Our privatization challenge calls for a fresh approach
The government should focus on maximizing long-term value instead of just selling PSUs to raise revenue
PremiumThe budget declared an aggressive “disinvestment" target—of ₹1.75 trillion—with little clarity on how it will be achieved. Achieving it poses a challenge that cannot be met without thinking outside the bureaucratic sandbox.
India, save for a brief period of time during the Atal Bihari Vajpayee era, has followed a ‘partial privatization’ model focused on raising revenue by selling non-controlling stakes in public sector units (PSUs) while retaining total control over the decision-making apparatus at these companies. To be fair, India is not alone in succumbing to the attraction of partial or ‘revenue’ privatization. A study by Jones, Megginson, Nash and Netter (Share Issue Privatizations as Financial Means to Political Ends, Journal of Financial Economics, 1999) shows that only 11.5% of the firms in their sample were completely privatized between 1977 and 1997, and less than 30% sold more than half their equity. Moreover, the firms that were fully privatized were largely concentrated in the UK and France, while firms in other countries were partially privatized. This strategy suffers from steeply diminishing returns.
Its first drawback is that despite being partially privatized, these firms are hamstrung by political interference and managerial inefficiency, and thus lag others in market valuation. This means that the government is unable to monetize its shares at fair value. Secondly, this strategy puts an upper bound on the extent to which these assets can be monetized, as the government may not be willing to see its shareholding drop below the 51% mark. India’s government faces both these constraints. Its PSUs, especially banks, currently trade at a steep discount to their private-sector peers, and its shareholding in most is very close to the 51% threshold. Moreover, some PSUs may have raised debt by leveraging their status as government sponsored or controlled entities, and so a fall in the Centre’s stake to a level under 51% may violate such covenants.
On the other end of the spectrum, the sale of controlling stakes in PSUs could also prove difficult. Given the nature of India’s polity, strategic privatization will likely face opposition from unions and activists, apart from political brinkmanship and legal challenges. Several thorny economic issues will also have to be sorted out. Primary among these will be to disentangle the status and value of several concessions that PSUs enjoy by dint of being ‘public’ in nature. These concessions range from land parcels in prime areas to exclusive access to public resources. Some of these concessions are critical to their profitability, and valuing them fairly or extricating them from the disinvestment process will be difficult and riddled with controversy.
Another model of monetizing PSUs involves financial engineering. PSUs can use their physical assets and status as government-backed companies to raise substantial amounts of debt, which they can then transfer to the government either as dividends or via share buybacks. Another tactic could be to get cash-rich PSUs to buy other PSUs. This tactic, similar to a ‘Matryoshka Doll’ holding structure, allows the government to monetize its stake without losing control.
However, both these models of financial engineering ignore the key economic argument for privatization. Its primary rationale is not just to raise revenue, but to increase efficiency, limit political interference and expose PSUs to market discipline. The value of a firm lies in the efficiency of its operations and not in the nature of its ownership. The government’s goal should not be to merely get money, but to maximize the value of its assets.
This can be achieved with or without a controlling stake. Temasek, for example, is one of the most successful holding companies in the world. It is wholly owned by Singapore’s government, but professionally run with the sole objective of maximizing the value of its investments. One way for India’s government to maximize the value of PSU shares would be to consolidate them in a newly-constituted holding company to be run by professional managers. This would free PSUs from the clutches of the bureaucracy and professionalize their management and decision-making. This will also allow them to take advantage of the synergies of being managed under a single umbrella holding company. The government can then offload small stakes in this holding company to raise revenue. This way, it can maximize value and raise revenue without losing control.
Another strategy is to separate the rights of control, management and cash flows at PSUs. This can be done through a multiple-class share structure in which the government relinquishes management rights and dilutes its cash flow rights, but retains control through golden shares. Megginson, Nash and Randeborgh (The Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis, The Journal of Finance, 1994) show that this method has been used successfully, especially in the UK. The privatization of Volkswagen, in which the German state of Lower Saxony retains a 20% voting interest, is an example.
While the government is under pressure to raise privatization revenue, by focusing on financial engineering or partial stake sales, it risks missing the woods for the trees. A more holistic approach would be to focus on long-term value maximization. PSUs have hoarded huge resources over the years that are yet to be fully valued. One must be careful not to kill the goose capable of laying golden eggs just to fulfil short-term goals.
Diva Jain is director at Arrjavv and a ‘probabilist’ who researches and writes on behavioural finance and economics. Her Twitter handle is @DivaJain2
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