Rethinking Privatisation Methods

Attitudes to privatisation are very diverse in Lithuania. Regrettably, quiet often this perception is rather pessimistic. Opponents argue that privatisation increases unemployment, creates monopolies, discourages formation of local capital, etc. However, opponents of privatisation do not recognise or do not want to recognise that these problems are caused by reasons other than privatisation. In this article we present the conclusions of analysis LFMI carried out in order to ground the need for privatisation and to explore the problems confronting the privatisation process.
Private ownership is more beneficial for an economy and society than public ownership. Governments are less effective than private agents at managing property because they have less incentive to do well and confuse economics with politics, using public property for solving day-to-day political concerns. What a private agent risks is his own and not someone else’s property. His profits reflect an increase in his own and not somebody’s wealth; likewise, his losses reflect a decrease in his own wealth, not somebody else’s.
Critics pay attention to the fact that privatisation increases unemployment. It is true that newly privatised companies often reduce the number of employees. However, this is aimed at increasing the efficiency of a company. If the efficiency were not increased, it would mean not only that resources are wasted, but it could lead to a higher probability of bankruptcy as well. Transferring money from taxpayers into the hands of inefficiently functioning state enterprises does not solve the problem of unemployment either. This problem requires other solutions. Reduction of the tax burden and liberalization of the market are the solutions. Indeed, analysis performed by the Property Fund shows that some privatised enterprises created new jobs. These results became possible due to a more efficient use of resources and successful development of new markets for their products.
Opponents of privatisation also criticize the acquisition of state property by foreign investors, arguing that this hampers the formation of local capital, and earned profits travel abroad. Privatisation of large companies by foreign investors is often a result of the low financial capability of local investors and of current privatisation policy to sell state owned stock in one parcel rather than through the stock exchange. However, the participation of foreign investors should be welcomed. It increases both competition and price. Taking into account the fact that the purchaser places the risk of losses upon himself, his expectations are rational and reasonable. The property that was acquired for a higher price is likely to be employed more efficiently.
The fear that foreign investors will repatriate profits does not have much justification either. Foreign investors bring their own resources to Lithuania Even if profits are repatriated, this does not necessarily mean that Lithuanians will become poorer. On the contrary, earned profit results in increased wealth for the Lithuanian people, since the earned profit shows how much society values the services of the privatised company. As was already mentioned, the higher the price of the privatised company, the higher the expectations of profits and therefore utility for the society. Restricting foreign investments would be just as detrimental as restricting Lithuanian investments. In order to attain better privatisation results, investors must not be discriminated against based on their country of origin.
Therefore, neither the supposed increase in unemployment, nor the possible growth of foreigners’ influence can be regarded as a danger or harm resulting from privatisation. The true harm to society and effective market performance arises when, in addition to property privatisation, citizens’ freedom of choice is “privatised.” Such mistakes, when privatisation is accompanied by the granting of certain privileges, have been made in Lithuania as well. For instance, during the privatisation of Lietuvos Telekomas amendments to the Law on Telecommunications were passed granting the telecom monopoly rights in terrestrial communications. During the privatisation of Mažeikių nafta oil refinery the state obliged itself to provide loans amounting to approximately 1.2 million Litas; to extend loan guarantees worth 284.5 million Litas; to reduce tariffs for the use of services of the Klaipėda Oil Terminal and the Lithuanian Railways; and, if necessary, to increase import duties on fuel. So, although the sale of enterprises is deemed to be positive, the processes accompanying the privatisation of individual enterprises are not always desirable. If such dangers are to be avoided, no restrictions should be placed on other entities and no privileges should be granted to companies under privatisation.
Further in the article we overview the privatisation process in Lithuania, problems of privatisation, and possible solutions to these problems.
Two rounds of privatisation of state property were envisioned in Lithuania. The first round of privatisation was launched in September of 1991. State property was sold for investment vouchers that were distributed free of charge to all Lithuanian citizens. Other natural and legal persons could purchase state property for cash. State property was sold through open and closed subscription of shares, open and closed auctions, restitution, “best business-plan” tenders, and by other methods.
The first round of privatisation was designed to create conditions for every Lithuanian citizen to take part in privatisation and to become an owner and, by doing so, to ensure social justice. For this purpose, a large portion of state property was sold only through the voucher system and only to Lithuanian citizens. The large-scale voucher privatisation permitted the formation of a wide layer of private ownership. On the other hand, a large number of inexperienced small shareholders coupled with restrictions placed on foreign investments prevented the fast and efficient restructuring of enterprises. Even more, in some cases established privatisation rules were circumvented.
Presently, Lithuania is in the second round of privatization, which was started in August of 1996. The main feature of the second round is that privatisation is based on cash sales. Foreign and local investors have equal rights in the privatisation of state and municipal property. The State Property Fund carries out privatization of state property. The Law on Privatisation defines several methods of privatisation of state and municipal property (hereafter referred to as state property). Real estate are privatised by public auction or leased with the right to purchase. Public shares in enterprises are sold by public tender, direct negotiations, by public auction, public sale of shares on the stock exchange or by the transfer of control of state-owned enterprises.
The method of privatisation is selected depending on the size of an enterprise, the area of its activity, the quantity of shares, etc. Privatisation may be organized according to special laws. For example, special laws were passed to regulate the terms and procedures of privatisation of the Mažeikių Nafta oil refinery. Public shares in three enterprises were sold according to the Law on Public Trading. According to special laws are to privatised state-controlled commercial banks.
The experience of the second round of privatisation indicates that in many cases privatisation is slow, many entities cannot be sold in the first attempt, or enterprises intended for privatisation have large debts and losses. Very often already privatised enterprises are put in preferential conditions. So, one can conclude that privatization was not so succesful as it could be.
The results of privatisation depend largely on what methods of transferring state-owned property to private hands are used. Problems caused by improper methods of privatisation are examined further in the study. These problems are divided into two groups: general and specific problems. General problems refer to the preparation of objects for privatisation and concerns common to different methods of privatisation. Specific problems are related to individual methods of privatisation.
Goals of Privatisation
Privatisation goals are not laid down in the Lithuanian law. However, the State Property Fund has declared several goals, namely privatising state property for the maximum price, ensuring a transparent, high-speed privatisation process while not aggravating the problems of unemployment, ensuring large investments, and creating conditions for the development of capital markets. The aims are fine. However, while efforts are focused on ensuring large investments and preserving jobs instead of leaving this to the market, other aims – such as a maximum price, transparency and speed – suffer. Even worse, the measures designed to ensure a high rate of investment and preserve jobs in privatised companies distort rather than develop market relationships. The key criteria and strategic objective of privatisation is to create conditions for the free operation of market forces. This attracts maximum effective investment and creates a maximum number of well-paid jobs. Therefore the main aim of privatisation should be defined as privatisation for the highest price without any legal constraints inhibiting free market performance.
Selection of Items for Privatisation
A major obstacle to privatisation is the fact that some entities that are slated for privatisation have a special legal status, e.g. enterprises of special designation, public organizations, and budgetary institutions. Privatisation of these entities is very complicated and, regretfully, has been put off without any economic justification. Therefore, we propose to alter the existing regulations and to extend privatisation to these entities by diminishing existing restrictions on privatisation and by restructuring these entities into enterprises.
Enterprise Restructuring before Privatisation
The Law on Privatisation assigns the Property Fund the right to restructure state-owned enterprises if such restructuring enhances the prospect of its privatisation or increases its selling price. Although a policy like this may seem logical, it harbors a number of pitfalls. The concept of restructuring an enterprise in order to improve its performance provokes much criticism, since it is the goal of privatisation to ensure a more efficient means of company performance. Therefore, restructuring must be left to the private owners of a company.
Quite often restructuring is used as a pretext for postponing privatisation. Loans are drawn and guarantees are granted on behalf of the state. However, there are no guarantees that restructuring will eventually help achieve desired results, or that the Property Fund will take responsibility for the failure of the restructuring process. Experience both in Lithuania and abroad indicates that the restructuring of an enterprise is a lengthy process. While enterprises are being restructured, their performance is deteriorating and assets are being dissipated. Foreign research findings show that the state would generate more revenues by privatising companies without any prior restructuring. For instance, while the privatisation process was being initiated with “Lietuvos kuras,” the enterprise incurred losses of millions of litas. Once the privatisation process was completed, the company’s debts totaled 133 million litas, and the company was sold for one litas. Controlling agencies confirm that state-held companies are being plundered. This is illustrated by violations that took place in both “Lietuvos kuras” and “Lietuvos energija”.
Enterprise restructuring is justified only when the goal is to split a company into several independent entities in order to reduce the company’s monopoly position. However, in such cases it is important to ensure that the restructuring will not delay privatisation, and that the state will refrain from undertaking tasks that private owners can perform. It is equally important to remember that for competition to give results, it is not the number of market participants but legal conditions for free market entry and exit that matter.
Minimal Price
All methods of privatisation laid down in the Law on Privatisation authorize the Property Fund to set up a minimum selling price for shares. If shares are not sold for this minimum price, the privatisation process is halted. In this case the Property Fund has two options: either to prepare a new privatisation program and lower the price or to propose to the Government the removal of these shares from the privatisation list.
Placing a minimum limit on the price of shares is expected to prevent investors from knocking down the price. However, protracted privatisation can hardly lead to an increase in the value of shares. A large number of entities slated for privatisation were not sold in the first attempts. Only after the price was considerably reduced were these (objects) finally sold. Such limits only protract privatisation increase costs, and create more work for privatisation executives. Shares should be sold at market price, even if it seems rather low. Otherwise, the state will have to shoulder the burden of delayed privatisation. In order to receive higher revenues from privatisation, the state must refrain from placing any restrictions on investors’ participation in the privatisation process and from assuming any additional obligations regarding the privatised entity.
If this is unacceptable, it remains necessary to improve the methodology of setting up a minimum price. The aim should be to achieve a price level similar to the market price. The comparative value method should be utilized, as it allows a share price to be established at a level that is the close to the market price. Other methods listed in the Law on Privatisation may be used only when the comparative value method cannot be applied.
Assessment of Investors’ Credibility
If privatisation takes place through direct negotiations, public tender, or by public auction, the Property Fund may request competent state institutions to examine the credibility of potential investors. However, there are no criteria that could be used to examine the credibility of investors and deem them unreliable. The conclusions of the state institutions are not made public.
A lack of transparency creates conditions for corruption and speculation, and discredits the idea of privatisation. For instance, during the privatisation of “Vakarų laivų remontas” in 1998, one foreign company was deemed unreliable and consequently was not allowed to participate in the privatisation of the enterprise. The company publicly blamed the privatisation executives with corruption. Ironically, the company that won the tender offered the purchased shares to the company that had been declared unreliable.
An assessment of a potential investor’s reliability cannot ensure full protection from all supposed threats. Therefore, such assessments might be applied only in exceptional cases. Criteria used to determine the credibility of potential investors and deem them either reliable or unreliable should be made public. This would increase the transparency of the privatisation process as well as reduce opportunities for corruption and speculations.
Public Tender and Direct Negotiation
Public tender and direct negotiations are the methods of privatisation by which one or several items are sold to the investor who has offered the highest price and the best investment proposal. Privatisation through these methods stipulates to the investors special requirements regarding the preservation of jobs and the duration of investment. Moreover, in order to participate in direct negotiations, a potential investor must fulfil special qualification requirements prescribed by the state. It is intended that special requirements for investors and applied privatisation procedures will attract credible investors and ensure a high level of investment. However, due to the reasons outlined below, these privatisation methods do not always bring the desired results.
Qualification Requirements
Qualification requirements are applied when “strategic” investors are sought. A “strategic” investor is described as a credible company with a high level of efficiency and a large amount of experience in a specific field of business. Because of these qualities, it is expected that the “strategic” investor will restructure and manage a newly privatised enterprise better than an “ordinary” investor.
The concept of a “strategic” investor is ambiguous. Privatisation executives have the right to set up different qualification requirements in individual cases of privatisation. An objective methodology in choosing the “strategic” investor does not exist, so the qualification requirements are established arbitrarily. Qualification requirements reduce the transparency of privatisation, allow corruption, and restrict investors’ ability to enter the marketplace. Moreover, if an investor is granted the status of “strategic” investor, it is possible for him to negotiate with state representatives for preferential business conditions.
The hunt for a “strategic” investor is justifiable only when private owners carry out the search. However, the state as an owner is not driven by the same motives. Therefore, this method of privatisation is difficult to implement in practice, and it may have negative implications.
Requirements to Preserve Jobs
Quite often a lack of modern production technology and management in state-owned enterprises inhibits the ability to operate at an efficient level. Therefore, newly privatised companies must introduce new production technology and restructure their management. Consequently, a reduction in the number of jobs is unavoidable. In hopes of avoiding the problem of unemployment, the state requires investors to maintain, for a certain period of time, the same number of jobs that existed before the privatisation process took place. However, this means additional social guarantees for employees of newly privatised enterprises. Employees are entitled, through employment contracts, to many social guaranties in case the restructuring of a production process and/or work organization is implemented.
The job preservation requirements place a heavy burden on society, since these requirements result in the reduction of the entity’s price and lower privatisation revenues. It does not solve the problem of unemployment either. This problem is simply put off, since the investor is only required to preserve a fraction of the total number of jobs for a limited period of time, usually from 3 to 5 years.
Investment Requirements
The aim of investment requirements is to assure the continuity of enterprise performance, to introduce new management and production technology, and to supply higher quality, lower price products for consumers. However, in market conditions, an investor is forced to invest an optimal amount of resources necessary to attain efficiency without any commitments to the state.
Other shortcomings are revealed when the state creates special business conditions for a newly privatised enterprise. For example, during the privatisation of state-owned shares of “Lietuvos telekomas” the “strategic” investor assumed obligations to preserve nearly 10,000 jobs and to invest 900 million litas in the company. The state granted the enterprise monopoly rights in terrestrial communications. The granting of these monopoly rights will hardly increase the company’s efficiency.
Assessment of Proposals
Given the aim of increasing the amount of investment in a newly privatised enterprise, the state agrees on a lower selling price on condition that the investor increases investment in the enterprise at a later date. To that end, privatisation rules stipulate that the winner of a public tender must be the investor who offers the highest price and the largest amount of investments.
This condition involves a certain amount of risk, because the possibility remains that the potential investor has no credible business plan. The experience of other countries proves that investors frequently breach such commitments. For example, in Germany every fifth enterprise that is privatised in this way does not obtain the amount of investment initially agreed to between the investor and the state.
One additional problem must be mentioned. According to Property Fund data, the purchasers of “Alytaus Tekstilė” refused to fulfil their obligations when the enterprise was not allowed to work in three shifts. So, there was a need to amend their privatisation contract. This shows that obligations may be declined not only because investors may be unwilling to comply, but also because it may be impossible to list all necessary privatisation conditions in a contract, especially given the continually changing nature of governmental policy. In this case obligations become meaningless.
Partial Acquisition of Shares
The winner of a public tender or direct negotiation may choose to acquire shares in parts; however, he will be obliged to pay interest equal to the average interest rate on time deposits in commercial banks. The existing situation entails two potential pitfalls. First, as was already mentioned, by creating preferential conditions, the state risks selling enterprises to investors with unreliable business plans. Second, the investor is allowed to acquire all stocks over a five-year period, which means that the actual period of privatisation is extended to five years.
Negotiations for Amending Proposals
Privatisation rules allow privatisation executives to engage in negotiations with potential investors in hopes of achieving better proposals concerning the purchase price and the amount of investment. This may help achieve some improvements in the investors’ proposals. However, confidential information may be lost and the potential for corruption increased. This possibility is illustrated by the privatisation of “Klaipėdos Hidrotechnika” when a potential investor, who in the first stage had produced the highest bid and had not amended its proposals in the second stage, did not win the tender and accused privatisation executives of corruption.
Public Sale of Shares
Public sale of shares is a method of privatisation in which shares are sold on a stock exchange without quantitative restrictions to the number of buyers or the amount of shares purchased. If this method of privatisation is used, no special requirements are applied to investors regarding qualifications, amount of investments or the preservation of jobs.
Privatisation executives maintain that the public sale of shares is used to promote the development of the capital market. However, this method is used strictly for the privatisation of small state-owned share packages. In 1999, the state sold share packages of 26 enterprises through the National Stock Exchange. This amounted to only 0,92 percent of the total turnover of shares on the stock exchange. So, the declared aim was not achieved.
The development of the capital market through the public sale of shares should not be the main goal of privatisation. The main reason for employing this method is the fact that trading procedures on the stock exchange ensure open, transparent and fast privatisation. Moreover this method helps to sell state property for the highest possible price.
According to the Law on Privatisation, the public sale of shares may be applied only in privatising open join stock companies. The law forbids the sale of shares of closed joint stock companies. The main reason for this, according to privatisation executives, is the fact that shares of closed joint stock companies are not the objects of public trading. Therefore, the shares of closed joint stock companies are sold through other methods, most often by public auction. The difference between public auction and public sale rests only in the sales mechanism. At the same time, the principle behind these methods – to sell publicly – remains valid in both cases. Therefore, it is unreasonable to prohibit the sale of closed joint stock companies’ shares by the public sale of shares. Creating additional mechanisms of privatisation and additional work for privatisation executives is costly and ineffective. Shares of closed joint stock companies should be sold through public sale, provided that all shares are sold in one parcel.
Public Auction
Public auction is a method of privatisation whereby the number of potential buyers is not limited and the privatisation contract is concluded with the investor who has offered the highest bid. Public auctions are used to sell state-owned shares of open and closed joint stock companies as well as real estate and movable property. Shares are sold in one parcel. Investors may be subject to special qualification requirements and requirements regarding the amount of planned investments and the preservation of jobs.
Open auction has some advantages as compared to direct negotiation and public tender. However, open auction is slower and less transparent than the open sale of shares. Also, this method permits the application of requirements regarding investment, preservation of jobs, and investors’ qualifications. Even if these requirements are removed, state-owned shares in open and closed join stock companies should be sold by the public sale of shares. Open auctions may be used to privatise state-owned real estate and, in exceptional cases, shares.
Other Methods
State property may be privatised by lease with the right to purchase and by the transfer of control of state-owned enterprises. These methods are used only in special cases, when an entity was not privatised in the first attempt or in combination with other methods (the transfer of control). The aim of these methods is to make the privatisation process simpler. However, there would be no need to apply these methods if the problems analysed in this study were removed.
In Lithuania, state property may be, and in some cases is, privatised not only by the Law on Privatisation, but also by special laws or rules. For instance, “Mažeikių nafta” oil refinery was privatised and state-owned commercial banks are to be privatised according to special laws. Evidence shows that such privatisation is less transparent, and investors have the opportunity to negotiate preferential conditions and various other benefits with the state. As a rule, regulations prescribed by special laws are less strict than the primary legislation on privatisation. In order to ensure efficient privatisation, general rules should be applied to the privatisation of state property, except when state property is privatised according to the Law on Public Trading of Securities.
The aim of privatisation should be to privatise state property for the highest possible price without creating legal restrictions to free market performance. Consistent with this aim, privatisation should be completed not only in the sectors of commerce and manufacturing, but also in infrastructure, the healthcare system, education, culture, social security, and other sectors. The creation of monopolies or other preferential rights for newly privatised companies should be avoided in the privatisation process.
Enterprise restructuring can be justified only in cases when the goal is to split a company into several independent entities in order to reduce the company’s monopoly position. However, such restructuring is necessary only in exceptional cases, since monopolies are harmful only when the law protects them. It is important to ensure that restructuring does not delay privatisation, that the state refrains from undertaking tasks that can be performed by private owners, and that legal conditions exist for free market entry and exit. In all other cases the restructuring of a company should be left to the private owner.
Existing rules regarding the selection of privatisation consultants are not transparent and allow for the selection of consultants whose proposals do not necessarily match the state’s needs and the consultant’s capabilities. No restrictions should be placed on potential consultants’ participation in a tender. Requirements applicable to tender bids (rather than assessment criteria) should be established before announcing the tender, and bids should be assessed based on price.
The success of privatisation depends directly on the method of privatisation used. In order to ensure efficient privatisation, methods of privatisation should be transparent, and privatisation should be conducted in a quick manner. No potential investors should be restricted from participating in the privatisation process. In Lithuania, state property is privatised by direct negotiation, public tender, public auction, public sale of shares, transfer of control of state-owned enterprises, lease with the right to purchase, and by special laws.
Direct negotiations and public tenders restrict the opportunity for potential investors to participate in the privatisation process. These methods do not ensure open, transparent privatisation. Lengthy privatisation procedures protract the sale of state property. “Strategic” investors have the opportunity to negotiate preferential conditions. The benefits received from “pledged” investments and preserved jobs are short-term. These requirements restrict investors’ future activities and create the need for control. As a consequence, these methods do not achieve the desired results and should be repealed.
The inconsistency and fragmented regulation related to the privatisation process create another set of concerns. When privatisation of a certain entity is subject to specific rather than general rules, it becomes less transparent, and investors have the opportunity to negotiate preferential conditions and benefits. In order to ensure efficient privatisation, the general rules of privatisation should be applied to the sale of all state property, with an exception only in cases when state property is privatised according to the Law on Public Trading of Securities.
The most effective ways to private state property are the public sale of shares and public auction. Immovable property and, in exceptional cases, shares should be privatised by public auction without placing any requirements regarding investors’ qualifications, the amount of future investments or job preservation. In all other cases state-owned shares should be sold only on stock exchanges and at market price. The requirements for “mandatory tender offer” should be applied when open join stock companies are privatised.
Privatisation on the stock exchange eliminates the need for new state institutions to implement and supervise the privatisation process and thereby helps save both time and money. The use of a transparent trading system in the stock exchange would increase efficiency and the pace of privatisation. If privatisation is conducted on the stock exchange, more potential investors are involved, and shares are sold for the highest possible price. In addition, the use of the stock exchange in the privatisation of state property significantly accelerates the development of the capital market.