Lessons of Experience No. 1: Privatization: Principles and Practice Executive Summary

Executive Summary
By David Donaldson and Dileep Wagle (1995)


Since the term "privatization" was given wide currency by the sale of British Telecom in 1984, many developing countries have launched privatization programs, and many more are in the process of joining the club (1). In pursuit of its mandate to further economic development by encouraging the growth of productive private enterprise in developing countries, IFC has naturally and increasingly been involved in supporting this movement, both as an adviser and as an investor. Nearly a decade has passed since IFC's first recorded privatization transaction. This paper reviews this experience.

The dimensions of the privatization revolution have been huge. The most profound change of all has been experienced in Eastern Europe and the countries of the former Soviet Union after the fall of communism, which have adopted a variety of techniques to transfer ownership rapidly to private hands. For four countries in Eastern Europe (2), the average share of national GDP attributable to the private sector increased from 20% to more than 50% over the three year period 1990-1993.

In other regions, ownership transfer has been largely by cash sale. An IFC-compiled database of larger, non-voucher-based sales records about 2,300 transactions in over 60 developing countries between 1988 and 1993, yielding US$96 billion in revenues (3). These figures exclude the rapidly growing number of new private entrants to infrastructure sectors, such as independent power producers. There has been considerable regional variation; the bulk (57% by value) of privatizations took place in the Latin America and Caribbean region, while very few have taken place in sub-Saharan Africa and the Middle East and North Africa. There is a symbiotic link between privatization and capital markets development: faster rates of privatization are associated with broadening and deepening the supply of domestic and international capital.

The economic benefits of privatization are now widely accepted, and can include: improving enterprise efficiency and performance; developing competitive industry which serves consumers well; accessing the capital, know-how and markets which permit growth; achieving effective corporate governance; broadening and deepening capital markets; and, of course, securing the best price possible for the sale. Chapter 5 of this report indicates that IFC's experience lends strong support to this view. Privatization is always political, however-political in the sense that governments have aims that are non-economic. These can involve, as in the former Soviet Union and Eastern Europe, the swift transfer of assets to private hands, in the full knowledge that the needs of the new owners for help in turning the enterprises round would remain for another day. Other political objectives include achieving a wide shareholder distribution, targeting certain classes of buyers (and excluding others, particularly foreigners), ensuring that enterprises do not close, reducing budget deficits/raising money, and maintaining employment and other social obligations. There are also political impediments to overcome, primarily the conservative or sometimes obstructive attitudes of existing managers and employees of state-owned businesses, who may be fearful of the challenges of the market place.

Accommodating political objectives and overcoming political impediments have economic costs in lower purchase prices; in reduced competition for the sale; in lost access to markets; and in continued inefficiency after privatization. It is in this context that IFC operates. As an advisor, its history has been one of developing techniques custom-tailored to the political market that allow privatizations to be concluded and maximize the economic gains to be realized. In doing so, it combines a knowledge of markets and investment finance, the ability to manage complex transactions and an understanding of what matters to sellers and potential purchasers, with an ability to perceive the national and public viewpoint, and build confidence on the part of governments that it is able to do so. As an investor, on the "buy" side of privatization, it provides the support and comfort private sector sponsors are looking for when they bid for privatized assets, either as a co-investor or a financier of investment programs post-privatization, and assists with the mobilization of the necessary funds. In both, the art practiced is to make the transaction succeed in spite of political constraints-to "do the doable."

This report therefore discusses IFC's experience from two perspectives: as an advisor involved before the sale, where it illustrates how IFC assists in the tradeoff between political and economic goals to conclude the deal; and after privatization, where IFC's investment finance experience enables a discussion of the economic benefits that have ensued. This dual perspective is almost unique to IFC. The report goes on to address indicators of the development impact of IFC's involvement, and its future directions and role.

The Experience Base

The range of IFC's advisory assignments has been wide. Assignments have included a central catalytic role in developing practical models for the nationwide transfer to private hands of the vast bulk of Russia's industry, commerce, and agriculture. This has featured cash auctions for small, primarily retail, businesses, the auction-based use of privatization vouchers for medium and large ventures, and a system of certificates permitting the auction-based breakup of collectivized farms. In addition, to being involved with the design and pilot implementation of these models, IFC has also been involved in their roll-out, first throughout Russia, and then to Ukraine and Belarus. IFC's advisory effort has also featured single enterprise sales-around 60 assignments started to date-which have served as model transactions at the early stage of privatization programs. The first were in Poland and the Czech Republic, and involved flagship, large industrial and manufacturing enterprises. IFC's efforts were then expanded, first to Latin America, and a wider range of sectors, and then to other countries. Examples include the electricity sector privatizations in Peru, Colombia and Trinidad and Tobago, airlines in Kenya and Zimbabwe, and, more recently, two of the first public offerings in Russia, and a group of nine large privatizations in Haiti. To date, the 22 completed sales have generated revenues for governments of over US$1.2 billion, and commitments to future investment of more than US$0.5 billion.

As an investor IFC will not finance any part of the purchase price of privatized assets (4), but is prepared to arrange financing for the post-privatization investments without which the purchase would make less or no sense. A total of 63 investments have been approved in direct association with privatization ranging from small banks in sub-Saharan Africa to giant industrial concerns in Eastern Europe. A further 23 approvals have been granted in support of post-privatization investment programs in infrastructure, such as the Mexico City toll road and the municipal water and sanitation system in Buenos Aires. In total, these two groups have accounted for around 12% of IFC's approval volume over the period 1992-95. Two categories of broader support to privatization are not covered in this report: (i) over 80 greenfield investments approved in infrastructure sectors such as power, telecommunications and railroads, which have, until very recently, been dominated by public ownership and management, and could therefore be deemed "privatization by entry"; and (ii) investments in funds, particularly in Europe, which are partly designed to take positions in privatized companies.

Before: Making Privatization Work

Each stage of privatization involves balancing economic and political goals. What is possible is also shaped by the specifics of the business involved, and other country economic circumstances, particularly those relating to the stage of development of domestic finance markets. This panoply of factors determine the institutional framework and approach to the whole program: how to structure each particular divestiture, the steps that need to be taken in preparation for sale, and how to manage the sale and negotiations.

At each point, the keynote is political transparency. Insisting on transparency maximizes the popular perception that the playing field is level-and strengthens support for privatization. Signals are often conflicting; different government officials hold different views and the legal and administrative authority for decisions is not always clear. While there is no easy solution to this, it is not IFC's role to judge the "fairness" of different political objectives, or whether the "correct" balance has been struck between economic and political goals. Rather, IFC informs the decision making process by advising on the likely economic cost of political aims. In doing so, it plays an implicit, and sometimes explicit, advocacy role for maximizing economic gains. The eventual decisions must be widely acceptable, however, to avoid popular disaffection with the entire process. A key tenet of IFC's approach is therefore that the process be transparent and in the public domain.

The appropriate institutional framework and approach depends largely on government strength and commitment. It may be top down, as in Peru, where a strong government accorded economic goals precedence in all its divestitures, including the breakup and privatization of the power authority, Electrolima. Where the risks are very high, the approach has to be bottom-up. The key feature of small-scale and land programs in Russia was that IFC worked with a progressive local provincial authority to take the political risks inherent in developing models for rapid transfer. They were demonstrated to be practically workable and garnered widespread popular support. Achieving this entailed the promotion of competition, the mounting of effective information and publicity campaigns, and in the case of smaller-scale work, a grass roots dialogue with the affected public to respond to public concerns. The national authorities could (and did) then embrace this approach with much of the political risk already defused.

In Eastern Europe and the former Soviet Union, the rapidly deteriorating economic conditions translated into a need for speed; the size of the economies and the sheer magnitude of the task of transformation, required a need for replicability. The privatization results in Russia since 1992 are illustration of this: 75,000 small-scale businesses have been auctioned; 14,000 medium and large scale firms sold; and, 30-40 million new shareholders created. A transformation so fast, and so profound, is unparalleled in recent times. The speed meant, however, that individual appraisal of each transaction was not possible. Consequently there remain many post-privatization needs, particularly relating to capital markets development, which form a growing part of IFC's work.

For a privatization program to gain momentum, early sales have to succeed. This suggests privatizing the easy candidates first. Unfortunately, the pressures on governments mean that they are often tempted to pass on the headaches first: the loss-makers, the indebted, the already-closed-down, and so on. The adviser, with a knowledge of the marketplace and an ability to judge the enterprise, has to help the government make the choice, and once the choice is made, has to deliver the sale. IFC's role is to advance the process by delivering on difficult assignments. The privatization of Altos Hornos Zapla-a near-defunct steel mill by a near-exhausted iron mine up-country in one of Argentina's poorer provinces-for example, was a successful prelude to the Ministry of Defense's future program of 30 more divestitures.

Political pressures are not restricted to strategic design; they often make themselves felt most acutely when the deal is being structured. The government may wish to retain strategic control. This need not always be anathema to the buyer, though the sales price will almost certainly suffer. The flexibility demonstrated by the Peruvian Government in putting up a 60% majority shareholding in Lima's electricity distribution system, enabled a difficult sale; the insistence of the Government of Trinidad and Tobago on retaining 51% of the power generation business had costs, but it was possible to engineer a sale with detailed attention to shareholder agreements. More generally, how many shares are sold to whom is often politically determined. In the former Soviet Union (FSU) and Eastern Europe, management and workers have acquired control of companies to varying degrees, depending on the political power they exercised-strongest in countries like Ukraine, and weaker in those such as the Czech Republic. Whether foreign strategic buyers are courted depends on how serious business needs are, and how seriously these are taken. Many of IFC's large industrial advisory assignments in the Czech Republic involved enterprises which needed an infusion of modern technology that only a foreign strategic investor could supply, but not all chose to follow this route.

The quality of the company's future corporate governance is also affected by the deal structure, though even when this appears to have been sacrificed, market institutions sometimes finds unexpected ways of working. Promoting competition is also desirable, as in the breakup of the Russian trucking industry though vested interests may disagree, and accommodation may have to be reached. There are different ways of ensuring competition, and the best should not be the enemy of the good. Buyers may be prepared to accommodate prescriptions on job retention, but they are reluctant to take over company schools, houses and hospitals. Finally, capital markets need not be viewed as insuperable constraints-privatizations are often the ideal vehicle to achieve capital market broadening and deepening (e.g., the SFM furniture factory in Poland, among many others), and the adviser should be able to assist with this.

A variety of steps can be taken in preparing for sale. There are rules of thumb, but the real art lies in knowing when to cede to pressure to break them. Governments should often absorb debt in order to sell an enterprise (in some cases, e.g., SFM simply in order to restore positive value to the company)-but this can provide the wrong signal to SOE managers still waiting their turn. Furthermore, big companies are a smaller swallow when they carry some debt. Government should almost never invest before sale-except to complete ongoing programs and keep enterprises open. Requiring a purchaser to sign up to an investment program after sale is commonplace, and does not often cause problems-though complicated requirements have costs, as in the case of the methanol company in Trinidad and Tobago. Valuation is best left to the market, but governments are often concerned to demonstrate they have got a good deal and advisers are almost always asked to price a sale beforehand. Deciding how to pitch this is as political as it is technical. Reorganization is best left to the new buyer-but improving accounts is useful, and good management while the enterprise is on the block is critical. Otherwise it will, as did First Brno in the Czech Republic. Finally solutions to past environmental misdeeds must be found which reconcile the government's desire to wash its hands of future liabilities with the private purchaser's reluctance to sign a blank check.

Managing the sale process itself involves balancing two factors. The first is the nature of the business in question-in particular its size and complexity, and, not often appreciated, its attractiveness to potential buyers. The second is the need of governments to be seen to have been fair, and, especially, not to have undersold the "crown jewels." While maximum transparency and completely open competition offer the best way of doing this, they are rarely feasible, or desirable from the business point of view-apart from for the very simplest, smallest transactions. Ensuring the buyer is properly qualified may be important if the future development of the company is a concern; many aspects of complex sales cannot be simplified to a cash price; and, for some businesses there may be only one or even no buyers. Pre-qualification of buyers, pre-negotiation of tender conditions (particularly under the pliego model), or simultaneous negotiation after tender submission with more than one bidder offer solutions to combining a measure of transparency with getting the best deal. In circumstances where transparency has to be sacrificed, IFC's perceived independence as a member of the World Bank Group can help.

After: Post-Privatization Experience

In many ways achieving a sale represents success in privatization-the mere fact that private investors have been found who are prepared to risk their own money on the company indicates that they believe they can make it work, and creates an incentive for them to do so. IFC's experience as an investment partner of companies after they have been privatized, and in following up on certain of its advisory assignments, allows this to be examined. Have the concessions made to political aims and interest groups in guiding the privatization to its conclusion been so great that the transfer has made little difference to how the enterprise is run? And if there are benefits, are they fairly shared?

Such concerns have been particularly pronounced in the FSU, but there are already indications that Russia's new entrepreneurs are rising to the challenge. Of 1,000 buyers of small-scale businesses, two-thirds had undertaken repairs in their first year, and in 90%, employees were now working more intensively than before; nearly three-quarters were profitable, and in two-thirds the number of customers had increased. Eighty-six percent of the businesses had plans for future growth: and, four out of five said, if the sale were repeated, they would do it all over again (Box 5.1). The voucher privatizations of larger enterprises are leading to some share consolidation, and there is anecdotal evidence that in a significant number of cases, the new principal shareholders-often voucher or investment funds-are starting to supervise management more closely. And though the program has moved more slowly, the pilot participants in land privatization appear, even in their first years, to be performing as well as, if not better than, state farms, employee motivation has improved, and new downstream ventures like processing factories and cafes are being created.

Concerns are also frequently voiced regarding privatizations in markets with natural restrictions on competition. Does not privatization substitute a private monopoly for a public monopoly? How, then, can consumers be expected to gain, unless the monopoly is closely regulated? IFC's experience in 15 infrastructure investments-including port terminals, a toll road, gas distribution, water and sanitation, local and international land-line telecommunications, railroads and power generation, transmission and distribution-points to three answers. First, they are not the natural monopolies they were once thought to be. Competition can be introduced at the point of sale, or by auctioning concessions by breakup, by using "yardstick" measures, by regulation, or simply-as in the case of the Argentine railroads-by leveling the playing field to allow private service providers to compete on fair terms. Second, key cases for which there is evidence suggest that there are major economic gains from privatization, including better and cheaper services, rapid increases in coverage and a reduced drain on government budgets. Finally, even when a monopoly continues to exist, as in the case of the Buenos Aires water supply and the Chilean telecommunications system, consumers were much better off.

This evidence is supported by aggregate indicators of the performance of the privatizations considered here. Two-thirds of the firms involved saw profitability improve after privatization, whereas only three saw it worsen. The performance of the group for IFC's portfolio is somewhat better than average. Supervision reports suggest a moderate incidence of problems. Finally, an overall snapshot classification of those transactions for which there is operating experience suggests clear economic benefits in around 70% of cases; and few instances where privatization could be fairly blamed for any deterioration. Individual cases reinforce the message that the benefits of privatization depend on improving the accountability of managers, and on the sponsors' capital being at risk.

Indices of Impact

The report presents four main measures of IFC's development impact in its privatization work, the premise being that IFC's role increases with the difficulty of the circumstances surrounding the privatization. The majority of IFC's advisory assignments and investments relating to privatization have been made in countries where the business and political environment could be described as moderate to poor, using an independent index of country risk. Projects have been pursued in Mozambique, Rwanda, Nigeria, Ukraine, Russia and Estonia, as well as Argentina in the early days when country creditworthiness was still low. A substantial proportion have been in markets which have been traditionally viewed as non-competitive (particularly the infrastructure sectors), and where private sector participation is a relatively new idea, and requires careful management. Relatively few have been in both risky countries and uncompetitive markets; though infrastructure advisory assignments in the pipeline in Haiti, Bolivia, Uganda and Kenya, are steadily reducing this no-go area.

Another indicator of role is the prior profitability of the enterprise, Governments often want to sell loss-makers, which are naturally less desirable; when IFC aids such a sale it adds value by strengthening commitment to the process. Nearly half of the firms for which data was available were either closed or performing poorly before sale, and only one-third could be described as enjoying good prior profitability.

Finally, many of these privatizations featured circumstances which presented challenges. Of the 22 discrete advisory assignments and 62 investments which have resulted in sales to date, around 15 have been truly innovative, including much of the large and continuous effort in the former Soviet Union, and transactions such as the Aguas Argentinas concession, which offered the first major privatization of water and sanitation in the developing world. Around 30 have been among the first privatizations in the country, or in a key sector such as infrastructure or banking; and around 8 have introduced direct foreign investment for the first time in the country, or in a key sector. There have also been at least 15 examples of direct capital market developments new to the country, most directly facilitated by IFC. In all, four out of every five IFC involvements in privatization has featured one or more non-trivial "firsts."

Future Directions and Role

Privatization is always political, and IFC's role in privatization is defined by the evolving frontiers of political commitment. In "doing the doable," IFC helps to expand the envelope of what is possible: in its advisory assignments, by helping design transactions which balance political and economic objectives, and serve as models for the process as a whole; in investments, by providing the comfort needed to bring investors and finance to the table in difficult circumstances; and in developing capital markets institutions to mobilize savings and enable popular participation. This role in privatization fully complements the top-down, policy-based advisory and lending operations of the World Bank, the pattern following that of cooperation between the Bank and IFC in private sector development work in general. This includes using IFC's transactions-based experience to contribute to the analytical debate and policy outcomes.

In regional terms, where IFC plays its future role is entirely dependent on evolving government commitment to privatization around the developing world. Eastern Europe is likely to remain prominent to the year 2000. In Latin America and the Caribbean (LAC), the process is near-complete in a number of first-tier countries (Argentina, Chile, Mexico), but commitment is growing in a second group (Peru, Bolivia, Brazil, Trinidad and Tobago). Asia is likely to continue to focus primarily on concessions and joint ventures rather than direct privatizations, particularly those featuring trade sales. The Middle East and Africa are likely to see continued slow growth, though there will be some exceptions in individual countries, and infrastructure will start to open up.

IFC only plays a role until private sector advisers, investors and bankers are able to take over. Advice will continue to be focused at the early stages of the privatization program, to develop model transactions with practical lessons for program design, involving skills transfer and capital market development. It will also continue to feature the larger, more complex and politically sensitive transactions as privatization programs evolve. The investment role will be to support a wide range of purchasers in early privatizations, to be more focused on infrastructure in programs that are underway, and to concentrate on capital market development and mobilization in the more mature cases. In regional terms, advisory concentration is likely progressively to shift from first-tier countries in Europe and LAC to second-tier countries, and to feature the more complex transactions, including in the infrastructure sectors. Investments in privatized companies are likely to continue to arise as part of IFC's regular investment program in Africa and CAMENA, and in countries that are newcomers to privatization elsewhere in the world. In Eastern Europe and LAC, where the process is maturing, these are most likely to be in infrastructure, and in capital markets development.

Although individual country scenarios are difficult to predict, it is certain that the momentum of privatization will be sustained worldwide in the medium term. This paper illustrates the role IFC has played, and can continue to play, in supporting this process, and indicates some of the lessons of IFC's experience in the field. In general, it demonstrates that the approach to privatization can encompass many shapes, and that there are few set prescriptions. The future will see continued rapid evolution, and innovative new solutions to new problems. IFC will continue to practice the "art of the doable" on this frontier.

    1. Though some prefer to use different terminology "corporatization," "capitalization," "restructuring," etc.
    2. Poland, Hungary and the Czech and Slovak Republics.
    3. Frank Sader, "Privatizing Public Enterprises and Foreign Investment in Developing Countries, 1988-93" FIAS Occasional Paper 5, IFC, 1995.
    4. Except in unusual circumstances, such as Hungarian Telecommunications Company.