''''~~~~~~~~~~~ 19 9:: - ~~Foreign Investment Advisory Service Occasional Paper 8 Facilitating Foreign Participation in Privatization Kathy Megyery Frank Sader Foreign Investment Advisory Service a joint facility of the Intemnational Finance Corporation and the World Bank I Foreign Investment Advisory Service Occasional Paper 8 Foreign Investment Advisory Service a joint facility of the International Finance Corporation and the World Bank Facilitating Foreign Participation in Privatization Kathy Megyery Frank Sader The World Bank Washington, D.C. © 1996 The International Finance Corporation, and the World Bank, 1818 H Street, N.W., Washington, D.C. 20433 All rights reserved Manufactured in the United States of America First printing January 1997 The International Finance Corporation (IFC), an affiliate of the World Bank, promotes the economic development of its member countries through investment in the private sector. 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Library of Congress Cataloging-in-Publication Data Megyery, Kathy, 1962- Facilitating foreign participation in privatization / Kathy Megyery, Frank Sader. p. cm. - (Occasional paper / Foreign Investment Advisory Service; 8) Includes bibliographical references (p. ). ISBN 0-8213-3824-2 1. Privatization. 2. Investments, Foreign. I. Sader, Frank. II. Foreign Investment Advisory Service. III. Title. IV. Series: Occasional paper (Foreign Investment Advisory Service) ; 8. HD3850.M44 1996 338.9'2-dc2O 96-36763 CIP Contents Abstract v Preface vi Acknowledgments vii Executive Summary viii 1. Introduction 1 2. The Role of Foreign Investment in Privatization 2 Why Privatize? 2 Why Sell to Foreigners? 3 3. Fundamental Principles of Successful Privatization 7 Three Overarching Principles 7 Political Commitment 8 Business Orientation 8 Fairness and Transparency 9 The Application of these Principles 9 4. Privatization Strategy 11 The Need for a Political Master Plan 11 Company Selection 11 Government Stake 12 Privatization Methods 13 5. The Legal Environment 17 The Basic Requirements For Privatization 17 Review and Adjustment of the Existing Body of Law 17 The Law on Privatization 19 The Regulatory Framework 20 6. The Institutional Framework 22 Introduction 22 Depoliticizing the Institutional Framework 22 Institutionalizing Privatizations 23 Creating a Business-Oriented Privatization Agency 26 iii 7. The Process of Privatization: Step-by-Step 28 Company Selection 28 Preparation for Privatization 30 Asset Valuation 32 Preparation of the Sales Guidelines 33 Sales Announcement and Promotion 33 Registration of Interest 34 Pre-qualification 34 Bid Evaluation 35 Authorization and Contract Adjudication 36 Divestiture 36 8. Conclusion 38 Annex: Foreign Investors Surveyed 39 List of Tables 1. Overview of Implementation Resources 26 2. Sample Evaluation Criteria 35 List of Figures 1. The Importance of Scope and Stability of Privatization 5 2. Successful Privatization and FDI Inflows 6 3. Fundamental Principles of Successful Privatization 7 4. The Impact of Fundamental Principles on Key Aspects of Privatization 9 5. Institutional Framework Functions 24 6. Privatization: The Step-by-Step Process 29 List of Boxes 1. The Perspective of Foreign Investors on Fundamental Principles 10 2. Basic Guidelines on The Treatment of Investors: An Illustration 18 3. Dealing With Claims of Former Owners: Two Approaches 19 4. Privatizing Infrastructure: Experiences in Argentina and Peru 21 5. The Privatization of a Polish Chocolate Factory 23 6. Poland: Five Privatization Ministers in Five Years 24 7. Hungary: The Problem of Dual Authority 24 8. Peru: Example of a Well-Structured Institutional Arrangement 25 9. The Selection of Companies for Privatization: Two Approaches 29 10. Hungary: Leaving Major Restructuring to Investors 30 11. Hungary: At the Service of Investors 33 12. Price-Based Selection in Peru and Argentina 36 iv Abstract Foreign direct investment can play an important governments have to take into considera- role in making a privatization program success- tion investor concerns. Political commitment, ful. The inclusion of foreign investors increases business orientation, and transparency are fun- the pool of potential bidders with strong finan- damental principles of any successful privatiza- cial resources and technical expertise, raising the tion program. Only if every element of the pro- chances for these enterprises to be transformed cess-from the design of the general political, into efficient and profitable entities. But foreign legal, and institutional framework down to investors will not just automatically participate every single step in the actual sales procedure- in any privatization. In order to design an attrac- is based on these principles, can a government tive privatization program, developing country expect strong participation by foreign investors. v Preface In recent years, the developing world witnessed Mozambique, Peru, the Philippines, and Poland, a rapid increase in foreign direct investment where we conducted field research between inflows. A number of countries used the sale of September 1994 and March 1995, we tried to state-owned enterprises as an effective instru- identify the major impediments and enabling ment to attract foreign investors. However, not factors in attracting foreign investors in privati- every country which pursued a policy of privati- zations. The countries surveyed were selected zation found itself automatically subject to for their geographic, political and economic strong interest from investors from abroad. In diversity as well as their strong experience in fact, a number of countries seem to have difficul- privatizations. Within their regions, each of these ties in attracting foreign investors as active par- countries stands out as having one of the most ticipants in their privatization programs. In active and intensive privatization programs. order to develop a better understanding of this Based on the review of these privatization pro- mixed performance of foreign direct investment grams combined with interviews at the head- in privatization programs, the Foreign Invest- quarters of about thirty foreign investors, we ment Advisory Service (FIAS), member of the have attempted to isolate the fundamental World Bank Group, together with the Canadian principles underlying successful privatization. consulting firm Groupe Secor, undertook a Based on these experiences we tried to develop review of the major privatization programs in some best practices in structuring and managing the developing world. privatization with foreign investment, from the With a particular focus on the privatization establishment of the general policy framework programs in Argentina, Ghana, Hungary, Mexico, up to the actual divestiture process. vi Acknowledgments This study has received generous financial the individuals, government officials as well as support from the Canadian International Devel- company employees, who were so kind to sacri- opment Agency (CIDA). FIAS is indebted to all fice their time and share their views with us. vii Executive Summary In recent years, an increasing number of devel- chances for the government to select the best oping countries have embarked upon extensive suited bidder to turn a SOE into a profitable and privatization programs within the framework of efficient entity. In addition, the fact that foreign macroeconomic reform and liberalization. How- investors can freely participate in a privatiza- ever, the performance of these individual privati- tion program advertises the country as an attrac- zation programs differed substantially, especially tive investment location, and additional FDI with respect to foreign direct investment (FDI). flows in, further supporting the private sector The most successful privatizers managed to sell development. numerous state-owned enterprises (SOEs) with But foreign investors do not just jump on any strong participation by foreign investors. At the privatization opportunity that presents itself. A same time, FDI inflows not related to privatiza- review of some of the most successful privatiza- tion sales also increased rapidly, reflecting the tion programs in the developing world shows increased confidence of the foreign investor com- that foreign investors are particularly loath to get munity in these countries as attractive invest- involved in a highly politicized environment, ment locations. Many other countries, however, marred by excessive bureaucracy and unpredict- have been struggling. The number of privatiza- able decisionmaking. While investors tend to be tion transactions as well as the sales volume sympathetic to the political difficulties surround- remain small, and interested bidders from ing the sale of SOEs, they want to see a firm com- abroad are generally absent. Overall FDI flows to mitment by the government to the reform pro- these countries also remain stagnant, contrary to cess in general as well as individual privatization the general experience of rapidly increasing transactions. Participating in a privatization sale inflows to developing countries worldwide. is resource-intensive and expensive for foreign This correlation between the success of priva- investors. They will be hesitant to enter into a tizations and a country's attractiveness to for- privatization if they get the sense that final sales eign investors is not accidental. In fact, a strong decisions are based on criteria other than the participation by foreign investors is a reflection technical and financial elements presented in bid of the attractiveness of a privatization program, proposals. The more they feel that they are wast- and is therefore in itself an indication of success. ing their time in an unnecessarily bureaucratic More importantly, strong foreign investor and convoluted process, confronted with too involvement plays an important role in support- many government officials who lack the neces- ing the effectiveness of a privatization program. sary skills, the more they will be tempted to walk The inclusion of foreign investors as active away and not to bid. participants raises the level of competitiveness If a country wants to derive the maximum of the bidding process. Higher bid prices benefits from its privatization policy, it has to and stronger technical proposals increase the make sure that the program is sufficiently investor viii friendly. As long as foreign investors feel com- * The agency should have the right to select fortable with the skill level, commitment, and individual state enterprises for privatization decisionmaking authority of their government primarily based on market criteria, free of counterparts, they will also feel comfortable in any political disputes regarding their avail- participating in the privatization process. On the ability for privatization. other hand, any attempts to limit the involve- In preparing a particular enterprise for ment of foreign direct investment can cause sub- privatization, the agency will have to make stantial damage to a country's privatization pro- sure that all the pertinent information is gram in the eyes of the public as well as the available to and easily accessible for inter- foreign investor community. ested investors. An attractive privatization program should therefore be characterized by three fundamental * Prior to the sale, some SOEs might require principles: political commitment, business orien- restructuring work to make them attractive tation, and transparency. These are not esoteric to potential investors. However, in order to and theoretical concepts, but should rather be avoid lengthy delays, the agency should applied during the design of a privatization pro- focus on those restructuring activities in gram as the guiding elements in every step of the which the government has a comparative process. For any privatization program to be reli- advantage, such as shedding liabilities or able and attractive to a foreign investor, it has to labor force reductions. Investments in the be publicly declared as a key element in an over- rehabilitation or expansion of existing facili- all reform process. The process should be ties should be left to the new private owner. embedded in a simple, but comprehensive legal * Privatization agencies typically undertake a framework which clearly specifies the scope as valuation of the assets to be privatized in well as the decisionmaking authority for the order to determine an acceptable sales price. divestiture program. However, asset valuation is more an art than To implement a privatization program, an a science, being very much dependent on appropriate institutional framework has to be the underlying assumptions and methods designed based on these principles. While no applied. The only true assessment of a com- two institutional setups are alike, one fundamen- pany's market value results from a competi- tal rule is that the individual sales process has to tive bidding process. Agencies therefore be separated from general policy decisions. The tend to fare better when more resources are privatization agency's primary concern should applied to the attraction of potential bid- be to efficiently conduct sales transactions, and it ders, rather than on the determination of an needs the necessary authority to do so, free from artificial asset value. any political interference. To obtain the finan- cially and technically most attractive offers, the * When announcing a SOE for sale, the agency will have to focus on having as many agency has to make sure that the company is competitive bidders as possible participate in the advertised for a sufficiently long period of tender. time domestically and internationally, to To create an attractive privatization program, allow potential bidders to prepare an ade- the agency will face the challenge of combining quate and sincere response. The agency the political requirements of privatization with should register these expressions of interest, an investor-oriented sales process. Experience and should engage in a strong promotion of reviewed in this paper shows that privatization the company to maximize the number of agencies are more effective the less they are bidders. involved in the political process of privatization. * Transparency is key in the selection of the In fact, the more time and energy the agency's winning bidder in order to avoid criticism staff can invest in serving potential investors, the from investors as well as the public that more likely is the success of the overall privatiza- decisions have been reached in a biased and tion program. unfair manner. In the pre-qualification as Care should be taken to make this investor ori- well as the final evaluation of bids received, entation a cornerstone in all the steps of the the agency should ensure that all decision privatization process: criteria are clearly specified and known to ix all interested parties. The more the final objectives. Many developing countries lack a suf- decision is based on simple quantitative ficiently large pool of private sector expertise comparisons of the various bids, rather than precisely because of the previous dominance of qualitative judgments, the less likely it is the public sector. This can, and should, be that the agency will be subject to damaging overcome by making extensive use of external criticism. advisors and consultants with international * The eventual transfer of the assets to the experience. winning bidder should be handled as fast as Such advisors can be especially helpful in the possible. In many cases, privatization agen- promotional aspects of the privahzahon pro- cies engage in lengthy post-bid negotiations cess. Most privatization agencies have not been on key elements of the contract. But if inves- particularly successful in developing a strong tors are led to believe that the tender is outreach program, capable of generating addi- mostly an administrative step with every- tional interest for particular SOEs in the interna- thing open for negotiation afterwards, they tional markets. Especially foT medium-sized have no strong incentive to provide sincere enterprises, investment promotion is often and reliable offers during the bidding neglected, with the scarce resources available process. being used primarily for the largest, and there- fore most visible, projects. A stronger promo- To conduct such a privatization process effec- tional effort can support the overall success of a tively requires a highly trained and skilled staff, privatization program simply by attracting addi- familiar with private sector motivation and tional bidders. x 1 Introduction Over the past decade, an increasing number of Canadian consulting firm Groupe Secor, under- countries have embarked on programs to priva- took a review of the major privatization pro- tize public enterprises, reversing the earlier grams in the developing world. We selected a set strategy of public enterprises as the engine of of eight countries-Argentina, Ghana, Hungary, economic development. Indeed, the pace of Mexico, Mozambique, Peru, the Philippines, and privatization has increased dramatically over the Poland-which are considered to have extensive past five years. In the period 1988 to 1994, devel- and successful privatization programs in their oping countries around the world sold about respective geographic regions. Based on a de- 3,300 state-owned enterprises (SOEs) with sales tailed study of these programs as well as inter- revenues rising from only US$2.6 billion in 1988 views with about thirty large foreign investors, to a peak of US$29 billion in 1992. Foreign who have been active in these programs, we investors played an important role in this pro- tried to identify the major impediments and cess, representing about 40 percent of the total enabling factors in attracting foreign investors in sales revenue of US$112 billion accumulated privatizations. during this period.' This report attempts to isolate the fundamen- However, while the number of countries tal principles underlying successful privatiza- undertaking privatization programs is steadily tion, and to develop some best practices in struc- increasing, not all of them are equally successful. turing and managing privatization with foreign On the one hand, Argentina, one of the most suc- investment throughout the process. Rather than cessful privatizers in the world, effectively man- providing a detailed review of the individual aged to complete its divestiture program in a privatization programs studied, we use these four-year period. Since 1990, it has sold about specific country experiences to underline the 120 major enterprises for US$17.4 billion, includ- findings. While some countries might be cited ing foreign investment of US$8.2 billion and the more often than others as negative examples, it is retirement of almost US$18 billion in external important to keep in mind that all these coun- debt.2 Many other countries, on the other hand, tries have been quite successful in implementing burdened by political difficulties, struggle along privatization, especially when compared to with only a few sales per year and a lack of inter- many other developing countries. ested buyers, especially from abroad. In order to develop a better understanding of Notes this mixed performance of foreign direct invest- ment (FDI) in privatization programs, the For- 1. The World Del,t Tables, 1996, Appendix 8, The World Bank, Washing- eign Investment Advisory Service (FIAS), mem- ton, D.C. ber of the World Bank Group, together with the 2. World Bank Privatization Database. 1 Thne Role of Foreign Investment in Privatization Why Privatize? taxation, reduce the public sector deficit or repay domestic and foreign public debt out- State-owned enterprises, initially thought to standing; enhance the process of economic development, * reduce and/or eliminate the financial drain performed disappointingly in most developing of SOEs on the State through subsidies, countries. Financial losses resulting from ineffi- unpaid taxes, arrears, etc.; cient management, antiquated technologies and bloated workforces often posed a major burden * limit potential future demands to provide for already hard-pressed public budgets. For capital for expansion and upgrading or the example, in 1989 SOE losses as a percentage of rescue of SOEs in financial difficulties. gross domestic product reached 9% in Argentina and Poland, while half of Tanzania's 350 SOEs Efficiency and Economic Development persistently ran losses that had to be covered from public funds.3 Eventually, economic reali- * enhance the domestic private sector ties became too pressing to be ignored, and an economy; increasing number of developing countries * attract foreign capital and expertise; began to privatize their SOEs. Generally, governments hope that the change * improve the level and/or quality of goods in ownership will decrease the financial and services produced; demands made by SOEs on strained government . romote the economy's efficien and com- budgets, and that it will improve the efficiency of yt. the economy, resulting in an overall net positive effect on the country's economic and social * promote innovation through better access to development. However, depending on the exist- new technologies; ing political environment, there is a vast array of a develop efficient capital markets. additional specific objectives that governments might want to pursue in the process of privatiza- Distributional Objectives tion. All these objectives can be grouped into four broad categories:4 * foster broader, widespread capital owner- Financial Objectives ship combined with the development of a national middle class; * maximize net proceeds of divestiture in * encourage economic development of a par- order to fund other expenditures, reduce ticular group in society; 2 * promote employee ownership to elicit pub- cles when formulating a privatization strategy. It lic support for initially costly liberalization will depend largely on country specific condi- policies; tions. However, governments should never lose * restore full property rights to previous sight of the primary motivation for privatization: owners. to transform SOEs into efficient and profit-mak- owners. ing private enterprises. Political Objectives Privatization will have its greatest impact on national welfare if the efficiency objective is par- the size and scope of the public sector; amount. A competitive and profitable enterprise rec 1is the most effective mechanism against unem- * reorient public administration efforts away ployment, for future investments, and for the from public production towards engaging in development of a private sector. The potential of enabling and regulatory activities; a well-functioning private sector is also the most reduce opportunities for corruption and effective way to attract foreign investment. A exploitation of public assets by governmient strong effort to privatize, with efficiency gains at officials and SOE managers; its core, sends a strong message to foreign inves- official andSEmanagers;tors that the host country is willing to open itself * reduce the influence of particular pressure up to private entrepreneurship and to provide groups such as parties, the bureaucracy, or support to private economic activity and compe- labor unions; tition. * reduce the possibility for a successor gov- Why Sell To Foreigners? ernment to reverse the privatization process. All these objectives may, and often do, conflict. Few issues related to privatization are as conten- For example, any limitation on eligible investors tious as the sale of state enterprises to foreigners. through preferential treatment of employees or In most countries with a long history of publicly- specific domestic investor groups will jeopardize owned companies, the general opinion is that the goals of revenue maximization and company SOEs represent the fruits of decades of domestic efficiency. Dispersed ownership can also pose savings and investment. Thus, the sentiment difficulties to enterprise efficiency. If ownership often is that these enterprises belong to the peo- is spread too broadly in support of local capital ple and should not be given away to foreign markets and the involvement of domestic inves- interests, amounting to "selling the family tors, efficiency of the company might suffer due jewels". Any opposition to large-scale privatiza- to the lack of a strategic investor. But too many tions, typically motivated ideologically or by goals may not only conflict, they might even concerns about the potential loss of economic jeopardize the viability of a privatization pro- rents, can generate strong public support gram as a whole. Thus, attempts to accomplish especially by appealing to these nationalistic multiple objectives can result in failure to sentiments. achieve any. In order to forestall such opposition, govern- Thus, the definition and determination of ments often send ambiguous signals to foreign privatization objectives is an important step investors. While generally acknowledging the which should be carried out immediately at the benefits of their participation, governments, not beginning of the process. Many privatization infrequently, succumb to political pressure, giv- programs have stalled or fallen apart simply due ing preferential treatment to domestic buyers. to the lack of a clear set of objectives or because Some countries even impose limits on foreign of simultaneous pursuit of incompatible objec- investment to a certain percentage share in tives. Setting objectives is not an abstract domestic enterprises, or prohibit foreign parti- exercise. The government's strategic task in the cipation in certain types of enterprises and process of privatization is to balance conflicting activities. objectives and prioritize them, which will often This behavior clashes with the increasing liber- involve identifying, assessing and resolving alization of foreign investment regimes around policy tradeoffs. the world when the involvement is in the form of No two countries are likely to be facing exactly new enterprises via greenfield investments or the same configuration of problems and obsta- joint ventures with local partners, reflecting the 3 political nature of the privatization decision. A ficulties to collect on the initial promises. By the strategy dominated by short-term political goals end of 1995, after seven years of relatively rather than economic efficiency considerations intense privatization activity, domestic investors can however be quite costly, not only for the have paid only about 17 percent of the total privatization program itself, but also for the pro- investment amount they committed to, com- cess of private sector development as well as the pared to 83 percent by foreign investors. foreign investment climate in the country. However, privatization has implications far The exclusion of foreign investors is detrimen- beyond the sale of individual state enterprises. In tal to the success of any privatization program. fact, privatization should be one of the main The most immediate effect is that the exclusion components of a broad liberalization program, of any potential buyer simply reduces the num- designed to stimulate private economic activity ber of offers received, while the competitive and to tie the country into the global economic pressure among the bidders is limited. A recent system. In many cases privatization represents econometric analysis of 346 privatization trans- an opening of the economy after years of protec- actions in Mexico5 shows that increased bidder tionism and isolation. Foreign investors tend to involvement results in substantially higher sales be careful in evaluating such radical policy prices. In fact, according to this study an extra changes, and they will want to be reasonably cer- bidder in the final auction would have raised the tain that the government is serious about its price by 15 to 20 percent, while the exclusion of reform agenda. Only when convinced that the foreign bidders as a preferential treatment to government is truly interested in creating an local investors had a substantially negative effect attractive and open environment for private on prices. The same argument holds for other business, will they be willing to commit substan- bidding components such as future investment tial resources in the form of investment projects. commitments. Thus, by opening the program to Privatization can be used as an important tool foreign investors, the government simply raises in this process, reflecting the government's com- the probability of a successful privatization pro- mitment to open up the country's economy by cess. It ensures that it will receive the maximum systematically reducing the influence of the pub- price for the enterprise as well as attract the lic sector. And in fact, privatizations appear to strongest investor. have played a vital role in the rapid growth of In addition, the exclusion of foreigners can foreign direct investment to developing coun- also be detrimental to the development of a tries since the late 1980s. A recent FIAS study6 country's private sector. A major problem in shows that during the period of 1988-93, about many economies dominated by public enter- 10 percent of total FDI inflows resulted from prises and isolated from international competi- privatization sales directly. In addition, privati- tion is the general scarcity of domestic entrepre- zation appears to have an important signaling neurs and investors. Technical and managerial function. An econometric analysis for a cross- skills are often scarce, while private savings are section of 36 countries indicates that each dollar too low to satisfy the economy's investment in privatization revenue attracts another 88 cents needs. Many governments find it tempting to of foreign direct investment independent of the use a privatization program to directly create a privatization sales themselves. private sector, giving preferential treatment to This implies that privatizations can have a domestic bidders. Almost invariably, such strong advertisement effect for a country, capa- attempts run into major difficulties, with the ble of generating additional foreign investments. companies sold not improving in terms of effi- However, this is not invariably the case for all ciency and performance, and buyers not being countries that have some type of privatization able to generate the funds to undertake neces- program. Foreign investors will take the perfor- sary investments or even to pay the bid price, mance of the privatization program as an indica- often negotiated as installment payments over tor for the sincerity with which governments time. Especially in poor countries, the most qual- pursue reforms. Figure 1 shows that the size and ified investors are often foreign. In Mozambique, stability of the privatization program has a for example, the government allows domestic strong impact on foreign investment inflows. investors to pay in installments. Most of the In fact, for the period of 1988-93, the countries domestic investors have run up substantial that conducted large privatization programs in arrears, and the government has substantial dif- terms of revenue as well as the countries whose 4 Figure 1: The Importance of Scope program remained very stable and reliable dur- and Stability of Privatization ing this time both received substantially larger privatization revenues as well as FDI inflows per SIZE MAM~ERS capita compared to the developing world as a (Average Vatue for 1988-93 whole. The annual growth of FDI inflows also was larger in both cases. On the other hand, US$ Percentage Growth of FDI (%) other privatizing countries that did not have 80 35 large or stable privatization programs, clearly 30 lagged behind in all three categories. 60 Categorizing the countries based on their abil- 25 ity to establish a successful privatization pro- 20 gram, defined as the combination of size and sta- 40 bility, the effect on FDI inflows over time is i5 impressive (see Figure 2). The most successful 10 candidates managed to establish their credibility 20 by selling a large volume of state assets with a 5 stable involvement of foreign investors over o _vaMe 0 time. Consequently, foreign investors accepted All Developing Largest Other these countries as attractive investment locations Countries Privatizers Privatizers and FDI grew rapidly from only US$6.5 billion in 1988 to almost US$22 billion in 1993. Even more STABILITY MATTERS revealing, when privatization revenues began to (Average Value for 1988-93) decline in 1993 because most of the large enter- US$ Percentage Growth of FDI (%) prises had been sold, FDI continued to rise. On 60 35 the other hand, countries which were only mod- 50 30 erately effective in their ability to establish a siz- 50 \ , 30 able and stable privatization program, FDI 40 _g 25 inflows reached only about US$9.7 billion, hav- 20 ing started at almost the same level as the most 30 - successful privatizers. Finally, for countries which 15 failed to convey the impression of a systematic 20 10 reform program, with individual privatization 10 E __decisions caught up in political indecisiveness 10 5 reflected in small and volatile privatization pro- o 0 grams, FDI inflows effectively stagnated. AllDeveloping Largest Other Thus, privatizations can have a strong impact Countries Privatizers Privatizers on the future development of the foreign invest- n Privatization Revenue Per Capita ment climate. In fact, governments can use Xl FDllnflowsPerCapita privatization programs as a highly effective D RateofGrowthinFDI advertisement tool to attract additional foreign investors. In order to be effective, however, gov- Note: "Largest Privatizers" is based on privatization revenue per ernments will have to convincingly prove to the capita, 1988-93, and includes: Argentina, Barbados, Chile, Czech Republic, Greece, Hungary, Jamaica, Malayisa, Mexico, Portugal, foreign mvestor commumty that they are com- and Venezuela. 'Very Stable Privatizers" is based on the continuity mitted to a serious reform program geared of the divestiture program, and includes: Argentina, Chile, Czech Republic, Hungary, Jamaica, Malaysia, Mexico, the Philippines, and towards a liberalizaton of the business environ- Portugal. ment. The most convincing proof certainly is the Source: World Bank Privatization Database. effective withdrawal of the state from the eco- nomic sphere. Only when investors recognize that the country promises to be an attractive in- vestment location, free of unnecessary govern- ment interference, will they be willing to risk their own funds to establish long-term operations. 5 Figure 2: Successful Privatization and FDI Inflows US$ Billions SUCCESSFUL PRIVATIZERS 25 _ Other Privatization Revenue_l 20 * FDI from Privatization \ Total FDI Inflows = 15 10 5 0 1988 1989 1990 1991 1992 1993 MODERATELY UNSUCCESSFUL US$ Billons SUCCESSFUL PRIVATIZERS US$ Billions PRIVATIZERS 25 ~~~~~~~~~~~~~25 El Other Privatization Revenue El Other Privatization Revenue 20 U EDI from Privatization 20 U FDI from Privatization -Total FDI lnflows --Total FDI IMfows 15 1 10 10 5 5 ~~~~~~~~~~~~0 f! 5;0 iSvfik 1988 1989 1990 1991 1992 1993 1988 1989 1990 1991 1992 1993 Note: Successful Privafizers" includes: Argentina, Chile, Czech Republic, Hungary, Jamaica, Malaysia, Mexico, the Philippines, and Portugal. "Moderately Successful Privatizers" includes: Barbados, Benin, Brazil, Estonia, Ghana, Honduras, Indonesia, Laos, Morocco, Nicaragua, Nigeria, Pakistan, Peru, Poland, Sri Lanka, Thailand, Togo, and Tunisia. "Unsuccessful Privatizers" incudes: Bangladesh, Bolivia, Bulgaria, Colombia, TZte dilvoire, Egypt, Greece, India, Kenya, Lithuania, Mozambique, Nepal, Romania, Turkey, Uganda, Ukraine, Uruguay, Venezuela, Viet Nam, and Zambia. Source: World Bank Privatization Database. Notes 3. See Kikeri, Nellis, and Shirley, Privatization: The Lessons of Experience, 5. Florencio L6pes-de-Silanes, "Deteroinants of Privatization Prices", The World Bank, Washington, D.C., 1992. mimeo, Harvard Untiversity, January 1994, pp.28f. 4. See also Pierre Guislain, Divestiture of State Enterprises: An Overview 6. Sader, Frank, Privatizing Public Enterprises and Foreign Invest|ent in of the Legal Frainewvrk, World Bank Techinical Paper No. 186, Washing- Developing Countries, 1988-93, Foreign Investment Advisory Service ton D.C., 1992, p.e4. Occasional Paper, The World Bank, Washington, D.C., 1995. 6 3 Fundamental Principles of Successful Privatization Three Overarching Principles In all countries, foreign investors tended to equate the effectiveness and efficiency of a priva- A privatization program is successful, when it tization process with the government's sincerity results in an efficient transfer of public enter- and commitment to reduce the role of the public prises into private hands under the conditions sector, opening the economy to private entrepre- that the sales generate the maximum price neurship on a broad scale. A technically sound attainable in the market and that the future via- and business-oriented treatment, untainted by bility of these companies is improved. In all of subjective political decision-making and bureau- the eight countries we studied, the degree of suc- cratic incompetence, was mentioned by practi- cess of their privatization initiatives was strongly cally all investors as the outstanding feature in related to the extent of competition among bid- ders. Whenever governments managed to attract several investors for individual SOEs, they typi- Figure 3: Fundamental Principles of cally received a high sales price combined with a S strong business plan and large investment com- mitments. Some countries-notably Argentina, Mexico, Peru, the Philippines, as well as Hungary in the early stages-generally managed to attract a number of potential investors. The other countries, however, did not manage to do so in many cases, resulting in unsatisfactory or .."s even failed sales which often led to criticisms of the privatization program as a whole. S Strong competition does not only result from . Successful - the attractiveness of the individual SOE sold, but privatization "0 is also very much dependent on the attractive- ness of the privatization program itself. While the effective structure of any privatization program may depend on country specifics and political circumstances, the successful cases we Fairness studied had three fundamental principles in common: political commitment, business orien- tation and fairness. 7 Argentina's and Peru's privatizations, clearly that is unduly lengthy due to bureaucratic pro- indicating to them that the government under- cedures and indecisiveness on behalf of the stands the concerns of the private sector. Finally, government translates into increased costs to investors need to be convinced that they will be the investor and renders the project less attrac- treated in a fair and objective manner, free of any tive. Serious bidders find themselves with type of corruption and red tape. Wherever that resources tied up in the process which are not was not the case, investors expressed their con- available for alternative investment opportuni- cerns to enter the privatization process. ties. In addition, after announcing their sale, SOEs typically lose in value the longer they are Political Commitment caught in this interim stage, with workers and management being unmotivated due to the Political commitment is a sine qua non to the uncertainty related to the imminent change in success of privatization. Foreign investors will ownership. only be interested in participating in a privatiza- Potential investors monitor the performance tion program when they are convinced of the of the privatization program carefully, and diffi- sincere commitment by the government to carry culties encountered in individual transactions out the reform program. Especially in the case of will translate into an overall loss of reputation Argentina, investors emphasized the determina- and investor confidence. Among the countries tion of President Carlos Menem as the driving we studied, we encountered a noticeable differ- force behind the privatization effort. ence in this respect. The vast majority of inves- However, political commitment does not sim- tors interviewed in Argentina, Mexico, and Peru ply consist of policy statements by the govern- expressed their strong satisfaction with the ment, announcing and supporting a general privatization process. They described their privatization policy. More revealing for investors counterparts in the respective privatization is the size of the program, reflecting the govern- agencies as highly competent and endowed ment's willingness to actually part with their with the necessary authority to make binding SOEs. If the program includes only a few select decisions. In fact, several investors admitted enterprises, investors will not perceive the pro- their own surprise to have been able to conclude gram as a fundamental reform of the country's such a transaction just as effectively as a stan- economic structure. In addition, for the program dard private investment in their home country. to be truly convincing, it must include most of Especially in Ghana, Mozambique, and Poland, the large SOEs. on the other hand, foreign investors frequently The sale of a large and well-known enterprise complained about the general sense of hesitance can have a strong demonstration effect as in the and indecisiveness they encountered when case of Argentina's national telephone company entering the privatization process. In several Entel which effectively jump-started the entire cases, investors did not seem to have a clear pic- country's privatization program in 1990. This ture of who effectively was their counterpart was followed by the sale of a vast number of with decision-making authority. Many of these enterprises, including the national petroleum investors expressed their doubts about the effec- company YPF for about US$3 billion. Similarly, tiveness of the privatization program and did Mexico sold not only its telephone operator not recommend entering the country in this Telmex, but also transferred the entire banking fashion. industry to the private sector, amounting to total Thus, an unattractive process will result in a sales revenues of approximately US$12 billion. smaller number of interested bidders and conse- These large-scale privatizations indicated that quently reduces the probability for the govern- the governments were determined to push the ment to find the desired investor who is willing reform process, not shy to tackle even the most to pay an acceptable price. In order to establish a difficult areas. successful privatization program, governments will have to be careful that the needs of the Business Orientation investors are being met. We found the competi- tion strongest in those countries where investors However, willingness and commitment alone had confidence in the process. In the other cases, will not by itself make a program attractive to sales frequently failed or were publicly criticized foreign investors. A privatization transaction due to the lack of competitive bidding. 8 Fairness and Transparency Such criticism represents a danger to the repu- tation of the privatization program. The bid Given the political nature of the process, a priva- preparation is costly for investors, requiring a lot tization program will almost invariably be sub- of time and resources. The perception that the ject to the suspicion of insider deals and corrup- government's decisions are subjective and tion. The danger of decisions being based on unpredictable will frighten off investors from other criteria than the merits of individual bids is abroad, especially those who are less familiar always present, especially in developing coun- with the country and fear to be disadvantaged tries where government salaries are typically by not having strong political connections. Many low. Political opponents as well as unsuccessful of the ones remaining, on the other hand, will be bidders will tend to be critical, challenging the pro- tempted to enhance their chances of winning by gram as a whole as well as individual decisions. gaining the inside track, thus fostering the same Foreign investors in Argentina, Peru, and the culture that is so dangerous to the reform process Philippines, in particular, commented with a in the first place. remarkable frequency on the complete lack of irregularities in the decision-making process, The Application of these Principles regarding their own project as well as the pro- gram as a whole. In some of the other countries, Political commitment, business orientation and however, a frequent complaint was that crucial transparency are not independent from each decisions in the process were overturned in the other. In fact, they reinforce each other in every last minute, apparently for purely political rea- step of the way, and should be the guiding prin- sons, to avoid a politically inconvenient transfer ciples underlying all aspects of a privatization of ownership. This seemed to be a particular program, from the establishment of long-term problem in Ghana and Mozambique. While policies, through the creation of the institutional investors generally praised the governments for and legal framework, to the actual divestiture a strong commitment to privatization, they process (see Figure 4). seemed concerned that decisions were very The commitnent to sincerely pursue privati- much dependent on authorities outside the zation as a key element within a long-term established process. Even if individual investors reform agenda will only be convincing if it had been unaffected by such interferences per- clearly indicates the government's willingness to sonally, they were well aware of such occur- withdraw from the economy. The government rences in other transactions and tended to be crit- will have to provide a reliable and clear legisla- ical of the overall transparency of the process. tive environment, designed to enhance private Figure 4: The Impact of Fundamental Principles of Key Aspects of Privatization The Privatization Strategy The Legal Environment Successful privatization The Institutional Framework The Process of Privatization Fairness 9 participation in the economy in exchange for public sector activity. Both the institutional setup Box 1. The Perspective of Foreign as well as the process itself have to be credible Investors on Fundamental Principles and operational. Foreign investors will distrust public statements of general commitment if this The comments of foreign investors surveyed does not translate into an overall privatization strongly confirm the importance of these princi- approach that will actuallv produce results ples as the basis of successful privatization. The acceptable to all involved, most frequent criticisms based on their experi- acceptable toalivle.ences in privatization programs were: In order to be credible, the privatization pro- gram must also be transparent. Transparency * excessive bureaucracy; requires, among others, straightforward laws and well-defined institutional responsibilities, * too much political interference; i.e., foreign investors have to know whom to * too many people with the potential to influ- address at various stages of the process and to be ence the process; assured that the information they receive is trust- * lack of a clear, consistent process; worthy and the process non-discriminatory. lack of business capabilities; Finally, investors will participate in privatiza- tion only if they have a sense that they are not * lack of clear, objective, publicized decision wasting their time. Incompetence and unprofes- criteria; sionalism. in the design of the program and strat- * insufficient commitrnent to sell; egy as well as the actual process because of poor *the need to ensure that transactions are based decisions or the delays they create will deter on commercial and not political consider- investors, and even lead them to withdraw from ations; the process. * unrealistic guarantees required particularly regarding maintaining the labor force. 10 4 Privatization Strategy The Need for a Political Master Plan In general, the privatization master plan has to convey the government's commitment to with- Strong political commitment can best be demon- draw from the economic sphere. For such a plan strated through a comprehensive privatization to be more than simply a political announce- plan which forms an integral part of an overall ment, the government should clearly state the economic reform agenda. Such a plan should manner and extent to which companies are spell out the government's vision, objectives and selected and sold. This will avoid unnecessary methods of privatization. The absence of clearly initial criticism regarding the scope and trans- stated objectives weakens not only the percep- parency of the privatization program. tion of the process but also its execution in that the government does not formally commit itself Company Selection to a comprehensive restructuring of its economy. This raises concerns that the government might A core element of the government's overall strat- back out of difficult or controversial decisions egy is the selection of the companies that will be and fosters doubts in the minds of investors subject to privatization. While eventually priori- regarding the reliability and viability of the ties will have to be established regarding the pro- privatization program. motion and sale of individual companies or At the same time, however, such a master plan whole sectors, commitment to the process is has to be realistic. As Hungary realized over the most clearly signaled by adopting an overarch- last two years, foreign investors are keen observ- ing strategy of privatizing all companies. The ers of how intended privatization results com- sale of some particular enterprises might be post- pare to the actual outcome. After the election of a poned for specific strategic reasons, but the start- new government in 1994, the attitude towards ing point should be the inclusion of all SOEs. The privatization changed drastically, and privatiza- Peruvian government, for example, announced tion sales practically stalled after a period of that effectively all its SOEs are available for rapid growth until 1993. At the same time, privatization. Mexico developed a short and inflows of foreign direct investment fell from clearly defined negative list of companies or sec- US$2.4 billion in 1993 to only US$1.2 billion in tors not to be divested. All the remaining enter- 1994. When asked about Hungary, the investors prises, however, were for sale, supporting the we interviewed tended to reminisce about the government's sincerity to withdraw itself from past, emphasizing that the once most attractive economic activity. In Mozambique, on the other investment location in Central and Eastern hand, each line ministry proposed individual Europe had lost much of its glamour. enterprises to be sold each year. This makes it 11 impossible for the country to develop a long- the reform process. In the case of Poland, the term privatization strategy, leaving the reform sekction of individtlal companies is dependent process in the hands of a number of different on the initiative of the potential investor who actors who might not always be supportive of first have to signal their interest. At the same divestiture. time, the worker council has to agree to the The first step has to be to identify all existing transformation of the company, providing exter- public enterprises. While this might sound obvi- nal forces with a strong role in shaping the priva- ous, in many countries individual ministries cre- tization policy. In Ghana, similar to Mozam- ated or absorbed enterprises over time without bique, the selection decision appeared to be the existence of a general register. Once the port- driven by immediate political concerns, lacking folio of companies slated for privatization has an overall, long-term strategy of systematic been established, an overall strategy regarding divestiture. the selection of individual companies to be sold must be developed. Efficiency and speed should Government Stake be the main considerations. It is important, how- ever, not to announce the actual sale of individ- The sale of a SOE does not automatically imply ual companies too far in advance of the target that it is being sold completely. For a variety of date for their privatization. Too lengthy a delay reasons, governments frequently decide to only between the time a company is announced to be offer a share of the company in the initial privati- privatized and the beginning of the process can zation. The government may want to retain a have negative side effects. Most importantly, the minority stake to benefit from the company's performance of a company tends to deteriorate future gains in efficiency and profitability, result- resulting from the uncertainties regarding its ing in dividend payments or an increased mar- future, thus reducing its sales value. In the case of ket value of its stake. The Mexican government Mozambique, for example, sales of companies to generally opted for a complete sale of its enter- be privatized dropped by an average 42 percent prises, with the exception of particularly large during the last three years prior to the sell-off. enterprises such as the national telephone com- In general, the selection will depend on the pany TELMEX or several of the sizable commer- government's overall objective and capacity. cial banks which were sold off during 1991 and Mexico, for example, decided to start its privati- 1992. Argentina, on the other hand, often sold zation process with smaller enterprises to learn less than 100 percent of the shares, while always the trade and to avoid making mistakes in larger making sure that the investor received majority transactions. Argentina, on the other hand, ownership. The government intends to float the started its privatization process with particularly remaining shares on the Buenos Aires Stock large enterprises such as the national airline and Exchange at a later stage. the telephone company. This achieved the goal of Governments also might find it politically immediately convincing foreign investors of the attractive not to sell a SOE completely to counter government's sincerity regarding economic domestic criticism of "selling out", and to soothe reform, and resulted in large inflows of FDI concerns of the labor force or the management of through privatizations as well as in the form of the enterprise. Many governments earmark a new, greenfield investments. In Peru, the Philip- certain percentage, typically between 10 and 20 pines, and Hungary (in its early phase up to percent, to be sold at a discount to the company's 1993), the privatization agencies would each management and employees. This technique year select those companies that had been suffi- effectively serves as a compensation scheme ciently prepared and for which they expected geared at creating a more cooperative attitude strong investor interest. At the same time, these towards privatization within the firm by provid- countries remained careful to be realistic by not ing the workers with an incentive to favor a taking on more transactions than the staff could strategy that enhances the future profitability of handle. their company. Especially in Mozambique and In each of these cases, the selection process Poland, this was a major concern which deter- was quite effective, helping to maintain the mined the extent of individual sales to strategic momentum of the reform process. In Ghana, investors. In both cases, labor forces have a sub- Poland, and Mozambique, on the other hand, the stantial influence in the privatization process, and selection process appears to be an impediment to the amount of shares retained by the government 12 or the workforce often turned into a difficult However, while the government determines issue during privatization. The investors we the form of privatization, it is important to take interviewed generally had qp difficulty with well- into consideration the investors' position to ing shares to the employees, as long as they were ensure that a particular choice does not lead to guaranteed control over the company. They did, an avoidable loss of bidders in the process. In however, frequently complain about a lengthy general, almost all techniques can be structured and politicized process. in such a way that they are interesting to foreign Investors know that they are acquiring a com- investors. The single most important issue is to pany that requires substantial restructuring. give the investor full control over the transferred Hence, they will need to have control over its enterprise, allowing it to structure the company's operations. In the survey conducted with foreign business operations. investors, invariably all rejected the option of a simple minority share in an enterprise. A few Management Contracts indicated that they would accept minority ownership, but only combined with a manage- Under a management contract, a private opera- ment contract and operational control, and tor takes over the management of a company in sometimes with an explicit guarantee to acquire exchange for a fee, while the government ownership at a later date. All other investors remains the company's owner. The contract is clearly stated that they were only bidding for typically specified such that the private manage- majority ownership. ment has autonomy in the daily operations of the Thus, only in exceptional cases can a country company, while all fundamental decisions such hope to attract strong strategic investors to a sale as investments remain with the public sector. of a minority ownership in a SOE. In general, the Governments typically establish a management government should be willing to surrender the contract in order to improve a company's short- majority ownership and with it the control over run efficiency. However, the private operator will its companies. By making this an explicit compo- not risk his own capital for any restructuring or nent of their overall privatization strategy, gov- future investments. ernments show their commitment to the process Thus, for most SOEs such an arrangement will as well as their understanding of basic investor not be sufficient to improve its long-term profit- concerns. ability, but can represent an intermediate step on the way to full divestiture. In fact, management Privatization Methods contracts are most frequently used in infrastruc- ture areas such as the water supply in Abidjan, While the choice of a specific privatization tech- C6te d'Ivoire or Conakri, Guinea. Here the gov- nique should rest with the responsible privatiza- ernments decided to introduce private sector tion agency and depend on the individual com- efficiency, but were not yet willing to take the pany to be sold, the government will have to step of relinquishing ownership. In both cases, define which type of techniques will be applied the efficiency in the supply and treatment of in the privatization program. At the most general water has improved drastically. At the same level, the government can decide to either ini- time, however, both also struggle on the issue of tiate a partial or full transfer of ownership future investments and expansion of the existing through some type of sales agreement, or to network. maintain ownership while involving private operators through a management contract, or a Lease and Concession Agreements lease or concession arrangement. While the latter approach is not a privatization in the narrow In a lease agreement, a private company effec- sense that the public sector hands assets over to tively rents an asset or company from the gov- private investors, it might still be an appropriate ernment for a specified period of time and measure under some circumstances. With retains the company's profits for its management respect to the effective sale of an enterprise, services. A concession agreement is similar, again several possibilities present themselves. except that here the investor is also responsible The choice of the technique depends on the gov- for at least some of the investments. Such ernment's political objectives as well as the spe- arrangements are particularly attractive for com- cific conditions of the particular company sold. panies with substantial fixed assets as is the case 13 for most infrastructure services such as energy or tender basis. In order for a public offering to be water distribution. Most investors consider an successful, several ground rules have to be outright acquisition of such companies too risky, observed. given that the company's main assets, the distri- First of all, in order for the enterprise to be bution networks, cannot be disassembled or attractive to the general public, it has to be well moved in case of changes in the business known as well as financially sound with good environment, leaving the investor vulnerable to future potential. Secondly, an adequate distribu- sudden changes in government policies and tion network for the shares has to exist, com- regulations. bined with a good marketing strategy in order to Argentina, especially, made extensive use of generate sufficient interest. Finally, it is impor- concession arrangements in its recent privatiza- tant that the share price reflects a fair market tion efforts. In a wide range of sectors, covering value of the company. Too high a price discour- television channels, petroleum drilling areas, ages investors and could stall the privatization, railroad operations, roads, port facilities or live- while too low a price might draw criticism of stock markets, the government concluded con- poor management of public assets. cessions worth approximately US$1.5 billion While limited to only a small number of SOEs, between 1990 and 1993 with strong involvement governments typically value public offerings of foreign investors. Currently Mexico is also in because they allow a wide dispersion of owner- the process of awarding concessions in a number ship including domestic investors, strengthen of infrastructure areas, which initially had been the developing capital market, and are by design excluded from the privatization process. very transparent transactions. Foreign investors gain additional confidence regarding the privati- Direct Sale zation, because the involvement of a large num- ber of domestic investors makes it even less In all of the countries we visited, direct sales likely that the process will be reversed. On the have been the dominant form of privatization, other hand, they typically find the shares an especially with respect to small- and medium- attractive investment opportunity only if the sized enterprises. For investors, a direct sale rep- future profitability potential of the company is resents the most straightforward method for high. One way to support this perception is to acquiring control over a SOE. The government, combine a public offer with a direct sale of part on the other hand, can directly select the future of the company to a strong strategic investor. owner, making sure that the company is sold to a In the case of Mexico's TELMEX, for example, strong strategic investor as reflected in his com- the government decided to first sell a minority mitment to future investments. share of about 20 percent together with a man- The most effective way of finding the best agement contract to a foreign consortium. It then suited investor and to maximize government sold another 25 percent in the domestic and revenues from the sale is through competitive international capital markets, resulting in a total tender. Direct negotiations with a single buyer revenue of about US$6 billion, predominantly in rarely generate the best possible deal for the gov- hard currency. The Argentinean government ernment. We came across cases in several coun- decided to sell majority stakes of 60 percent each tries where individual transactions were criti- in its two telephone companies (Entel North and cized and sometimes even canceled based on South) to foreign investor consortia prior to claims that the government sold assets too cheap offering the remaining shares in domestic and via negotiations with only one investor. international stock exchanges, generating a total revenue of about US$3.3 billion. Public Stock Offering The need for a strategic investor is of less importance in companies whose future potential A public offering of SOE shares entails the sale of is driven by the access to valuable raw materials. all or part of the government's holdings in a In 1993, Argentina sold 45 percent of its national company to the general public via domestic or oil company YPF in a domestic and international international stock markets. The price of shares offer for US$3 billion. Similarly, Ghana's can be fixed and backed by an underwriter or the Ashanti Goldfield offering in the London and government itself, or the offering may be on a Ghana stock exchange resulted in proceeds of 14 US$316 million in 1994. In both cases, the sale ventures can form an interesting component of supported the local capital market; the Argentine the overall privatization strategy, while not the government successfully revived its depressed dominant one. stock exchange, while the Ghana's stock market capitalization increased almost tenfold with the Liqiuidationi and Asset Sale Ashanti offering. However, in all these cases, effective distribu- When a SOE is in a particularly bad financial tion mechanisms existed. Either the companies condition with high liabilities, a direct sale might were so wellknown that their shares could even prove impossible. In such a case, the government be offered on stock exchanges abroad, or a well- might opt to liquidate the enterprise and sell its functioning stock market existed at least in the assets. The advantage for the investor is that he country. Thus, Peru managed to successfully can acquire the company without the attached privatize a number of smaller companies on the liabilities. While this might be the onlv option Lima stock exchange. On the other hand, left for the government, it has to be aware that, Mozambiquean government officials had to real- similar to the situation with joint ventures, it will ize that any attempt of a public offering is be left with the unsellable parts of the assets after doomed to failure without a local stock market, investors are finished "cherry-picking", i.e., hav- relving solely on over-the-counter trading. ing acquired all the valuable components of the enterprise. .oint Vetutlre Vouchier Privatizations In a joint venture, a whole SOE or part of it typi- callv forms a new company together with a Many Eastern European countries created mass strong outside investor. In most cases, the out- privatization schemes in which vouchers were side investor brings in new capital and technol- given to all citizens essentially free of charge. ogv, while the SOE provides existing physical These vouchers could then be exchanged into assets. Governments often favor this type of shares at special auctions. The main advantages arrangement, because it allows them to maintain of this approach are that the process of privatiza- control, or at least strong influence, over the tion gains speed by simplifying the task of enterprise, while the company obtains the divesting a large number of SOEs, that the trans- financing and expertise required for its modern- fer of ownership is highly equitable, and that it ization. Especially in former socialist economies, supports the formation of local capital markets. governments tend to place too much emphasis However, this method clearly will not generate on this approach relative to the other alterna- any government revenue, and the gain in pro- tives, hoping to obtain the needed capital with- ductive efficiency and profitability of the enter- out surrendering control over the assets. How- prises will be delayed because the initially atom- ever, this hope is misplaced. As in all other cases, ized ownership does typically not translate into the foreign investor will require control to justify a change in operations and management. his investment. The involvement of strategic investors can be In some instances, however, this approach sped up through the creation of investment might prove preferable to other techniques. In a funds which are allowed to hold vouchers for cit- few cases, the company to be privatized is so izens or directly buy them, to exchange them large and wellknown that the government will into blocks of shares in individual enterprises. try to maintain the brandname through the Foreign investors, while excluded from the first arrangement of a joint venture. For that reason, phase of voucher privatizations, can theoretically the Czech government favored such an arrange- buy shares from citizens or investment funds ment between the country's largest car manufac- afterwards. This step is, however, difficult and turer Skoda and West Germany's VW. This tech- risky, because the investor will have to acquire nique can also be attractive in cases where it numerous minority shareholdings in order to proves impossible to sell a company completely eventually obtain the desired majority stake. as going concern. Some of the assets might still Even in the Czech Republic, probably the most be attractive, and a joint venture will allow to advanced voucher privatization program in the salvage those parts of the enterprise. Hence, joint world, there is no indication that strategic 15 foreign investors have participated to any signif- to make use of this option. Politically this icant extent in share trading on the secondary approach is particularly attractive, avoiding the market. criticism of "selling out" to foreign interests. In reality, however, this strategy is often counter- Management/Employee Buy-out (MBO) productive. Due to the lack of funds, manage- ment and workers are usually allowed to pay at Many governments are tempted to support a discount or in installments. This implies that domestic investment through MBO schemes, even less financing is available for investments where the management and employees of enter- to upgrade often dilapidated and antiquated prises have the right to make an offer for their facilities. Meanwhile the same management enterprises prior to privatization. Given the stays in place and no major restructurings are uncertainty involved with privatization, the undertaken, resulting in no significant improve- incentives are strong for managers and workers ments in the overall productive efficiency. 16 5 The Legal Environment7 The Basic Requirements for Privatization Review and Adjustment of the Existing Body of Law The legal environment is not only the basis for privatizations, but it effectively represents the The sale of public enterprises affects a wide cornerstone for private economic activity. Inves- range of existing laws and regulations in a coun- tors will not only want to find a simple and clear try. Many of these laws were enacted to accom- definition of the privatization process itself, but modate public enterprises without particular also have to be assured that they will be able to consideration of the needs of private entrepre- conduct their operations in a market-friendly neurs. Hence, an essential initial task is to review and open environment. Many countries that the existing legislation and to rewrite or amend it engage in privatizations also do not have an whenever necessary to make the transfer of own- extensive experience with private investment ership legally possible. due to the previous dominance of the public sec- tor. Foreign investors, in particular, tend to place Constitutional Chatnges great emphasis on the existing legal framework in order to judge the viability of their projects. In most of the formerly centrally-planned econo- As for any type of foreign investment, equal, mies, all productive assets are by constitutional non-discriminatory treatment of all investors- law defined as public property. In many other domestic as well as foreign-has to be a guiding countries, certain sectors are reserved for the principle. Furthermore, all foreign investors state. In such cases, the transfer of ownership should have the right to remit profits in anv cur- would effectively be unconstitutional. This was rencv desired at the existing market exchange the case in Hungary and Poland which until rate and should be allowed to employ expatri- recently recognized the right to private property ates without restriction. There should also be no only to a very limited extent. Constitutional limitations on the acquisitioni of land or other amendments to allow for full private ownership assets required for the efficient operation of the of productive assets were required to allow investment. Expropriations should be allowed privatization to proceed. only in exceptional cases and emergency situa- tions, and only under fair compensation. All Thle Legal Status of SOEs these principles serve to minimize the risk of operating abroad, rencderinig the country an The rights and responsibilities of public enter- attractive investment location relative to the prises are often explicitly specified by law. They home countrv. are typically granted special privileges such as 17 Box 2. Basic Guidelines on the Treatment of Investors: An Illustration "All investors and enterprises are entitled to the * The right to freedom from expropriation: There basic rights and guarantees provided in the Philip- shall be no expropriation by the government of pine Constitution. Among other rights recognized the property represented by the investments or by the government of Philippines are the following: of the property of enterprises except for public use or in the interest of national welfare and *The right to repatriation of investment: In the defense and upon payment of just compensation. case of foreign investments, the right to repatri- In such case, foreign investors or enterprises ate the entire proceeds of the liquidation of the shall have the right to remit sums received as investment in the currency in which the invest- compensation for the expropriated property in ment was originally made and at the exchange the currency in which the investment was origi- rate prevailing at the time of repatriation; nally made and at the exchange rate prevailing at * The right to remittance of earnings: In the case of the time of remittance. foreign investments, the right to remit earnings * The right to non-requisition of investment: there from the investments in the currency in which should be no requisition of the property repre- the investment was originally made and at the ex- sented by the investment or of the property of change rate prevailing at the time of remittance; enterprises, except in the event of war or national * The right to foreign loans and contract: The right emergency and only for the duration. just com- to remit, at the exchange rate prevailing at the pensation for the requisitioned property may be time of remittance, such as may be necessary to remitted in the currency in which the investment meet the payment of interestandthepn was originallv made and the exchange rate pre- meet the payment of Interest and the principal on vingathtmeormtace,8l foreign loans and foreign obligations arising vailing atthe timeof remittance." from technological assistance contract; tax exemption, guaranteed access to cheap raw experienced serious problems of asset stripping materials, monopoly status, or special customs and pilfering prior to the sale, resulting in unnec- and tariff regulations. On the other hand, they essary complications during the privatization also often have special responsibilities such as because the corresponding decline in asset value the requirement to supply their goods and ser- is impossible to monitor, often creating disputes vices at a subsidized price or to provide certain between the winning bidder and the government. social services. All these will have to be abol- ished in order to allow for operation under pri- Property Law vate ownership in a market system. Furthermore, SOEs typically have to be corpo- Privatization involves the transfer of ownership ratized prior to privatization, i.e., the company from one entity to another, requiring undisputed has to be reorganized in such a manner that it is and clear property titles and other documenta- subject to the ordinary company law and the tion necessary to establish ownership. The own- business laws applicable to private companies. ership status of any asset to be sold will have to The typical procedure is to convert SOEs into be cleared prior to the sale and investors will joint-stock companies with all shares held by the have to be assured that their ownership rights government until privatization. An alternative is are adequately protected. In many countries the to dissolve the SOE at the time of privatization need to define and clear-up property titles result and to set up a new private company. in lengthy delays. Often previous owners chal- This process of converting SOEs into normal lenge the privatization decision by contesting the companies also includes the surrender by gov- government's right to sell enterprises that have ernment of its existing control over the enter- been nationalized in the past. prises, previously maintained through the right to appoint the management and board members. Labor Laws The control of the existing management over their companies also has to be limited until the SOEs are often subject to special labor provi- sell-off is completed. Several countries have sions, providing employees with guarantees for 18 relationship, which might not only jeopardize Box 3. Dealing with Claims of Former the future viability of the enterprise, but also Owners: Two Approaches reduce the attractiveness of the Mozambiquean privatization process as a whole. A privatizing Dealing with the claims made by former owners government should therefore establish mecha- on property to be privatized is complex and can nisms that allow for the reduction of the work seriously impede the speed of privatization and force in exchange for an acceptable compensation. even deter investors. Two fonns of redress can be used: restitution or compensation. Overall, Environmental Legislation 10 compensation is preferable in the context of privatization, particularly in the absence of a deadline pre-privatization for filing claims. Potential investors need to know the extent of While such deadlines obviously eliminate the their liability for environmental damage or viola- risks to an investor of having his newly pur- tions of environmental legislation which the chased property confiscated, restitution can be company incurred as a SOE. If SOE facilities do seriously detrimental in slowing down the pace not conform to environmental regulations, will of privatization. This was the case in Germany exemptions be granted or will there be a reason- where the privatization law provided for resti- able time frame in which to comply? The central tution. The impact on privatization was nega- issue is who carries the responsibility for repair- tive as sales were held up as property titles had ing environmental damage and ensuring the to be cleared. A law was then passed whereby ngenvion menta en andensuringrthe "New investors able to preserve jobs or provide operatn cnformseto envirnearly samndards addtina investment tak In many instances, particularly among the additional investrnent takce precedence over, prior owners".9 Hungary's approach, on the heavy polluting industries such as chemical, other hand, was to favor compensation right mining, steel, or smelting, the question of allocat- from the start, as stated in the Compensation ing the environmental cost will bear heavily on Act of 1991. Former owners are paid a lump the privatization process since the new owners sum in the form of coupons which may be used will tend to avoid the responsibility for previous to buy property sold by the State. owners' operation, while the governments as owners/operators will try to shift as much of the burden on new owners as possible. Disputes regarding the responsibility for past life-long employment and making it almost environmental damages delayed many transac- impossible to fire. This can create serious diffi- tions especially in Eastern European countries. A culties during the sell-off, given that SOEs are satisfactory solution is not easy to find, but gov- typically substantially overstaffed. In Mozam- ernments should generally accept the financial bique, for example, investors are generally responsibility for damages that are the result of required by law to take on all of the existing previous operations under state ownership and labor force of an enterprise and even guarantee eliminate the uncertainty of potentially signifi- life-long employment. Investors invariably cant financial liabilities clearly beyond the con- expressed their concerns regarding this policy trol of any new owner. One major European mul- and clearly indicated that they simply cannot tinational, for example, refused to sign any guarantee livelong employment. In order to privatization contract in Poland until the govern- bring the labor force down to an efficient level, ment issued clear guarantees that it assumed many new owners implied that they will have to responsibilities about environmental damage find reasons of personal misconduct, allowing from previous operations. In Peru, the privatiza- them to fire a worker. tion of Centromin, the country's largest mining Understandably, governments are tempted to operation, stalled on similar issues, forcing the leave such issues unresolved, fearing public government to undertake a major environmental opposition. But the creation of an efficient private clean-up prior to resuming the negotiations. enterprise being the central goal of privatization, the maintenance of a large and unproductive The Law on Privatization labor force is very expensive, clearly rendering any SOE less attractive. In the particular case of Most countries legally initiate their privatization Mozambique, the legal restrictions set the stage program by passing a law on privatization for a potentially antagonistic labor/employer which specifies the scope of the program, 19 establishes the institutional authority to conduct National Defence Council may from time to time the privatization program, and defines the most determine". While Ghana has pursued privatiza- important elements of the process. However, a tion vigorously, the vagueness of the process separate law is not necessary in all cases. Exist- does not give investors much comfort, knowing ing legislation may be sufficient to conduct that the rules of the game can be changed at any privatizations. point in time. The advantage of a specific privatization law is At the same time, there is always the danger of a higher degree of accountability and formal overspecifying a law. If defined too narrowly, the authority for the entity in charge of conducting agency in charge might lose the necessary flexi- the program. In addition, the existence of such a bility to conduct individual transactions. Thus, law clearly indicates strong political support and rather than attempting to define a tight legisla- commitment by the government. However, there tion to cover all eventualities, the guiding princi- is also the danger of major delays through a ple should be to provide a coherent and concise drawn out political debate in parliament prior to framework, leaving the details of implementa- passing the eventual law. In fact, many countries tion to the privatization body through subordi- began their privatization programs even without nated legal means such as administrative guide- a specific law. This was the case in Hungary lines and regulations. where privatization began in 1988 with "sponta- neous privatization" which enabled (by virtue of The Regulatory Framework Act VI of 1988 on Companies) the transformation of state enterprises into companies on the basis In some cases the companies to be sold have the of management decisions and thus allowed the character of a natural monopoly, not allowing for sale of part of state property. The country had by the introduction of any significant competition. then begun its transition toward a market econ- Thus privatization has to be accompanied by an omy and privatizations followed naturally, even effective regulatory framework. This is a particu- though there was no specific privatization law. larly important issue in the privatization of infra- However, because the process was unmanaged structure services such as telecommunications, and led to abuses, in 1990, the State Property energy and water distribution. Agency was established and a legal framework While more complex, the privatization of such for privatization put in place. infrastructure companies is generally beneficial Privatization legislation typically specifies the to the country's economic development. First of extent of privatization by generally defining all, most of these services suffer from outdated what is to be privatized. Rather than listing indi- facilities and a lack of new investments, creating vidual companies that will be sold, the law substantial difficulties not only for the popula- should provide a general right to privatize all tion as a whole, but also for any type of private existing SOEs. The government might choose to economic activity. Foreign investors frequently define a short and clear negative list of individ- complain about the additional costs and risks ual enterprises or sectors that will not be subject resulting from a defunct infrastructure in most to privatization because of their special status or developing countries. The privatization of these strategic importance. companies almost invariably results in large new The law should also define the specific entities investments and a substantial improvement in responsible for privatization, clearly specifying the service provision, raising the general stan- their basic rights and responsibilities. It is partic- dard of living as well as the overall business ularly useful to establish clear authority and con- environment. Furthermore, most of these infra- trol over the process to avoid misunderstandings structure companies are sizable, and their sale and political quarrels later in the process. The under difficult circumstances, including the crucial steps in the process should also be out- politically sensitive issue of unsubsidized, lined in the law in the form of general guidelines. higher user charges for the public, has a strong This will give investors the assurance that the signaling effect, reflecting the government's process is firmly established and follows clearly commitment to open up the economy. defined rules. In Ghana, for example, the 1993 However, in order to conclude such a priva- divestiture law states in Article 1: "The divesti- tization, the government has to strike the fragile ture by the State ... shall be in accordance with balance between attractive and profitable such policy directives as the Provisional business conditions for the investor on the one 20 hand, and fulfilling the national development Box 4. Privatizing Infrastructure: needs without creating an unconstrained private Experiences in Argentina and Peru monopoly on the other. Hence, a regulatory agencv has to be established which sets the According to Argentina's privatization law, the framework within which the private investor is state retains authority over the activity of priva- allowed to operate. Rules and regulations have tized utilities through the creation of agencies to be established on issues such as pricing, mod- vested with regulatory powers. The Govern- . ment pushed the privatization of a large number e or ensin. of infrastructure companies such as the national The proper sequencing of setting the regula- telephone company ENTEL, numerous power tory framework and privatization is critical. utilities, the Buenos Aires waterworks, as well Before preparing a serious bid, any investor will as various railroads and roads. However, while want to know the conditions under which he the speed of the process was impressive, diffi- will have to operate. This requires a clear defini- culties arose in several sectors after privatization tion of all the rights and responsibilities of the for the simple reason that the regulatory frame- private operator and the creation of a counter- work effectively was not in place yet. In addi- part from the government who is in charge of tion, the staff consisted mostly of former overseeing his activities. Equallv important is employees of the now privatized utilities who that the investor will have to be convinced that often lacked a good understanding of the func- the established arrangement is stable and reli- fioning of a private company, and who seemed tempted to operate rather than regulate the utili- able, not subject to unpredictable political irflu- ties. Instead of working cooperatively, antago- ences and changes. This implies that the regula- nism arose with private operators questioning tory framework effectively has to be established the regulators' competence. prior to the privatization in order to avoid a lack Peru, by contrast, was able to benefit from the of investor interest as well as major disputes experiences of other countries. It created its reg- after the sale. ulatory agencies prior to the start of the privati- zation of utilities. Agencies such as OSIPTEL, Notes the telecom regulatory body, were active partici- pants in the preparation of the privatization pro- 7. See Guislain (1992) for a more detailed discussion of the legal issues cess and the sales promotion of utilities. This in prvatization. established a strong degree of confidence among 8. "Omnibus Investments Code 1987" (Executive Order No. 226). investors and, relative to its size, Peru's Entel tumed out to become the highest-priced tele- 9. Guislain op. ciLt. phone company ever privatized. At present, the 10 See Gretta Goldenman, "Environmental Liability and Privatization relationship between regulator and operator in Central and Eastern Furope", The World Bank, Washington, D.C., appears to be excellent, and OSIPTEL also has 1993. for a more detailed discussion. been put in charge to promote and supervise the 11 Especially foreign investors consider the privatization of infra- competition when the long distance market is structure an important step. Sader (1995) shows in an econometric deregulated in 1998. analysis that infrastructure sales among all other privatizations have deregulated in 1998. the strongest impact on attracting addltional foreign investment into a country 21 6 The Institutional Framework Introduction groups. These include management of the com- panies slated for privatization, workers who face The established legal framework provides the an uncertain future under new ownership, and basis for the institutional setup, required to members of the government itself. implement and conduct privatizations. Specifi- Governments are very vulnerable to accusa- cally, the legal determination of the institutional tions of "selling out" to foreigners, or insuffi- framework requires the definition of the roles, ciently promoting ownership by local entrepre- responsibilities and authority of the various neurs. This pressure has raised accusations in actors in the divestiture process, such as the leg- some countries that foreign bidders may lose out islature, the government, individual ministries, to a local consortium, despite having the higher and the divestiture body. bid because of the political pressures to sell to Countries have adopted different institutional nationals. This is more likely to occur in structures for carrying out privatizations. Cer- instances where the process is not clearly defined tainly no single structure or organizational or lacks transparency. In addition, within gov- model will apply to every country. Nonetheless, ernment itself, not all ministries embrace privati- it is possible to identify features which underlie zation with equal fervor. Line ministries will the design of the institutional arrangement for often resist the privatization of enterprises under privatization as well as advantages and short- their authority because of the loss of political comings associated with various arrangements. leverage and power, which they derived The institutional setup strikes at the heart of from controlling the SOEs. The heads of state the three fundamental principles underlying themselves, irrespective of their stated commit- privatization. The design of the institutional ment to privatization, have at times backed off framework and definition of authority are highly for fear of nationalist backlashes and/or loss of reflective of the extent of government's willing- popularity. ness to conduct a non-politicized, transparent The inclusion of various interest groups in the and business-oriented privatization program. decision making process can transform a divesti- ture rapidly into a highly politicized event. This, Depoliticizing the Institutional Framework however, invariably results in delays and uncer- tainty for the bidders involved. When foreign While governments throughout the world have investors recognize that politics and indecisive- eagerly embarked on the process of privatiza- ness are central features of a privatization pro- tion, not all players in the process are unequivo- cess, they will be hesitant to participate, resulting cally enthusiastic. Privatization is politically in the loss of bidders and potential investors for dangerous and is bound to affect many interest the privatizing government. 22 To avoid such a politicization of its privatiza- has a clear mandate and authority will increase tion program, any government should be con- their trust in the overall process. cerned with establishing a clear-cut chain of Beyond the feeling of confidence which for- command, unrmistakably specifying the author- eign investors derive from the knowledge of a ity to privatize. The right to make individual transparent process, the stability of any particu- sales decisions should be concentrated to reduce lar institutional arrangement is crucial. Foreign the risk of political interference and lengthy investors need to know the identity of their internal debates. Of particular importance is the negotiating counterpart and be able to develop exclusion of any party that has particular short- an ongoing relationship. Changes in the arrange- term interests in individual companies, espe- ment typically force investors to start the process cially the workforce, the management, and the all over again, resulting in costly delays and line ministries. Only under these conditions will unnecessary uncertainty. the government be in the position to effectively Countries have adopted different institutional offer a SOE for sale in a business-oriented frameworks characterized by varying degrees of manner. independence of the divestiture body from the political apparatus or the head of state. At one Institutionalizing Privatizations end of the spectrum, the privatization body is an extension of the political apparatus with limited Any privatization body can function effectively autonomy and authority. This can include a spe- only if it is sufficiently empowered to execute its cialized government ministry or agency as in mandate. There should be no question of Poland and Hungary, or a sectoral ministry as in whether the agency requires outside clearance in Argentina. The other options center around order to make individual decisions. This ability politically independent, empowered entities to carry out decisions is directly linked to politi- who are formally fully in charge of the imple- cal commitment-that is entrusting a mandate to mentation of the process within the broader the privatization body and providing sufficient framework of government-established objectives powers, latitude and freedom from political and policies, such as in Mexico, the Philippines, interference to implement privatization. For for- or Peru. It should be noted however, that the eign investors, the knowledge that the agency establishment on paper of a certain structure Box 5. The Privatization of a Polish Chocolate Factory The case of Goplana illustrates several of the diffi- Treasury. Politically, as well, it was felt that selling culties which can occur when various interest to a "flagship" company such as Nestle would pro- groups have the power to turn privatization into a mote Poland to other investors. The situation was highly political event. complicated by the fact that the workers, who in Goplana is a major Polish chocolate plant which Poland hold veto power over privatization transac- had a 15% market share in the early 1990s. Nestle, tions, wanted the joint venture arrangement and already with an established presence in Hungary decided to oppose the Nestle deal. At the price of and the Czech Republic, became interested in considerable lobbying and PR efforts, Nestle even- Poland with its market of 40 million people. tually managed to get workers on its side, and the In 1993, when Nestle decided to purchase government announced to hold an open tender for Goplana, ED & F. Man, a British sugar and cocoa a joint venture arrangement. brokers and its partner, Elite Industries, a major In the tender, ED & F. Man's offer was $31 million Israeli food processor, had set up a joint venture for 46% share of the joint venture vs. Nestle's offer of with Goplana management which required only $35.9 million for a 47% share. In order to enlist the the privatization minister's signature. support of workers, Nestle offered pay raises, shares However, the privatization minister had appeared in the joint venture and employment guarantees to have reservations regarding the joint venture comparable to ED & F. Man. It also established close arrangement, since the foreign partner's funds contact with the workers' council to resolve out- would flow into the company as opposed to a trade standing differences. Nestle was eventually declared sale where the funds would be received by the the winner, and the deal was sealed in late 1993. 23 Box 6. Poland: Five Privatization Box 7. Hungary: The Problem of Dual Ministers in Five Years Authority In Poland, privatization has been a highly politi- Hungary's privatization process, while overall cized process since its beginning. The impact of quite successful, has suffered from the creation this has been compounded by frequent elec- of an institutional twin structure. Initially the tions-there have been five privatization minis- task of privatization was delegated to the State ters since the program formally got underway. Property Agency (SPA) directly under the Min- This has resulted in frequent changes in policy ister of Privatization. After elections in 1992, direction, privatization priorities and strategies however, the new government in addition cre- as well as of the teams in place. Further, the ated the Hungarian State Holding Company Polish process can require authorizations from (HSHC) with the mandate to take control over several levels of government and ministries as strategic enterprises in which the government well as approval from managers and workers. intended to retain at least some ownership. For foreign investors, the complexitv of under- Being more critical of privatization than its standing the role of the various players, discon- predecessor, the new government transferred tinuity in procedures and the difficulty of estab- many large SOEs from the SPA to the HSHC, lishing on-going relationships have been major which rapidly grew into another large privatiza- impediments to investing in Poland in the con- tion agency (see Table 1). Not surprisingly, the text of privatization. existence of two privatization agencies created political tensions, overlapping authority, and, at least initially, confusion over the effective responsibility for privatization in Hungary. Bv late 1994, the decision had been taken to does not de facto guarantee absence of govern- regroup the two bodies under the supervision of ment interference. In fact, it crucially depends on a specially appointed commissioner, motivated the government's commitment to let privatization in large part by the desire to streamline the pro- run its course, and no particular setup will automat- cess for investors. However, this process proved ically generate a successful privatization program. politically difficult, and Hungary's privatization By definition, privatization is an odd mix of program came to a virtual halt until mid-1995. politics and business. While a privatization pro- gram obviously is political by nature involving the transformation of an economv's structure, it be privatized as well as the method of privatiza- effectively translates into the sale of enterprises. . . . s The main challenge lies in striking a balance tion, and the final approval of divestiture. bhetween cratinge animpleminstring agealancy tThe executive agency is the entity that effectively bewe cratn an impemetinagncvtha implements privatizations by actually selling the has sufficient authority to carry out its mandate imlenspvaztinbyculysligth ofs sellingeStEsuinoaiefficientrmanne i. .nde SOEs. It should be established as an independent of selling SOEs in an efficient manner indepen- dent of any interference from within or outside of the government, while at the same time avoid- ing for the government as a whole a loss of con- Figure 5: Institutional Framework trol over the privatization process. Figure 5 shows the most structured approach to institutionally solve this issue of political con- Policy trol versus independent sales procedures. Steering elopment Effectively the privatization body is split into a Committee Process political steering committee and an executive agency which is responsible for actually con- ducting the sales. The steering committee is typi- Executive cally composed of high-level government repre-| Agency Implementation sentatives and is ultimately accountable for the privatization process. Reporting directly to the Head of State, it is normally responsible for the ia o development and tracking of broad policies Support Division or guiding privatization, the supervision of the Task Forces executive agency, the approval of companies to 24 agency, reporting only to the steering committee. Typically, this agency develops the guidelines for Box 8. Peru: Example of a Well-Structured the sales, proposes which enterprises are to be Institutional Arrangement sold by which techniques, and finally controls the complete sales process until the signing of Peru's privatization agency COPRI represents the sales contract. In order not to overburden an excellent example of an "arms-length" rela- itself with the time-consuming details of individ- tionship between government and the privatiza- ual transactions, such an agencv often creates tion agency. The COPRI is very independent committees or task forces for each partic- and operates outside the political environment. specal SOE.These committees report back to the This freedom was certainlv a key factor in ular SOE. These committees report back to the speeding up the process and rendering fast deci- agency and make detailed proposals on each sions. COPRI's board, which consists of five key sales transaction. In addition, the agency should ministers, sets policies and objectives. Under it, have some support services such as legal and the Executive Directorate has a relatively small technical advisory capacity at hand, either in- staff of only 14 employees who coordinate the house or through external services. These will transaction work which is effectively conducted typically provide specialized services to the task by the special committees called CEPRIs. Each forces, facilitating their work while guaranteeing CEPRI has three to four top executives, usually continuity of the agency's procedures. from the private sector, with one committee for Thus, the first critical success factor in trans- each SOE to be privatized. forming a political program into a business-ori- Based on this structure, Peru managed to ented structure is a clear separation of the develop one of the most effective privatization programs in the world. Privatizatioin has, to a responsibilities between the political steering large extent, been unaffected by short-termn committee and the executive agency. The demar- political concerns. A dvnamic and highly moti- cation of the roles of the steering committee and vated staff combined with the experience of the implementing body is a necessary precondition senior managers in the CEPRIs have resulted in in that it separates decision-making on particular a very business-oriented process, and virtually issues that are primarily political from the task of all investors involved praise the agencv for its "selling". Typically, the clearer the distinction efficiency, fairness, and technical skills. The between the two levels, the more likely that the result has been an intense competition for most implementation committee is equipped to han- of the enterprises for sale, translating into sales dle transactions in a business-oriented way. prices often beyond the most optimistic expecta- Many countries have adopted some version of this type of institutional structure. Peru's experi- ence is illustrative (see Box 8). However, Peru's success story is not simply On the other hand, Argentina and Mexico, two the result of its institutional setup. Ghana and of the world's most successful privatizers in Mozambique, for example, created a similar recent years, conducted their privatization pro- institutional framework without being able to grams under institutional arrangements which, side step the thorny issue of political interference at first glance, appear less than optimal. In (while certainly being more successful in this Argentina, SOEs were primarily entrusted to the respect than other countries in Africa). Both Ministry of Economy with only some falling privatization agencies, Ghana's DIC as well as under the responsibility of the Ministry of Mozambique's UTRE, were formally established Defense. Similarly, Mexico's UDP was estab- as similarly independent agencies in charge of lished directly under the control of the Ministry carrying out privatization transactions. Legally, of Finance. Both arrangements appear to lend both have the authority to conduct sell-offs, and themselves to substantial political interference. are quite capable of concluding privatizations in In fact, however, this did not occur, and both a reasonably efficient manner despite some agencies managed to operate very efficiently. The investor criticism that they seem to suffer from a Mexican government was well aware of the lack of sufficient technical and financial skills. In dangers of politics and bureaucracy in privatiza- practice, however, political intervention is not tion, and, driven by the desire for an efficient unusual. Often individual ministers or even the administrative solution, it granted the agency heads of state themselves intervene by overturn- broad powers and autonomy. In Argentina, the ing decisions by the privatization agencies to success of privatization is attributed in large part force a politically more acceptable outcome. to the iron-clad will of the President in 25 harnessing privatization to support his eco- Creating a Business-Oriented Privatization nomic turn-around program. His commitment Agency and drive actually overcame some of the short- comings of the institutional framework. Having created an autonomous and indepen- The examples of Ghana and Mozambique dent privatization agency in charge of the dives- illustrate how well-designed institutional set- titure process, the critical challenge now lies in ups do not in themselves eliminate political transforming this agency into an operational interference. Government involvement is often a business unit that can effectively conduct actual function of the agendas and style of individual sales. In order to obtain the best possible offer for heads of state. Motivated by the wish to mini- an asset, as many bidders as possible have to be mize negative political fall-outs from some attracted to the process, requiring the agency to privatization decisions, to speed up the process make it interesting for investors to participate. In by taking advantage of contacts with potential order to do so, the agency has to develop a clear investors, the desire to favor certain investors understanding of private sector mentality and over others (i.e., "flagship" investors), to pro- how investors approach a potential project. mote local entrepreneurs, or any number of con- The main problem many privatization agen- siderations, they can, at any point in the process, cies encounter is that, at time of their creation, override the authority of the privatization body. most of the staff come from the public sector Thus, success is crucially dependent on the with only very limited private sector experience. government's commitment to surrender control In many countries investors complain about the over the SOEs. In cases where this commitment lack of skills as well as the bureaucratic organiza- is not in question, such as Argentina and Mexico, tion of the privatization agencies. Table 1 shows any institutional arrangement will do. However, the general staffing features of the privatization in countries where such a steady support and agencies in the surveyed countries. commitment from the whole government might The Philippines and Peru, two of the most not be possible, it is typically better to establish a business-oriented privatization programs, rely well-defined separation between the privatiza- almost exclusively on private enterprise experi- tion agency and the political apparatus. Any ence for their staff. Argentina and Mexico did increase in the effective autonomy of the privati- rely more on civil servants, but due to the zation agency will give assurance to potential already well developed private sector in these bidders that the business aspects of privatization countries, public sector employees also had a are separated from the political ones. good understanding of the private sector. The Table 1. Overview of Implementation Resources Cofunltry Hungary Poland The Philippines Argentina Mexico Ghana Mozarnbiquc Peru Ministry Agency SPA HSHC MOP COP of Economny UDP DIC UTRE COPRI Staff 300 200 400 20 NAa 1ob 1ob 1ob 14b Training Civil Civil Civil Enterprise Civil Civil Civil Civil Enterprise Servants Servants/ Servants Servants Servants/ Servants/ Servants Enterprises Enterprise Enterprise Use of External Advisors Limited Limited Almost Limited Extensive Extensive Limited Limited Extensive none a. The privatizaton process had been completed and the unit disbanded by the time of the mission. b. Includes only resources at the Executive Directorate level. Individual commissions, sectoral groups or tasks forces consisting of 3-10 experts carry out implementation. 26 Eastern European and African countries, on the tions or occasionally acting as advisors on some other hand, were forced to rely on civil servants specific aspects of the process (see Table 1). Only to a significantly larger extent due to the small in relatively few circumstances did privatization size of the domestic private sector. Even the staff bodies use advisors extensively or even entrust members with company experience in most cases them with the full task of divesting. However, had to be recruited from state-owned enter- especially in the final steps of the process, the prises. Thus, it is not surprising that it was in promotion of the company to be sold and the these countries that investors complained more finding of potential investors, can external advi- often about bureaucratic procedures and the lack sors be particularly useful. of technical and financial understanding by their Privatization agencies are typically reluctant counterparts, resulting in bothersome delays. to involve external advisors extensively. Govern- However, even when available, privatization ments tend to be concerned with losing control agencies often find it quite difficult to attract pri- over the process, while the costs of such services vate sector expertise. Most importantly, being a are typically high. In order to limit the costs, public entity, the agency typically is limited to privatization agencies should always use a com- the standard public sector pay scale, while civil petitive tender in which advisors bid for the servant salaries in most developing countries are right to provide their services in a specific comparatively low. Thus, private sector expertise project. The project itself and the tasks expected comes at a price, but the incorporation of this to be carried out by the advisor must be carefully experience into the agency is essential. defined and their progress supervised continu- Some countries resolved this issue by involv- ously to ensure that they are performing accord- ing domestic top executives for the purpose of ing to expectations. managing specific sales transactions. The German In addition to the technical expertise gained, government, for example, apparently used its the use of external resources also increases the political influence to entice executives from the agency's flexibility. Eastern European countries largest West German companies to advise on have typically opted to establish very large individual transactions. In a similar fashion, privatization agencies. While this is partly Peru's COPRI managed to staff its special com- explained by the task to transform an entire mittees with senior managers from the country's economy, this approach often results in the cre- largest enterprises. Mexico initially used the then ation of a stiff bureaucracy which is not suffi- still state-owned commercial banks as agents to ciently flexible to accommodate individual inves- oversee the sale of individual enterprises. tors. Thus, the privatization agency might itself This strategy of using domestic human become a bureaucratic hurdle rather than a coop- resources is, however, limited to countries that erative counterpart. Instead, the institutional already have a reasonably sizable private sector. structure of a small executive body which super- Privatization agencies in much of Eastern vises special committees provides more flexibility. Europe or Africa, on the other hand, do not have The executive body itself supervises the priva- access to a comparable pool of talent. In such a tization process and gives it continuity by initiat- situation it might be necessary to hire this exper- ing the divestiture of individual SOEs, establish- tise from abroad. The hiring of such external ing the special committees, and ensuring that the advisors is often more efficient and less costly individual transactions are in line with the coun- than developing and maintaining a large staff of try's overall policy goals. The special committees specialists in-house. Many international invest- are responsible for all the detailed work involved ment banks and consulting firms are well suited in an individual transaction and are in charge of for this purpose with strong industry-specific carrying it through the divestiture process as effi- expertise and a global network of contacts. They ciently as possible. In addition, the executive can be very helpful at any point of the process body might provide support services to the indi- from evaluating and restructuring a company vidual committees through specialists and through sales promotion to bid evaluation and experts on specific legal or technical issues. In contract negotiation. such a setup, the bidders for particular compa- Some countries, notably Argentina, Mexico, nies have one main counterpart with the special and Peru, tend to rely on external advisors to committees who will be receptive to all their supplement their knowledge and speed up the specific questions and concerns, rather than process. However, overall the role of outside facing a large bureaucratic entity with a large advisors is often limited to preparing evalua- number of counterparts for individual issues. 27 7 The Process of Privatization: Step-by-Step The implementation of privatization really cess, but the management and workers of the should follow a fairly standard process (see company have veto power, often forcing inves- Figure 6). Companies are selected for privatiza- tors to effectively "buy" their cooperation tion and entrusted to the executing entity to pre- through some form of compensation. In order for pare them for privatization and carry out an the privatization process to start off reliably and asset valuation. The next stage consists of pre- effectively, the privatization agency clearly has to paring and promoting the sale of the asset be in the driver's seat. through a sales memorandum, advertisements While the selection of individual companies and other promotional tools. Once potential can never be entirely free of political criteria, the investors have expressed their interest, they are privatization agency should base its selection typically required to pre-qualify before being exclusively on technical criteria, driven by the allowed to submit a bid. Bids are then evaluated, agency's overall sales strategy and whether the and, after approval of the winning bid by the particular company is ready to enter the process. steering committee and final negotiations, can In general this depends on such issues as the the divestiture contract be signed. While the resource constraints within the agency, the length of such a process clearly would depend expected degree of difficulty of the particular on the complexity of the transaction and how transaction, and on how urgently the company well organized the privatization program is, on requires new investors. The final decision to go average a period of six to eight months should ahead with individual privatizations typically suffice to conclude a standard divestiture. rests with the political steering committee who will want to make sure that the actual process is Company Selection in line with the overall reform process. The strategy underlying the timing of the sale The first step is the selection of the particular can be based on a sectoral approach, the size of companies to be sold from the pool of available SOEs, or on the government's capacity to handle SOEs that has been cleared for privatization by transactions. Hungary, for example, adopted a the government. The privatization agency itself sectoral approach on the grounds that it was the should have the primary role in selecting the most effective way of ensuring that weaker com- individual enterprises, allowing it to develop an panies were not destroyed as stronger compa- overall sales strategy. The involvement of other nies were bought up and further strengthened entities in this decision will most likely introduce by the new investor. The major advantage of this political elements, jeopardizing the efficiency of approach is that it enables the development of the sales process. In Poland, for example, inter- sectoral experience among the staff. It also ested investors generally have to initiate the pro- results in efficiencies in promotion since it 28 Figure 6: Privatization: The Step-By-Step Process 0)Company Selection Divestiture Preparation for _ 0 Authorization Privatization Successful '%- & Contract -_ Iprivatization o Adjudication -I __ Asset Valuation Fairness Bid Evaluation 7 _ Preparation of the Sales Announcement Registration (t) Sales Guidelines ~ ($) and Promotion of interest enables investors in a certain sector to be approached for more than one potential acquisi- Box 9. The Selection of Companies for tion. On the other hand, privatizing an entire Privatization: Two Approaches sector as opposed to a single company may In Mozambique, individual ministries are in not actually favor the privatization of the enter- charge of submitting the names of specific SOEs prises most in need of restructuring and new under their responsibility for privatization. By investments. controlling the companies submitted for poten- Mexico and Argentina initially structured their tial privatization, primary stakeholders often approaches based on the size of SOEs. Mexico not amenable to privatization have de facto decided to focus on selling smaller SOEs in order assumed control over a key element of the to build up its institutional and marketing capac- divestiture program. In the absence of a "Master ity and expertise. This permits the privatization List" of parastatals, there is no way to ensure body to gather experience over time without that the appropriate companies are being put on jeopardizing the privatization program through the privatization block. highlyvisibl blundrs. Hwever,delayig theIn the Philippines, another approach to comn- highly visible blunders. However, delaying the pany selection was used. The selection of major privatizations can also have a negative privatization candidates was carried out right at budgetary impact, especially if the larger SOEs the beginning of the privatization process. A are running significant deficits. This is what special commission was formed by the Presi- prompted Argentina to launch its privatization dent to determine which government corpora- program with some of its largest SOEs which tions should be privatized. The primary crite- were running substantial deficits, namely air- rion used by the Commission was whether the lines, telephone, railways and oil. This "big- private sector could more efficiently manage the bang" strategy clearly has a strong promotional company or economic sector. Based on this effect by immediately alerting investors around determination, all selected SOEs were entrusted the world of the extensive investment opportuni- to the privatization agency which then assigned individual companies to the appropriate mar- ties in the country, made possible by an intensive keting or disposition entity. reform program. 29 Peru, on the other hand, placed all SOEs on the There are, however, other forms of, so-called auction block at once. The sequencing of privati- passive, restructuring, involving issues such as zations was essentially determined by the judg- the shedding of liabilities, reductions of the work ment of the privatization agency regarding the force, or reorganizing the company through ease with which individual enterprises could be breaking it up into smaller units. Such measures sold. If pursued consistently, the major advan- can substantially enhance the value and market- tage of such an approach is speed, but it requires ability of a company simply because many of a highly skilled and flexible privatization staff. these issues, if unresolved, will force the inves- Again, however, priority might not be given to tors to handle them, translating into an overall those companies which would most benefit from reduction in price they will be willing to offer. privatization. Public enterprises are often involved in a myr- iad of unrelated business operations, including Preparation for Privatization social services to the work force. Private inves- tors typically find it a burden to have to absorb Most SOEs require substantial restructuring in these assets when acquiring the company, this order to transform them into an efficient and being reflected during the privatization process profitable entity. The crucial question is who in lower bid prices and a smaller number of bid- should undertake this work. Generally, gov- ders. In such cases it might be advisable to break ernments will want to improve their SOEs prior the SOE up into smaller business units which to the sale in order to enhance their marketability will more easily attract the attention of strategic and maximize sales revenues. However, some investors. restructuring measures are very complex and The breaking up of individual SOEs is espe- time-consuming, significantly delaying the sell- cially interesting in the privatization of large off. infrastructure utilities. Not only can the gov- As a general rule, governments should not ernment target specifically the most qualified undertake any active restructuring, involving investors for individual activities by separating capital investment or physical restructuring. The the various business units of major SOE new owners are typically in a far better position conglomerates, it also allows for the introduction to carry out an effective investment program based on their business plan and long-term vision for the company. Any such restructuring undertaken by the government prior to sale Box 10. Hungary: Leaving Major might not enhance the value of the company Restructuring to Investors from the investors' perspective, and they will therefore not be willing to pay a price high In Hungary, restructuring is guided by the phi- enough to recover the investment costs. On the losophy that it is generally best left to investors contrary, the remainder of the enterprise might for the following reasons: decrease even further in value during the period of time needed for the restructuring. Thus, this "1.The new owner knows best how to operate strategy to increase the sales price might actually the company most effectively and how to backfire, resulting in an overall lower final sales price. 2. There were always limited resources for this In the privatization of a major Mozambiquean purpose and; cement company, for example, the government 3. According to the law, the SPA's task is to insisted on completing a rehabilitation program privatize, and since it owns the assets only involving new investments with bilateral finan- temporarily, it was better not to start time- cial support. The final buyer of this company consuming restructuring. However, in certain stated, however, that these new investments did cases, it was important to ensure the viability not contribute to the asset value because they did of enterprises. This was mostly needed when not match with the future plans the investor had their inherited debt burden hindered their for the company. The conclusion of the invest- effective operations, or when their deteriorat- ment rogra reslted n deays i theprivaiza-ing results originated from objective condi- ment program resulted in delays in the privatiza- tions such as the loss of Eastern European tion process without having a positive effect on markets".12 the sales price. 30 of some degree of competition in areas that were agree to maintain the work force when signing previously treated as public monopolies. In the contract. This imposes an often substantial Argentina, the electricity company SEGBA was financial burden on the future investor, and divided into eight business units, four genera- makes the successful conclusion of privatization tion stations, one transmission company, and transactions more difficult. Mexico experienced three distribution centers, prior to privatization. that kind of difficulty in 1991 during the privati- Similarly, the country's rail system was sepa- zation of Concarril, a major construction com- rated into six freight lines, six passenger lines, pany of railroad rolling stock. Despite massive and one subway line before arranging conces- labor surpluses, the government decided to sion tenders. solicit tenders for the company without any Another important task in the preparation prior restructuring. The tender had to be can- phase is to develop an internationally acceptable celed after only one investor proposed an unac- accounting system and balance sheets. It is not ceptably low bid. In response, the government unusual for SOEs to have large, and often hid- initiated an open bidding on the company assets den, liabilities which seriously jeopardize the only. All employees were formally laid off, and company's viability. Should this be the case, could be re-hired individually by the new owner. some financial restructuring in the form of liabil- After receiving various offers, the government ity shedding might be the only way to make the officially sold Concarril to a large Canadian com- company attractive. pany, which paid US$22 million in cash and Excessive manpower is another aspect of SOEs assumed the company's debt of US$46 million. that frequently poses a major impediment for Above and beyond enterprise restructuring, private investors. Maintaining all employees is some other issues have to be handled by the generally impossible for simple cost reasons, privatization agency to prepare a company for while massive layoffs clearly have a negative sale. Most importantly, it has to make sure all impact on morale, which is especially detrimen- ownership titles with the necessary documenta- tal right after the transfer of ownership, when tion are available and undisputed. Should the the new investor is trying to build a new com- property titles not be clear, a process has to be pany. Thus, this is one area where foreign inves- initiated to settle the issue conclusively, poten- tors have strongly expressed their desire for the tially through compensation or restitution. Resti- government to carry out restructuring measures tution in-kind is obviously much more complex through social and labor policies. since it involves transferring part or all of the Virtually all countries have experienced labor assets to the former owners, which can compro- problems, but some were more successful in mise investor interest and possibly even the dealing with them than others. In Argentina and entire privatization transaction. Peru, for example, extensive labor reduction The government must also clarify any possible prior to the sale is typically singled out as one of outstanding legal or environmental liabilities the most important elements that has contrib- against the company to be privatized. Such lia- uted to the success of selling their SOEs. The bilities can involve high future costs for the opposition by workers and unions in these two potential investor, and often create substantial countries was held to an acceptable minimum, uncertainty regarding the effective asset value. partly because the released workers typically In Peru, for example, the government had to benefited from the privatization gains through agree to clean up mine sites to comply with envi- attractive compensation schemes. Before offering ronmental regulations as part of the conditions Aguas Argentinas, the Buenos Aires water distri- of sale since investors were not willing to assume bution network, for sale, the state reduced per- the associated financial risk. sonnel from 7,500 to 3,600, and the released Finally, the privatization agency will have to employees received a compensation package collect all the available financial and technical worth two years salary. The private operator car- information about each enterprise. It is impor- ried out some further lay-offs, and by the end of tant to be as thorough as possible in the data 1995 salaries had increased by 40 percent. collection, because it will provide the back- In contrast, in countries such as India, ground information for all interested buyers. In Mozambique and Sri Lanka, the law prohibits many countries, investors complain about the the laying off of public employees for several difficulty to obtain this information as well as its years after the sale. Investors normally have to unreliability, and not infrequently the criticism 31 shapes investor attitude towards the privatiza- great difficulties in conducting reliable valua- tion agency as a whole. tions. All balance sheets tended to follow non- Western accounting standards, requiring a sub- Asset Valuation stantial amount of due diligence and auditing work. Many investors complained about the val- The issue of valuation can be a major stumbling uation as being the lengthiest and most conten- block in the privatization process. Naturally, the tious part of the privatization process. In an government will want to assess the value of the attempt to obtain an asset valuation closer to a asset at hand in order to get a good sense of the possible market price, Mozambique frequently potential sales revenue to be expected. In many conducts a calculation of the net present value of instances, however, valuation becomes a central the future cash flow, assuming certain invest- and time-consuming component of the process. ments undertaken by the new owner. This Especially in the African and Eastern European method does, however, result in highly hypo- countries we visited, investors frequently com- thetical and subjective values which often plained about the length of the valuation process grossly overstate the willingness to pay by and the often exaggerated price expectations. potential bidders. Ghana's divestiture program The main problem is that valuing a company tends to rely heavily on several asset valuations is far from being an exact science. Any valuation per project. Typically, three valuations are under- is highly dependent upon the underlying taken, one for the Divestiture Implementation assumptions as well the particular method Committee (DIC) by external consultants, one by employed, and hence the outcomes can vary DIC itself to validate that evaluation, and one by substantially. In an attempt to politically justify the potential buyer. While this almost invariably the decision to privatize as well as to ensure that results in a lengthy process, there is no guarantee the maximum price is being extracted, govern- that the final result is closer to the final sales ment valuations are often far too optimistic. price. In the sale of a major glass factory facing The experience of the Government of the bankruptcy, the DIC decided to use replacement Philippines in its attempts to privatize 65 percent value as the appropriate valuation method. The of the National Steel Corporation (NSC) pro- resulting asset value was far too high with not a vides a good example. When the government single investor being interested. announced the sale in mid-1993, the Commission Investors who participated in the privatization on Audit (COA), an agency explicitly created to programs of Argentina, Mexico, and Peru, on the assess asset values and to set minimum bid other hand, typically had no major complaints prices in privatization tenders, estimated a value about the asset valuation process. While valua- of P10 billion. Consultants to NSC itself esti- tions were undertaken in each of these countries, mated a value of P6.8 billion, and the highest bid the results obtained were typically considered received in the first tender among four interested benchmark values for informational purposes, groups was only P6.3 billion. The government and the government never considered them as opened a second round of bidding for a reduced the value towards which the sales price had to minimum price of P7.5 billion. The two remain- converge. Peru's COPRI, for example, set a mini- ing interested investors both declined, the priva- mum price before a tender. This price was tization failed, and NSC itself almost went bank- derived from valuation analyses, but was rupt due to its dismal financial state. The adjusted according to the extent and quality of government eventually decided to put another competition the agency expected during the ten- "Disposition Entity" in charge of this privatiza- der. Thus, in cases where only one investor tion, and direct negotiations were initiated with appeared to be seriously interested, the agency all four investors who had indicated an interest. would set the price close to the valuation to deter An agreement was eventually reached on October a low bid. In the more frequent case of several 31, 1994, when an agreement was reached with a investors being expected to bid, COPRI would Malaysian company for a 51 percent stake. set the price relatively low in order to attract Most governments try to protect themselves more competition, expecting the bid value to from accusations of selling out "the family sil- increase through stronger competitive pressure ver" by using some form of valuation to set a ref- instead. erence or even a reservation price in the bidding All these experiences show that a competitive process. Hungary, and especially Poland, had bidding process is the most effective way to 32 determine the market value of a company. If the activities to increase the circle of bidders. Foreign government uses an unrealistically high valua- investors will be interested in participating in the tion as the reservation price, potential investors privatization program only if the particular asset may shy away, reducing the number of potential for sale is attractive, and if the general business bidders. This loss of competition will translate climate is inviting. First of all, the agency should into lower offers by the remaining bidders, therefore engage in a general image building allowing them to discount the possibility of los- strategy, using the privatization program as a ing out to competitors. Thus, rather than empha- clear signal that a serious reform program is sizing the valuation of companies, governments underway through which the country has turned should be concerned with attracting as many into an attractive investment location. The sec- bidders as possible. In addition, by placing an ond stage involves a highly proactive and care- unduly strong emphasis on valuation, the fully orchestrated plan to attract investors to bid agency will tie up scarce resources which might on specific privatizations. This requires identify- be used more effectively in promotional activi- ing major global investors in the sectors of the ties instead. particular SOEs for sale. Once potential investors have been identified, the next step could be a Preparation of the Sales Guidelines series of "road shows" where information is pre- sented in order to attract the targeted companies Based on the information collected from the to participate in the privatization. enterprise, the privatization agency will have to The second part of this promotion effort is create a sales memorandum or prospectus which more skill-intensive than the general image will serve as an official sales announcement, but building part, and foreign advisors can play an also as advertisement material. Specifically, the important role in this aspect. Multinational in- sales guidelines should include a) specific infor- vestment banks and consulting firms have mation on the firm's activities and financial, access to a worldwide network of companies labor and commercial situation, etc.; and b) the and typically possess detailed sector-specific rules and guidelines pertaining to the tender knowledge. process. The importance of being able to provide These skills are often lacking within privatiza- foreign investors with relevant information on tion agencies, typically resulting in promotion the SOE cannot be overemphasized since inves- being a weak link in the privatization process. tors will be reluctant to bid if they cannot Most countries appreciate the importance of pro- adequately assess the value of the asset. The motion in theory, and have developed extensive description of the privatization process should agendas of promotional activities, including mis- outline all the steps required for an investor to sions, databases, advertisements and brochures. participate in the tender. Some countries, such as Hungary, have also set up Customer Service Bureaus to deal with indi- Sales Announcement and Promotion vidual investor requests (see Box 11). The privatization law should require a public sales announcement in local and international newspapers and clearly specify the exact time Box 11. Hungary: At the Service of period allowed between the announcement and Investors the pre-qualification or the tender. This is espe- cially important for foreign investors who often Hungary has invested in creating a system to are not very familiar with the country and service the information requirements of inves- require sufficient time to react to the announce- tors. In 1992, it created a Customer Service Cen- ment, carry out their due diligence and deter- ter which provides information on SOEs to be minen their duegy dge andudent privatized via publications or on-line. In addi- mine their bidding strategy. The announcement tion, through its own publications, it provides officially sets in motion the process within the information on upcoming privatizations as well defined timeframe. At the same time it serves as as the process itself. This publication is widely a first advertisement of a particular company for available internationally at embassies and sale. chambers of commerce and provides a good Besides the advertisement, however, the priva- promotional tool. tization agency should engage in promotional 33 Few countries, however, have successfully the bidder. The purchase of the Sales Memoran- designed and executed a promotional program. dum, which contains more detailed information In all the countries surveyed, foreign investors than the initial advertisement, acts as an early who participated in the privatization program signal to the privatization body to gauge poten- consisted overwhelmingly of companies with tial interest in the transaction. In the absence of previous ties to that country, or multinationals sufficient interest, the privatization body has the pursuing a strategy for the country to become a opportunity to adjust its promotional efforts. strategic investment location. This implies that The price of the Sales Memorandum should be the targeted outreach part of the whole adver- set so as to dissuade insincere inquiries but still tisement campaign is not functioning well, repre- ensure a broad enough pool of potential inves- senting a tremendous missed opportunity. tors. The combined effect of the requirement Argentina, Mexico, and Peru all have been imposed on interested investors to purchase the especially active in their promotion efforts. How- Sales Memorandum and sign a confidentiality ever, many government officials openly admit- agreement allow the privatization body to main- ted that the effectiveness of these efforts was tain control over the process. Because purchasers quite limited. Road shows for particular compa- of the sales memorandum are bound not to nies in industrialized countries rarely generated reveal its contents, all prospective purchasers additional investor interest. In many cases, they will be known to government, which can then seem to have been undertaken primarily for follow-up should the expressions of interest internal political reasons in order to prove to the translate into poor response to participate fur- public that everything was done to attract the ther. Finally, confidentiality ensures that individ- most suitable investor. Almost invariably, how- ual investors will not know the number of inter- ever, it turned out that resources for promotion ested parties, and hence will not be able to devise activities were used for the largest and most visi- a pricing strategy, based on the number and ble projects such as telephone companies or large identity of bidders. mining operations. In most cases, the number of potential buyers in these areas is quite limited, Pre-qualification and the existing players in these fields already tend to be well informed about new investment For most of the SOEs to be privatized, the opportunities. Thus it should not be too surpris- privatization agency will want to establish a pre- ing that no additional interest was generated. At qualification stage in which investors are the same time, however, medium-sized enter- required to demonstrate that they are financially prises and companies less known in the interna- and technically capable and experienced to oper- tional markets frequently did not receive much ate a particular enterprise. The challenge in pre- promotional support beyond the initial adver- qualification is to devise criteria to ensure the tisements for tender. Practically all the countries selection of desired investors while avoiding to we visited could have enhanced the effectiveness limit the pool of candidates unnecessarily. The of their promotion activities by focusing the elaboration of selection criteria should encom- available resources more towards those projects pass the financial and operational ability of pro- that would benefit most from additional visibility. spective investors to meet the minimum require- ments specified in the sales memorandum such Registration of Interest as investments, labor training, or technology transfer. The body responsible for the divestiture pre- The agency should try not to overspecify the pares the Sales Memorandum which is essen- requirements through a large number of techni- tially a descriptive prospectus containing the rel- cal criteria so as not to exclude investors with evant information about the company such as particularly imaginative business plans. The few financial statements, credit history, labor and criteria employed should be made public from commercial situation. Prospective investors are the outset and should be clearly specified to generally required to register their interest by reduce the possibility of subjective decision mak- purchasing the Sales Memorandum, agreeing to ing. For example, in the case of a gas distribution abide by the stated procedures, and signing a privatization in Argentina, interested companies confidentiality agreement. Generally, a copy of had to demonstrate that they had experience in the standard contract of sales is also provided to operating a minimum of a 1,000 km pipeline. 34 Bid Evaluation Table 2. Sample Evaluation Criteria The final evaluation of all bids received and the Basic Criteria (Pre-Qualification) determination of the winning bid is undoubtedly * Technical skills the most crucial step in the process, and also the . Sources of financing and financing ability one which is most often criticized by investors. In * Managerial capabilities order to avoid jeopardizing the overall reputa- Technical Criteria tion of the privatization program, the privatization * The overall business plan with emphasis on growth agency should make sure to establish a decision- prospects making process which is absolutely transparent * Investment plans and unquestionably fair. . Maintenance of the workforce This being the critical step in the privatization * Employee training programs process, governments understandably want to * Impact on the community make sure that they award the bid to the investor * Technology transfer they consider to be the best one. In many privati- * Environmental impact zation programs the various bids received are Price and Payment Terms being compared based on a number of different * Offer price criteria. Some of the most frequent ones are * Method and currency of paymennt shown in Table 2. While the bid price always * Payment terms plays an important role, much emphasis is often placed on the technical criteria to ensure that the eventual owner follows a business development strategy in line with the government's objectives. himself apart from the other bidders by develop- The main difficulty with this approach is that ing personal contacts with the privatization body subjectivity almost unavoidably creeps into the while persuading the agencv officials of the mer- process. Many of these criteria cannot be defined its of their particular business plan. narrowly enough so as to allow for ready com- In general, the result of allowing too many parison. And even if this can be done, the ques- underspecified elements to enter the final bid tion is how to compare different criteria to reach evaluation is that the privatization agency is left an overall objective decision regarding the best with a number of lengthy bid documents which proposal. While the individual criteria, on which cannot be compared objectively. Consequently, the final evaluation is based, are made known to the final decision has to be based on a vague and all bidders in the Sales Memorandum, the details subjective comparison. This renders the agency are often not sufficiently specified. Consequently, vulnerable to criticism from the losers as well as privatization agencies receive lengthy proposals the general public that the decision was made including detailed business plans that resemble illegitimately. At the same timae, the government marketing documents which effectively are typically refuses to make the decision criteria impossible to compare. publicly available, knowing how easily the deci- Both, Ghana and Mozambique, placed espe- sion could be challenged, further supporting the cially strong emphasis on the technical compo- claim of irregularities in the process. nents of bids, and in many transactions were One way to avoid this problem is to set priori- subject to criticism because of the subjective and ties among a very limited number of technical cri- non-transparent nature of the final decision. teria and define a point distribution system, Investors often found that the skill level at the clearly establishing the weight each criterion has privatization agencies was far too limited to in the final decision. All criteria should be defined allow for a serious analysis of the technical speci- so narrowly, preferably in quantitative terms, that ficities of individual proposals, and many the individual offers can be compared without any expressed a suspicion that the government used difficulty. However, even in such a system, which such vague technical criteria to cover up politi- appears to be more transparent and objective, criti- cally motivated choices. Some investors also cism will be unavoidable. The point distribution openly admitted that they would leave some system itself will always be questioned and any details in their proposal unclear, forcing the criterion that fails to allow for a straightforward agency to ask for a more detailed explanation. comparison will be used to challenge the decision This would allow the individual investor to set and the privatization program as a whole. 35 An alternative is to carry out bid evaluations usually a committee of ministers or the head of based on price alone (see Box 12). The decision is state. The contract is finalized between the two straightforward and cannot be challenged, while parties. In some cases, the declaration of a win- the privatization agency will have no reason to ning bidder and the signing of an agreement in hesitate in making its decision publicly available, principle are followed by further negotiations. allowing everybody interested to inform himself. This often is the result of not having specified all In fact, the process can be entirely transparent details sufficiently during the process and can through a public opening of the bids followed by have a very negative impact on the perception of an immediate decision. the privatization program by investors who Choosing a winner based on price alone does already went through a lengthy process to not imply that the government must give up acquire the SOE. selecting investors with a good strategic fit for One of the most important lessons the Argen- the country's development. Instead, the agency tinean government learned from its first privati- determines the technical requirements already zations was that declaring a tender won can be during the pre-qualification and writes them as quite meaningless, in case the details of what clearly determined elements into the final con- exactly has been tendered are not sufficiently tract. These criteria will then become pre-condi- specified. A sample contract was included in the tions any bidder will have to fulfill, and the final Sales Memorandum not so much as a final docu- awarding of the bid can be handled in absolute ment, but rather as an indication of the main transparency based on price alone. Handling the clauses and conditions which would be in the process of bid evaluation in such a manner will final contract. rhis resulted in the perception on also simplify and streamline the post-bidding the part of bidders that they could negotiate fur- negotiations. Fixing the crucial elements in the ther, which often led to a second round of contract will limit the flexibility of the investor as unplanned negotiations with the investor. well as the government to change the prelimi- Once the government has officially declared a nary agreement reached. winner, it will lose its bargaining power with the elimination of the competitive environment of Authorization and Contract Adjudication the tender. The investor knows his position as well as his potential competitors, while it is not The recommendation of the winning bidder very likely that the government will retract its must be ratified by the ultimate authority, decision easily. Thus, effectively all components of the transaction might be open for renegotia- tion, often resulting in lengthy delays while cast- ing doubt over the relevance and fairness of the Box 12. Price-Based Selection in Peru and whole privatization process. Argentina Divestiture Argentina and Peru include a contract in the terms of reference, stating the main clauses and The privatization agency is responsible for the conditions of the privatization as well as all crit- expedient transfer of property to the new own- ical technical components. The prospectus as ers. With the conclusion of the deal, some coun- well as the contract are unofficially circulated tries choose to make all relevant documents pub- several times for comments among the pre-qual- licly available. This reinforces the perception of a ified bidders. An official prospectus is then dis- transparent and fair process and, ultimately, tributed which, once sold to investors, can no enhances the country's image as an attractive longer be modified. The contract has to be investment location. signed by all bidders and presented as part of Mexico and Peru attach particular importance their bid, leaving only the price as the determin- ing factor in the evaluation of bids. At the time to the transparency of their privatization pro- of the tender or auction, the privatization agen- cesses. Once a sale has been completed, the spe- cies then typically open the bidding envelopes cial committee responsible for the actual transac- publicly, with the national media present, and tion prepares a document known as the "White immediately declares the winner based on the Book" which contains all the official documents highest bid price received. related to each stage of the sales process. It con- tains a description of the privatization process, 36 including the names of all the participating bid- the company, and is publicly available to any ders and the main components of their bids. It interested party. provides an explanation for all the decisions made during the process, including the final Notes award of the SOE to the winning bidder. This document is sent to the Ministry responsible for 12. "Privatization in Hungary", AVRT/SPA publication, 1994, p.16. 37 8 Conclusion Foreign direct investment can play a crucial role program, investors will decide whether the in supporting a country's industrialization and country does actually represent an interesting private sector development. Privatization of investment opportunity. public enterprises can serve as an important The government has to prove its commitment mechanism to enhance this process, not only to open the economy to private economic activ- through direct involvement of foreign investors ity by reducing public sector involvement. A in the privatization program itself, but also by wide-ranging privatization program has to be using the privatization program as an effective established that is legally and institutionally advertising program to show the international equipped to efficiently and effectively transfer investor community that the country is develop- ownership in SOEs to private entrepreneurs. ing into an attractive investment location. Expe- Equally important, the process has to be man- rience has shown that FDI inflows tend to aged in an objective and fair manner, assuring increase rapidly in conjunction with a successful investors that they can compete on a level pay- privatization program. ing field, free of any undue interference by the There certainly is no such thing as a standard government. model or a blueprint for creating a successful These principles of commitment, business ori- privatization program. However, certain funda- entation, and transparency have to be the guid- mental rules and principles exist which have to ing principles of the entire privatization pro- be observed, if privatization should serve as an gram. They are not disjoint and unrelated effective macroeconomic tool. Foreign investors conceptual activities, but have to shape every will carefully watch the government's privatiza- aspect, from the creation of an appropriate legal tion efforts in order to evaluate its sincerity to and institutional framework down to every sin- improve the business climate in the country. gle step of the actual sales process. Negative Public announcements and declarations in sup- experiences related to any of these elements can port of a reform program will not suffice. Based be sufficient to derail privatization and damage on the treatment of bidders in the privatization the country's reputation as a good investment process and the overall effectiveness of the location. 38 Annex: Foreign Investors Surveyed 1. GE 17. Acco 2. ABB 18. G.M. International 3. Alcatel 19. Taylor Woodrow International 4. Holsten-Brauerei AG 20. SIPEF 5. Pepsico 21. Gold Fields of South Africa 6. AEG 22. Marriott International 7. Reemstsman 23. S.A. Bottling Company (Suncrush) 8. Henkel Austria Group 24. Houston Energy 9. Irving & Johnson 25. Bombardier 10. Julius Meinl Int. 26. British Gas PLC 11. Unilever 27. Sancem International 12. Cimenteries CBR 28. Premier Food Industries 13. Siemens 29. Dominion Energy 14. Cargill 30. Railroad Development Corp. 15. MD Indol Int. 31. Southern Electric International 16. Guiness PLC 39 I * w THE WORLD BANK 4 A partner in strengthening economies and expanding markets to improve the quality of life fo people everywhere, C especially the poorest The Foreign Investment Advisory Service (FIAS), a joint facility of the International Finance Corporation (IFC) and the World Bank, was established to help governments of developing member countries to review and adjust policies, institutions, and programs that affect foreign direct investment. The ultimate purpose of FIAS is to assist member governments in attracting beneficial foreign private capital, technology, and managerial expertise. FIAS Occasional Papers report the results of research c on practical issues which the staff of FIAS identify in o the course of their work. The research has either been carried out or sponsored by FIAS. The Papers will be 3 issued as research findings become available. tr ~-. C D 9 70821 338247 ISBN 0-8213-3824-2