Privatization in Central Government
KeywordsCorporate Governance Capital Market Privatize Company Initial Public Offering Minority Shareholder
The transfer of ownership of a state-owned company from a government (public sector) to a privately owned entity or private investors (private sector).
The privatization of state-owned enterprises (SOEs) has become a common process all over the world and is considered a major component of the New Public Management (NPM). The sale of SOEs and their assets to private parties by the governments has been one of the most relevant issues in the reforms of the public sector, and privatizations are expected to correct inefficiencies associated with the public sector. Moreover, the requirement of the European Union of governmental neutrality, the globalization of markets, and changes in organizational and productive processes have led to the decrease of the intervention of governments in the economy.
Privatization has not only reduced the role of the State in the production of goods and services, but has also increased the size and efficiency of the capital markets and the participation of citizens in stock markets. In line with this, newly privatized firms have begun to operate in an environment of greater economic freedom and, therefore, have initiated an expansion to take advantage of the market and of the financial opportunities. For an effective transformation, organizational changes must be undertaken by these entities to guarantee their continuance in the market, and their goals must be modified as a consequence of a greater market orientation and environmental changes. There is a lot of divergence between public and private companies and, consequently, SOEs have undertaken internal changes to carry out an effective restructuring and to adapt to the new competitive environment.
Reasons and Factors for Privatization
Reasons that boost this process are the changing view of the role of the State in the economy, new perceptions about the control and distributional function of utilities, the growing demand for more and better quality infrastructure services, and technological developments in the telecommunications and electricity industries. Governments have given multiple reasons for carrying out the privatization process, including the increase of revenues for the State (Brusca et al. 2015), to promote economic efficiency, to reduce the interference of the Administration in the economy, and to introduce competition and to discipline SOEs through capital markets.
The reasons for privatization can be categorized as economic, financial, and political (Vickers and Yarrow 1991). Efficiency is the economic reason most frequently used by governments to justify privatization programs. In privatization processes, most governments assert that private companies are better managed and are more efficient than public ones, and economic theory admits that private ownership transforms SOEs into more efficient firms, especially in competitive industries (Megginson et al. 1994). However, there is no theoretical consensus about the capacity of private ownership to pursue social objectives such as the stabilization of employment or the provision of goods and services at reasonable quality for citizens. Currently, controversy continues about whether SOEs should maximize profits or have only social objectives. Theoreticians do not agree on whether a state monopoly is preferable or whether the monopoly must be private and subject to regulation.
Privatization has changed the perspective from which regulatory questions are addressed, as market failures associated with monopoly and externalities do not disappear with a change of ownership. Development of a modern regulatory system is neither simple nor fast. The problem is vast, and sustainable change requires not only reforms to thousands of instruments, but also new institutional capacities and a shift by the public administration from a culture of control and rent-seeking to a culture of results-orientation and client services. Therefore, countries face the task of moving forward with the transition to market-led growth to maintain economic performance in response to technological innovations, changes in consumer demand, and interdependencies in regional and global markets. In this transition, supply-side reforms to stimulate competition and reduce regulatory inefficiencies have become central to effective economic policy.
The Process of Privatization
Governments employ three basic techniques to privatize their SOEs – share issue privatizations, asset sales, and voucher privatizations – according to the objectives of the privatization process.
The decision about the transfer method of SOEs is not straightforward. Political factors like the ideology of the government about the market and regulation and economic factors like the financial position of SOEs and the conditions of capital markets are involved in the privatization process. Governments use the sale of an SOE as a tool to develop a capital market. Larger and more profitable SOEs are more likely to be privatized through capital markets, while governments that have less state control over the economy tend to privatize SOEs via asset sales.
In a privatization process, the method of privatization determines the management replacement, because it determines who the new owners are. In initial public offers (IPO), the company is usually restructured previously in order to prepare it for private ownership and to reach higher value in capital markets. Moreover, in privatizations by IPO, managers are exposed to the discipline of financial markets and the control of investors, and public companies are no longer immune to acquisition and to the threat of bankruptcy. The preparation for an IPO, and the IPO itself, causes organizational changes within a company that contribute to performance. The most relevant IPO-related changes that contribute to performance are related to innovation, financial management, and financial reporting (planning and control, capital budgeting, and internal communication).
In the environment of the post-communist transition of the Eastern European countries, privatization is a complex economic and political process. In these countries, voucher privatization has been the main method of sale by giving preferential treatment to citizens and workers of the privatized enterprises. Restructuring the company and substituting the management may lead to a successful privatization process; however, the literature shows that management has not been replaced in these countries. So, unless voucher privatization is coupled with the possible purchase of shares by foreign firms, the newly privatized state enterprises have difficulty making the restructuring with the existing management and face additional costs in purchasing managerial skills on the labor market because of adverse selection problem. Literature corroborates this idea in their analysis of companies privatized through voucher privatization as, with voucher privatization, financing and control mechanisms are unlikely to be introduced by external shareholders, so it is more complicated to improve the performance of companies privatized in this way.
Capital Markets as Disciplinary Mechanisms of Management
Privatization subjects managers to the pressure of the financial markets and monitors and disciplines profit-oriented investors. Therefore, objectives imposed by politicians in SOEs are redefined, and mechanisms that aligned managers’ incentives with owners’ financial interests are introduced. The accountability to shareholders gives a better incentive for state companies to operate efficiently. That is, the change of ownership has led to new incentive systems to enhance financial performance. Moreover, companies introduced instruments for performance measurement in order to enhance transparency and improve organizational learning. These changes in privatized companies give managers the possibility of increasing their salaries according to their level of efficiency. The change of ownership has generated more defined objectives and new incentive mechanisms for the managers.
SOEs may be less efficient because they are immune to capital markets. The public trading of shares of privatized companies in capital markets will increase their efficiency if privatization is linked to the possibility of takeover by outsiders, disciplines managers, and provides the ability to link compensation to performance. As a result, when shares are traded in public equity markets, managerial effort and accountability increase.
In the companies, agency problems arise between the managers (agents) and owners (principal). In private companies, these problems are reduced through the existence of a market for ownership rights, which enables the owners to sell shares if they are not satisfied with managerial performance (property rights theory), through the threat of takeover and bankruptcy, and through a managerial labor market. In the case of privatized firms, the possibility of issuing capital implies that the discipline of the financial creditor is replaced by the discipline of shareholders and, therefore, of the capital markets.
On occasions, the appointment of SOE managers is carried out according to their capacity of negotiation with politicians, their ideology, and the confidence of politicians in these managers. With the change of ownership, the labor market puts pressure on managers and disciplines them. If the management labor market is competitive, it will be a monitor mechanism and replace non-efficient managers. The conflicts between shareholders and managers are addressed using optimal contracts within a principal-agent framework.
In the privatization process, the capital markets work as a mechanism to establish management incentives. In efficient markets, the stock price incorporates performance information about future benefits from company’s decisions (Vickers and Yarrow 1991). This information is useful for shareholder-manager contracts and for defining managerial remuneration. The objectives of compensation plans are to help the company attract, retain, and motivate its executives and other employees. Privatized firms that have incentive systems show more performance improvements than companies that do not have them. Compensation plans motivate employees by providing a direct link between company performance and executive wealth, that is, employees are rewarded for achieving specific goals. These plans are an efficient mechanism in matching managerial pay to managerial ability.
The public trading of shares establishes the possibility of takeover by outsiders, and the threat of a takeover is another management control mechanism. These market operations may stimulate managers to achieve greater efficiency and to avoid being acquired by another company. A major consequence of privatization is that privatized companies can be targets of takeovers and mergers. Several takeovers in Europe involved newly privatized firms.
From these explanations, it can be observed that the level of development of capital markets is a key determinant of post-privatization efficiency gains. More developed markets facilitate access to private debt and equity, which allows a more far-reaching modernization and restructuring of companies. Companies whose shares are traded in more sophisticated and active markets can obtain greater performance improvements from the privatization process.
The Governance System in the Privatization Process
The privatization of SOEs has been one of the most important channels for improving corporate governance, which is a key element for enhancing economic efficiency and investor confidence. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in line with the interests of the company and of shareholders and should create trust in order to promote an efficient and transparent market economy. The change of the ownership structure has required modifications in the mechanisms of corporate governance of privatized companies. In these companies, governance depends on the effectiveness of relations between interest groups that control the strategic management and the performance of the company.
With globalization, institutional investors force companies to comply with the rules of transparency and corporate governance, as institutional investors acquire shares of companies to maintain shares in the long run (Megginson 2005). This author states that creating a satisfactory corporate governance system generally involves changing a nation’s corporate and securities laws, strengthening the listing and disclosure requirements for its stock exchanges, enhancing the independence and competence of the national judiciary, and establishing a regulatory regime capable of balancing the competing claims of managers, outside shareholders, and creditors.
Factors of corporate governance can be split into two groups: internal and external mechanisms. Internal governance mechanisms include ownership concentration, board composition, executive compensation, top management replacement, the monitoring of executive decisions, and the protection of outside investors. External governance mechanisms refer to the effectiveness of a market for corporate control that may permit the purchase of the firm when it is underperforming. Both types of mechanisms are influenced by environmental and organizational factors linked to the privatization process.
Finally, other corporate governance mechanisms are the legal system and codes of good governance. The country’s legal system must force managers to feel the discipline of the capital market. Markets affording greater shareholder protection are consistently larger and more efficient. Codes of good governance are a set of best practice recommendations about the structure of the boards of directors and act as a substitute for deficiencies in the protection of shareholders in the legal system.
In the privatization context, all these mechanisms are very important, and the government should prevent the newly created shareholders from being expropriated by the managers of privatized companies. Where the law affords weak protection to shareholders, governments are more reluctant to relinquish control of SOEs to avoid opportunist behavior on the part of privatized firms, and privatization efficiency is lower.
The property rights theory states that privatization must replace political managers to create an independent governance system in the companies. Furthermore, privatization to outsiders is associated with higher gains than privatization to insiders. That is, new owners will restructure the company to recover their investment and obtain a higher profitability.
Governments must enhance corporate governance systems to promote transparent markets and a successful privatization process. Investors decide to acquire shares and restructure the company in order to adapt it to the new competitive environment. Weak governance and a limited protection of minority shareholders intensify traditional principal-agent problems. These problems have relationship with issues of managerial discretion and expropriation, which occurs when large owners assume control of the firm and deprive minority owners of the right to appropriate returns on their investments. Post-privatization performance improves when corporate structures are introduced into the companies.
Results of the Privatization Process
The privatization process has reduced the role of the SOEs in the economy in order to fulfill economic, political, and financial objectives imposed by the governments.
The Depression and World War II pushed the government into a more active role in their economies, including the ownership of the production of goods and services. In the second half of the twentieth century, Western European governments debated how deeply involved the national government should be in regulating the national economy and which industrial sectors should be reserved exclusively for state ownership. They decided that the government should own at least the telecommunications and postal services, electric and gas utilities, and transportation. Many politicians also believed that the state should control strategic manufacturing industries such as steel and defense production. Another reason to boost state ownership was the general resentment toward foreign investors owning the largest firms, so privatization policies provided a preferential treatment to national investors in their early stages.
With the Thatcher government, privatization programs started in the UK, and the change of ownership of British Telecom in 1984 meant the beginning of privatization as an essential economic policy in the country (Martin and Parker 1995). The successful British privatization program persuaded other countries to sell their SOEs. The objectives established by governments through privatization processes define initial conditions of the sale of SOEs. All governments must take three decisions about privatization: how to transfer control of the company, what price to offer, and how to distribute the shares. A government that does not want to interfere with the privatized firms will distribute their sale over time to gain credibility. Firms whose value is highly sensitive to public policy choices will be privatized with smaller share sales to retain their control for long.
The ideology of left-wing governments is more inclined to privatize SOEs to foreign investors than right-wing governments, rather than decrease the sale price in order to carry out redistribution between domestic investors. Left-wing governments adopt strategies for obtaining more revenues. A market-oriented government will significantly decrease the price in the initial offer of privatization to signal to investors that it will not interfere with the privatized firm in the future. Most initial sales have political features such as preferential share allocations to domestic investors and employees.
Privatization – an appropriate regulation and the liberalization of the market can lead to efficiency improvements.
The agency theory predicts that change of ownership per se will lead to improvements in the performance of privatized company. This theory analyzes the differences between the performance of private firms and SOEs as a result of the differences in the principal-agent relationship. In the private company, divergences between shareholders and managers are managed through internal and external control mechanisms, but SOEs do not have these mechanisms as they do not operate in a competitive market. In SOEs, the principal’s objectives are related to the public interest whereas, in private firms, the principal’s objectives are related to maximizing the firm’s value. Furthermore, the manager (agent) of an SOE has two principals, voters and government, whereas, in private companies, the principal is the shareholders. Additionally, the public choice theory defends that the State is a self-interested agent that pursues its own interest and, consequently, SOEs have multiple and varied objectives. These theories are confirmed by literature (Boycko et al. 1996) and highlights problems in the SOEs using a model that shows the gap between the objectives of politicians and managers.
Although both theories defend that privatization improves the performance of companies, many studies do not agree with this assertion. There is considerable debate about whether the efficiency and productivity of an SOE depend more on regulation and competition in the market or on ownership (Yarrow 1986; Vickers and Yarrow 1991).
According to Vickers and Yarrow (1991), competition is one of the main components of improvements in the performance of privatized companies. Liberalization, more than privatization, forces public companies to be more efficient. Empirical studies like Megginson et al. (1994) assert that there are significant differences between the performance of companies that operate in competitive and noncompetitive markets. In these studies, it can be observed that all companies improve their performance after being privatized; but if the market is competitive, the benefit will be higher.
Currently, the regulatory decisions have been designed to introduce rules that do not interfere in the running of competitive markets, and regulatory powers are more widely distributed at the national, regional, and international levels.
Privatization processes have contributed to the development of capital markets
One of the objectives of privatization has been to promote the so-called popular capitalism, that is, the democratization of capital markets through the participation of citizens in privatization processes. Privatizations by initial public offering (IPO) have developed primitive capital markets, and the sale of shares of SOEs tends to be underpriced to attract the participation of investors. Companies privatized by IPO generally obtain higher market capitalization and values in the capital markets.
Quoted companies generate an economic benefit from the increase in efficiency and liquidity that they provoke in the capital markets. The efficiency of capital markets promotes economic growth and allows the financing of investment opportunities of companies, not only in capital markets, but also in bond markets. So, the privatization of SOEs promotes the development of fixed income markets.
In privatization processes by IPO, investors purchase shares and resell them to earn significant positive returns. One reason is that IPOs may be significantly underpriced. In the long run, important gains are generated, which indicates that the market underestimates the total efficiency gains due to privatization. Parker (1997) analyzes the privatized sector in the UK and asserts that gains for investors are due to the high profits of privatized companies and the low level of competition in the first years after privatization, which lead to high returns to investors. Investors have gained experience about important variables such as the cost of capital, asset values, and depreciation rates of regulated firms, so they can evaluate the real price and the market price and avoid underpricing.
The privatization process modernizes a nation’s corporate governance system.
The change of ownership aims to increase corporate efficiency and transform corporate governance by introducing incentives systems in companies and creating arrangements that are conducive to effective governance.
The adoption of privatization programs strengthens a nation’s governance systems and leads to significant improvements in the market regulation and financial systems. So privatization programs have forced governments to improve effective governance systems so that the change of ownership of SOEs is perceived as economic and political success. This is more complex than the simple fact of selling SOEs because it implies that many rules and institutions have to change simultaneously. Concern about the security issues of capital markets has risen with the privatization process, and the law has tried to strengthen the defense of minority shareholders. Another consequence of a successful privatization process is the change of the legal system in order to protect investors.
In recent years, governments have boosted privatization by public offer and have established a regulation to increase the confidence of potential investors and guarantee that the capital markets are appropriate for investing in these companies. This has led capital markets to be more liquid and transparent.From these results, it can be observed that the privatization process has meant rapid changes in utilities and infrastructure companies. Global competition between multinational firms has replaced domestic and monopolistic markets by others that are more segmented and competitive. In spite of these gains derived from privatization, the relationship between these benefits and the change of ownership is not clear. The results of privatization take several years more than expected to appear. Privatized industries have grown and become more profitable, but the causality relationship runs from the growth and profitability to the privatization, not in the opposite direction. The benefits of privatization coincide with increasing dissatisfaction among and opposition from citizens. Macroeconomic and distributional gains are not equivalent to microeconomic gains, and in several cases the privatization process has not been transparent. Figure 2 shows factors that boost the privatization process and its main results. However, it is also necessary to consider that key elements such as regulation, competition, restructuring of privatized companies, and changes in corporate governance systems influence post-privatization performance.
The above theories and perspectives on privatization offer positive features, but they also carry serious problems of their own. For example, change of ownership is not enough to improve efficiency in privatized companies, which indicates that compliance with fiscal rules and the development of the capital markets may be the real reasons why the governments implemented the privatization process.
Capital markets discipline privatized companies because of the threat of takeover – when the company is not efficient enough – and the risk of bankruptcy. This is a consequence of the lack of financial support from the government, which no longer subsidizes privatized companies nor takes responsibility for their debts. Literature corroborates this idea and shows that companies privatized through public offers obtain a better performance in the short run than companies privatized through private sale or voucher privatization. SOE managers have freedom to take decisions, and they are only accountable to politicians. However, the change of ownership means that managers have to justify their actions to new private shareholders and are exposed to the risk of being replaced by more efficient managers. If the corporate governance system of a country is weak, investors’ rights are not protected, and there is no confidence in the financial system. This can explain why insiders, old employees and directors, rather than outsiders have acquired the control of the privatized companies. The lack of outsider control means that privatized companies’ performance does not improve with privatization.
Privatized companies have introduced management techniques and have carried out internal restructurings, modifying their objectives and strategies. Restructurings allow them to give a better economic image, and, consequently, governments can obtain higher revenues and reduce the public deficit with the share sales. Moreover, more investors are attracted to the capital markets, which promote the so-called popular capitalism. The internal changes require a learning process and a period of adjustment because companies do not receive financial support from governments and they need several years to adapt to the new competitive environment.
The conclusions presented here allow to assert that the results of privatization have not always been those expected because the companies have not improved their efficiency with the change of ownership. This indicates that governments have followed other aims, such as modernization of the corporate governance system or the development of the capital markets. Privatization is a necessary response to globalization and the liberalization of markets but not an independent trend.