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Tuesday, 4th August 2020
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Privatisation: lessons need to be learned Back  
David O€Flanagan highlights the areas to examine carefully in privatising State companies and suggests approaches to ensure success
After many years of lagging behind the rest of the world, Ireland has embraced privatisation in its various forms, with the planned sell off of a number of semi-state companies, and the emergence of Public Private Partnerships for infrastructure projects. However, the lacklustre share price performance of eircom, and the recent controversy over its initial offering price, risk discrediting the privatisation process in the eyes of the public. These are matters which must be addressed if future privatisations are to be successfully concluded.

Successfully completing a privatisation requires:

Clarity on objectives
It is vital that there is absolute clarity on the objectives of each privatisation. Generally, these can be defined in terms of:

€ The desire to improve competition in a particular sector and to increase the efficiency of the privatised entity;
€ To widen and deepen share ownership among the public;
€ To maximise the proceeds of sale, but on a basis which does not adversely impact on the achievement of other objectives;
€ To ensure a successful privatisation within a given timeframe; success needs to be measured from the perspective of Government, the company, its customers and employees, and the public. The continued fulfilment of public service obligations is an important criterion here.
€ Getting the balance right between these potentially conflicting objectives, and ensuring processes are established to constantly monitor the achievement of objectives are key ingredients of success. The public interest must be given the highest priority in every aspect of the process.

Careful preparation of the Company
Companies emerging from the State sector generally require significant grooming prior to a sale or IPO process. Key matters to be addressed are:

€ The nature and extent of competitive influences and the ability of the entity to compete on a sustainable basis in global markets; this may direct the privatisation down a trade sale rather than IPO route.
€ The need to transform the entity into a company established under the Companies Acts. A number of the semi-state companies are not so constituted.
€ The need for strengthening of the management team and the Board to enhance the commercial skills of the organisation. This is vital to the success of the company post flotation or sale;
€ The need for rationalisation and cost reduction programmes to ensure competitiveness; this will need early consideration of employment, redundancy and pension issues.
€ The financial track record of the company
€ The valuation of property assets, and whether their future realisation might give rise to windfall gains in the privatised entity, thus risking adverse publicity. To avoid this, a claw-back of the proceeds of sale of such assets above a given threshold should be built into the conditions of sale.
€ Preparing the company for privatisation can take some years, and is an essential part of ensuring a successful IPO or trade sale.

An appropriate regulatory framework
Many semi state companies, particularly the major utilities, operate in a full or near monopoly environment. This requires the establishment of a regulatory framework in advance of privatisation to promote competition and regulate the industry in a transparent and explicit manner. In many of these sectors, competition in the fullest sense will take some time to develop, and regulation is required to protect the customer from abuse of monopoly power. This necessitates regulation of pricing and quality of service.

The regulatory structure must equally ensure that the prospects of the privatised entity are not so constrained as to deter investor interest in the offering of shares.

Optimum arrangements for the sale
The arrangements for sale are arguably the key factors in ensuring a successful privatisation. The crucial decisions revolve around:

€ The method of sale
The decision here is whether to float the company or offer it for trade sale. In the writers view, the trade sale route is likely to be appropriate for a number of semi- state entities (VHI, parts of CIE).

€ Which market
The choice of stock market, and which market is likely to create the greatest level of competition from institutions and interest from private investors in the shares, are important factors.

€ The type of offer
The decision here is whether to pursue a full or partial tender offer, or a fixed price offering. The extent to which overseas interest in the offering is sought is also important, particularly where the offering is significant in scale. Tender offers risk depressing retail interest in the offering, thus potentially hampering the achievement of wider share ownership, for which a fixed price offer is best suited. A back-end tender, where a tranche of shares is reserved until after completion of the fixed price offer and offered to the highest bidding institutions, can be beneficial in maximising sales proceeds where the initial offer is likely to be fully subscribed. Bookbuilding, a process in which institutions are requested to specify , in advance of the pricing of the offer, the amount they would be prepared to invest within different price ranges, can be useful in creating competitive institutional pressure.

€ Incentives
Most privatisations involve incentives to retail purchasers, for example bonus shares where the offering shares are held for a stipulated period, or customer discounts, for example against future electricity or gas bills in a privatisation of these utilities. Employee incentives are also common, whether in the form of free and/or at discounted shares. In this country, employee equity participation is now firmly part of the process. It is essential that the cost effectiveness of any such incentives are assessed in any privatisations, including the extent to which they are required at all.

€ Phased sale
An early decision is required on whether Government sells its full interest in the privatised entity or continues to retain a shareholding to be sold in a future offering. Where Government retains a shareholding, investors may be concerned about its future voting intentions and whether the remaining shares would ever be sold, a factor which could overhang the market and depress the share price; furthermore, the decision to retain shares for sale in the future may impact on the timing of future privatisations, particularly potential clashes with the timing of future major public offerings. Government however may wish to retain a shareholding if there are major doubts about the pricing of the initial issue. In general, it is best to pursue a 100 per cent sale by Government.

€ Share pricing and valuation
This is undoubtedly the most difficult and potentially contentious area of the process. Underpricing the issue risks adverse publicity in terms of short-changing the taxpayer, and may even undermine confidence in the company if the market has expectations of a higher flotation price. Overpricing not only brings the risk of adverse market sentiment after the issue , but can also seriously undermine the objective of achieving wider share ownership on future privatisations. How many of the thousands who acquired eircom shares will rush back in the event of the potentially higher risk future privatisations?

To overcome the problems here:
€ benchmark valuations should be obtained at an early stage, around which a flotation strategy is planned. These should identify the parameters of valuation for a sale. At least one set of valuations should be obtained from a party whose fee is not dependent on the outcome of flotation. The valuations must establish the appropriate basis of valuation, including benchmarking against comparable companies. Key factors which affect pricing include proposed dividend yield, likely demand from domestic and foreign institutions and from the public, the need to create a satisfactory aftermarket in the shares, and prevailing market conditions.
€ advisors must be set performance criteria linked to the wider objectives of the privatisation , and not solely to maximisation of the proceeds of sale
€ advisory success fees need to structured in a way which do not drive an obsessive desire to maximise the proceeds of sale at all cost and thus militate against the achievement of the broader objectives of a privatisation. Some form of fee capping may be appropriate here.

The success of a privatisation issue is frequently judged by the achievement of a modest level of premium in the trading of the shares post flotation (perhaps up to 10 per cent) and the longer term retention of shares by the general public. This latter point does raise an interesting point; clearly many eircom shareholders continue to hold their shares, but how many would happily exit now but for the loss they would incur on the disposal?

I am of the view that an independent analysis of the eircom public offering is required to establish any lessons of benefit to future privatisations. This should critically evaluate the extent to which appropriate objectives were set by Government , and the extent to which these have been met. eircom should ideally have established a positive disposition among the public for what will be more difficult offerings in the future; because of sector and scale future privatisations could be considerably more difficult to achieve. Without this, the risk of future privatisations being tarnished by the eircom experience remains. This is an area which could usefully be reviewed by the Controller & Auditor General - let us hope he does so.

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