Privatization and Business Valuation in Transition Economies

Chapter 9 Privatization and Business Valuation in Transition Economies

Raj Aggarwal a, Joel T. Harperb aGraduate School 0/ Management. Kent State University; hFlorida Atlantic University

Key words: Abstract:

Privatization, Equity Valuation, IPOs, Vouchers (JEL: G24, 034, P34) As the global -economy moves ever more to market-based economic systems, increasing numbers of state-owned organizations are being privatized. However, privatization in transition economies generally faces significant macro-economic instability, non-existent or underdeveloped capital markets, and unreliable and inconsistent information. In addition, for the owning national authorities, maximizing the sale prices may be only one of many economic and political goals. Thus, the valuation determinants of privatized firms in the emerging economies are significantly more complex than share offerings in developed capital markets. This chapter reviews the results of the various privatization procedures, and presents some empirical results and concludes that voucher privatization can be one of the more successful procedures in distributing and fairly pricing ownership in formerly stateowned companies.

1. INTRODUCTION Privatization has been a major global trend over the last quarter century, and it has accelerated in the 1990s with the widespread ideological move to market driven economic systems. Megginson and Netter (1998) report that the 18 largest and 33 of the 38 largest share offerings have been privatizations. Privatized firms represent over 20 % of the non-US value of L. L. Jacque and P. M. Vaaler (eds.), Financial Innovations and the Welfare o/Nations. © 2001 Kluwer Academic Publishers.

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Financial Innovations and the Welfare of Nations

the 1000 largest firms and such firms are the most valuable public firms in Japan, Italy, France, Spain, Russia, Mexico, Brazil, Singapore, Hong Kong, China, and are second most valuable in Britain and Germany. These privatizations in both developed and developing economies have raised many important issues including the effects of privatization on firm performance, goals and motivation for privatization, and the pricing and valuation of firms to be privatized: Accurate market based valuation signals are important for investors and corporate managers, but valuation of new firms, especially firms to be privatized is very challenging. As the literature notes, valuation of initial public offerings (IPOs) even in highly developed capital markets is fraught with uncertainty (e.g., Rock, 1986; Kim and Ritter, 1999). Traditional asset valuation is based on the present value of expected future cash flows discounted at a risk-adjusted discount rate but neither of these two components is easy to estimate. Investment bankers and accounting firms can and do assist in the valuation process by conducting due diligence reviews and providing certification (both reduce risk), while government agencies such as the Securities and Exchange Commission enforce regulations that prevent fraud. Indeed, the difficulties in valuing companies is illustrated by the significant underpricing of IPOs and the large takeover premiums paid in the US and other countries (e.g., Logue, 1973; Ibbotson, 1975; Miller and Reilly, 1987; Kunz and Aggarwal, 1994 and Jarrell and Poulsen, 1989). Privatization of state-owned enterprises (SOEs) encounters even more difficulties than the valuation of IPOs in well-developed capital markets. Many such privatizations take place in environments characterized by significant macroeconomic instability, inadequate and often insolvent financial institutions, and under-developed or non-existent capital markets. In these environments, not only are market valuations unavailable, inefficient, or incorrect, there is also a lack of domestic demand for the new shares. Further, much of the economic value in firms to be privatized may already have been appropriated by various stakeholders (e.g., managers, • This chapter focuses on valuation, but country and cases studies by Boardman and Vining (1989), LaPorta and Lopez-de-Silanes (1997), Eckel, Eckel and Singa\ (1997), as well as multi country studies by Megginson, Nash and van Randenborgh (1994), Boubarkri and Cossett (1998) and D'Souza and Megginson (1999) generally support the hypothesis that privatization improves firm performance. The literature on privatization in transition economies is expanding following privatizations in early to mid 1990's in Poland, Hungary, and the former Czechoslovakia, and Soviet Union. Barberis, Boycko, Shleifer and Vishny (1996), Claessens, Djankov and Pohl (1997), Frydman, Gray, Hessel and Rapaczynski (1997), Pohl, Anderson, Claessens, and Djankov (1997), Claessens and Djankov (1998) and Harper (2000) analyze the restructuring of firms following privatizations in transition economies.

Privatization and Business Valuation in Transition Economies

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workers, customers, suppliers, and government officials) who have private and preferential information about the firms' prospects through a series of informal agreements. Information about these pre-privatization appropriation of economic value is usually not available publicly. Privatizations also face other inefficiencies resulting from political goals of the governments that own these companies (e.g., Jones, Megginson, Nash, and Netter, 1999; Megginson, Nash, Netter and Poulsen, 1997). Government commitment to privatization is often uncertain and, for example, the goal of maximizing privatization revenue may be compromised to achieve wider share distribution or other political goals (Perotti, 1995; Boycko, Shleifer and Vishny, 1996; Kane, 1998). Thus, given this backdrop, the countries of Eastern Europe and the former Soviet Union faced great uncertainties and many challenges as they moved toward marketbased economies and privatized many of their SOEs. The accurate valuation of firms, including those in privatization, is an important aspect of capital market development. Privatization is an important source of investment opportunities and often a critical part of capital market development in transition economies (e.g., Aggarwal, 1995; Svejnar, 1995). Capital market development is an important part of the move to market driven economies and has been shown to be correlated with rates of economic growth (e.g., Levin, 1997). In addition to intermediating savings and investment, capital markets are important because market valuation signals are a critical source of information for the efficient management of companies. Accurate enterprise valuation in privatization is, thus, very important for the development of a transition economy. This chapter focuses on enterprise valuation in privatization transactions. It reviews the most common methods, including asset sales, public offerings, and voucher auctions, used in transitional economies for the privatization and valuation of formerly state-owned firms. The experiences of Poland, Hungary, Russia, and the Czech Republic are assessed. Of particular interest is the use of vouchers in the privatization-valuation process, and how IPO valuation in these transitional economies differs from developed economies. While business valuation in privatization continues to be very difficult, this chapter finds that when done correctly, voucher privatization can be an efficient way to price and distribute shares in large state-owned firms. However, due to the informationally inefficient environment of privatization programs, it may be better to sell shares in tranches. Further, the economic success of privatization programs also depends heavily on the development of capital market infrastructures of regulated but independent accounting and security analyst professions and security trading exchanges and brokerage firms, and an environment of enforceable property rights and product market competition.

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2. PRIVATIZATION VERSUS PRIVATE COMPANY IPOS 2.1 Privatization of State-Owned Firms Among the many procedures used for privatization, asset sales, public offerings, and voucher auctions seem the most important. Megginson, Nash, Netter and Poulsen (1998) analyze the determinants of a government's choice of privatization method. Using a logit analysis, they find that countries that have a higher per capita wealth favor public offerings. Privatization through asset sales are more numerous (but generally smaller in size) compared to privatizations done through public equity offerings. Asset sale privatizations are used more frequently in lesser-developed capital markets and in countries with larger budget deficits when the objective of privatization is to maximize sale proceeds. However, because of the nonpublic nature of asset sales, the economy does not benefit much from valuation information and the underpricing associated with this type of privatization is difficult or impossible to measure since price data based on trades in the secondary markets are unavailable. Perotti (1995) and Boycko, Shleifer and Vishny (1996) develop theoretical models for underpricing and the ownership structure following privatization (including the amount of government ownership retained). In Perotti's model, a government committed to privatization will retain a passive stake in the firm to bear risk and signal its commitment to the privatized firm. Underpricing of the shares being sold is often used to make such a commitment credible. Boycko, Shleifer and Vishny (1996), theorize that shares should be sold to large blockholders instead of individuals and employees to facilitate restructuring of the newly privatized firm. A large percentage of shares sold to individuals and employees is generally not optimal as there is pressure to deter restructuring that may lead to reduction in the number of employees.

2.2 Privatization versus Private IPO Underpricing As in the case of IPOs, underpricing in privatization equity offers is also significant. In fact, the degree to which privatization differs from underpricing in private company IPOs as well as the underlying determinants of privatization underpricing is a matter of great interest. Perotti and Guney (1993) find significant underpricing in privatization sales - underpricing that is greater than in the traditional IPO market. Furthermore, such underpricing is found in both developed and developing capital markets. In their sample, many privatizations are partial


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sales, with the stakes retained by the government sold in subsequent offerings. While there are no direct tests of the determinants of the privatization underpricing, they contend that their fmdings are consistent with the government building a reputation in the market and bearing some of the risk (by retaining a partial stake). Huang and Levich (1998) test several hypotheses related to underpricing in privatization equity offerings. They find underpricing to be less for seasoned privatizations than for IPO privatizations, and consistent with previous fmdings, underpricing is greater in less developed capital markets. In addition, consistent with the results in Jones et al (1999), Perotti's (1995) reputation building hypothesis is supported by the results presented. Huang and Levich (1998) also fmd support for traditional theories of IPO underpricing including those based on information asymmetries. However, their sample reveals no significant difference between the underpricing in privatizations and in private company IPOs. Further, contrary to other evidence on the importance of political motivations in privatization underpricing, their results indicate value-maximizing sales. Dewenter and Malatesta (1997) present a direct test of privatization underpricing and its determinants compared to private IPO underpricing. Overall, they also find no significant difference in underpricing between privatizations and traditional IPOs. However, they fmd underpricing in privatizations varies by country, with the level of capital market development inversely related to the underpricing of privatizations. Consequently, privatizations in Poland, Malaysia, Thailand, and Hungary experienced greater underpricing than those in Canada, U.K., Japan, and France. They also find that firms in regulated industries experience greater underpricing than those in unregulated industries. Overall, they find support for the hypothesis that underpricing in privatization is a result of political objectives, and not just a result of information asymmetries as in private company IPOs. Jones, Megginson, Nash and Netter (1999) expand upon the political and economic factors that affect privatization underpricing. In their relatively large sample of 630 IPO privatizations from 59 countries, they test several hypotheses relating to political, economic, and revenue maximizing objectives. They find evidence of privatizations being used to satisfy political as well as economic objectives. Specifically, they find that common political objectives in the privatization process include wide share distribution and long-run national economic goals. These political objectives result in preferential share allocations to domestic investors, preferential selection of a domestic investment banker, and the use of fixed price offerings instead of competitive bids. As in Dewenter and Malatesta (1997), they also find that governments with restrictive economies and

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underdeveloped financial markets must underprice privatizations more than governments in developed capital markets. Consequently, Bel (1998) argues against the sale of all shares in a firm's privatization. He argues that since IPOs exhibit a greater degree of underpricing than seasoned offerings in privatizations, the optimal strategy is to privatize the firm in tranches in order to maximize the revenue.

3. PRIVATIZATION IN EMERGING AND TRANSITIONAL ECONOMIES Much of the previous empirical research on privatization (e.g., Dewenter and Malatesta, 1997; Jones et aI., 1999; and Huang and Levich, 1998) is in agreement that for public offering privatizations, firms in lesser developed capital markets experience greater underpricing than in more developed markets. Why is this the case? Two factors that may account for these differences between developed and developing country privatization underpricing include macroeconomic instability and underdeveloped capital market institutions. Macroeconomic instability is a natural result of the move from statedirected to market-directed economic systems. Most state-owned firms have been inefficient and many are inslovent. Consequently, the banking system is rife with bad debts and is often itself insolvent. Further, economies in transition are characterized by unstable government revenues, large fiscal deficits, expansionary monetary policies, accelerating inflation, and lack of consumer income. In addition to this macroeconomic instability, while many countries may have a stock exchange, economies in transition often also lack the institutional structure necessary for well-functioning financial markets. For example, such economies may lack a legal system of enforceable property rights. They generally also lack an independent and efficient accounting profession, trained financial analysts and credit rating agencies, and efficient government regulations to ensure fair trading practices and adequate disclosure of financial and business information necessary to assess risks and expected returns for potential investments. Information about informal nonowner appropriation of economic value in firms to be privatized is particularly unlikely to be available. All of these limitations mean that emerging financial markets in transition economies are much less efficient than financial markets in developed economies (e.g., LaPorta et ai. 1997; Aggarwal and Mejstrik, 1992). The lower levels of market efficiency in emerging and transition economies means that there is likely to be higher levels of underpricing in public equity offerings in such countries. Another


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major challenge in such markets is to find sufficient buyers for the companies being privatized as there generally is a lack of domestic savings and investment capital. Ramamurti (1999) assesses the differences between developed and developing country privatizations. He contends that privatizations in welldeveloped capital markets are mainly motivated by firm-specific factors, especially the transfer of ownership in order to reduce agency costs. Following privatization, firms become more productive and efficient due to a clearer statement of goals and increased monitoring. In contrast, privatizations in emerging markets seem to be motivated more by industry or country factors. State-owned enterprises generally emerged and operated in an environment with many market imperfections; as state-directed economies move to market driven systems, such imperfections decline, encouraging privatization. Indeed, even though privatization alone often does not significantly improve firm performance, as the industry environment becomes more competitive, either through foreign competition or technological advances, the pressure to privatize state-owned enterprises (SOEs) increases, if only to reduce the taxpayer burden of loss making SOEs (e.g., Havrylyshyn and McGettigan, 1999; Nellis, 1999). As this brief review of theories and empirical findings indicates, privatization methods are influenced not only by the state of financial market development but also by economic and political considerations. The goal of gaining the maximum sales proceeds possible in privatizing a SOE may be sacrificed in order to achieve political goals. Compared to the factors influencing privatizations in western or even emerging markets, privatizations in transition economies face several unique conditions. First, a large proportion of the economy was state-owned or controlled and a very large number of SOEs had to be privatized in a comparatively short time period. Second, the citizens of these countries had little or no private wealth to participate in the privatization process. Third, financial markets in these countries were either non-existent or very underdeveloped. Thus, the privatization process, including establishing a value of the SOEs to be privatized, has been much more challenging in the transition economies than similar processes in established market economies.

3.1 Privatization Methods in Transition Economies Because of the problems discussed in the prior section, many alternative privatization methods that were developed and used reflected the unique characteristics of each country. The methods were politically and economically motivated and were designed to contribute to the development of a market economy, to the equitable distribution of state-owned assets, and

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Financial Innovations and the Welfare ofNations

to the establishment of appropriate control and ownership property rights in the restructured firm. In the furtherance of these goals, transition economies used restitution and compensation, management and employee buyouts (MEBO), asset sales, and voucher programs in addition to traditional public offerings. Gray (1996) discusses the advantages and disadvantages of these methods and reviews some country experiences. Table 1 provides examples of privatization plans used in different countries. Three of the more important privatization methods seem to be asset sales, public offerings, and voucher auctions, either by themselves or in combination. Table 1. Examples of privatization methods used in transition economies

Method of Privatization Management and Employee Buyout

Countries Russia, Ukraine, Poland, Slovakia, Georgia,

..............................................................................................................................~~~~!.;. . ~~~~.~.~!!!.;...~~~y.~!!!.;.. 9:~~~!~.................. ....~~.~E.~~.~!.~!!~. ~~ . ~~.~~!.~!!.~!! ..................................................g~~.~.~.!.~. M.~!.~~y.~..~~.~~!.~..~~~.~~. ~~p.~~.~!.~......... Voucher Mass Privatization

Czech Republic, Slovakia, Russia, Poland, Kazakhstan, Romania, Bulgaria, Ukraine,

..............................................................................................................................!::!.!~.~.~.!~. !::~!.Y..!.~. ~.~~.!~.................................................. Asset Sales

East Germany, Hungary, Estonia,

..............................................................................................................................~.~~.!~?...~~!.~~y.~ ............................................................... Public Offerings

Poland, Russia, Chile

3.2 Asset Sales Hungary is the best example of a transition economy using asset sales in privatization. Hungary has had the greatest reliance upon asset sales with 42% of firms privatized through tender offers as shown in Table 2. In a direct asset sale, the government invites potential buyers to bid and/or opens bidding to interested investors for a percentage ownership in the company. To help in valuation, the government hires outside auditors and consultants to establish a fair value for the company. The actual purchase price is established in negotiations between the investors and the government. Factors such as a strategic investor, commitment to maintaining employment, a cash deal, and the market position of the company are often important additional influences on the final purchase price paid. The privatization of Hungarian companies through direct sale was not rapid but was a rather lengthy and complicated process. During the first privatization program, twenty of the better performing firms that could be sold easily were selected by the government for privatization. However, this first privatization program was considered to be a failure in that only a few of these companies had been sold after three years. One of the primary


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causes for the failure was that the privatization agency asked for unrealistically high prices and could not find foreign investors. Table 2. Hungarian privatization techniques

Privatization Techniques Tenders Compensation and Property Vouchers Issuing of Shares Commercial Selling without Tendering Management, Employee Buyout Other Tech~iques (Leasing, etc.) Combination of Various Solutions Total

Percentage 42% 18% 15% 10% 5% 5% 5% 100%

Source: Hungarian Privatization and State Holding Co. (1998)

However, after the initial failure for this privatization program, Hungary adopted a second more active privatization program in addition to implementing self-privatization and investor initiated privatization programs. In investor-initiated privatization, an interested investor makes a bid on the firm. After an initial bid, the government then calls for other tender offers to determine if the initial bid was competitive. With the implementation of these new methods, the privatization process accelerated (see Table 3). Table 3. Tender sales in Hungary by year

Year 1990 1991 1992 1993 1994 1995 1996 1997

Number of Transactions 11 53 204 500 410 256 205 206

Number of Companies 9 45 175 448 356 201 188 177

Contract Value (HUF mil) 2,355 35,173 54,829 166,980 103,118 476,800 117,275 359,020

Average Contract Value (HUF mil) 214 664 269 334 252 1,863 572 1,743

Source: Hungarian Privatization and State Holding Co. (1998)

There are some benefits that make asset sales desirable. In the case of a sale to foreign investors, the privatization raises hard currency for the government that helps in financing other restructuring projects. Asset sales also allow the state to influence the direction of the economy through the selection of the buyer and through other agreements made with the new owners. However, the Hungarian experience demonstrates the difficulties in

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asset sale privatization on a massive scale. First, asset sales are generally slower methods of privatization and do not lead to rapid transformation. Second, due to inadequate domestic purchasing power, many of the 'jewels' are sold to foreign investors and cannot be owned domestically. Finally, assets sales do not encourage market valuation. While some valuation measures exist through accountant and investment banker estimates, a true market value is not determined. In addition, when companies are sold completely through asset sales, companies become private but do not help develop the country's capital markets.

3.3 Public Offerings The country that had the greatest initial reliance upon public offering privatization was Poland (though, as shown in Table 4, it was not the only method used). In most cases, the goal of the IPO was to issue shares to foreign (and sometimes domestic) investors in order to raise capital with a secondary goal of developing equity markets. While controlling interest in these firms was often sold, it was not always the case, and the IPOs were only a part of the privatization plan for the firm. In addition to the IPO sale, employees usually gained a large stake in the company (especially in Poland and Russia), some shares were sold directly to other investors, and the government often retained a stake in the firm. Table 4. Number of firms privatized and transformed in Poland as of September, 1997

Method of Transformation Transformed into Commercial Companies Capital Method National Investment Fund For Sale Direct Privatization (IPOs) Liquidated for Economic Reasons

Number of Firms 1,220 209 512

499 1,408 1,467

Source: Polish Ministry of State Treasury

The first IPOs in transition economies often failed or fell short of their goals for privatization. In Poland, the first twenty companies scheduled to be privatized through IPOs in 1990 were believed to be the strongest and most financially sound companies that would be most easily privatized. Only five of these companies were privatized in 1990 and netted about 60% of the initial asset valuation estimates. As the home country financial markets and stock exchanges matured, IPO privatizations became more successful. Thus more recently, Poland has experienced greater success in IPO type privatization with many of the offerings fully subscribed. The later


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success of IPOs in Poland has been attributed to more stable economic conditions, the development of the equity markets, and the underpricing of shares to promote full subscription of issues. While they were relatively popular in Poland, IPO privatizations were not used in other transition economies as frequently as other methods. First, there is the difficulty of valuing the firms to be privatized, especially given their socialist background with unusual accounting and lack of disclosure. Second, another problem for IPO type privatization is that the secondary market for shares is either not yet in existence or is highly illiquid and underdeveloped. Third, there generally is very little or no domestic investment capital.

3.4 Voucher Privatization Voucher privatization is the most common method of mass privatization and has been successful in transferring large blocks of ownership to private hands. In voucher privatization, vouchers to be used to bid for shares in companies being privatized are distributed at a nominal cost to all adults in the population. Thus, voucher privatization was a solution to the problems of uncertain enterprise valuation and limited domestic investment resources when using traditional privatization plans in Eastern Europe. While voucher-based programs provide a solution, they also have significant limitations. Vouchers raise very little capital for the firm and the government, both of which need financial capital. Vouchers also limit participation of foreigners and other strategic investors. While minority stakes may be sold directly to strategic investors, the distribution of remaining shares through vouchers make it difficult for a strategic investor to easily increase their stake and take control. Finally, voucher sales can lead to dispersed ownership following privatization, slowing down or preventing restructuring and mitigating against the development of a strong ownership culture. In response to these concerns about voucher privatization, Goldberg, Jedrzejczak and Fuchs (1997) recommend that IPOPlus voucher programs be used in transition economies. In this method, vouchers are dispersed to individuals, but the vouchers are then used for forming privatization investment funds that own enterprise shares. These funds act as large blockholders that can monitor and restructure the firms on behalf of the individual owners. In addition, in this approach investors also have a diversified portfolio. The voucher programs of Poland, Russia, and the Czech and Slovak Republics have received the most attention. However, voucher privatizations were also used successfully in Bulgaria, Kazakhstan, Kyrgyz Republic, Lithuania, Mongolia, Romania, and the Ukraine. Boycko, Shleifer

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and Vishny (1994) provide a good description of how the Russian, Polish and Czechoslovakian voucher programs operate and describe the important differences between these programs. Gray (1996) and Djankov (1999) do the same for some of the other lesser-known voucher privatization programs.

3.4.1 Russia The Russian voucher plan distributed vouchers with a nominal value of 10,000 roubles to all citizens. These vouchers could be sold in the open market or used in auctions to bid on shares in privatizing companies. Voucher trading quickly became the most active and liquid financial market in Russia. However, the valuation of the vouchers varied widely over time and even had different values on the same day in different regions of Russia. Voucher privatization in Russia proceeded regionally, one firm at a time. The decentralized approach led to charges of corruption and preferential treatment of individuals and firms, resulting in a highly politicized process that has contributed to and suffered from the unstable political and economic conditions in Russia. Most firms that participated in voucher privatization were also partially privatized using other methods, especially employee and management purchases. Under Russian privatization law, firms could choose among several privatization schemes. The most common allowed 51 % of shares to be sold to employees in exchange for vouchers and/or cash at a 30% discount from book value. The remaining shares are sold on the open market, where the employees can buy additional shares with vouchers and/or cash. However, placing the controlling interest of the firm with the employees limited foreign investment and obscured the market value of the firm. Further, given that the privatization process was regional and not simultaneously executed nationally, accurate comparative or relative valuation of firms was not available.

3.4.2 Poland Poland used a more centralized approach. Because of the relative degree of economic freedom that existed in Poland before 1989, firms were given even greater control over how they would be privatized. In essence, the firm had veto power over the privatization process. This delayed mass privatization through vouchers until 1995. The Polish privatization ministry divided the firms to be privatized between the 15 national investments funds (NIPs with 60% of shares), employees (15% of shares) and government holdings (25% of shares). For each company in the voucher program, one NIF would become the major shareholder and own 33% of the shares while the other NIPs would split the remaining 27%. There were 512 firms in the


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NIF pool to be privatized and NIF certificates were sold at a fixed price of 20 zloti (Zl) between November 1995 and November 1996. Each adult was entitled to buy one certificate and these certificates could be sold or traded after purchase. The NIF certificate was converted to NIF shares beginning in May 1997 and trading in NIF shares began that June (NIF shares opened on the Warsaw Stock Exchange at 160 Zl). Valuation of individual firms in this type of voucher privatization is very difficult for two reasons. First, the market value of the NIF shares is dependent upon how many shares are outstanding and is not related to the initial offer value (20 Zl) of the NIF certificates. Each certificate sold dilutes the fixed claim on the NIF pool. The market value of the certificate was only known after the sale of certificates was completed in November 1996. The second difficulty in valuation is that the value of the certificates represents a pool of 512 companies. Individual companies did not trade on the stock exchange and their individual market values were not known. Deconstructing the value of the certificates to obtain the value of the individual firms did not occur, and will only occur when 1) the parties involved decide to divest their holdings in a firm, or 2) the NIFs decide as a group to list an individual firm. However, without the involved parties' willingness to trade shares, the market for these firms is likely to be illiquid and subject to minority-stake and restricted-share discounts (as in Silber, 1991; Holthausen, Leftwich, and Mayers, 1987; and Lease, McConnell, and Mikkelon, 1983). Nevertheless, the much delayed voucher plan along with the IPO privatizations have contributed significantly to the development of the equity market in Poland. In addition, the Polish voucher privatization plan created large blockholders through the national investment funds to monitor and direct firms. It is the hope that these investment funds will restructure the firms they own. However, Ellerman (1998) casts doubt on the investment funds ability and motivation to restructure their firms. He argues that the funds will move the economy away from the real industrial sector to an artificial financial sector. 3.4.3

Czech and Slovak Republics

The Czech and Slovak Republics implemented an alternative voucher privatization program. While the Czechs had the greatest reliance upon voucher privatization, it was not the only method used (for details, see for example, Aggarwal and Mejstric, 1992). Table 5 shows the privatization methods used through 1993. 1,777 large firms were approved for conversion to joint stock companies and voucher privatization and 3,438 (46%) much smaller firms (with little more than 10% of the book value of firms to be

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privatized) were approved for other types of private sale. In the Czechoslovak privatization plan, managers submitted the basic privatization plan to the Ministry of Privatization. Outsiders also submitted competing plans to the ministry. After the closing deadline for privatization plans, the ministry selected the best plan for each firm, with the management plans being selected most frequently (54%). Table 5. Methods of privatization in the Czech Republic as of December 1993

Method Approved Public Auction Public Tender Direct Sale Privatization Joint Stock Company Unpaid Transfer Total

Number of Firms 514 502 2,422 1,777 2,318 7,533

Percentage 6.82% 6.66% 32.15% 23.59% 30.77% 100.00%

Book Value of Firms 5,811 19,188 62,288 754,263 30,013 871,563

Percentage 0.67% 2.20% 7.15% 86.54% 3.44% 100.00%

Source: Svejnar (1995)

For firms that were selected for voucher privatization, a major auction took place in 1992, with a smaller one in 1994. This process was very different from the regional sequential auctions in Russia or the fund-based group privatization in Poland. In the Czech system, all citizens could buy vouchers and could use them in the auction or assign them to an investment privatization fund (lPF) in return for a share in the fund. The composition of the IPFs' portfolio was determined during the auction and was not known beforehand, so that investors only knew what the objective of the fund was and not its assets. In 1992, all firms being privatized with the voucher system were auctioned off simultaneously in a five-round auction. To assist in bidding for shares, basic financial and descriptive information was available for all firms in the auction. Bids for shares of each firm were made directly and simultaneously by individuals and by IPFs. These privatization auctions had five rounds of bidding and share prices in each round were adjusted by the privatization agency in response to supply and demand conditions for a firm's shares in that round. The five-round auction process allowed a determination of relative market valuation. Since the auction value was based upon voucher points, an actual monetary market valuation occurred only after shares began trading on the secondary markets. With auction participants being both individual (uninformed) and institutional (informed) investors, there was no reason to expect efficient relative valuation. However, with over 70% of the vouchers in the first wave submitted to IPFs, most bids were considered to be informed and, not surprisingly, the auction process was found to have led to an efficient relative market valuation of the privatized firms.

0.029

Industrial

-5.938

23.631

1.46 -1.23

1.97

114.840

ExcDem3

Q55

Q8Q

Q22

N~53

Q2B

N~09

• Significant at the 0.05 level; •• at the 0.01Ieve1; First eleven Variables are firm-specific, including five for ownership, while the last twelve (three for each of the first four rounds) are auction-generated vairab1es

N~717

ExcDem4

QQI

.3.67 4.34

16.631 50.954

R4Volum

N~734

159.00

1.001

R4Value

B-SIJJlms

-0.10

1.17

-0.03

1.14

-1.13

-0.62

2.10

1.37

1.16

0.27

-0.37

-0.13

0.47

-0.09

0.63

0.68

-0.68

-0.86

-1.01

0.39

-2.20

T-Ratio

-1.008

N~675

1.87

135.830

R3Volum

15.193

17.11 1

-9.522 -0.004

1.47

46.834

-0.261

30.924

2.20

1.14 1.633

-1.07

16.740

49.576

0.81 -0.57

0.778

-0.11

-2.259 -3.434

-0.96

9.199

-10.668

21.787

0.573

-0.65

1.11

-0.02

0.55

-0.95

-2.033

-0.71

-1.580 -0.003

-1.19

0.74

0.000

-95.302

0.65

13.82

60.686

ExcDem2

-1.78 -1.46

Round 5 Est. coerr

1.751

5.10

40.124

R2Volum

•• •• ••

-134.100

-32.200

15.370

-1.061

-14.572

-171.820

310.250

-2.015

18.487

-3.885

-17.976

-0.043

11.329

0.000

-129.170

T-Ratio

19.912

10.43

1.600

R2Value

••

Est. coerr

Round 4

R\3Value

1.65

-0.10

-2.07

1.61

-1.37

0.56

0.87

-2.07

0.26

-1.33

0.42

-0.92

2.36

-6.03

-2.43

-0.412

-6.104

10.190

-17.676

12.690

32.511

-25.359

0.270

-3.732

0.002

-2.632

0.000

-44.321

T-Ratio

20.175

•• ••

••

•

••

Est. Coeff

Round 3

-23.510

2.58

-0.010

GovVote

2.00

15.89

1.99

-0.006

ForOwn

36.543

1.03 -1.49

15.961

-0.33

-0.92

-0.060

PrvtOwn

9.683

-38.177

-2.49

36.432

-1.28

0.016

PermGov

-1.567

ExcDeml

0.10

-0.034

TempGov

••

1.79

R1Vo1um

-0.55

0.003

Debt Ratio

5.194

0.95 0.83

-0.86

3.15

-0.003

Sales

0.003

2.031

3.76 -0.87

-2.182

-1.06

0.000

SaleslEmp

••

0.000

15.261

RIValue

2.77

-0.14

0.017

ROS

••

-3.27

0.36

T-Ratio

-8.973

89.22

0.969

0.000

Est. Coeff

Sales

Round 2

T-Ratio

Round 1

Est. coerr

Intercept

Variables

Table 6. Regression model for the determinants of equity valuation in each auction round

•• •• ••

.

00

1.0

.

-

~

~

C

:::!

~ C

:::!

C

-.

~

:::;..

~

s;.

-.

~ ..... §

~

..,~

s; .

C;

b::l

~

§

C

:::!

-

f:i. ~

-.~~

190


A number of empirical studies have focussed on the voucher auction in the Czech Republic including Hingorani, Lehn, and Makhija (1997), Claessens (1997), Hanousek and Kroch (1998), Mertlik (1997) and Hillion and Young (1996). Aggarwal and Harper (2000) estimate the share trade volume and valuation impact of both firm-specific information and marketgenerated share trade information revealed in each round of the auction. They find that firm-specific information was used to bid on shares in the first round and that some influence of this historical information is still evident in second-round prices. However, as shown in Table 6, they find that in later rounds of the auction, such firm-specific fundamental information (the first set of 11 variables in the table) becomes less important in determining demand for shares and in these later rounds market-generated volume and price information becomes more important. In addition, share prices and market demand remain highly related in the later rounds of the auction. The evidence from this study indicates that the Czech voucher privatization auction provided efficient relative valuation of firms being privatized. Aggarwal and Harper (2000) also find evidence that supports the findings in Hillion and Young (1996) and Hingorani et al. (1997) that there was mispricing in some rounds of the auction process. Hillion and Young contend that this mispricing was due to the political desires of the privatization agency to absorb voucher points and complete the distribution of all shares available for privatization. Claessens (1997) finds that the Czech and Slovak voucher privatizations resulted in relatively concentrated ownership especially as two-thirds of the vouchers were signed over to (poorly-regulated) investment funds with the ten largest funds owning 72 % of those shares. Other critics of the Czech voucher privatization also note that the irresponsible actions of these investment funds contributed to the poor post-privatization performance of Czech economy (e.g., Ellerman, 1998; Nellis, 1999). Nevertheless, with respect to enterprise valuation at privatization, Hanousek and Kroch's (1998) study of both waves of the Czech voucher privatization finds that, while the IPFs behaved differently from the individual investors, the overall market behaved efficiently in the progressive bidding rounds. Shares from the first voucher privatization auction were distributed about six months after the completion of the auction and trading of shares began quickly thereafter. Hingorani et al. (1997) estimated the relationship between voucher prices and subsequent market prices. Table 7 presents part of their findings. Since all prices in the Czechoslovakian auction started at 33.33 points per share, the price in round 2 was the first relative valuation of shares and prices adjusted to demand in the following rounds. Using log of voucher prices and the log of subsequent prices on the RMS stock market, Hingorani et al. find a significant positive relationship between the voucher and subsequent stock exchange prices. Their finding supports the claim that


191

this voucher auction led to efficient relative valuations of the Czech companies being privatized. Table 7. Relation between Voucher Share Prices and Auction Volumes and Subsequent Stock Market Prices

Dependent V~riable Share Demand, Total Share Demand, Individuals Share Demand, Funds Round 2 Share Prices Round 5 Share rices

RMS Price, July 8, 1993 CoetI Std Err. Ad'. R2 1.652 0.023 * 0.883 1.440 2.805 0.880 1.146

0.023 0.098 0.018 0.024

Source: Hingorani et ai, 1997, Table 9.

3.5

* * * *

RMS price, December 1, 1993 CoetI. Std. Err. Ad'. R2 1.388 0.039 * 0.589 1.182 2.281 0.821 0.994

0.783 0.574 0.724 0.725

0.040 0.103 0.021 0.030

* * * *

0.499 0.357 0.589 0.508

(* significant at the .05 level)

Discussion of Voucher Privatizations

The many variations in voucher plan designs and relative successes lead to important policy implications for the valuation of privatized companies. While voucher privatizations have the disadvantage of raising limited or no revenue for the generally fiscally strapped transition governments, they also have many advantages. None of the voucher privatizations so far have been perfect, but the Czech voucher auctions led to the greatest degree of valuation transparency. To promote transparent valuation, vouchers should be used directly in an auction process as in the Czech program, and not used as a general claim on a pool of assets as was done in the Polish program. The auction process should be centralized and be simultaneous so that it involves a large number of firms and so that accurate relative valuation can occur. Finally, firm-specific historic information should be made available prior to the auction to assist in valuation. The method of distributing vouchers is of secondary importance in valuation and can be defined mostly by political objectives such as the goal of wide distribution to the population. Vouchers have a secondary benefit of establishing the foundations for the development of capital markets. The development of debt and equity markets is an important part of the development of a market economy. The use of voucher privatization provides the best opportunity to establish efficient relative valuation for privatized companies.

3.6 Comparison of Privatization Methods As this brief review of privatization methods shows, initial public offerings of firms to be privatized provide a direct valuation of firms.

192


However, only a limited number of firms can be privatized with this method for two reasons. First, in transition economies there is limited capital among the populace to purchase shares being offered. Second, the due diligence and preparation required for an initial public offering is a lengthy process and the government does not have the resources to proceed quickly on a large number of firms. Further, as transition capital markets tend to be underdeveloped and inefficient, market prices of privatized firms may not be accurate and generally suffer from illiquidity and restricted share discounts. Direct sales and tender offers encounter the greatest problems in valuation. Since there are only a few buyers, competition in bidding and valuing the firms is limited. After the firm is privatized and sold to another entity, it may not be publicly traded again, or only have a minority stake traded in the public market. The negotiations for purchase and tender offers often involve supplemental conditions such as the need for strategic buyers, guarantees to employees, and future capital investment. In addition to the valuation of future cash flows, these conditions also influence the valuation of the firm. In addition, government desire to maximize revenue hinders the process of privatizing firms and often leads to failed privatization attempts (as in the early Hungarian plans). Direct sales of companies to be privatized is more effective in a more developed market setting as was the case for later privatizations in Hungary and Poland. However, even in these cases, the evidence suggests deep discounts from initial book value based valuations. In contrast, to these other privatization methods, voucher plans are the quickest way to privatize large firms even in the relative absence of investment capital, to establish consistent relative valuation of firms, and to provide a strong foundation for the development of equity markets. However, successful voucher plans must also be preceded by widespread dissemination of firm-specific information to optimize the price-setting process and the privatization auctions must be held simultaneously to ensure all supply and demand for each firm's shares are available for clearance. Indeed, as all privatization methods generally face significant informational inefficiencies, it is useful to privatize firms in tranches so that information generated by the trading of shares can be used to value new shares to be sold (e.g., Bel, 1998). If investment funds are allowed to pool vouchers to bid for firms, they must be appropriately regulated. Indeed, given the negative postprivatization experiences with capital markets in Poland and the Czech Republic, voucher privatization should be followed by the development and implementation of legal, accounting, security analysis and trading infrastructures, and regulatory frameworks to encourage the development of well-functioning capital markets. Such capital markets are essential not only for financial intermediation, but more importantly they are critical for providing continuing valuation signals for corporate management.


193

4. CONCLUSION The last decade of this millennium saw the resolution of a century long struggle between socialism and capitalism as ever more countries made the ideological switch to free markets. The development of capital markets is not only an essential aspect of the move away from centrally directed socialist economic systems to market directed economic systems, it has also been shown to be correlated to economic growth rates. Capital markets not only encourage savings, investment, and financial intermediation; they also provide valuation signals essential for enterprise management and the efficient use of capital. Privatization is an important part of the development of capital markets as it is important in creating and expanding the supply of available investments. Thus, the issue of firm valuation in privatization is an important issue. Business valuation in privatization continues to be very difficult and there seem to be few if any definitive answers. The evidence thus far from privatized firms in transition economies suggests that firm-specific historical information plays an important part in valuation, but the method of privatization substantially influences the emphasis placed on that information. Firm valuation also depends on government political goals and relative emphasis on revenue maximization in privatization sales. Countries that expect to maximize privatization revenue tend to choose direct sales/tender offers and initial public offerings. However, these privatization methods may not be appropriate in many situations especially when there may be little domestic savings and when capital markets are underdeveloped. In such cases privatization efforts generally tend to end up with a heavy reliance on foreign capital investment. Similarly, IPOs that are only open to domestic investors severely underprice the value of the firm due to the limited availability of investment capital. In addition, the use of these privatization procedures is associated with purchase agreement conditions and formal and informal stakeholder agreements that cloud the true economic value of the firm being privatized. In contrast, voucher privatization can provide fairly accurate relative valuation under conditions similar to the Czech voucher auctions, but can just as easily obscure the valuation of individual firms in the Polish case. The primary purpose of voucher privatization is not to obtain accurate valuation nor to maximize revenue, but to distribute shares in privatized companies widely and equitably and to help restructure ownership to improve firm performance. However, due to the significant informational inefficiencies faced by most privatization programs, it is generally preferable to privatize firms in tranches. Further, as capital market valuation signals are an important source of information for enterprise management, it is clear

194


that appropriate legal and regulatory framework to provide important and critical support for the effective development of capital markets must be also be implemented for privatization to succeed.

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