strategies generated a range minimal government actions are recommended. of valuations, reflecting alternative ways of "adding share- However, of crucial importance would be eliminating holder value" to the acquired companies. initial approvals from state enterprises and minimizing gov- Negotiations over the highest sale price, or other terms ernment retention of equity shares. Removing the need for of sale, may take up valuable weeks and months. For inves- initial approvals from state enterprises would avoid a major tors, recognition that the final terms of sale would be set roadblock that could stop many privatizations in their tracks. only after weeks of negotiations would discourage some And allowing the sale of majority-control of state compa- from proceeding. Under rapidly changing market conditions, nies would give strategic investors the flexibility they need with a company in limbo and with restrictions on enterprise to reorient and restructure the former state companies·. The management against sale or purchase of new assets, many paper suggests that governments particularly focus on these state enterprises may lose value ·during the negotiations. two important areas. Thus, emphasis should be placed on speed - and on mea- Whether a state enterprise is privatized by a trade sale sures to expedite the sale process. While governments may or by another privatization method, the same issues will need valuations to estimate future budgetary revenue from arise at some point. In trade sales, investors will not sign sales proceeds and to assist in negotiations with strategic the legal agreements without resolution of the issues, and investors, this focus may be misdirected. Rather than trying the issues must be resolved prior to sale of the state com- to protect against the sale of assets below their "value," gov- pany. By contrast, voucher-holders cannot set the same re- ernments should focus on obtaining acceptable terms of quirements. Privatization methods such as vouchers can sale that are achievable in a short period of time. It is im- leave some issues unclear to be resolved after privatization portant that governments avoid using complex valuations. - and thereby accelerate the sale process. However, trade Instead, measures should be taken to increase competition sales do not give the same flexibility. among investors and to establish clear policies (on issues One solution is a privatization program that permits such as environmental liabilities) that leave little room for - and encourages - privatization through any of several additional negotiations over details of the sale contract. methods. As is seen in the case studies, trade sales can of- Resolution of the nine problems listed would improve ten be combined with voucher sales, and management the trade sale process - by making more state enterprises buyouts with trade sales. The most efficient trade sale pro- available for sale to investors, by clarifying undefined risks cess is still likely to require some final negotiations to sell for investors, and by reducing the need for protracted ne- one company at a time. Where the government's goal is to gotiations over terms of sale. Not all of the nine problems sell thousands of state enterprises rapidly, mass privatization lend themselves to government action, but government ac- methods such as voucher sales, management buyouts, and tion could make more state enterprises available for sale liquidation and auctions of assets .will be needed. Where and increase competition among investors in the following government resources can be spent on selling one company six areas: eliminating initial approvals from state enterprises, at a time, or where the companies are of individual impor- improving disclosure of financial information, establishing tance to the economy, or where the number of state enter- clarity of property title, defining environmental liabilities, prises to be sold has diminished to less than a few hundred, assuming termination fees on prior legal agreements, and then trade sales may be the best option. For these situa- minimizing government retention of shares in privatized tions, the recommendations in this paper could prove use- companies. In the other three areas -weak financial posi- ful and could make the process more efficient. 8 SELLING STATB COMPANIES TO STRATEGIC lNVBST0R.5 1 V0U.JMB ONB INTRODUCTION In 1989-90, the primary aim of governments in Central Eu- networks. To do so, investors committed capital and mana- rope·was to rapidly convert an economy dominated by the gerial talent to strengthening the privatized companies and state sector into a market econoqiy. This was an enormous making their products competitive in world markets. task. Governments needed to raise prices to market levels, By the end of 1993, between 30 and 60 percent of state implement a program to stabilize the national economy, and enterprises in Central Europe had been transferred to pri- reduce the size of the state sector. By the end of 1993 they vate investors by means of one or_ another privatization had largely met their goal. Private enterprise generated 50 method (Table 2). Of these, about 23 percent (or about to 60 percent of gross domestic product (GDP) in Central 1,300 transactions) were trade sales, of which more than Europe (except in the Slovak Republic where private en- one-half were sales to domestic strategic investors. While terprise still contributed less than 30 percent of GDP). This the number of trade sales was relatively small, the enter- success was, however, largely due to thousands of emerging prises were generally larger in terms of revenues and em- private businesses. At least initially, privatization of the state ployment than most state enterprises, and thus important sector lagged behind. to the national economy. Furthermore, trade sales are likely In designing privatization programs, governments in to remain an important method of privatizing large and me- Central Europe envisaged several privatization methods. dium-size enterprises. For governments reviewing their trade All countries included trade sales as one method of sale programs or initiating a new trade sale plan, crucial privatization' but Hungary and Poland had intended to rely questions arise. Is the trade sale process flawed? Are there heavily on trade sales as a primary form of privatization. ways to improve trade sales? A review o_f the experience in 11-ade sales are sales of controlling blocks of shares to stra- Central Europe provides interesting insights into these ques- tegic investors - often multinatjonal companies in the same tions. trade or business as their investment. The conventional wis- dom was that trade sales were the best way to ensure the Methodology viability of post-privatized state enterprises and to contrib- To arrive at a better understanding of trade sales in Central ute cash to the state treasury. 2 While all privatization meth- Europe, 22 case studies of large and medium-size enter- ods had their strengths and weaknesses, the comparative prises were prepared (6 in Poland, 7 in Hungary, 6 in the advantage of trade sales was that they attracted the strate- Czech Republic, 2 in the Slovak Republic, and 1 that gic investors needed to restructure and reorient state enter- spanned both of these Republics).3 All of the companies in prises. Trade investors generally merged the acquired com- the survey were sold to strategic investors in the same busi- panies with their international production and distribution ness or trade as their investment. Sixteen sales were to for- eign multinational companies, 3 to local private investors, 2 1 For further discussion of the privatization process, and of the to financial institutions, and 1 to company management government privatization programs, see Marko Simoneti and Andreja Bohm, Privatization in Central and Eastern Europe 1991, Central and Eastern European Privatization Network, Ljubljana 3 The initial list of enterprises was from the international press. In 1992. See also Roman Frydman, Andrzej Rapaczynski, John S. addition, one-quarter of the companies were suggested by the Earle, et al., The Privatization Process in Central Europe, Central government privatization ministry or by local consultants. In all European University Press, 1993. cases, the companies agreed to participate in the survey. 2 Other privatization methods also have important advantages. The preparation of the case studies was undertaken in two Voucher sales can rapidly privatize a large number of state stages. Using a six-page questionnaire developed by the research enterprises- once the enabling legislation has been passed- and team, local consultants interviewed company officials and col- can generate popular support for the government's privatization lected press clippings on the companies. With this as background program. Employee and management buyouts can also allow the information, the research team held meetings over six weeks with rapid transferof state enterprises to the private sector. Initial public company management, local representatives of the investors, and, offerings (IPOs) promote broad share ownership, while restitution in some cases, government officials responsible for the transaction, of properties to former owners responds to popular demand for and legal and financial advisers to the parties. Volume One "fair" treatment of illegally seized real estate. Furthermore, the includes quotes excerpted, and in some examples adapted, from privatization methods are not mutually exclusive and different the case studies. The reader is advised to refer to the full text of the programs can be combined. case studies in Volume Two. Table 2. Privatization Statistics 1990 1991 1992 1993 TOTAL Poland Percent of GDP produced by private secior 35% 40% 45% 50% n.a. Number of medium and large state enterprises privatized (Out of 8,440 in 1990) n.a. 213 1,839 465 2,517 Number of trade sales 6 22 22 48 98 Hungary Percent of GDP produced by private sector 24% 30% 44% 60% n.a. Number of medium and la_rge state enterprises privatized (Out of 1,848 in 1990) 27 198 215 434a 874 Number of trade sales 18 43 271b 332 Czech & Slovak Republics Percent of GDP produced by private sector 5% 8% 20% 44% n.a. Czech Republic n.a. n.a. n.a. 57% n.a. Slovak Republic n.a. n.a. n.a. 27% n.a. Number of medium and large state enterprises privatized Czech Republic (Out of 4,339 in 1990) n.a. 21 1,614c 784 2,419d Slovak Republic n.a. n.a. n.a. Number of trade sales Czech Republic n.a. n.a. 880 8 Slovak Republic n.a. n.a. n.a. a The number of Hungarian privatized enterprises for 1990 and 1991 refers only to transformations in those years. For 1992 and 1993, majority interest in the companies was sold, and the State Property Agency retained less than 50 percent of the shares of the privatized companies. b Trade sales in Hungary include the sale of blocks of shares to both industrial and financial strategic investors. c Privatized enterprises in the Czech Republic include only those in the first "wave" of privatization. The second "wave" was initiated in May 1994. d From January to August 1994, another 603 medium and large enterprises were privatized as part of the "Large Scale Privatization· program for a total of 3,022 enterprises. Note that the number of private firms resulting from privatization was higher (4,339), since often two companies were created from each state enterprise. • Czech trade sales include sales to both domestic strategic investors (750) and foreign strategic investors (130) to August 1994. Data apply to Czech Republic only. They are based on aggregated government data. Data for trade sales in the Slovak Republic are not available. Notes: n.a. Not available or not applicable. Negligible. The data are taken from government sources. Trade sales are defined as stakes of controlling blocks of shares to strategic investors. In some cases, particularly in the Czech Republic, they were sales of minority shareholdings, where the strategic investor was the single largest investor and other shares were set aside for vouchers, or other programs. The table does not include trade sales in which the strategic investor bought shares after the enterprise had been privatized (through vouchers, management buyouts, or other methods). The table also does not include sales to other state-owned companies. 10 SELLING STAT E COMPANIES TO S T RATEGIC INVESTORS, VOLUME O N E which later sold the company to a foreign investor. The of trade sales. From the companies in the survey, the gov- annual revenues of the state enterprises ranged from US$4 ernments raised in total over US$800 million in cash for million to nearly US$300 million. The size of the work force the state treasuries or in shares in new joint ventures, and varied between 100 and 7,700 employees. The average another US$500 million in minimum future capital invest- employment was almost 2,200 and 10 companies had more ments for the privatized companies. than 1,000 workers. The companies' products ranged from Although it is too early to tell, it appears that 19 out of cookies and chocolates to refrigerators and industrial met- 22 companies (or 86 percent) benefited from sales to stra- als. Of the 22 companies, two-thirds produced consumer tegic investors, as the companies gained access to new ex- goods and one-third manufactured materials used by in- port markets, installed new capacity and technology, and dustrial corporations. All produced goods for industries sub- arranged new financing. Virtually all the companies saw ject to domestic and foreign competition. In addition, all major restructuring after privatization, or, in response to were trade sales in which a sale (or joint-venture) contract investor proposals, as part of the privatization process. had been signed, and in this sense all were successful One unexpected finding was the low level of com- privatizations. The cases reflect the ways in which prob- petitive bidding among potential investors. In two-thirds lems were overcome. Because of the selection criteria, the of the case studies, several investors submitted prelimi- companies studied may not be representative of all trade nary bids. However, in almost half the 19 cases for which sales or even of all trade sales in the countries surveyed. information was available, only one investor was in the fi- Even so, the cases lend themselves to recommendations nal round of bidding; among the rest, only four cases saw for addressing the problems found in trade sales. vigorous competition among investors. The issue is signifi- cant. In all countries in the survey, either legislation or gov- Case Study Findings ernment policies (or both) required competitive tenders. The problems associated with trade sales, say many ob- Moreover, competition was important to establish a mar- servers, outweigh the benefits. Sales to "strategic" inves- ket-determined price, and to establish a level of transpar- tors are thought to be slow, cumbersome, and resource- ency for state enterprises. However, as often as not, the intensive. To a large degree the case studies confirm these companies of the case studies were sold as negotiated sales. commonly held views, although the number of case stud- A number of factors may have contributed to the low ies per country is small and is subject to sampling error. level of competition among investors. These included the The 22 case studies, however, constituted a sizable pro- weak financial position of the enterprise, unclear rights to portion - up to 6 percent - of all trade sales completed assets, and potential third-party claims. However, the low in each country (Table 3). level of competition was also seen in the close ties estab- On average, 15 months had passed from the time con- lished between enterprise management and the final in- sultants were hired to the date of sale. The longest prepa- vestor. In 15 of 22 cases, the final investor was the same ration and negotiation period was two years; the shortest company originally identified by enterprise management. was three months. 11-ansaction costs were also high. Much Even where the government required an open tender, the time was required of government privatization officials, in firm originally proposed by management was the company addition to the hundreds of hours of consultant time. On that won the bid. average, nearly three advisers were hired for each trade In six out of seven cases (86 percent) in Hungary, the sale, with over 30 person-months of time per transaction. final investor was the company initially id~ntified by enter- The cases also confirmed the well-recognized benefits prise management - even though ·the -government Table 3. Key Findings from Case Studies • Czech & Slovak ·Poland Hungary Republics • Number of Case Studies 6 cases 7 cases 9 cases • Ratio of Case Studies to Country Trade Sales 6% 2% 1% $216 million ;i • Total Cash Generated $179 million $151 million • Investment Commitment $247 million $76 million ~221 million • Average Cash Price versus Book Value 134% 131% 114% • Average Time to Privatize Enterprise 13.0 months 16.3 months 15.4 months • Number of Advisers 3.3 advisers 2.4 advisers 2.9 advisers • Cases where Restructuring Occurred after Privatization 83% 86% 57% • Cases with Several Investors Submitting Competing Bids 20% 75% 56% .ANALYSIS OF ISSUES 11 privatization agency supervised the privatizati~n proc~ss and t}ie sale of their enterprise. The weak financial position of gener~lly required that a tender be conducted. (In Hun- the enterprise, unclear rights to assets and potential third- gary bids were evaluated by a committee consisting of offi- . party claims, and the need for major restructuring of the cials from the State Property Agency, its advi~er, enterprise enterprise were major risks for trade investors. To offset management, and the line ministry.) In the Czech and Slo- them, investors needed as much information on the enter- vak Republics, preselection appeared to have occurred in prise as possible - and enterprise management was gener- seven out of nine cases (78 percent). The same was true in ally the source of such information, even for large state en- Poland, where the Privatization Ministry assumed direct re- terprises. Furthermore, most strategic investors also hoped sponsibility for the privatization of state enterprises - al- to integrate the local management with their worldwide though only in 33 percent of the cases. In some cases, en- organization. They generally intended to train local manag- terprise management conducted an informal. process of ers in their corporate culture and practices, and after a few contacting the major companies in their industries and se- years, turn management of the Central European compa- lecting.one firm after negotiations with several companies. nies over to locals. Therefore, investors generally preferred And in each country the privatization ministry or agency friendly acquisitions, and may have worked out an arrange- had the option of requesting another tender, or of inviting ment with enterprise management before they bought the other investors to bid. However, the data from the case stud- company from the government. ies suggest that. enterprise management has often The case studies suggest that there may exist measures preselected the final investor before a privatization plan is governments could take to increase competition among stra- submitted to the government. tegic investors. The next section looks at the problems that All the factors that increased the risk for trade inves- arose in the case studies, and suggests ways governments tors also enhanced the role of enterprise management in could avoid such problems. 12 SELLING STATE COMPANIES TO STRATEGIC lNvEsTORS, VOLUME ONE THE PROBLEMS In the course of review of the case studies and the trade council, on which workers elected only a third of the coun- sale process in Central Europe, nine problems emerged. cil members. Thus, in supporting privatization Polish ~ork- One reduced ~e number of state enterprises that would ers lost one of their prime forms of representation to their otherwise be available for sale to investors. The remaining employers. The government tried to offset this by creating eight problems left issues open - and risks exposed - for other incentives for workers to ·support privatization. After strategic:: investors. The problems were not seen in every privatization, workers were entitled to buy equity in the case study, and not all had equal weight in the trade sale privatized company at one-half the nominal value of the process. But all had a material impact on some of the com- shares. In addition, the excess wage tax (or popiwek) was panies surveyed, and they may reflect problems seen in other eliminated, giving workers the possibility for increased trade sales outside the survey. wages. The nine problems were: In the case studies, however, Polish workers bought • Need for initial approvals by the state enterprises discounted employee shares only when they were offered • Weak (and deteriorating) financial position of the an immediate resale to the strategic investor. Discounted enterprises prices (even with below-market financing) did not other- • Poor disclosure of financial information wise appear attractive to company employees. Elimination • • Unclear property title to land and buildings of the excess wage tax was a greater incentive for workers and was cited in one-third of the Polish case studies.4 The • Open-ended liabilities for environmental cleanup uncertain future of many privatized state enterprises, how- • Termination provisions on prior legal agreements, such ever, left many workers - and managers - fearing layoffs. as licensing (or franchise) agreements Such uncertainty, combined with the loss of direct repre- • Need for enterprise restructuring sentation in management, appeared to discourage many • Government retention of equity shares in privatized workers' councils from supporting transformation. companies The problems in Poland were tied in part to the • Reliance on valuations in setting sale prices. country's history. In the early 1980s with the increased power of the trade unions, workers' councils replaced the Com- Initial Approvals from State Enterprises munist "cells" in state enterprises. At the same time, work- Perhaps the most fundamental obstacle to trade sales in ers' councils gained much authority, including the right to Central Europe was written into the privatization legisla- hire and (with the support of the sectoral ministry) to fire tion. The legislation in Poland and, to a lesser degree, in enterprise management. Hungary created an unintended roadblock by requiring Economic changes also increased the power of work- approvals from the state enterprises before privatization ers' councils. Until 1989, all Polish state enterprises were could begin. In both countries, the first step was the legal tightly controlled by government, which controlled the price transformation of the state enterprise into commercial form. of the enterprise's products, the interest rate on loans, tax Following transformation, ownership of the state enterprise rates, and, to a lesser degree, access to energy, raw materi- was assigned to the Privatization Ministry (in Poland) or to als, credit, and foreign exchange. In late 1989 and early the State Property Agency (in Hungary) . Under Polish law, 1990, restrictions were lifted. With the enterprises no longer however, transformation of a state enterprise needed the so dependent on the state for their financial well-being, the approval of the workers' council. Under Hungarian law, workers' councils became more influential. In 1990 they transformation of "self-managed enterprises" (most Hun- used their power to replace 40 percent of all Polish enter- . garian enterprises) had to be supported by the enterprise prise managers. council. It was only in the Czech and Slovak Republics that With the strong position of workers' councils, and a no enterprise approvals were needed to begin privatization. There were strong incentives for Polish enterprises to 4 The excess wage tax (popiwek) was later abolished and was no oppose transformation. The workers' council would be abol- longer a factor in encouraging employee support for privatization ished after transformation and replaced by a supervisory of state enterprises. history of active labor unions, the drafters of the Polish failed to do so, the sector ministry (or other founding body) privatization legislation were concerned that investors would was obliged to prepare this plan. Alternative privatization be reluctant to invest in companies with strong worker rep- methods (such as the voucher program and open auctions re~entation. The legislation therefore established that, fol- to investors) were available for all state enterprises ..Thus, lowing transformation of a ~tate enterprise, the workers' other factors (such as lack of investor interest, illiquidity on council would be replaced by a supervisory council, in which the stock exchange, or inadequate financing for employee employees would have limited representation. As a com- or management buyouts) would not thwart the privatization pr~mise, workers' c~uncils were given the. right to veto the of any state enterprise. In addition, the timetable set.by the transformation of enterprises. It was a compromise among voucher program ensured that where a trade sale (or other government, labor unions, and state enterprises necessary form of privatization) had not been concluded by a certain to gain .approval for the initial privatization legislation. At date, the enterprise would be privatized through vouchers the time•, many in government thought the need for approval (or other privatization methods) . Thus the timetable put from workers' councils would not be an issue. However, it pressure on investors as well as government and company proved out to be a Trojan horse. By the end of 1993, more officials to come to an agreement on the terms and condi- than 5,500 state ~nterprises (out of the original 8,440 en- tions of sale. The results were impressive. By the end of terprises) had not.·been transformed into commercial form. 1993, after the first "wave" of privatization, about 60 per- In Hungary, trade sales were also slowed by the need cent of medium and large enterprises had been privatized. for approvals from the state enterprise. Most Hungarian By August 1994, 75 percent had been privatized. enterprises were run by an enterprise council dominated by For trade sales, as for other privatization methods, a enterprise management. Management could veto transfor- large pool of eligible enterprises is needed. Approval mecha- mation, although, as an incentive for privatization, the law nisms for transformation should be streamlined and should provided for 20 percent of the sale proceeds to be returned not allow enterprise workers or management to block the to management. (In joint ventures, 20 percent of the cash privatization process at the outset. Attempts to offset hesi- invested was often placed in a capital surplus account used tancy regarding privatization with financial incentives may to fund equity shares for company management.) not be enough to gain the support of these groups. In Hungary, legislative changes in 1985 had divided Initial approval of privatization legislation may require state enterprises into two groups: self-managed enterprises, a compromise that would give state enterprises (and their which included most competitive industries and represented labor unions) a strong voice in privatization. But that voice 80 percent of all state enterprises and state-administered should be limited, for example, to preparing an initial enterprises (20 percent of enterprises), which included utili- privatization plan. To accomplish rapid privatization of hun- ties and other strategic industries. Until the 1993 legisla- dreds, or thousands, of state enterprises, enterprises should tion, the government could only sell thos~ self-managed not have a veto over their sale. enterprises whose transformation had been approved by enterprise councils, and public utilities. Only under certain Weak (and Deteriorating) Financial Position of the conditions could the government force self~ managed state Enterprises enterprises to begin privatization. The weak financial position of state enterprises was often a The governments of both Poland and Hungary have problem in privatization. jt deterred investor interest and recognized the difficulties inherent in making the first legal reduced the price that strategic investors were willing to step in privatization (transformation) subject to approval pay for state enterprises. In over a third of the case studies, by enterprise management or employees. In 1992 Hungary the enterprises were insolvent and unable to meet cash ob- enacted legislation to force all remaining state enterprises ligations. The years 1990-92 were a tiine of major to either submit the legal documents for transformation or macroeconomic change in Central Europe. In all three coun- to allow the State Property Agency to complete their trans- tries, output fell steadily in 1990 and 1991 and by the third formation into commercial form. As a result, by the end of quarter of 1991, GDP had fallen to 65 to 70 percent of 1993 fewer than 200 state enterprises (from the original list • 1989 levels. of 1,848) had still not been converted into commercial form The most dramatic change was in Poland. In 1987 the or liquidated. The Polish government drafted similar legis- Polish government tentatively began to phase out price con- lation, but as of September 1994 the Polish Parliament had trols. Full price liberalization was implemented in mid, 1989 not approved the law. and, combined with wage indexation, led to near- In contrast, privatization legislation for the Czech and hyperinflation. In January 1990 the government intr?duced Slovak Republics did not require initial approvals from in- a "big bang" package ofs.imultaneous µiacroewnomic sta- dividual state enterprises. By law, all enterprises were re- bilization and price and trade liberaliz;ition. quired to prepare a proposed plan for privatization. If they The result was a radically changed environment for state 14 SELLING STATE CoMPANIBS TO STRATEGIC lNvBST0RS, VOLUME ONB enterprises. Shortages were eliminated, and for the first time was well below international standards, which made further in over 40 years market competition was introduced. State penetration of Western markets difficult. At the same time, Kwidzyn suffered from a lack of capital to enable it to install enterprises suddenly faced a "barrier of demand" and found new technology and thus improve the efficiency of its opera- that they could no longer sell all the goods they produced. tions and the quality of its products. Typical of a capital-in- Revenues of state enterprises, particularly in the industrial tensive industry competing on a worldwide level, a pulp and sector, collapsed- falling some 30 percent in 1990. In early paper company with insufficient capital reinvested will lose 1991, the Council for Mutual Economic Assistance (CMEA) its competitive edge. fell apart. As a result, many of Poland's state enterprises lost their most profitable markets and, with the recession in With Elektrosignal, a producer of airfield lighting de- Western Europe, were unable to find new markets. vices in the Czech Republic, the company's financial posi- Hungarian state enterprises shared some of these dif- tion in the two years of negotiations with the strategic in- ficulties. The economic reform had begun in 1968, but in vestor deteriorated - and the investor withdrew from ne- December 1989 the government's major concern was the gotiations. hard-currency debt of US$20 billion. Debt service con- Elektrosignal's financial position began to deteriorate with sumed a full 44 percent of hard-currency earnings. In March the onset of economic liberalization in 1990. The enterprise's 1990, the government introduced an austere economic pro- market share in the Commonwealth of Independent States gram for macroeconomic stabilization, full price liberaliza- (CIS) fell to about 45 percent by 1990 and to 5 percent by tion, and privatization. The deflationary aspects of the pro- 1992. This decline was primarily due to the breakup of the gram (as well as the collapse of the CMEA) were .seen in former COMECON markets and the growing presence of foreign competitors, primarily Siemens (Germany), Idman the decline in output. (Finland), and Thorn (United Kingdom). Sales were also sig- State enterprises in former Czechoslovakia also suffered nificantly affected by the steep reduction in domestic mili- from the effects of macroeconomic reforms, but foreign debt tary spending. and inflation were not major concerns. The economic re- form program implemented in January 1991 consisted of a N orblin, a Polish manufacturer of copper and brass "big bang" price and trade liberalization, combined with billets, rods, and wire, was initially chosen as a prime the elimination of subsidies to state enterprises and the rapid privatization candidate because of its hard currency rev- installation of a program of privatization. But the cutbacks enues from exports. in government spending, restrictive credit policies, and the collapse of the CMEA markets caused industrial activity to In 1990 Norblin experienced a sharp decline in sales caused by (1) the onset of recession in Germany; (2) the collapse of decline substantially:5 the COMECON bloc; and (3) a sharp decrease in domestic The difficulties in adjusting to rapid· macroeconomic construction activity. The crashing of the enterprise's three change were evident in the case studies. In 6 of 22 case main markets caused 1991 sales to drop by more than 60 studies, the state enterprise was nearly insolvent at the time percent in real terms compared with 1990. As a result, of privatization. Consider 3 examples. Before 1990, all were Norblin' s financial situation deteriorated significantly and the considered to be strong state enterprises ~ith good mar- enterprise incurred a tremendous debt. Almost overnight, Norblin went from being an ideal privatization candidate (a kets. profitable, well-respected enterprise with significant hard Kwidzyn was a pulp and paper manufacturer in Poland currency revenues) to a debt-laden enterprise on the verge with export markets. of bankruptcy. With the increased competition and lower capacity utiliza- Because of the change to a market economy, and to tion, Kwidzyn's financial position had begun to.deteriorate market-determined prices for raw materials and for their by 1990 and the enterprise suffered a net loss in 1991, al- products, many formerly strong state enterprises found though Kwidzyn did not as yet have significant debt outstand- ing. Given the enterprise's huge undepreciated asset base, themselves unable to compete in international markets. In these financial difficulties were exacerbated by the dividenda Central Europe the need to stabilize the macroeconomy (an assettax levied regardless of profitability) and the popiwek worsened an already weak domestic economy. Moreover, (excess wage tax). In addition, despite the company's mod- controls put in place to prevent enterprise managers from . ern equipment, the quality of paper produced at Kwidzyn selling assets or taking on new debt also restricted management's ability to modify strategy to respond to chang- 5 For additional information, see Eastern Europe in Transition: ing markets. Even after state enterprises were transformed From Recession to Growth? Proceedings of a· Conference on the into commercial form under the state treasury, corporate Macroe~onomic Aspects of Adjustment, Cosponsored by the International Monetary Fund and the-World Bank, edited by governance often remained weak. In 5 out of 13 case stud- Mario I. Blejer, Guillermo A. Calvo, Fabrizio Coricelli, and Alan ies in Poland and Hungary, the companies continued to de- H. Gelb, 1993. teriorate after their commercialization. ANALYSIS OF ISSUES 15 F<;,r investors, the difference between strong and weak 0 1990-92 generally failed to allow for provisions considered financial enterprises was important. Strong enterprises were standard practice under international standards. They did valuable for their customer base and market share, while not allow for write-offs of uncollectible accounts receivable, weaker enterprises were often losing their markets. For en- even for clients that were insolvent and had filed for bank- terprises with a weak financial position, the value to inves- ruptcy. Nor did the laws allow for provisions for obsolete tors was generally the "liquidation value" of the physical inventory. In addition, the legislation generally failed to re- assets - the cash that could be generated from the sale (or quire the disclosure of important contingent liabilities, such auction) of plant and equipment. If the plants were old, or as third-party guarantees. if they used out-of-date technology, the value to investors The differences between local accounting laws and in- could be limited to the value of the real estate held by the ternational standards were often substantial, particularly in enterprise. 1990-92. The differences were seen in seven cases, but two This suggests that governments should place a high pri- of these cases clearly illustrate the problems created for for- ority on speed of privatization. Protracted negotiations eign investors. In both cases the restatement of the could increase the cash receipts from sales, but they could enterprise's financial statements in accordance with inter- also cause the company to accumulate greater losses and national accounting standards reduced the company's net further reduce its value to investors. In addition, the more worth by more than 20 percent. rapid the privatization of an enterprise is, the more quickly management can reorganize and restructure the company. In Lehel, the Hungarian manufacturer of refrigerators, the Furthermore, the slowness in concluding individual trade investor and the company jointly hired an international ac- counting firm to conduct a preliminary audit of Lehel's fi- sales also slowed the transformation of the national economy nancial statements and to restate the enterprise's balance to a market-based system. Governments should allow state sheet according to international accounting standards. The enterprises to be sold at market-clearing prices, which in result of the audit for the period ending June 1990 was to some cases may be lower than the government had antici- reduce the enterprise's share capital from approximately Ft3.8 pated. Governments should adopt clear policies on sensi- billion to Ft2.4 billion (from US$61 million to US$40 mil- lion, or by 35 percent) as write-offs were taken for overdue tive issues, such as environmental liabilities,-and thus re- receivables and obsolete inventory. duce the need for extended negotiations with investors. In addition, governments should ensure that other privatization For SSZ, the Czech road-building company, the investor ap- methods are also available. For example, the presence of a pointed an international auditing firm to restate the voucher program (such as that of the Czech and Slovak company's financial statements in compliance with interna- Republics) can put pressure on investor and government tional accounting standards. Provisions were made to reflect a reduction in accounts receivable for doubtful receivables, negotiators to come to a speedy agreement. and a reserve (based on the estimate of the environmental audit) was set aside for the costs of environmental cleanup. Poor Disclosure of Financial Information The combined effect of the revisions was to reduce the Even where the financial position was relatively strong, state company's book value from about Kcs 870 million (US$31.3 million) to Kcs 660 million (US$23.7 million), about 24 per- enterprises generally suffered from inadequate disclosure cent. of financial assets and liabilities. The lack of adequate dis- closure caused foreign investors to insist on a full restate- Another case demonstrated investor concerns over lo- ment - and sometimes a full audit - of the company be- cal accounting laws. The Polish company Porcelana, a manu- fore they proposed the final purchase price. In every case facturer of porcelain ware, was purchased by domestic in- study involving a foreigner, the investor required that the vestors who did not require an international audit (or gov- company financial statements be restated and revised in line ernment indemnification against third-partydaims). How- with international accounting standards. ever, uncollectible receivables and an undisclosed third-party One of the legacies of socialist administrations was in- guarantee (discovered after privatization) represented nearly adequate accounting rules. While financial accounts had 20 percent of the company's book value. been maintained using standard double-entry bookkeep- ing, accounting regulations were set by law, with little flex- Following privatization, the investors in Porcelana discovered ibility for interpretation. In the past, accounts were main- additional liabilities that had not previously been disclosed tained primarily for two purposes - to calculate taxes due (and, according to the investor, that were not known to Min- istry officials at the time of sale). In February 1991 the to the government and to ensure completion of production company's book value had been set at Zl 13 billion (US$1.2 targets. The systems ·failed to provide an accurate reflec- million). After privatization, the investor discovered that more tion of the financial position of a state enterprise operating than half of the company's Zl 4.5 billion (US$211,000) in in a market economy. In particular, the accounting laws of accounts receivable was uncollectible. The investor also found 16 SELLING STATE COMPANIES TO STRATEGIC INvEsroRS, VOLUME 0NB that in 1990 Porcelana had provided a guarantee for a Z1 250 tracts would eliminate (or at least minimize) the need for million (or US$26,300 in 1990) loan by a commercial bank negotiations between investors and government officials on to the local glass factory. When the glass factory defaulted on the loan, the guarantee was called. By May 1993 outstanding issues of financial disclosure. princip'al and interest had accumulated to Zl 850 million (US$39,800). Unclear Property Title At the outset of privatization, issues of property rights were Even after a full legal audit, and a ·restatement of the often expected to be problems for trade sales. Unclear - financial statements, investors were often still concerned or contested - property title was an issue in 14 of the 22 about undisclosed liabilities and possible third-party claims cases. But among the studies it was rarely a major obstacle. on assets. In three of the cases, investors insisted on gov- Part of the reason for this must lie in the quality of the ernment warranties that all third-party claims had been dis- Central European legal codes prior to the introduction of closed. For example, the contract for sale of Csemege war- socialist law. Poland, Hungary, and Czechoslovakia ~11 had ranted that the Hungarian state was the owner of the prop- • thriving market economies in the years before 1939, and erty being sold and that no claims from third parties cur- the Polish legal codes, for example, were thought to be rently existed. For Prior stores, the Ministry of Privatization among the most progressive in Europe. During socialist ad- agreed to indemnify and compensate the investor against ministrations, some legal codes (such as those of Poland) undisclosed liabilities. Similarly, for Polam Pila, an indem- remained largely in force but were superseded by provi- nity clause was included to protect the investor against any sions of socialist law. Others (such as those of Hungary and undisclosed liabilities that exceeded 5 percent of the Czechoslovakia) had been materially redrafted. -In,1989, company's total value. the major revision needed to establish private property rights Since 1992, governments in Central Europe have re- in the legal codes was to remove the hierarchy of property vised their accounting laws, but investors still complain of rights that existed under socialist law and to place private the lack of crucial financial information on commercial com- property and state property on an equal footing. 6 panies. Others n:ote that the generally accepted accounting In the case studies, there were three types of issues principles (GAAP) of the United States and the United relating to property rights: sale of state enterprises where Kingdom were designed for market economies and that its transfers of rights of land ownership were limited to trans- rules overemphasize investor protection. The GAAP regu- fers of the usu/ruct (or in-perpetuity lease), or simply:trans- lations may therefore be more applicable for companies al- fer of the "management rights" alone; transfer of state prop- ready privatized than for state enterprises (that may be tech- erty to the local governments; and restitution of properties nically insolvent). But it is crucial that the same rules and to individuals whose properties had been confiscated·by regulations apply to both state enterprises and privatized the socialist administrations. companies. Otherwise the transition from state sector to private sector will continue to be· slowed by the constant TRANSFER OR SALE OF LAND RIGIITS .Under socialist law, need to restate the financial statements of enterprises in state enterprises generally held "management rights" (or accordance with some form ofintemationally accepted ac- "handling rights") over land they used:for operations. In counting principles. Czechoslovakia, management rights over land generally At a minimum, governments should revise domestic belonged to state enterprises, which could transfer the right accounting legislation to reflect int~rnational standards, par- to use the land to a separate body, or even ·another state tici:ilarly for treatment of bad debts and obsolete inventory, enterprise. In early 1993 new legislation transferred rights and also for disclosure of third party claims. In. !!ddition, over land to local governments, but they were limited to where a state enterprise is expected to be sold to foreign management rights. In Poland, starting in 1989, some steps corporate investors, the government could require that the were taken, the first of which permitted the management enterprise hire an international auditing firm to restate the rights of state enterprises to be converted into usu/ruct leases financial statem~nts in accordance with international stan- (or in-perpetuity leases of 99 years). As a second step the dards. Such steps would encourage investors to submit bids state treasury was named as the legal owner of the land. In since more accurate financial information would be avail- 1990, when local governments were reestablished (having able. been abolished 40 years earlier), they were given the au- In addition, the government should warrant that all thority to sell land outright. In Hungary, the 1990 legisla- I I known third party claims have been disclosed to the inves- tor. For thj~,' the government could rely on enterprise man- 6 For further discussion of the legal syst~ms in Ce~tr~l Europe, see, Cheryl W. Gray and Associates, Evolving Legal Frameworks/or agement -to identify and disclose any known liabilities. In- Pn'vate Sector Development in Central aizd Eastern Europe, World cluding such a warranty as a standard provision in sales con- Bank Discussion Paper No. 209, 1993. l ANALYSIS OF ISSUES 17 tive changes gave the municipal governments the right to on which compensation to local governments will be deter- sell land rather than simply lease the properties. 7 However, mined. In addition, investors should have the option of in the case studies there were no examples of difficulties making cash payments to local governments, rather than due to the use of usu/ruct leases, or assignment of manage- being obliged to set aside equity shares whose value is un- ment rights. certain until they are sold. LOCAL GOVERNMENTS The rights of local governments to RESTITUTION The countries of Central Europe took differ- receive cash compensation (in Poland) or equity shares (~ ent approaches to the issue of restitution and the question H~ngary) gave rise to problems in three cases. The 1990 of fair compensation to those whose properties had been laws on local governments in Poland and Hungary gave the illegally seized by former socialist administrations. Initially municipal governments the right to receive payment for the restitution created some problems regarding property rights leases or the sale of land. In Poland a major issue was the for privatized enterprises. basis of calculating payments, with the case study on Among the case studies, problems related to restitu- Porcelana highlighting the difficulties. tion were most commonly seen in the Czech Republic. In 1990 the Czechoslovak government enacted legislation to At the time of Porcdana's transformation, the local govern- return properties to the individuals holding the land before ment had the right to claim compensation for the company's land as well as the non-real-estate assets, that is, for its plant nationalization, or to pay compensation to these individu- and equipment. The company therefore incurred two debts als. Most restitution "in-kind" was under the "small" resti- to the voivod, one for ZI 14 billion (US$1.3 million) with tution law for properties seized under the 1955-61 govern- respect to the value of the land and another for ZI 18 billion ment decrees that contravened (then) existing legislation. (US$1.6 million) with respect to the value of the non-real- The properties, primarily apartment houses and small busi- estate assets. Subsequent changes in the Land Law removed the right of the voivod to make claims for non-real-estate as- nesses, rarely affected trade sales. In ~ddition, legislation sets, and thus the ZI 18 billion debt was canceled. However, enacted in 1991 provided for restitution-in-kind of some 20 percent of the amount owed had already been paid to the agricultural properties, but this also had little impact on trade voivod and the company requested reimbursement of this sales. money. The ZI 14 billion debt for land was assumed by the More pertinent to trade sales in former Czechoslova- investor and, as of June 1993, remained outstanding. kia was the "large" restitution law, which called for com- Until 1992, in Hungary local governments were entitled pensation to individuals whose properties had been seized to shares in privatized companies in exchange for the land under the 1948 nationalization law but to whom compen- within their administrative territories. Subsequent amend- sation had never been paid. Restitution under this law has ments to the legislation clarified that local governments were largely been financial and has been paid with shares in to receive onetime cash payments - and the payments could privatized state companies, either given directly to claim- not exceed the "value" of the land. In some of the large ants or placed .with the Restitution Funds established by transactions, particularly of utilities with local distribution the National Property Funds. • facilities, local governments were an active participant in Both forms of restitution - financial compensation privatization and were thought to have slowed down the and restitution-in-kind - were seen in the case studies. process in the protection of their rights. However, slo~ness Financial compensation in the form of equity was seen in due to negotiations with local governments was rare in the two Czech cases. With the chocolate producer, Cokoladovny, case studies - even for the food distributor, Csemege, with 4.5 percent of equity shares (rather than the standard 3 34 municipalities together receiving 8.6 percent of the percent for restitution) was set aside for individual claims company's shares. Only for the producer of ceramics, that had been negotiated (and signed) prior to the submis- Zalakeramia, did one local council initially disagree with sion of enterprise management's privatization proposal. In the valuation of the land, claiming that it was low in rela- the Czech manufacturer of writing instruments, Centrop~n, tion to real estate values in its district (which included the .the restitution claim for financial compe;:nsation influenced resort area of Lake Balaton). the form of privatization, and thus encouraged the This suggests that land legislation providing compen- privatization of the company. sation for local governments should clearly state the basis Enterprise management discovered that there were viable competing projects under preparation - one by an Austrian 7 Until 1992, local governments held the management rights for competitor and the other by a restitution claimant, an expa- triate Czech businessman and the son of the original founder I I state enterprises where the local government was the founding of Centropen. Some Centropen managers favored a sale to a I body. After 1992, such managementrights were transferred to the strategic investor and submitted a competing project jointly government privatization agency. with the restitution claimant. 18 SELLING STA,E COMPANIES TO STRATEGIC INvESToRS, VOLUME Om Restitution-in-kind created problems for two compa- State Property Agency decided to set aside 5 percent of nies whose properties were returned to former owners. In Csemege' s shares for the compensation coupon program. Ac- cording to the press, a substantial portion of the Csemege the department store chain, Prior, one store was dropped shares sold initially on the Stock Exchange were bought by from the investor's initial list of desired acquisitions because the investor, which had previously purchased compensation the property was subject to restitution claims of former coupons on the secondary market at a significant discount. owners. While this reduced the amount of property avail- able for sale, it did not halt the sale of the other Prior stores In 1990-92, Poland had no restitution law in place. to the strategic investor, since the stores were largely self- Since the case studies included only enterprises that had standing entities. A greater problem created by restitution- been privatized, it is not clear whether restitution might in-kind was the prospect of conflicting property claims that have removed some state enterprises from consideration could be resolved only in the courts - as with Severokamen, for privatization. Some have estimated that as much as two- the Czech producer of crushed stone. In this case, the in- thirds of Poland's GDP could be tied up by restitution is- vestor took comfort in government assurances that the title sues, 8 although official claims are far lower at Zl 350 billion was free and clear - and in the investor's legal right to (or US$160 million). Certainly, in one Polish case study res- abrogate the contract if such warranty was not met. titution issues delayed the investor's final payment - de- spite the government's warranty on free and clear title. For Severokamen, the deadline for submission of restitution claims was January 1993 . However, as of May 1993 the su- A portion of Norblin's facilities is located on property sub- pervising body responsible for resolving disputes related to ject to restitution claims. The Ministry of Privatization agreed restitution claims had not yet begun to compile lists of claims to indemnify the investor with regard to any valid restitution submitted, and Severokamen was of the opinion that it might claims. The Ministry of Privatization had agreed to allow the be several years before the restitution issues were finally re- investor to pay the amount in two equal installments: the solved. According to the investor, the contract signed by the first was paid on the. date of sale and the second one year National Property Fund provided assurances that later. (The investor provided the Ministry with a promissory Severokamen held free and clear title to the property, and note, co-signed by a Polish bank to guarantee the second that Severokamen had the requisite authority to develop the installment. ) However, the investor was unable to pay the quarries. The investor could withdraw and abrogate the con- second installment of the purchase price because of financial tract if the courts found either to be incorrect. In addition, difficulties, and the Ministry of Privatization postponed the the National Property Fund agreed to make every effort to payment date for another year, until April 1993. As of June ensure that any person claiming restitution of land for which 1994, payment had not been made, as the investor claimed the investor had a mineral extraction permit would be of- that it was promised clear title to all of Norblin's property fered alternative land under the 1991 Land Act. and that the costs associated with this process were roughly equivalent to the value of the second payment. In contrast with the program in former Czechoslova- kia, Hungary's restitution program allowed only financial The Polish government often did not provide a war- compensation for properties seized and did not transfer land ranty to investors that title to property was free and clear. or buildings to former owners. Under the 1991 Hungarian This forced investors to do their own verification. law, compensation was made available for property expro- priated after 1939 (and thus included claims for properties For title to the buildings, the pulp and paper manufacturer, seized from Jews and Germans between 1939 and 1949). Kwidzyn, first needed to obtain consent from the local gov- ernment to confirm title to the buildings which were built on Compensation was solely in the form of coupons with a State 'Ireasury land. Kwidzyn proved that all investments maximum value of Ft 5 million (or about US$50,000). The made for the construction of these' buildings had been fi- coupons could be used to buy state property, such as apart- nanced by a bank loan, and therefore had been paid for by ments, land (under certain conditions), or shares in specific the enterprise. All 'Ireasury subsidies had been spent on so- privatized state companies. As a result of the government's cial assets rather than on buildings. Therefore, Kwidzyn was not required by law to make payments to the local authori- policy to make financial compensation, restitution did not ties for the buildings. In this way, Kwidzyn managed to ob- create problems for any of the Hungarian case studies. tain clear property rights on the facilities. In one of the Hungarian case studies, however, an is- sue arose in the operation of the restitution program. Ow- By contrast, the governments in Hungary and Czecho- ing to public concerns over the quality of companies in the slovakia generally gave warranties that title to land was free coupon program, the Secondary value of the coupons often and clear. The.warranties were based on investigations by traded at a substantial discount. In one case study, the in- enterprise management. vestor used compensation coupons to increase his The experience suggests that restitution-in-kind can ere- shareholding in the company. 8 Oxford Analytica, July 12, 1992. In the case of the Hungarian food distributor, Csemege, the ANALYSIS OF ISSUES 19 ate problems for trade sales, since some claims are unlikely trade sale. Th~ Czech _ and Slo'[ak Republics had a. clear to be immediately resolved. Where feasible, governments policy established by g~v~rnment rulings," but in practice should rely on financial compensation rather than return the details reflected tailor-made solutions for each trade ofland and buildings to former owners. However, even the sale. setting aside of shares can create problems, since this re- The policy of the Czech and Slovak Republics was to duces the equity available to trade investors. Thus, inves- have the privatized company implement the cleanup pro- tors should be given the option to make cash payments in gram. In principle, where the pollution was caused by ac- lieu of setting aside shares. In addition, the government (as tions of the state enterprise prior to privatization, the gov- seller of the state enterprise) shoul.d pr9v_ ide a warranty of ernment would indemnify the company for cleanup costs. free and clear title to the real estate held by the state enter- In the initial trade sales, the government agreed to indem- prise. nify the investor for 50 percent of the actual cleanup costs for subsoil and groundwater pollution; in later sales, the OrnER PROPER1Y ISSUES In the sale of the Budapest hotel amount was raised to 100 percent. In addition, the Duna, there were minor filing errors of a type usually re- government's liability was often defined by an environmental solved administratively in market economies. The issues audit that described the major environmental problems. A were no doubt heightened by the secured debt financing in government agency, the National Property Fund in each the transaction. Republic, was to indemnify the investor for cleanup costs, but the total payment was limited to the cash purchase price In Duna, due diligence reviews by the investor and its lend- for the privatized company - and was limited (in fact, if ers raised two possible problems concerning property rights. not by contract) to the funds received by the National Prop- Both were minor filing errors usually resolved administra- tively - in market economies. However, the State Property erty Fund from all privatizations. 9 In addition, eligible ex- Agency felt that no outstanding issues existed regarding prop- penses were limited to those identified in a cleanup plan - erty rights and was willing only to provide its standard war- and negotiated between the investor and government envi- ranty of one year against third party claims. On the basis of ronmental authorities at the time of the company's this warranty, the investor was willing to complete the acqui- privatization. sition. In theory, the solution was to use part of the proceeds of privatization to pay for cleanup expenses but to leave to Open-ended Liabilities for Environmental Cleanup private investors the responsibility for implementing the Among the most complex of the issues negotiated between cleanup. In practice, the governments adopted a range of the governments of Central Europe and private investors were those of ·environmental liability. This was particularly methods to identify the risk of future cleanup expenses and to share the risk with private investors. In 10 of the 22 cases, true of the initial phase of trade sales. Years of inadequate environmental issues arose, and in these 10 cases, 7 differ- legislation had permitted state enterprises to pollute the ent approaches were taken. In most cases the amount of environment. The governments recognized that they were liability was estimated by an environmental audit. obliged to bear the costs of remediation of prior environ- In two of the cases the government retained most, if mental damage caused by state enterprises. Moreover, gov- not all, of the environmental liability- but the government's ernments rea:lized that if they did not cover the costs it would maximum liability was limited in amount - and was de- be difficu!t to privatize some state enterprises. But they fined by an environmental audit commissioned by the in- also recognized that government budget funds were lim- vestor. ited. In general, the privatized company bore responsibility For SSZ, the investor assumed 2.5 percent of the cleanup for mitigating ongoing damage such as air pollution. How- costs. The National Property Fund accepted responsibility ever, the assignment of liability for-cleaning up prior envi- for the remaining environmental liabilities, up to the amount ronmental damage to subsoil and groundwater basins ran a of the purchase price of Kcs 100 million (US$3.5 million). wide gamut - from the government accepting ::ill environ- mental liability to the investor assuming all responsibility. For Elektrosignal, an environmental audit was prepared by a local Czech firm. They estimated the cost of the cleanup of But in most o{ the case studies, the risk of an open-ended soil damage at Kcs 1.7 million (US$6(000). The purchase expense was shared by the government and the investor agreement stipulated that the cleanup cost based on the en- (Table 4). Th~ government of Poland took an ad hoc ap- proach to negotiating environmental liabilities. The gov- 9 By the end o( 1993 the Czech Republic had set aside Kc 28.8 I billion for remediation of pollution daniage. This represented a ernmeo,t of Hungary, as a policy, either provided a warranty total of 50 trade sales, or almost one-third of trade sale agreements on environmental liabilities or reduced the sale price of the with foreign investors. See Pn"vatization Letter ofthe Czech Republic state company and negotiated a separate agreement for each and Slovakia, April 1994. 1 20 SELLING STATE COMPANIES TO STRATEGIC lNvESTORS, VOLUME ONB Table 4. Sharing of Environmental Liability Approaches to Environmental Liability Case Study Examples Government Paid for Cleanup Amount limited to sale price for state company SSZ - Government assumed environmental liability for amounts in excess of 2.5 % of cleariup costs and up to the amount of the sale price. Liability retained by state enterprise Polkolor & Szolnoki - Government retained environmental liability in state enterprise remaining with the government. Severokamen - Liability remained with shell enterprise. Amount of liability identified in an environmental audit. Shares retained by government as compensation for cleanup Tatramat - Based on environmental audit, equity shares costs equal to estimated costs retained by government. Investor Paid for Cleanup Sale price reduced by the amount of estimated cleanup Lehel - Final sale price was adjusted for actual cleanup costs. Based on an environmental audit, reserves were set aside in company's books. Unresolved legal issues remain. Additional shares in privatized company transferred to Polam Pila - Based on costs identified in an environmental investor audit, governmenttransferred an additional 15.7 % of equity to investor. Government warranty to investor that all known damage had Kwidzyn & Cokoladovny - Although plant operations met been disclosed Western environmental standards, investor requested government to provide warranty that all known damage had been disclosed. Investor commissioned own environmental audit. No additional compensation or contractual protection for Porcelana - No environmental audit conducted since investor investor felt it was not needed. Zalakeramia - Investor required an environmental audit, but no major problems discovered. • Kyje - Investor assumed environmental liabilities. vironrnental audit would be covered by the National Prop- impact on the environment, and potential environmental li- erty Fund. ability was a critical factor for the investor. As part of the negotiations for the sale contact, the environmental obliga- In three cases the government, through a state-owned tions relating to the depleted quarries were retained by the original state enterprise - now controlled by the National enterprise, retained the environmental liability as part of Property Fund. The depleted quarries needed to be·filled in the restructuring of the enterprise. While the investor ac- and covered with grass and trees. Severokamen had estimated cepted responsibility for the e~vironmental .liability, the the cost of the environmental restoration at Kcs 10 million mafor risk had been assigned to a state shell enterprise. This (or about US$350,000) In addition, the share purchase agree- sometimes left the government with unusable assets, such ment stipulated that the National Property Fund would re- imburse the investor for any environmental cleanup costs as depleted rock quarries, as seen in the case of the Czech relating to the quarries purchased for an· amount up to 50 producer of crushed stone, Severokamen. percent of the purchase price paid. Expenditures·as a result d environmental-damage.were not expected to exceed the In Severokamen, the company's operations had a significant sale price of £1.1 million (US$1·.7 million). , ANALYSIS OF ISSUES 21 Similar methods were used for the Polish manufacturer the initial agreement was that the final purchase price would of color television tubes (Polkolor) and the troubled pulp be adjusted by the amount of the cleanup costs incurred by and paper manufacturer in Hungary (Szolnoki), although the company. But since the estimate of the cleanup costs in both cases the state enterprise retained other assets and was higher than the purchase price for the company, the liabilities in addition to the environmental liability. government agreed to indemnify the company for any costs In another case the government paid all cleanup costs in excess of the purchase price. Part of the problem lay in (in excess of the minimum amount) but retained some eq- trying to estimate costs in 1_990-91 when virtually no do- uity shares in the privatized company. It was expected that mestic companies were providing services for environmen- if the government were obliged to pay for cleanup costs, it tal remediation. Another problem was related to the tax would sell the company shares and use the proceeds to cover treatment of the cleanup costs - and the resetting of the /ts expenses. purchase price based on the final cleanup costs. For the Slovak company Tatramat, the environmental liabili- As a state enterprise, Lehel had used both on-site and off- ties for past damage caused by the production of washing site waste dumps. An environmental audit, carried out by a machines were one of the major issues in the negotiation of West German environmental consulting firm, determined that the joint venture agreement. An environmental audit con- Lehel's refrigerator production had contaminated approxi- ducted by a Slovak firm estimated the cleanup costs for soil mately 50,000 cubic meters of soil with chlorofluorocarbons and water contamination to be between Kcs 20 million and (CFCs). The firm estimated the probable cleanup cost at DM Kcs 25 million (or US$690,000 to US$865,000). In the final 70 million (about US$41 million) and the maximum cleanup joint venture agreement, the investor agreed to pay cleanup cost at DM 100 million (about US$59 million). The process, costs of up to Kcs 23 million, with any excess covered by the which involves removing dangerous waste as well as cleaning Slovak National Property Fund (for which about 10 percent the soil, would take five years to complete. Initially the agree- of the shares of Tatramat A.S. had been set aside). It was ment was that the State Property Agency would retain the anticipated that, if the NationafProperty Fund were obliged off-site dumps and would be directly responsible for their to pay any cleanup costs, the Fund would sell its shares on cleanup. Subsequently, however, it was recognized that the the stock market. Agency lacked the necessary funds. The investor agreed to finance the cleanup and the State Property Agency agreed to In the four remaining cases, the investor paid for the reduce the purchase price with retroactive adjustments. Ac- cording to the Lehel management, the maximum amount es- environmental cleanup. In one case shares were used to timated for the environmental clr::anup, DM 100 million, was compensate for environmental risk - but the investor re- set aside as reserves in Lehel' s transformation balance sheet. ceived the shares and assumed the environmental risk. . The State Property Agency also agreed to indemnify the in- vestor if the fmal. costs were higher. Environmental issues As Polam Pila's operations could have involved a significant were still, asof mid-1993, the largest problem for Lehel. The negative impact on the environment, the investor recruited tax treatment of the cleanup costs was unclear, and as ofJune local ground and water pollution appraisal specialists to con- 1993 was the subject of a lawsuit between Lehel and the Hun- duct a series of environmental studies and to estimate the garian Tax Authority. enterprise's liability under Polish environmental laws. The studies showed some soil contamination from chemicals and For the two remaining cases, there was no compensa- also provided inforrn:ation regarding removal and preventive tion for assuming environmental liability. In the case of the procedures in addition to estimated cleanup costs. The in- vestment needed to mitigate the environmental damage and Polish paper coi:npany, Kwidzyn, the investor covered all to bring the company in compliance with prevailing environ- liability but required that the Ministry warrant that all mental standards was estimated to be between Zl 40 billion needed cleanup known to the Ministry be disclosed, and and Zl 100 billion (or about US$4 million to US$11 mil- that the Ministry provide an indemnity for damage caused lion). The results of this audit were used in the negotiation of by Kwidzyn to third parties prior to the sale. With the Czech the contract. The investor promised both to clean up past environmental damage and to invest in methods that would . bottling company, Kyje, the investor agreed to assume all help Polam Pila meet basic environmental standards. The environmental liabilities -without government warranties. Ministry of Privatization agreed to transfer an additional 15. 7 Of the seven different methods used for assigning en- percent of the total shares of Polam Pila for these environ- vironmental risk, all resulted in completed trade sales and mental expenses. Thus, by the time the transaction was com- were, in that sense, effective measures for resolving the is- pleted in May 1991, the.investor had increased its stake in the company from the initial agreement of 51 percent to 66. 7 sue. However, two methods pr~ved particularly cumber- percent of the equity. some: reduction in the final sale price by the amount of expenses incurred, and transfer of shares to compensate In another case, the government reduced the purchase for possible environmental costs. As is seen in the Hungar- I price (by the maximum estimated liability) but required the ian case study on Lehel, the reduction in the final sale price investor to implement the cleanup. The government agreed may create tax issues for the investor and thus be subject to to pay for any excess. For the Hungarian company Lehel, future litigation between the government and the investor. 22 SELLING STATE COMPANIES TO STRATEGIC INvESTORS, VOLUME ONE 'Iransfer of equity shares is also not recommended. Use of privatization, many such agreements were still in place or shares as compensation - to the government or to the in- had recently been renewed. The legal agreements typically vestor - for accepting additional environmental risk is an called for payment of "liquidated damages" in the event of inefficient solution since equity has unclear value in the ab- early termination of the agreement - in effect a termina- sence of an active secondary market. Preference should be tion fee payable by any investor except the company hold- given to cash payments for actual cleanup costs. illg the licensing agreement. To simplify the trade sale process, the government The question of liquidated damage provisions arose in should pay for all c1eanup of prior environmental damage only four of the case studies, but in two, termination pay- (that is, damage to the subsoil and groundwater basins) but ment was the overriding issue in the company's privatization. should leave it to the investor to supervise the cleanup pro- In both cases the initial amount of liquidated damages was gram. Pollution (such as air pollution) created by ongoing high, at almost half the final sale price. However the two operations should be the responsibility of the privatized cases were handled differently. In Pampa, the Polish manu- company. Such a policy has two advantages: it establishes a facturer of papermaking machinery, the government took clear starting point for negotiations between the govern- no action to reduce the amount of liquidated damages - ment and the investor, and (since the government is paying even though the contract which had been signed in the 1960s the bill) it ensures a rapid cleanup program. However use was due to expire in four years. Other investors failed to of such a policy also has disadvantages: it may increase the bid for the company, and the government was obliged to government's costs, and it may place a drain on the budget sell it to the holder of the technology. • funds. The alternative is an ad hoc approach in which the amount of the government's liability is determined through A decisive factor in the final evaluation of investor proposals negotiations with investors. But this also creates difficul- was the existing license agreement, which gave Fampa the right to use technology from one of the investors. The license ties. Such complex negotiations require a high level of skill agreement was due to expire in four years in December 1994. among government negotiators and ' an efficient decision- Nevertheless, if Fampa were to be sold to any other investor, making process within the government. Many governments Fampa could no longer continue using the license and would lack one, or both. Furthermore, such negotiations can con- have to pay a penalty of US$4 million for early termination tribute to the slowness and complexity of the trade sale pro- of the license agreement. The proposal of the competing in- vestor stipulated that the Ministry of Privatization should be cess. responsible for paying the liquidated damages. Therefore, In the case studies, the policy of the Czech govern- the price offered by that investor was necessarily US$4 mil- ment - to pay the costs of cleanup for prior damage as lion less than any price offered by the investor holding the identified by an environmental audit (and up to the amount license agreement. of the sale price) - was a clear policy, established by gov- ernment rulings. While it assigned the residual liability to By contrast, in the sale of the Budapest hotel, Duna, the investor, the policy clarified the 'amount of funds the the government took twp actions: they announced that re- government would pay for cleanup, but required that the gardless of the winning bidder the government would can- privatized company implement the plan. The government's cel the franchise agreement and pay the cancellation fee; liability was limited to prior damage and was identified and they negotiated the fee to a lower amount. By paying through an environmental audit. Only those expenses iden- the fee directly (from the proceeds of the sale) the govern- tified in the cleanup plan (agreed upon in advance by the ment clarified that all bidders would be considered on the investor ·and the regional environmental authorities) were same basis. By reducing the fee to a smaller amount, the eligible for indemnification. Funds to cover cleanup ex- government ensured that the fee could not be inadvertently penses were paid from the proceeds of the sale of the en- considered an important issue by government officials. terprise. While environmental issues were the single most controversial issue in the Czech case studies, the In Duna, the first round of bidding did not require binding offers but was intended to test the market. No offers were government's policy allowed for eventual resolution of the received during the first round. The State Property Agency issues without the probability of future litigation. Such poli- was concerned.that the lack of competing bids was due pri- cies are an effective method of expediting the trade sale marily to the perceived advantage of one investor as party to process while ensuring the cleanup of existing pollution. the existing franchise arrangement.' Therefore, the Agency decided to negotiate the early termination of the franchise Termination Fees oil Prior Legal Agreements agreement. The agreement had been extended only in 1989, and early termination was thus only possible upon payment In the 1960s and 1970s, many state enterprises in Poland of a cancellation fee. It was agreed that the agreement would and Hungary signed technology licensing (or franchise) be terminated, at a cost of US$3 million, even if the same agreements - to modernize their production facilities with- investor were to win the bid. In this way that company would out giving up ownership in the factories. At the time of not have an advantag:: over competitors when bidding .on I ANALYSIS OF Issuas 23 • the price. The fee for liquidated damages would be paid from J from Zl 684 billion (US$ :43.J.million)'in 1992 to ZI 2,171 the sale proceeds paid by the winning bidder, even if the com- billion (US$ 101.7 million) in 1993. pany holding the franchise agreement were the winner. Polkolorwas also able to access.the investor's distribu- This experience suggests that governments should tion network. check whether state enterprises have outstanding legal agreements that could restrict potential investors by requir- As of mid-1993 the company was selling 25'percent of its ing liquidated da~ages. The government should examine production on the Polish market, and another 70 percent legal options to define the enterprise's legal liability. To in-· was sold outside the former COMECON countries through the investor's international distribution network. Sales to crease the perception of a "level playing field,'' the govern- Western Europe grew from virtually nil to almost 60 percent ment could directly assume the liability for payment of dam- of total revenues in 1992. ~g~s on early termination - and make the payment from the proceeds of the sale of the state company. In this way, In the case studies, enterprise restructuring was most investor concerns regarding a comparative disadvantage . effective when it was carried out by investors after would be allayed and more investors would bid for the state priyatization of the state enterprises ~ or as part of the company. privatization process and in response to investor proposals. Need for Enterprise Restructuring PRE-PRIVATIZATION RESTRUCTIJRING The governments in Cen- In Central Europe the need for the restructuring of state tral Europe generally left the restructuring of state enter- enterprises was unquestioned. State enterprises were often prises to the private investors. The goal of the privatization conglomerates of unrelatea businesses. The work . forces officials was to sell the enterprises in their existing condi- were generally large with a high proportion _of administra- tion and let private investors implement restructuring. In tive staff. Enterprises were burdened by social obligations, half the cases, enterprise management had done some re- such as kindergartens, resort hotels, and money-losing hous- structuring before privatization, but this was limited. In five ing for employees. Often the enterprises had loans in hard cases management reduced the size of the work force (by currency that remained unpaid. At the same time, the·en- 20 to 40 percent), but in all cases this was done through ~erprises neede_d capital to modernize and expand (Table attrition rather than formal restructuring. In Poland, at least, 5). ·Any strategic investor would be committed to a major this was motivated more by the desire for higher wages than restructuring program. While some of these enterprises were by the need to make the enterprise competitive. At that "diamonds in the rough," the need for restructuring could time an excess wage tax (or popiwek) for an enterprise was discourage potential investors. On the other hand, govern: applied based ori the average wage per employee of the pients might find that their efforts to restructure state en- enterprise. Thus, with a smaller work force, all employees' terprises would consume valuable time and money and wages could be increased. would not materially increase the sale price for the company. Enterprise management had also tried to spin off some Although it is too early for a definite assessment, it ap- social obligations (or so-called "social assets"). In five cases, pears that mo_st of th~- companies in the case studies were management tried to divest some social assets before strengthened by the restructuring that followed sales to stra- privatization. For example, the Polish manufacturer of pa- iegic investors. Net profits after privatization were mixed, permaking equipment Pampa, transferred a school to the but in 9 out of 12 cases export revenues had increased within local government but was unable to spin off the other sub- two years of privatization. Three companies had dramati- stantial social assets, ~hich included two holiday resorts, cally improved the quality of their products to internation- more than 700 apartments occupied by employees, a social ally competitive levels. . ·• club and canteen facilities, as well as a local school. Taken Consider, for example, the Polish manufacturer of color together, social assets repre~ented a third of the company's television tubes, Polkolor. In February 1991 the company book value. Another company, Lehel (the Hungarian manu- was insolvent and the pla'.nt had been close_d. . • facturer of refrigerators) unsuccessfully tried to sell a zoo but was only able to sell off some employee housing to the , With the forma~io,n of the joint venture, Polkolor was able to increase sales and improve 'production quality significantly.. company's workers. The company's product defect rate was reduced from nearly • •.• Some .financial restructuring was completed for trade 20 percent of production to less than 1 percent (between 0.4 sales, but in two of these three case studies the restructur- percent and· 0.8 percent) _by mid-1993, a level comparable ing was flawed. For the Hungarian pulp and paper manu- with the standards of the inyestor's facilities worldwi_ de. facturer Szolnoki, the effect of restructuring was to increase Polkolor expected to produce i.3 million color picture tubes in 1994 - more than the company's prior cumulative pro- the difficulty in privatizing the factory. The sector enter- duction over 12 years from .1977 t.o 1991. Also, sales increased pri~~ JHung~ri.an Paper.Works) had .earlier divided its ops 24 SELLING STATE CoMPANIES TO STRATEGIC !NvESToas, VOLUME ONE Table.5. Enterprise Restructuring in the Case Studies Restructuring Sequence Actions Case.Examples By Enterprise Management Restructuring of debt Szolnoki - Parliament approved debt restructuring plan. before Privatization Polkolor - Split enterprise, requested creditors to accept equity in new joint venture. Reduction in size of Fampa, Zalakeramia, Szolnoki, Prior, Elektrosignal-Redu9ed work force size. of work force by up to 25%._ Divestiture of social Fampa - Transferred school to local government. assets Centropen - Transferred kindergarten to local government, sold housing to employees. • By,lnvestor after Privatization New capital investment Fampa - Completed sewage treatment plant. and refinancing of debt Polkolor - Upgraded production facilities, renovate: d plant infrastructure. Lehel - Made investments to improve product mix. Zalakeramia - Expanded production capacity. • Oroshaza (Hunguard) - lnstallecl new production process with new machinery, refinanced debt. . . •Polam Pila - Improved production faciiities, refinanced debt. Porcelana - Refinanced debt. •• ·, • Tatramat - Joint ventures refinanced debt. •Reorganization of work' Polam Pila - Improved quality control and.cost reduction. force Porcelana - Introduced new system$ for jriventory control and product costing. ' ••• • • • Fampa, Norblin, Polkolor - Changed management. Cokoladovny - .Reduced number of: brands, centralized marketing departments, increased·. numbe~.of employees . . Oroshaza (Hunguard). - Reassigned staff when factory temporarily closed for conversion of manufacturing 'process. Lehel - Hired consultant to prepare· reorganization study; layoffs followed. Szolnoki - Changed management, used foreign experts as ~d. cons4ltanh;; factory, event.ually clqs_ Duna - Introduced n·ew organization structure. Prior - Revamped organization structure. Severoka:men ·- "lrriproved sales and marketing. biye~Uture of non-core Polkolor - Started spinning off its 81 unrelated businesses: activities • Lehel - Shed nonstrategic-busines!;les. Szolnoki - Change_ d producJ mix. Disposal of social assets Lehel Transferred zoo to local governmerit (but agreed O ~o support it for another 4 years), transferred kindergarten 'to church, auctioned vacation homes. By Government ai "Joint ventures Polkolor - pf6duction facilities for color TV tubes contributed Part of Privatization ·. to joint venture. Other facilities remained with state enterprise. Oroshaza (Hunguard), Szolnoki, Duna- Individual factories, or parts of factories , were given to joint venture. ' Investor bids' for selected ~yje - Investor bid for a bottling plant only. . . .. assets ' Tatra:mat - Washing.machine and tool and die businesses privatized separately fror'ri' state enterprise. • • Prior - Individual stores bought by investor. , ANALYSIS OF IssuES 25 ~rJti~i}firi:iong five new state enterprises and assigned most In all cases, when enterprise management first ap- of the debt of the sector enterprise to one of these enter- proached strategic investors one of management's primary prises. The company was later privatized, but its operations goals was to find new capital for expanding and moderniz- •\'9i,d not generate enough cash to meet the company's debt- ing. But among the 22 cases, only 11 companies raised '§ervic;~:,payments. The factory was closed less than a year new capital. Some of this was substantial. For example, ilie' after company's privatization. after privatization Hunguard installed new production fa- A second case of a troubled pre-privatization restruc- cilities costing US$125 million (or more than eight times . turing was the Polish manufacturer of color television tubes, the sale price of the company). In 2 cases the capital was Polkolor, where not all parties had agreed to the proposed used just to refurbish existing facilities and repair infra- . :financial restructuring before the privatization was signed. structure, such as a US$1 million sewage treatment plant • In February 1991 one international investor had submitted for the Polish manufacturer of papermaking equipment, an offer to form a joint venture with the state enterprise. Pampa. In 3 cases the investor used its credit position to The offer proposed a splitting of the state enterprise and a refinance the debt of the acquired companies and estab- complex debt-equity swap. lish new banking relationships for the privatized compa- nies. Creditors to the state enterprise were offered equity interest Overwhelmingly, the restructuring implemented by the in the joint venture in exchange for their outstanding loan. investor was not investment of new capital or refinancing When it was a state enterprise, Polkolor had borrowed Zl 350 billion (US$37 million) from four banks. Of this amount, of debt. Rather it was organizational restructuring needed Zl 138 billion (US$15 million) represented a loan by the Paris to make the enterprise competitive in international mar- office of a state-owned Polish bank, PKO BP. PKO's loan kets. In two cases it was a "rationalization" of product lines was guaranteed by BRE, the Export Development Bank (then or production facilities. At Lehel (the Hungarian manu- state-owned), which was in turn guaranteed by one of facturer of refrigerators) the investor sold its production Polkolor's suppliers, KGHM Polska Miedz, the state-owned copper mining concern. facilitie_s for ipdustrial heat exchanges and large compres- The creditor banks had participated in discussions on a sor units, seeing both as non-core and nonstrategic assets. debt-equity swap but had not finalized an agreement on the After privatization, the Polish television tube manufacturer, swap before the creation of the new joint venture. The cop- Polkolor, began divesting its 81 separate businesses. per enterprise was not made aware of the proposed debt- - - - • •Ofte~ ·the restructuring was oriented toward more ef- equity swap until about December 1991, when PKO called . . upon the guarantee of the Export Development Bank, which fect1ve management of enterpnses - and a smaller work in turn seized the copper enterprise's cash on account with force. Among the 22 cases, 9 saw their work forces fall in the Development Bank in the amount of the guarantee. (The the months after privatization. Between the date of . Bank was undergoing privatization at the time and was un- privatization and mid-1993, the net decrease was about able to meet the guarantee.) The copper enterprise, which 5 500 or about 12 percent although the amount of the had not been a party to the prior negotiations and was not ' . . ' . interested in participating in the debt-equity swap, began le- reductions was unevenly dispersed. In ~e case studies, em- gal action against the parties concerned. One of the concerns ployment fell on average 25 percent m Hungary, 18 per- raised by the copper enterprise was that the equity in the cent in Poland, but less than one percent in the Czech and joint venture was not sufficient to pay back the debt and Slovak Republics. Some reduction in staff was due to spin- interest owed to the c~pper enterpris~, let alone that ow~d ning off divisions and product lines and some to organiza- to the other three creditors. Complet10n of the debt-eqU1ty . l " . . ,, ( . . b . kn . h swap was also complicated by the unwillingness of the Ex- tiona re-engmeermg as lt is ecorrung own 1Il t e port Development Bank and PKO (itself a privatization can- United States). For example, for the Hungarian manufac- didate) to take a significant loss. The debt-equity swap was turer of refrigerators, Lehel, the investor redesigned the to have been completed within 90 days (that is, by Decem- company's organizational structure and reduced the size ber 1991). As of mid-1993, this had not_occurred. Further- of the work force. more, none of the banks had taken action and the copper enterprise had suspended its lawsuit, since all were hoping As of mid-1993, the investor in Lehelhadintroduced West- that the government would assume some of the liability or ern cost and financial accounting standards and had created that some other solution would be found. over 200 cost centers within the company. The investor changed Lehel's organizational design dramatically from a POST-PRIVATIZATION RESTRUCTURING The enormous need traditional pyramid structure to a matrix, despite general for restructuring of state enterprises in Central Europe could resistance among the work force. Over an 18 month period be seen in the restructuring put in place by new private following privatization, Lehel reduced the work force from investors after privatization. Among the case studies, · the 4,800 to 3,300. Many layoffs resulted from the termination of the production of industrial heat exchanges and large com- primary forms of post-privatization restructuring were new pressor units. Also, in July 1992 the investor had commis- capital investment, refinancing of debt, and new organiza- sioned a local management consulting firm to redesign the tional structures. company's structure in order to improve the ratio of pro- 26 SBLLING STATB COMPANIES TO STRATEGIC lNVBSTORS, VOLUME ONB I ductive to nonproductive employees from 1:1 to 2:1. As a nearly half) of the Hungarian cases, privatizations were result of this study, Lehel decided to cut 470 further jobs by through joint ventures. the end of 1993. On the other hand, the Czech and Slovak governments However, not all organization restructuring resulted in permitted (and even encouraged) investor offers for spe- lower employment levels. For example, in Prior, the Czech cific assets. The basic privatization proposal submitted by department store chain, the investor reorganized the man- enterprise management typically called for the privatization agement information systems and sales focus of the stores of the state enterprise as a single entity. Competing propos- - but did not reduce the number of staff on the payroll. als (generally from outside investors) could "cherry-pick" certain divisions of the state enterprise, particular factories, Since privatization, the investor has provided extensive train- or even specific assembly lines. This was clearly seen in the ing in areas ranging from techniques of centralizing purchas- privatization of Tatramat, the Slovak manufacturer of wash- ing to methods of in-store presentation of retail goods to use ing machines, dishwashers, microwave ovens, water heat- of computer technology in inventory control. Beginning with ers, tools and dies, and vending machines for hot and cold the largest stores, the investor reorganized the "work flow." Previously, sales staff were responsible for individual prod- drinks. uct lines, and, beyond a certain minimum, had to pay from their own wages for any losses due to shoplifting. The inves- Initially, Tatramat management was interested in negotiating tor established department managers (covering several prod- separate joint ventures for each major product line: (1) .wash- uct lines) with a sales staff assigned to the department man- ing machines, dishwashers, and microwave ovens; (2) tools ager. Sales staff were directed to focus on customer service and dies and vending machines for hot and cold drinks; and - rather than on preventing theft. The investor also estab- (~) electric and gas water heaters. However, after initial dis- lished centralized buying through the Prague and Bratislava cussions with potential investors, the Tutramat management headquarters. Employees from the Prior stores were given decided that the company's assets should be divided into its training in the investor's buying methods, which included three main product lines. Production of washing machines working with vendors and manufacturers to meet the would be spun off into one joint venture and manufacture of investor's standards, especially in packaging of retail goods. specialty tools and dies into another. Tatramat decided to Both changes reduced the need for some positions, but there retain the manufacturing of water heaters since it felt that it have been no layoffs and any reductions have been accom- could manufacture the water heaters competitively on its own. plished through attrition. The investor expects that within Tatramat also decided to retain the parts manufacture and five years they will have built a local management team, with servicing for all of its former products. local staff managing the company. Competing proposals allowed outside investors to sub- New investors also tried to dispose of all social assets mit offers for less than all the assets of a state enterprise. immediately a&er privatization. At. least in Poland, employee This sometimes benefited investors, as with the purchase housing was often the most troublesome. Fampa sold 706 of the Kyje Bottling Plant in Prague, for which the investor apartments to a cooperative on a 25-year interest-free line submitted a competing proposal that differed from of credit, and the cooperative sold apartments to employ- management's proposal. In other cases, the option of al- ees on preferential terms. Polam Pila had greater difficulty lowing a state enterprise to be sold in bits was to the disad- in disposing of employee housing. Apartments built to at- vantage of the trade investor, as with the Czech producer tract university graduates to Pila could not be sold since of crushed stone, Severokamen. their rents did not cover operating costs, and rent control regulations prevented any rent increases. Domestic investors submitted projects calling for the indi- vidual privatization of 4 of Severokamen's 22 quarries. The REsTRUCTIJRING AS PART OF PRIVATIZATION Some enterprise Ministry of Industry supported these projects and forwarded restructuring was done as part of the privatization process all of the projects to the Ministry of Privatization with the recommendation that the 4 units be spun off and sold to in response to specific offers by private investors. This was Czech investors and that the remaining 18 units be sold to useful in situations in which the constituent parts of a state the foreign investor. However, as pan of the negotiations for enterprise were more valuable t·o investors than the com- the sale contact, the environmental obligations relating to pany as a single entity. Where the enterprise was engaged in the 3 depleted quarries were retained by the original state unrelated industries, some investors preferred to buy only enterprise - controlled by the National Property Fund. the businesses they knew. Of the 22 cases, 7 were sales of assets. In Poland and Such restructuring o&en le& a state enterprise, or a state Hungary this took the form of joint ventures where the gov- agency, with unproductive assets having negligible market- ernment contributed specified assets from the state enter- able value. For this reason, this type of restructuring may prise and the private investor contributed cash. This oc- be a second-best solution. curred in only 1 of the 6 Polish cases. By contrast in 3 (or Despite the need for enterprise restructuring, trade sales ANALYSIS·OF ISSUES 27 ,were still completed.The major forms·of pre-privatization percent of the 'company, particu,arly if the acquired com- _restru~turing were some reduction,of the work force_arid, pany is financially troubled: • -- in two cases, refinancing of debt. In both cases the debt On the' other hand, governments have large financial refinancing made the, privatization of the state asset even obligations, and equity shares were thought to be an easy more difficult, and in one case ideft major issues open, and inexpensive way to cover'the obligations: And shares in since not all parties had agreed to tpe terms of financial companies with strategic investors were generally thought restructuring.. _ _ to be more valuable than shares in companies privatized by By contrast, investor restructuring after privatization other-means. In addition, governments in Central Europe was yery successfµl. Apart fr~m disposal of social assets, often used equity in privati:ied companies to satisfy a myriad the cases suggest- no instances in which_ the government of objectives. They used equity to provide incentives for could have efficiently restructured state enterprises before workers to support privatization, and for investors to meet privatization. their capital investment commitments. But governments also Despite the strong need for enterprise restructuring, used shares to satisfy their own revenue obligations - as such efforts should be left-to private investors, in particu- finan~ial restitution.to former property ~wners, as sources lar, the investment of new c~pital and other forms of finan- o_f income for local governments,. and as compensation to tjal resµucturing. However, as a measure to encourage in- investors for assuming environmental risk. . ~estor interest where none :i~ present, investor.s should be encouraged to sµbmit offers for selected assets held by state EMPLOYEE SHARES In Poland, Hungary, and the Czech and enterprises. In ili,is way, restructuring by the government Slovak Republics, shares of privatized companies were set can be limited to-responding to detaile_d ~vestor propo~als, aside for company employees. Privatization legislation in whi~h will theri be ~plemented as part of a trade sale Poland mandated •that 20 percent of the shares of every privatization. ; privatized company be set aside for the company's 'work- ers. In. Hungary the airi6unt of '~mp}oyee shares was gener- Government Ret~ntio'n of Equity. Sbar~s. ally set at 10 percent of the company's equity. In the Czecl;i One poss_ibility\~ai c9uJd increase investor 'interest would and Slovak Republics ~mployee sh.ares were limited to no be for governments to'minimize, and if possible avoid, re- more than 5 percent of the capital of the privatized com- taining partial holding~~ privatized enterprises: In all ~oun- pany. - . tries utjdergoing privatitation of si:ate ~ompanies, the ques- The prices for employee shares, however, differed. Th~ tion of bwnership Strµciure is ~~nsitive and controversial. Polish law set the price at a substantial discount - 50 per~ 'Irade investors g~rierally insist qn majority control of th~ cent of the nominal price (based on the company's boqk acquired co~panies'. ·For some irivestors_ this is a simple value). However, in four out of six case studies, 'employee's majority of 51 percent of the shii'es. Other investors ~ant failed to buy the allotted shares. In two ca~es (Porcelana enough equity (ei~et 66.67 or 75 percen~ of tlie shares, and Kwidzyn) workers were offered subsidized financing- depending .on the c'ountry's commerci~l codes) -to b~·able but they still did not buy the shares and instead requested to change the co~pa~y's statutes, if necessary. Some buy- that share~ be made av!illabl~ free of charge. In two Polish ~rs adopt as a cotpqrate policy the requirement that they c~se studi~s; employe~s pu~chased virtually all discounted purchase all the equity. bn th~ other hand; governments shares.- But'in both ~ases (F~mpa and Pol~ P~fo:), Bie in° are concerned ahqut the political impact.of selling offthe ve~tor had promised an immediate buy-back ~f the shares shares in ~tate enterpri~es'. particularly. when the ·investors at the full nominal ~alue'. The irivestor bought the shares to are foreigneri. ' ' ' ' iiicrease its control over the company:__ and to ensure that· - Yet to resµucture the privatized c9mparries, and to add , to n~ shares were s~ld possible cO~petitors; or other out- valu~ to.theirJ.nvbtmerit,' trade inve~tors generally-need tq side shardioldets.' In Fainpa the only shares retained by c~ntrol all the shate~ 'in the' acquired compacies. J:nt~~ests ' employees were held by coiripany managers. held by other investors necessarily dilute the shareholding ' fu'Hungary, employee shares wei-e sold at a minimum of the strategic 4Ivestor l:lfld thus make it more'difficult to - price of 50 percent of th(! market price, although, undet - restructure the cdmpany _as ne'eded: Furthermore, the_sti-a- Parliament~approved asset policy guidelir_ies and the State - tegic investor is the one to pour time and energy into re- Property Agency's own regulatio:ns, other restriction~ o~ building' and r~vitalizing the privatized company. Many in- preferential'prices for employee shares al~o applied. These' vestors feel that if they take all the risk of restructuring and restrictions were based on the number of company employ- reorganizing a company, they should receive all the increased; ees and the minimum animal wage levels. Only two of seven value for the company, and that :minority shareholders -are Hungarian cases included employee shat~s at preferential free riders. As a'result, 'some'corpbrate inv~stors are reluc- 0 prices. tant to invest where they'cahnot-purchase arid control 100 'By contrast, k '-i:he Czech and Slovak Republics the 28-. SELLING STATE COMPANIES TO STRATEGIC INVESTORS, VOLUME ONE new owner of the privatized company could sell_ shares to a minimum inv~stment program, some of which was - often employees at any price belo~ the nominal value of the shares in the form of noncash contributions, such as management - as long as the company's owner had initially putchased training and the use of trademarks and licensed technol- ;t he shares at the· nominal value,: and no more than 5 per- ogy. This was seen in the case study on the Czech producer cent of the company's capital was .allocated for such em- of crushed stone, Severokamen; . . . ,• . . ployee shares, and the nominal val~e-of shares per employee did no~ exceed Kcs 20,000 (or about US$670). Employee As part of the sale contract, the investor made a commit- shares were made avaµable in four of nine Czech and Slo- ment to invest a total of £5 .5 million (US$.8.3 million) over a period of ten years, particularly in the areas of capital expen- vak case studies, but for at least one company in the Czech diture and ~echnology transfer, the latter including profes- Republic employee shares were intended for company man- sional training for Severokamen management. This invest- agers and other "key" employees: ment would raise. the· investor's shareholding.to 60 'percent and would thus give majority control to the investor while For the _ Czech manufacturer of writing instrume~ts, diluting the stake of other shareholders. The share purchase Centropen, a transfer of 5 percent of the shares to employ- agreement stipulated the formula for crediting in-kind in- ees was the maximum amount allowable by the Czech Com- vestment, which was to be valued by an fudependent firm. • ' mercial Code. The employee shares were reservedfor30 key employees and managers who were agreed upon at a share- The voucher program appears to have had a mixed holders' meeting after privatization. As was specified in the impact_ on trade sales. In the Czech·and Slovak Republics; Commercial Code, these employee shares were not tradable outside of the company. • • vouchers were an important method of rapidly transferring thousands of state enterprises to· the private sed:oi:-. While Although etnpla'yee shares we~e meant to increase they did not immediately raise new capiti:i'.l forstate compa- worker support for privatization (at least in Poland) none nies, they established a market where shares in former state of the Polish case studies r~vealed high worker suppod based enterprises could be freely traded. In addition, •the pres- on cut-rate prices for company shares. Only two Polish ~ases ence of the voucher program put.pressure ,on government describ.e d the reasons for empioyee support for privatization, and investor negotiators to·come to an ·agr~ement. How- and they cited th~ prospect of higher wages owing to the ever, the set aside of shares for vouchJi-s •also limited the elimination of the excess wage tax, and anticipated higher equity available for sale to strategic investo~s. profitabiJity with a strate~c inv_estor in charge_ . Indeed, em- In six of the nine Czech and·Slovak ~ase studies the ploy~e .shares were not mentjoned in a single case as area- set-aside ofshares for vouchers did not create a problerii son cited by workers or man·a gement for supporting for investors. The companies expec~edto i,mmediately coni~ privatization. This suggests that, to encourage bro_ ad em- p~ete the capit::ilinvestment program ~rid thereby acquire a ployee support for privatization, measures other than dis- majority shareholding: They viewed voucher holders as rni- counted share prices should b~ considered. • •• norio/ shareholders ~th little impact bn the ~ompany' s op- erations. In th~ee, cases; however, investors decliQed to buy SHARES FOR VOUCHERS AND CAPITAL !NvESTMEN; , To counter state companies if they could not 'pur~hase 100 percent. criticism of a sellout to foreigner~ and to ens~r~ that protn~ This;was· seen, for example, in the ~cquisition ~f th~ Prior ised capital investments would be made, the Czech govern- department stores: As a corp6rate policy, the investor de- ment often limited the initial amount of shares sold to trade purchase 'all the equity. While clined to invest if it could not_ investors -to a minority sha~eholding'. A substantial prop~r- mostinv~stors insist only on co~troi ofthe ~tqQired com- tion of° sli~es was ~et aside to be ~old through voucl}~rs. It pany - and freedom from government interfer~nce in ii:~ w?.s oi:ily wit~ the completion of the capital investment plan operations - some insist on full ownership. Particul~ly·if • that adru,tional shares would be issued to investors, and th~ major ·restructuring of the company is requir~d. such: inves- increase in share capital ~ould dilute the aggregate hold. tors prefer riot .to h1:1ve minority sharehplder~ .in their ~: vestments. ' • • • ••• • : • • ings of voucher holder~. Th~ ~se of the share ~t~cture 'to encourag~ compliance with investment cornmitm~nts had •. The government's ,Policy sho~ld irtcorporate'_ other' orie major ad~~htage over investment penalties. It provided forms of priva~ation (including youcli~rs) _ but 'the' policy strong incentives for investors to meet their· commitments shoul~ ,also permit invest.ors.to buy ~t least majority con- while a~oid~g the n~ed for legal actio~ or arbitration t~ trol, a~d up to mo percent of th~ eq~~ty ,of the ~?mP!l_ ny. ensure ~o~pliance. . . . • •• . • • •' In six of the nine Czech and Sl~vak case studies the SHARES FOR REsn:runoN PRO<;iRM1S Restitution for past inhial sal~ to the trade investor ~~s. f~r'a min~rity . policies of the socialist.gqyernrneti.t~ was a sensitive issue in shareholding. But the sales contracts provided for an:lm- countriesin.Ceptral,Europe; In tlie'Ci~ch and Slovak all _ mediate increase to a majority stake with the completi~n ~f Republics the origin1:1~ rrop~rtie~ were re~ed . t o the origi- ANALYSIS OF ISSUES 29 nal owners, and in addition a standard 3 percent of the shares vealed that the government sometimes exchanged shares of all privatized enterprises was transferred to the Restitu- for future environmental cleanup expenses, although it was tion Funds established by the National Property Funds. If not government policy in either country. This was seen in there were specific restitution issues outstanding, additional the case study of the Polish light bulb manufacturing com- shares were also transferred to the Funds. It was expected pany, Polam Pila, where the shareholding of the investor that where the original property had been destroyed, or was increased from 51 percent to 66. 7 percent in exchange could not be returned to the original owner for other rea- for assuming environmental liabilities. In the Slovak case sons, other compensation would be made. of Tatramat, the National Property Fund retained about 10 In Hungary the government offered compensation cou- percent of the company shares to cover environmental li- pons. The coupons were issued on the basis of the amount abilities related to washing machine manufacture. As with of property illegally seized after 1939 with a maximum of financial obligations from restitution claims, to improve Ft 5 million (or US$50,000). They could be used for sev- trade sales strategic investors should be given the option of eral purposes, including the purchase of shares of privatized paying cash in lieu of shares. companies. The Hungarian compensation coupon program avoided SHARES FOR LoCAL GOVERNMENTS The Hungarian govern- many of the property title controversies in the Czech and ment also used shares in privatized companies as a method Slovak cases. But it also meant that the government was of generating income for local governments. The number obliged to set aside shares for the program. In theory, 10 of shares was based on the "value" of the land held by the percent of the shares of privatized companies was to be set state enterprise. The need to gain the support of local gov- aside for compensation coupons. In practice, the amount ernments was often thought to slow down trade sales, but varied for each case. Popular concern over the "quality" of this was not supported by case studies. Even at Csemege, shares placed in the program caused the secondary price with 124 food stores throughout Hungary, shares for local for compensation coupons to fall substantially below par. governments was not an issue. Thirty-four municipalities In rnid-1993 the coupons were trading at only 35 percent received 8.6 percent of Csemege's shares without substan- of their face value. tially delaying the process. The compensation coupon program was an issue in two Poland adopted a different approach for settling prop- Hungarian case studies. For example, the investor in erty claims. Rather than giving shares to the local govern- Zalakeramia (the tile producer) complained of the prob- ments, investors were given the right to make cash payments lems of being in a joint venture with the government - to the municipal governments. In 1992 Hungary changed and of the government's reluctance to allow dilution of its its legislation to adopt a similar approach. holdings. In one case in the Czech Republic, however, the inves- tor agreed to set aside shares for the local governments: for In Zalakeramia, the investor claimed that the participation Severokamen, 3.28 percent of the shares was transferred ofZalakeramia shares in the compensation coupon program to the local governments to cover past and future claims for created an "overhang" of additional shares. This had the ef- relocation costs incurred during the development of new fect of depressing the market price for Zalakeramia shares quarries. There were no such transfers in non-Hungarian and thus reducing the market value of the investor's mutual cases. fund which included some Zalakeramia shares. In addition, the investor referred to the difficulties of having the govern- Although shares for local governments raised a prob- ment as a joint venture partner. The investor wanted to fi- lem in one case study, the issue may be more of a problem nance needed capital improvements through an issuance of in other trade sales. The resolution adopted by Hungary of new equity. However, the State Property Agency was reluc- allowing investors to make cash payments rather than giv- tant to either allow a dilution of its shareholding in ing shares to municipalities would be a workable solution. Zalakeramia or provide cash to fund its share of the capital improvements. In the end, the investor put pressure on the State Property Agency to divest all government holdings of SHARES HELD BY A STATE HOLDING COMPANY In addition, Zalakeramia shares. in Hungary about 160 state enterprises were held by a state holding company (AV Rt). The companies were considered An alternative to setting aside shares for financial resti- to be important strategic activities. By law, AV Rt was i;-e- tution would be to allow the investor to make a cash pay- quired to maintain a minimum level of ownership in the ment to the government's restitution fund in lieu of shares. shares, generally 25 percent or 50 percent plus one share. The government could then make direct cash payments to None of the case studies included companies held by the holders of compensation coupons. state holding company, but such limitations on sales of shares to investors would be expected to restrict the government's SHARES FOR ENVIRONMENTAL CLEANUP Two case studies re- ability to sell the remaining shares to trade investors. 30 SELLING STATE COMPANIES TO STRATEGIC INvESTORS, VOLUME ONE Reliance on Valuations in Setting Sale Prices cash flow periods. This exercise resulted in a range from Zl One of the most sensitive issues in trade sales is the sale 67 billion to ZI 248 billion (US$7.l million to US$26 mil- price. Critics of privatization complain that the government lion). The adviser dismissed the discounted cash flow valua- tion, arguing that it required excessive guesswork and that is "giving away the family silver" and that the price of any therefore the final results were unreliable. Two additional valu- state enterprise is too low. To protect themselves against ations were conducted, based on net asset values and price- such criticisms, most governments require market valua- earnings ratios. The net asset valuation was ZI 47.773 billion tions of enterprises that are to be privatized. . (US$5.03 million), while the price-earnings ratio resulted in Typically in Central Europe the government (cir its ad- a valuation ranging from US$5.8 milli~n to US$9.1 million. visers) prepared two market valuations: (l) a business valu- The Hungarian refrigerator manufacturer, Lehel, dem- ation based on the future earnings, or cash flow, of the en- onstrated the difficulty in estimating future earnings - not terprise; and (2) an asset valuation, or "book va.lue" of the •an uncommon problem even in fully developed stable mar- company, used as the opening balance sheet when the state ket economies. enterprise was transformed into a commercial company. Both forms of valuations had their weaknesses. In February 1990 Lehel's enterprise council decided that a Business valuations were difficult to estimate, particu-. business valuation should be undertaken to enable the en- terprise to negotiate more effectively with foreign investors larly in the rapidly changing economies of Central Europe and appointed an international accounting firm to conduct in 1990-92. In the case studies, business valuations were the valuation. Later, after the State Property Agency was es- generally prepared using two te.chniques common in mar- tablished, the Agency asked an international investment bank- ket economies for operating companies: discounted cash ing firm to prepare a second business valuation. Lehel's man- flow projections and price-earnings ratios (also known as agement disagreed with the banking firm's valuation, par- ticularly, according to the Lehel management, with the broad market multiples). The governments of Central Europe did range of values presented by the adviser, which had the ac- not adopt a uniform methodology for business valuations, •coun. ting firm's value as the midpoint .of the range. The and even within each country there were frequent differ- broader range stemmed from the banking firm's treatment ences. However, to a large degree, the Polish cases tended of wide fluctuations in Leh el' s earnings. In 1989 Lehel' s prof- to rely on both discounted cash flow projections and price- its had fallen to Ft 310 million (US$5 million) as a result of the introduction of the value-added tax, for which the enter- earnings ratios, while the Hungarian cases used primarily prise was not able to adjust prices immediately. In 1990 Lehel discounted cash flow projections. In former Czechoslova- adjusted its prices accordingly and profits increased to Ft 848 kia the policy was that state enterprises would be sold to million (US$13.8 million). The banking firm claimed that domestic investors at the "book value" and to foreign in- the 1990 earnings were unusually high whereas the Lehel man- vestors at the "market value." In all the Czech and Slovak agement claimed that the 1990 profit level was potentially sustainable, as was later evidenced by the 1991 profits of Ft case s~dies, market value was interpreted to be book value 600 million (US$7.9 million). net of adjustments. The adjustments reflected the differ- ences between domestic acc~unting laws and international The range of business valuations varied widely. In the accounting stand\lrds, such as provisions for uncollectible 11 case studies for which business valuations were avail- debt.s and for obsolete inventory or.other unusable ,issets. able, the highest valuation was 180 percent of the lowest (More recently the Czech government has also relied on value. In one case - that of the Polish light bulb manufac- discounted cash flow projections to determine market •turer Polam Pila - the range was over 600 percent. value.) • Furthermore, business valuations were often difficult Some of the case studies provide rich detail on the to use because they were viewed differently by private in- preparation of valuations by the government advisers. vestors and governments. Private investors, whether sellers Fampa, the Polish manufacturer of papermaking equipment, or buyers of a company, focus on the assumptions embed- was the first trade sale in the case studies and was com- ded in the v~luation and; in particular, on the basis for esti- pleted in February 1991. Following government instructions, mating future earnings and on the."risk adjusted" discount the advisers prepared complex discounted cash flow valua- rate used for the net present value calculation. These valu- tions and then dismissed them, turning to valuations based ations provide background for the investor's negotiating on net assets and on price-earnings ratios. All the valuation . strategies and determine a range of prices acceptable to the methods generated a wide ra~ge of values for the company. investor based on the investor's own guesses for the future and appetite for risk. In addition, business valuations vary For Pampa, the financial adviser conducted a valuation, em- depending on the corporate strategy of different investors. ploying three methods. It first conducted a discounted cash Most international businesses look for an opportunity to flow valuation using several potential scenarios - base case, optimistic, and pessimistic. The valuation used discount rates "add shareholder value." They look for ways to reorient the of 17.5 percent and 22.5 percent over 5-year and 15-year operations of the acquired company and thereby increase • ANALYSIS OF ISSUES 31 •• its market value. Depending on their,