Palms & Company Document

THE OBJECTIVES OF PRIVATIZATION

by

Dr. Pyotr Johannevich van de Waal-Palms

The objective of privatization is to transfer the control of companies to private ownership, thereby allowing them to compete in a market economy and make decentralized decisions regarding the allocation of resources and capital.

A symptom of this process is the liquidation (bankruptcy) of inefficient enterprises and the concurrent fall in production output in the short-term. The much heralded fall in GDP during 1992-1993 shows the reform have been progressing. In 1994 Yeltsin will appear to moderate support for reform in general and by inference privatization. Y. Gaidar and B. Federov have left the Government, but serve as elected members of Parliament and will bide their time until disillusionment develops with Chernomydyn's subsidies (called investments in Russia) and the resulting hyper-inflation and financial chaos, including another free-fall in the ruble exchange rate to a level of R4000 =$1.00 in 1994 and perhaps as low as R10,000 =$1.00 in 1995. Budget deficits can be expected to approach 80 Trillion rubles and could exceed R120 trillion in 1994 and exceed IMF guidelines by more than 100%.

The ability to maintain the rate of ownership transfer lies in the hands of Anatioli Borisovich Chubais. A stock certificate is issued and voila!, socialism becomes private enterprise. Capitalism is avoided as long as the government reserves the right to instant conversion back to socialism by imposition, without legal limitation, of taxes, by decree. It is a gesture humoring the West to qualify for economic assistance. Such action has already been imposed in several industries. Barring such 'bankruptcy through taxation', the continued existence of privatized companies will nevertheless further depend for their continued existence largely upon their ability to attract Western capital and management for revitalization, modernization and product line transformation. The likelihood of attracting such capital depends upon willingness of the Government, as yet not evidenced, to modify existing privatization regulations to enable Western investors to apply good management and financial planning practices to privatized industries, without encountering artificial barriers created by ill conceived legislation. For the moment, "Privatization" remains a numbers game without substance.

When that changes, Western capital participation in Privatization auctions may increase. Otherwise privatization is likely to remain largely an internal national phenomena with Western capital biding its time to negotiate in later years with privatized firms, when applicable law evolves and becomes supportive of co-investment relationships with non-Russian investors. In that case however the value of the company is arbitrarily increase significantly without justifiable rationale. There is still an unwarranted concern about foreigners buying up Russia which is without foundation, and it is a deterrent to economic recovery. Most present "foreign" investment" is in fact Russian "flight capital" cloaked as Western investment.

The Characteristics of Privatization Policy in Russia have been:

1. Three main options for management and employee participation: Reorganization in an Open Joint-Stock Company; Reorganization into an open joint stock company; and Tender or Auction.
   
2. A public auction of shares for vouchers
   
3. Retention of equity by the government, occasionally controlling interest.
   
4. Transfer of vouchers from individuals to institutional Voucher Fund Managers.
   
5. Bidding by Russian Voucher Funds for shares.
   
6. Deferred payment terms, including credit for employee purchases or immediate employee purchase for cash.
   
• 25% preference shares free of charge
• 10% sold by restricted subscription with 30% discount on the par value with a three year grace period for payment
• 5% Option to buy shares at par value granted to managers
• 60% state owned shares (placed with the public)
• No free charge transfer of shares or grace sale, but employees can pay up controlling block of shares (51%)
• Common shares sold by restricted subscription at a price of 1.7 x par value
• 49% state-owned shares
• A block of shares is sold to a group of employees who assume responsibility for the enterprise's performance
• 20% To all employees with 30% discount, 3 year grace
• 20% option to group of employees to pay up shares within 1 year at par value, subject to privatization implementation by the buyers and their guarantee the enterprise does not bankrupt. Requires substantial performance guarantee deposit.
• 60% state-owned shares

When 100% of an enterprise is sold by a commercial or investment tender, employment guarantees under Russian law continue to apply to the work force. When restructuring is to an OJSC (Open Joint Stock Company), general provisions of law subsequently apply to eventual termination of the work force and further employment of personnel. New owners must conclude a collective bargaining agreement within 6 months after acquiring ownership. Tender agreement may include provisions for extending the existing jobs, up to one year, including social guarantees and social programmes such as schools and housing and hospitals, which are the obligation of the enterprise. There may also be requirements and commitments to maintain previous production levels of certain products and the obligation to maintain such requirements in subsequent resale of the business, unless it is agreed to close down the business or modernize it.

Twenty one decrees, laws, provisions, memorandums and directives have been issued between 1991 and 1993 by the Supreme Soviet, The President, Ministry of Finance, The Government, and State Committee on State Property, all having competence and jurisdiction and authority for their acts.

In October 1992 the Russian government began to distribute, to every citizen, a voucher which can be used to bid for and buy shares in companies at privatization auctions. The first pilot auctions were held in December.

The voucher is a compulsory means of payment in privatization of 29% of State shares. Participation in privatization auctions is confined to voucher owners. Voucher validity is currently scheduled to expire July 1, 1994. Vouchers may be invested with Voucher Fund Managers and can also be used to buy shares of OJSC's created under the privatization program, or enterprises sold at auctions, enterprise sites, state and municipal housing, and shares of non-state pension funds

Voucher Funds are restricted in their activity from 9 specified activities. Closed typed Voucher funds are not obliged to return shareholder money on demand in exchange for shares. If such policy applies also to CJSC's it raises the question how OJSC's would meet obligations to redeem shares. Voucher Funds appear to serve only the function of investment guidance for individual voucher owners in acquiring shares. They have as yet not contributed to revitalization and post privatization investment of additional capital, which is one of the primary weaknesses of the privatization program.

In March 1993 I participated with Deputy Prime Minister Anatoli Borisovich Chubais, William H. Donaldson, CEO and Chairman of the New York Stock Exchange, and Arthur Hartman, former ambassador to the former Soviet Union, in the board-room of the New York Stock Exchange, together with 40 CEO's of Fortune 500 companies, in a review of the results of this activity and received a schedule of proposed future auctions and valuations for 204 companies that would comprise such auctions. The valuation for auction purposes, of the companies presented by Anatoli Borisovich is significantly below replacement cost or book value by western standards. For example market value of the companies comprising the Dow Jones Industrial Average is an average of $1 million per employee. In contrast Russian companies had received valuations of an average of $27 per employee.

The property assessment is made by a Working Commission on privatization. It is based on the balance sheet as of July 1, 1992. The fixed assets appraisal is based on the residual value (excluding depreciation) at 1985 prices. Beginning July 1992 all assets were reappraised for all cases other than privatization, the cost of reappraised assets now being 25-40 times higher. Therefore the value of privatized property is made up of two unequal elements: the cost of fixed assets at "old" prices, and the cost of current assets at "new" prices. Post privatization reappraisal of authorized capital is permitted, using unidentified coefficients approved by the Government for each type asset to adjust for current prices, if it does not change share participation. This may be accomplished either by increasing existing share par-value or distributing new issue of shares among all shareholders. Social, cultural and engineering infrastructure is not included in appraised property.

The Russian Legislation on Privatization does not allow the reorganization of privatized enterprises into close(d) joint stock companies. OJCS's may have a continuing obligation to redeem shares upon demand. Privatization of affiliates of state enterprises (including joint ventures) is only possible by way of privatizing the parent company, i.e. shares in possession of a state owned enterprise are included in its property appraisal according to general rules. Therefore, employees of affiliates do not have the right to privatize them independently and to enjoy all of the privileges granted by law.

The Russian Government has privatized more than 6,000 large enterprises using these methods in 1993. More than 30,000 small and medium size companies have been privatized with many more scheduled for privatization in 1994.

Russian privatization models have not addressed the need for capital injection following privatization. This is essential component to achieve revitalization, renovation, product and quality change and improvement, export marketing, technology transfer, and acquisition of management "know-how". Unless such a role is created for Western venture capital, privatization will not lead to economic revitalization or a market economy.

There is significant Western interest in providing capital for investment to most of the Republics. But present privatization regulations fail to encourage that interest. There is a significant opportunity to convert idle assets to productive use and generate employment by utilizing financing methods such as "debt for equity swaps" and leveraged-buy-out techniques to finance the acquisition of such assets. Spin-offs, Divestiture and Turn-around management strategy offers opportunities for short term "exit" strategies for Fund managers. To date, Minister Federov, a Russia chief negotiator, has shown no inclination to allow such settlements of Russian debts to the "London Club" in his discussions with Deutsche Bank, the spokesman for the London Club. Prime Minister Chernomyrdyn continues to plan for all time high subsidies of as much as R43 trillion rubles ($27 billion), called "investments" in the Russian budget, to maintain employment at bankrupt businesses. All this gives Western would be investors of new capital the shivers.

The former USSR capital markets are in their infancy. Many are receiving advice from European Investment Bankers and the EBRD regarding the development of these markets. I attended the recent Vancouver Summit of Presidents Clinton & Yeltsin, as an accredited delegate, where such issues were discussed. The consensus was that the job requires $3 trillion over the next decade, and that it is available, but not under the present self-defeating rules.

Millions of Russians have exchanged their vouchers for shares in newly privatized companies, thereby providing a huge potential retail customer base for their exchange. The experience can be duplicated in other republics but ought to incorporate significant variation or improvements to eliminate current weaknesses.

To date 500 voucher funds have been authorized in Russia, providing the start to an institutional investor base. Since these funds compete for a total float of R700 billion in vouchers, or an average of $872,000 in potentially available money per Fund, there will be a shake-out to a level of perhaps six major Fund managers in Russia. Republics other than Russia can benefit from the Russian experience in developing their own privatization system. There are elements of the Russian model which should not be copied.

Recent monetary action of Russia eliminating pre-1992 rubles from circulation has severely impacted other republics which have received an influx of such rubles from other CIS republics which, as each in turn abolished the ruble, sent their worthless rubles to each other. New currencies include Latvian "lats", Lithuanian "Litas", Estoniasn "Kroons" Kazakh "Tenges, Tajiskistan "Manats", Uzbekistan "Soms". Turkmenistan "Manats" Armenian "Drams" Azerbaijan "Manats" Ukranian "Coupons" Moldavian "Leus" and Georgian "Titris" with the exception of the Baltics these currencies are losing value. Russia attempts to peg these currencies to

the rubles decline against the dollar, and has a virtual monopoly in the currency exchange markets in these currencies. By these actions Russia tries to create the false impression that these new currencies cannot stabilize more rapidly than, or independently of the ruble.It blocks the vision that there is an independent route for these currencies to the ruble via the dollar. In the long term, the creation of these new currencies nevertheless augers well for future monetary policy of the new republics and the establishment of exchange rates which will not be the captive of Russian inflation and currency devaluation. Privatization policy will be interdependent with monetary policy.

1. Depends significantly upon eliminating present regulations which prohibit post-privatization increases in capital which dilute share-holdings of the participants in the privatization process. Current regulations only permit an increase in authorized capital by increasing the par-value of existing shares or by reappraisal and requires a stock dividend to existing shareholders. Regulations prohibit dilution of existing shareholders by selling additional shares to new investors. This limitation discourages essential post-privatization equity investment for renovation, modernization and revitalization, which can only come from international investors ("foreigners").
   
2. Depends upon recognition of the de-facto presence of available Russian "flight capital" for re-investment in post-privatization. Such capital, owned by Russians, is now cloaked as Western capital. Available "flight capital" exceeds the total of all Western investment to date in Russia and the NIS and remains likely to continue to exceed the available amount of Western government sponsored economic assistance for several years. To retain its cloaking (protection), this "Western" Russian capital awaits Russian regulations that permit "foreign" investment" in the post privatization recapitalization.
   
3. Depends significantly upon the creation of Russian legal authority to execute cross-republic trans-national mergers and acquisitions to vertically and horizontally integrate OEM suppliers. In the long term, future privatization programs most likely will evolve the following characteristics. Western corporations will seek to acquire the fixed assets of post-privatization Russian & NIS enterprises for their shares and subsequently provide know-how and liquid capital. Most Western private investment (non-governmental) will be comprised of newly formed Western companies, doing business in NIS, which have "Western" shareholders, who are Russian and NIS nationals living in Russia and the NIS. The acquisition of Russian Venture Fund portfolios by Western Venture Capital Fund Managers. Obfuscation of limitations imposed on Russian VIF's through a maze of Western holding companies. The use of Malta and other tax havens for incorporation.
   
4. Newly privatized companies receiving Western participation in post-auction capitalization increases, on a reverse-takeover basis.
   
5. Companies incorporated outside NIS but with their business primarily within NIS.

In the short term Western government sponsored organizations will continue to contribute to the deferal of private capital investment through promulgation of investment criteria which is preferential and not market competitive. This creates the misperception with the Russian government and industry that similar terms should and will be offered by private industry. This misconception is gradually being erased by market forces. In the field of infrastructure rehabilitation, where inadequate ROI potential exists for private investment, preferential financing programs sponsored by Western governments are improving the likelihood of private investment in for profit industries, which depend upon such infrastructure, and thereby performs a supportive rather than competitive function. Many proposals by Western governments support approaches which encourage continued government ownership and government to government solutions, in which a role for private sector capital is until now absent. There seems to be little coordination of overlapping programs of various Western governments.

At the present stage of development of the NIS economies certain sectors provide better private investment potential, and constitute higher national priorities than others. In particular, private investment will focus upon those sectors which can generate hard currency revenues and exportable production and/or meet domestic high priority domestic demand for products, providing counter-trade and currency conversion is feasible and accessible to permit repatriations of capital and profits. They are:

1. Energy: Companies supplying equipment and services to the oil and gas industries.
   
2. Mineral/Mining: Companies carrying out mineral extraction and processing and those servicing them.
   
3. Forestry/Paper: Companies developing forests and downstream industries i.e. paper, packaging, furniture, housing.
   
4. Real Estate: Companies developing in-city sites for occupancy by western firms.
   
5. Communications: Companies modernizing the existing networks and those developing new networks.
   
6. Technology: Companies that will develop existing national expertise in areas of medicine, mathematics, physics and chemistry.
   
7. Tourism: Companies catering to dollar denominated revenues from international visitors.
   
8. Services: Companies providing services to Western businesses in Russia.
   
9. Food Industry: Companies providing technology in packaging and processing of food and wholesale distribution.
   

In addition to these sectors emphasis will be on developing domestic sectors that were neglected under the previous central planning systems. These sectors include:

1. Transport: Companies providing an effective distribution service. Particularly transport of freight for western companies.
   
2. Consumer Goods: Companies producing and distributing consumer goods. Particularly exportable products and products which replace current imports.
   
3. Food & Drinks: Companies producing and processing food and drink, and those distributing final products.

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