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Derailing divestment

Raghuram Rajan | January 31, 2003

The announcement of the details of the way the oil majors will be sold suggests the divestment minister was right all along.

Politicians who opposed strategic sales were not really interested in exploring alternative routes for privatising state-owned firms or genuinely concerned about the problems associated with strategic sales, but simply interested in keeping public assets within their continuing control.

Through these sham sales, we will lose the opportunity for a genuine experiment between two different methods of privatising: a strategic sale versus an open market sale. To see what this experiment might have been, consider the arguments for each type of sale.

A strategic sale is a sale of a controlling stake to a private party. The arguments made in its favour are that such a sale will allow the government to obtain a premium on the sale (otherwise known as a control premium), that management of the public sector enterprise will be improved when there is a large controlling party, and that there is no alternative because the public equity markets cannot possibly absorb the large sales that are being contemplated.

When do these arguments make sense? Private parties are in the business of making profits. A private owner will pay a premium if he can make more money from the privatised business than any one else can (including the incumbent public sector managers).

Some of the reasons the owner can make more money are good ones: He can exercise control over the managers, and since a significant amount of his own money is at stake, he has strong incentives to do so. He may also have expertise in the business and may be able to bring in new technology and new management skills.

But there are also less laudable reasons. He may be able to pay more. He may obtain a greater monopoly in the industry through the acquisition and may be able to charge extortionate prices to customers.

He may want to strip assets from under the other owners (for example, by selling the firm's assets to other companies he owns at below-market prices) and his controlling stake will give him the ability to do so.

Finally, there may be few bidders for the sale of a large block so he obtains the assets at a discount. Note that even if he pays a premium over fair valuation, given the public sector's current performance, the right comparison is whether he pays a premium over what the valuation would be if the firm's incumbent management were no longer shackled by government interference.

In sum, since the government is supposed to act in the public interest, it should sell through a strategic sale if it expects the quality of management or governance to be enhanced by the new owners. If the government is so convinced that private ownership will make a difference, it should not continue to shackle the prospective owners with a host of conditions, which defeat the purpose of privatisation.

If, on the other hand, it is not convinced that current management will be improved upon, it should consider a public, open market sale, which will leave current management in control.

A public sale is, however no guaranteed success. One concern is that the incumbent management will become a law unto their own, without any governance exercised over their actions. The way around this is to manage the divestment process so that a few large stakes are offered to private mutual funds, while the remaining shares are dispersed amongst the general public.

These funds would have the interest and the voting power to assure reasonable governance of the privatised entity.

A greater concern, however, is that under the guise of assuring good governance, the government will continue to retain a stake large enough to maintain effective control. The divested entity will continue to be run in the private interests of the bureaucrats and politicians who exercise that control.

Unfortunately, this concern seems to be borne out in the way Bharat Petroleum Corporation Limited is slated to be ‘privatised' with the government continuing to own 26 per cent of the shares.

Part of the problem seems to be with the words 'divestment' and 'privatisation'. What is important in this process is that the government give up control, not merely 'divest' its shares. In the process, it will restore to the public interest, national assets that are currently being run in the private interests of a few politicians, bureaucrats and pampered employees.

'Publicisation' is a better term and what the government proposes is simply not in the public interest.

As any student of corporate finance knows, control exercised with 26 per cent ownership is more damaging to other shareholders than control exercised with 51 per cent ownership, because the 26 per cent owner has less to lose when he makes bad decisions. If the government is interested in furthering the public interest, it should give up control and sell all its shares.

Furthermore, it should place a sufficient number of shares in the hands of large private funds so that some private governance is exercised over management.

The initial board should be manned, not by retired IAS officers and judges, but by private sector managers, lawyers, and accountants with a proven track record. The new board should be in place before the shares are sold so that the public believes the firm will be protected from government interference.

Over time, the board should evolve based on the share ownership, but the initial board is critical.

But all this is a pipe dream now. With the current proposal for BPCL, not only will the government not get as good a price as it could have obtained if it could credibly commit to not interfering in management, it will also lose a golden opportunity to reap the benefits from a genuine public sale.

Well-governed companies owned and controlled by the public could lead to a much-needed dispersion of economic power, away from the government and a few powerful families. As history suggests, this dispersion is needed for the public to lend their political support to a market economy.

A well-managed public sale where the offering is underpriced a little could also give citizens a good return, which will increase their appetite for further offerings and enhance stock market liquidity.

Furthermore, the dispersed shareholding can only further the development of corporate governance and the market for corporate control.

If, for example, newly privatised entities are poorly run, other private parties may take them over, increasing both the efficiency with which the assets are managed and the return the public gets. Such a market is unlikely to develop if the government continues to have veto power over who takes over.

Public sales could prove a genuine alternative to strategic sales. But the people opposing strategic sales have shown their true intent. The sale of Hindustan Petroleum Corporation Ltd has been spiked by putting so many restrictions that no serious private party will want to pay a premium for it.

The sale of BPCL has been hobbled by ensuring that the government retains control. The government has lost a golden opportunity to test two different methods of private ownership. Instead, the announced sales demonstrate two different ways our ingenious politicians will continue to exercise control.

The stage is set for the failure of these sales. After all, that is precisely what the opponents of divestment want.

The writer (rajan@gsb.uchicago.edu) is Professor, University of Chicago and Indian School of Business.



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