Mention the fat fees to be earned from privatization and the last place most investment bankers would think to go hunting for them is the US. But there is a privatization programme under way in the US, and 1996 is likely to witness the first sell-off since the Philadelphia-based Consolidated Rail Corp (Conrail) was returned to the private sector in the early 1980s.
It’s an unusual transaction. On the block is United States Enrichment Corp (USEC), a government-owned entity which currently has an 88% share of the domestic uranium-enrichment business and a 40% share worldwide. Its line of business, together with its role as a buyer of uranium from decommissioned nuclear warheads in Russia, make the USEC deal subject to special considerations.
Legislation sets out four statutory requirements for the sale. In addition to maximizing the benefit to the US taxpayer, the stated objectives are to ensure a continuing source of domestic uranium-enrichment services; to create a viable private corporation without any need for future government support; and to “support the nation’s national security objectives”.
This last point is linked to USEC’s role in implementing the swords into ploughshares contract that the US signed with Russia in the wake of the end of the Cold War. The break-up of the old Soviet Union left thousands of nuclear warheads lying around the region and, in the interests of stability, the US was anxious not to have new nuclear powers emerge from the old Soviet republics. It was also worried about the prospect of bomb-grade fuel being trafficked by Russian organized-crime syndicates.
Financial incentives have been provided by the US in order to help the decommissioning process, and USEC plays a critical role as a buyer of low-enriched uranium from Russia that has been blended down from the highly-enriched uranium contained in nuclear warheads. USEC can sell this uranium to utilities as fuel for nuclear power plants.
As a privatization plan submitted to Congress notes: “It is vital to world security that this material be purchased.” Not surprisingly, with such issues at stake, the implementation of the privatization is being closely monitored in Washington, and investment bankers working on the deal have had to testify before congressional committees as part of the process.
The advisory mandate was won by JP Morgan which, in 1994, saw off fierce competition from Wall Street to win the initial valuation mandate. This helped pave the way for Morgan to win the key position of financial adviser to USEC (there being no adviser to the government as such). “We’re following a dual-track plan,” explains Jim Derryberry, co-head of the natural resources and power group at JP Morgan. “There’s a need to pursue the strategic buyer market as well as a possible initial public offering.”
Appearing before a congressional committee in June last year, Derryberry estimated that an IPO could yield gross proceeds of between $1.5 billion and $1.8 billion. The US government wants to sell 100% and does not wish to be left with a minority stake.
As adviser to USEC, Morgan had a non-voting role on the committee to select the transaction manager which will close the actual sale. Morgan Stanley won this position and will do both the M&A work, in the event of a strategic sale, or act as lead underwriter, in the event of an IPO. Merrill Lynch was also selected as a senior lead manager in the case of an IPO, together with an underwriting syndicate which includes names such as Salomon, Lehman and Dean Witter.
In the run-up to the sale, Morgan has been involved in giving advice on how to restructure USEC in order to prepare it for its entry into the private sector, although USEC is far from a public-sector white elephant; it has been a reasonably efficient and profitable operator. “It was run as a government entity; it was not run to optimize profitability although it has always been quite profitable,” Derryberry notes, adding that “they needed to change the culture in order to operate in the private sector”. This has meant some management changes, cost-cutting and internal restructurings. USEC is now judged to be ready to take flight as a private company.
Unfortunately the sale process is being held up by the budget impasse in Washington and it could be three or four months after budget legislation is finally passed before USEC is sold. This will take the transaction deep into an election year. There is, however, bipartisan support for the deal from politicians on all sides to reduce the vast US national debt. Michael Marray
JAPAN
The telecoms dilemma
Japanese privatization is like a convalescent whose presence is urgently sought for important business. After a long confinement following bouts of high fever, the prospects of recovery are tantalizing, but the patient’s prognosis is still uncertain.
The dire condition of the Tokyo stock market since the 1990 bursting of the bubble and a string of horrendous IPO flops – JR East in 1993, Japan Telecom and Japan Tobacco in 1994 – have resulted in a huge backlog of pending privatization sales.
Two-thirds of Japan’s biggest company, Nippon Telegraph and Telephone (NTT), remains in government hands after five planned sales of 500,000 shares per year from fiscal 1991-92 to 1995-96 were all dropped by the ministry of finance (MoF). Previous NTT sales had become notorious symbols of the stock-price casino and did not endear the MoF to stung Japanese punters: in 1986 NTT shares were first offered for sale at ¥1.2 million ($11,400) each, and the following year reached ¥3.18 million, but now trade for around ¥800,000.
Now at last a new sale of 500,000 NTT shares, using a book-building system to set the price instead of an auction, as before, is expected in the next fiscal year beginning April 1. The MoF is dangling the carrot of a substantial international tranche, of between 20% and 40% of the issue, and all the main foreign investment banks in Tokyo have begun parading before the two bureaucrats – Akio Nakamura and Takuji Tanaka – in charge at the MoF’s national assets section of its finance bureau.
European houses are making much mileage out of Japanese bureaucrats’ conversion to book-building for future NTT and Japan Tobacco offerings. This is understood to remove much of the pricing volatility – which is largely a result of the considerable time gap between the price being set at auction and actual listing on the market – that has scarred past privatizations in Japan. The foreign firms’ avowed goal in this is to become global coordinator, or at least European lead manager, for the secondary Japan Tobacco and NTT offerings.
Whatever structure is used, the sale may be a tough one. The Japanese telecom market is vastly more dynamic and sophisticated than when NTT’s privatization was first mooted: 12 years ago NTT had a domestic monopoly, whereas now there are over 100 telecoms companies in Japan. The government has yet to decide whether to break up NTT.
NTT’s 5.4 million listed shares, worth ¥4.4 trillion ($42 billion), already comprise 1.2% of market capitalization of the Tokyo Stock Exchange First Section. “You’ve got to have exposure to NTT,” pitches George Olcott, executive director of SBC Warburg’s equity capital market group. Masako Egawa, executive director of corporate finance, adds that the chances of a break-up of NTT have become “very slim, politically”. In the past, the firm (along with Goldman Sachs and Kleinwort Benson) recommended NTT as a “buy” on the basis of a likely break-up.
Securities houses are sitting on both sides of the fence. Some privately recommend a break-up. Others want to cosy up to NTT in the hope of winning more business from the company in its present form.
“The issue is highly political, and it also depends on whether MoF believes the Japanese stock market can absorb this kind of billion dollar offering,” explains a source at Morgan Stanley Japan. “The government needs money, but MoF’s first priority is to protect the stock market. It’s a complicated situation,” agrees Andrew Boyle of Schroder Securities (Japan).
The same dilemma faces the government before giving the green light to four more bumper-to-bumper privatizations: some 270,000 shares of Japan Tobacco that were left unsold in the initial public offering (IPO) of October 1994; IPOs of two regional companies of the Japanese Railways Group, JR West and JR Tokai, that were thrown off track last year when the Kobe earthquake devastated their balance sheets; and lastly, the sale of the remaining 1.5 million shares held by the government in JR East.
Tobacco and railways are not foreign favourites but, given the political sensitivity of NTT at the moment, it seems likely these issues will come to the market first. Government budgetary blues are likely to speed the listing of JR West and JR Tokai.
As of April last year, the Japan National Railways Settlement Corp (JNRSC) was holding ¥26.9 trillion in debt left behind after the old state-run JNR was split into seven private companies in 1987.
The more disposals it can effect, through sale of its land and stock in the new companies, the smaller will be the eventual bill for the Japanese taxpayer. However, the slump in urban land prices has considerably delayed JNRSC’s debt repayment schedule: 40% of its land remains unsold, adding to the pressure for the JR West listing of 2 million shares and the JR Tokai listing of 2.24 million shares to proceed as quickly as possible.
Unfortunately, the two privatization front-runners are IPOs, for which Japan’s mandarins have yet to accept the merits of an international tranche. Interestingly the Japanese government’s sudden zeal for book-building does not embrace IPOs – JR West, for instance, will only use a combination of tender and public offer.
“The underlying problem is that the MoF doesn’t trust Japanese security firms. The MoF believes they would sell it pretty cheap to please its investors. An auction would at least be ‘God’s voice’,” says a source at Morgan Stanley. “The government is extremely conservative about disposing of national assets, so they don’t trust security houses for their IPOs. Once the stock is on the market, it’s a different matter,” adds Shimpei Kasama of Kleinwort Benson’s corporate finance team in Tokyo. Peter McGill
CONVERTIBLES
Not convertible to Maastricht
Privatization experts say it will be the year of the convertible. “Clearly last year a number of privatizations ran into some problems,” says Jerker Johansson, a managing director at Morgan Stanley. “I think issuers will look at convertible bonds as a viable alternative.”
His optimism is shared by Farley Bolwell, responsible for Merrill Lynch’s European equity-linked origination. “In the first month of this year there has been much greater awareness of the convertible product among government issuers than last year,” he says. A lack of supply means aggressive terms are on offer. “This market is on fire,” says one banker. “Doing these things is a no brainer,” says another. Demand will be further fuelled by up to 20% of international investors’ holdings of convertible bonds being redeemed/converted this year.
Privatization convertibles are not a new product. Broadly, there are two types. The first is a “mandatory exchangeable” which automatically gets exchanged into shares after a fixed period of time and has no risk of non-conversion. This is simply an equity play. The Balladur bonds issued in 1991 – which gave investors the preferential right to participate in French privatizations – were a crude extension of the idea. The issue for Swedish Steel in 1992, which carried a zero coupon but came with a warrant entitling the holder to exchange bonds into equity, was another innovative variation on the theme. Clearly nobody had any motivation to buy these bonds unless conversion was their goal.
The second is a plain vanilla convertible. It behaves like a bond but can be converted into equity once the underlying shares reach a pre-arranged price. The difference is that, for whatever reason, bondholders may decide not to convert their holdings to equity. The advantage to the investor is the limited downside. The bond component ensures that a coupon is received (below market rates). So even if the investor does not convert – maybe because the share price has crashed – there is a floor of absolute value, based on the bond’s yield to redemption. But the upside is theoretically limitless, depending on the strike price at which the investor can convert to equity – known as the premium – and how well the shares perform over the course of the bond.
So will government issuers be scrambling to take advantage of the sort of demand in the convertible market that had $11 billion chasing the biggest con-vertible ever, the $2 billion deal for Mitsubishi Bank last year?
One already is – the Republic of Italy. It has announced its intention to sell the second tranche of Italian insurance company INA, as a convertible bond. At L3 trillion ($1.9 billion), it will be the largest ever convertible in Europe. But at the time of going to press, the deal – mandated to Goldman Sachs and IMI – was stalled by the Italian political crisis. The window of 70 days from January 1 in which the deal could go ahead is rapidly diminishing. After 70 days a new government must be formed or elections called, and Goldman Sachs says the deal can only go ahead with political approval.
Dante Roscini, executive director in equity capital markets at Goldman, thinks INA could be the tonic the market needs: “Once there’s a major successful issue, it will open the market and others will follow.”
The convertible instrument will have two major advantages for Italy. First, it can be done quickly – literally in a morning and without the need for a worldwide roadshow or the fanfare of an international equity offering. Second, it taps a different investor base – a major consideration with the deal so close to the giant IPO of Italian state oil company ENI in December. For example, if bond funds in Germany and Switzerland take part, this creates a favourable price tension with traditional equity buyers.
But the Italian deal raises another problem which bankers, in their enthusiasm for the product, may have overlooked: the Maastricht Treaty’s convergence criteria on debt. Nobody seemed to have told the Italians that a convertible doesn’t reduce debt in the eyes of Maastricht – at least not until it is converted into equity at some point in the future.
A senior official at the European Monetary Institute (EMI), billed by a colleague as “an absolute specialist on this very specific question”, pronounced: “As a rule of principle, convertibles are part of gross debt and the Maastricht criterion looks at gross debt.” He adds: “I am not aware of any exceptions.” If anyone is in doubt they can consult the European system of integrated accounts (ESA), heading F50, which states that convertibles are classified as debt – not equity – until the day they are converted.
All of which means the act of issuing a convertible actually increases government debt as opposed to reducing it. If pro-ceeds are immediately used to pay down other debt, the effect will be neutral. But this is a little hard for European governments to swallow. Many are privatizing, not out of any ideological zeal but purely for budgetary purposes. So the convertible market may look good – but unfortunately not where the budget is concerned.
Mario Draghi (see profile page 56), director general of the Italian treasury, points out that this is the first year in 15 years in which Italian gross debt will decline. He explains: “Everything is geared towards Maastricht. We want to meet the Maastricht criteria.” The Maastricht criterion on gross debt says it must be no more than 60% of GDP.
He does not dispute the EMI’s verdict on convertibles. Which raises the question, why use one? “You have to be pragmatic,” he says. “You have to find the best instrument from the market viewpoint. We are listening to what the market tells us.”
Italy is budgeted to do L10 trillion of privatization in 1996. But one rumour says it will attempt to go for L13 trillion instead. The reason being that it cannot use the L3 trillion INA convertible in its Maastricht calculations.
The reaction of bankers to this potential problem has been varied. At one extreme are those who haven’t given the matter much thought. The worst case is the US banker who claimed confidently that it was not a problem because “all the debt is just netted out” – perhaps in an ideal world but not where Maastricht statisticians are concerned. At the other is the pragmatic view that you can tweak the convertible so that it converts before the Maastricht criterion is judged. But this does not give you much time since it is the 1997 accounts which will matter. Usually convertibles don’t convert for two to three years because they otherwise destabilize the underlying share price through arbitrage.
But forgetting the Maastricht issue, Johansson at Morgan Stanley, while bullish, says the difficulty of promoting convertibles as privatization instruments goes deeper: “The one argument that a government does bring up, which I fully understand, is that if they take the sometimes politically painful decision to privatize an asset, then they want to be sure they’ve sold it. The problem with doing an exchangeable is they’re not sure they have.” The bondholders may decide they don’t want the equity. Or the strike price is never reached because the underlying shares don’t perform. Here, the government must redeem the full amount at maturity. A treasury official can only tell the prime minister that the country has had several years of cheap finance (convertible coupons being lower than the sovereign’s standard bonds).
Less clear then is the bankers’ continued optimism that 1996 will be the year of convertibles, at least where European governments are concerned. It suggests the Maastricht question is not occupying much of their time – perhaps because they are sceptical of the timetable and of anyone meeting the convergence criteria anyway. In the case of Italy, where the republic’s debt is twice the Maastricht limit, the importance of privatizations such as INA is more to score points for showing willing. Steven Irvine
EASTERN GERMANY
Hardly a model
Five and a half years after Germany began the most concerted privatization in history there’s still an argument about whether the process went too far, too fast.
A number of industries that passed out of state hands have come back to haunt the seller, now called the BvS (Bundes-anstalt für vereinigungsbedingte Sonderaufgaben), chief successor of the privatization agency the Treuhandanstalt (Treuhand). Bremer Vulkan, west German buyer of three shipyards in Mecklenburg-Vorpommern, is itself in difficulty, and the European Commission is investigating suspicions that part of a Dm700 million subsidy for the shipyards was siphoned off to bail out the parent. Sket, a heavy engineering manufacturer bought by two west German entrepreneurs, is gobbling up a Dm200 million subsidy just to keep alive, while its order-book has dried up. Since the contract was never finalized the state is still officially the owner.
Last year, for the first time, the banks allowed a large east German company – construction firm Erste Baugesellschaft Leipzig – to go bust. The privatized hotel industry is also in trouble because of depressed occupancy and competition from newer, better hotels. Creditor banks have become majority owners of the Interhotel Group after capitalizing the bad debts of the two west German buyers.
Does this mean that the Treuhand didn’t always do its homework when selling to ambitious west German entrepreneurs? Most literature about the Treuhand praises its speed and efficiency in restructuring a bankrupt economy under the slogan “privatize quickly, restructure decisively, if there’s no other solution, shut down sensitively”.
The Treuhand congratulated itself on its achievement when at the end of 1994 it handed over to its successor the BvS – itself destined to close down in 1998. The Treuhand had privatized 6,321 large companies, secured commitments to employ 1.5 million people and undertakings to invest a total of Dm211 billion. This exercise cost Dm116 billion for the restructuring of companies and Dm33.5 billion for servicing and guaranteeing their debts. The actual proceeds were Dm37 billion against the book value of these assets, estimated at Dm50 billion. Of around 3,000 management buy-ins or buy-outs, more than 45% have been running successfully for three years now and 43% for two years, with 8% of them going to the wall. Non-German direct investment accounts for only about a tenth of the privatizations, bringing Dm6.8 billion in payments, with Dm19 billion committed for further investment.
The legacy of the Treuhand, apart from a bill to the German people of around Dm163 billion, was a rump of unprivatized companies, farmland and property. Some of the companies had been bundled into four management partnerships (Management-Kommandit-Gesellschaften – MKGs) in 1992. At the end of 1994, ownership of the MKGs, which consist of 49 companies and employ 14,000 people, was transferred from the Treuhand to the newly established Beteiligungs-Management-Gesellschaft Berlin (BMGB). During 1995 the MKGs sold off 12 companies and 7 divisions of companies. BMGB also presides over three so-called run-off companies – GVV which handles redundant mines, LMBV which is phasing out open-cast lignite mines and EWN charged with decommissioning the nuclear power stations at Rheinsberg and Greifswald.
The job of the BvS, on the other hand, has been to take over the unfinished business of the Treuhand, including negotiation and renegotiation of purchase agreements, mostly involving commitments to invest capital or safeguard jobs. In 1995 the BvS concluded the sale of the Buna Sow Leuna Olefin complex to Dow Chemical but with a Dm9.5 billion subsidy from the German government. The BvS also sold rolling-stock builder Deutsche Waggonbau to US fund manager Advent International for around Dm250 million. During the year it collected around Dm3.2 billion in payments due on privatizations, leaving about Dm4.9 billion outstanding. But perhaps its biggest task was auditing the terms and conditions on 6,000 contracts, of which around 4,500 were successfully confirmed. In a statement in December, BvS president Heinrich Hornef congratulated his agency for ensuring that actual employment and investment levels exceeded guaranteed minimums by 16% and that renegotiations affected the employment projections by less than 1%. This alarms some analysts who say that the BvS is too soft on preserving jobs, to the detriment of commercial realities.
The wrangling over terms and conditions goes on, in a worsening economic climate. The privatization balance sheet contrasts sharply with the estimate by Treuhand’s first chairman, the late Detlev Rohwedder, back in 1990 that east German enter-prises had a realizable net asset value of Dm600 billion. The value in retrospect appears to have been a minus figure of around Dm250 billion, including old debts, restructuring of companies and environmental costs. The German taxpayer is expected to continue to pay for this well into the next century by means of the extra “solidarity tax”.
There are also continuing recriminations about how the unification of Germany, and the privatizations, were costed and carried out. One controversial area is the opening Deutschmark balance sheets of east German enterprises and the status of their debt, which was converted into Deutschmarks at a ratio of Dm1 to two Ostmarks. Many of these credits on the balance sheets of east German banks were sold along with the banks to west German institutions. The west German banks took over management of the credits, but the default risk was protected by government-financed compensatory claims called Ausgleichsforderungen. Some opposition members of parliament have claimed that these assets were a risk-free gift for the banks, costing the nation an unnecessary Dm25 billion.
On balance, the privatization of east Germany is not a model for privatizations of other former communist countries. The safety net offered by an indulgent parent may ultimately have been counterproductive, driving up wages and expectations and pre-venting the region from finding a sound economic footing, however low that might have been. David Shirreff
PRIVATIZATION INDEX
Measuring the world
Many investors are disenchanted with the poor share-price performance of recent privatizations. But have privatization offerings been such a bad investment?
This is what the Global Index of Privatization Shares, launched over the Christmas holidays by UK investment bank NM Rothschild and specialist magazine Privatisation International, aims to find out.
The index measures the stock-market performance of 204 companies which have been privatized since 1980, with the list set to grow as new privatizations occur. Published monthly, the index is denominated in US dollars and weighted by market capitalization.
Calculated back to 1990, the constituents of the Index of Privatization Shares have performed better than those of the FT/S&P Actuaries World Index over the last five years.
To be included in the index a company’s initial public offering (IPO) must have been over $25 million. This criterion excludes several partial privatizations and seems slightly arbitrary. But Henry Gibbon, editor of Privatisation International, thinks it won’t distort the index much since “all the major privatized companies are included”.
Over 100 of the constituent companies are European – including 39 UK firms. A quarter are Asian and range from Singapore Telecom to Tsingtao Brewery A shares in China. A few companies from Australasia, Africa, and North and South America are also included.
So the index achieves global coverage but, in so doing, mixes together data for developed and emerging markets.
Few institutions feel such indiscriminate enthusiasm for privatization stocks, as selling governments have varying approaches to privatization which may attract or repel investors. For instance, money raised from the sale of a UK company goes into state coffers, but in return, the government cedes control to the new investors. A company in China, however, is usually privatized in order to raise foreign capital and effective control of the company may still reside with the government rather than the private shareholders. So the index has to cover a diverse range of privatization types.
Its practical value is limited. After all, the majority of international equity investment funds don’t specialize in privatization shares. The reaction of the non-specialists is summed up by Julian Johnston, director of Morgan Grenfell Investment Services, who says that they “look at privatizations on a one-by-one basis” so that the index is not “directly useful to us”.
Reaction from the specialist funds highlights the difficulties of a generic comparison. “We’re a European fund so we have to measure our performance against a European index,” says Vicky Sledden, senior fund manager at Mercury Asset Management (MAM). But she would be interested in a European version of the index, as would Simon White, managing director of the investment funds division at Kleinwort Benson.
It’s hard to say how the new index will fare, says Andy Nybo, president of Finmark Research, a database research company. He feels investors would prefer indices which track specific emerging markets.
Privatisation International confirms it is considering a breakdown by geographical regions such as Europe and Asia. Certainly this would make the index more user-friendly for investment funds.
In addition, following interested calls from fund managers, there are plans to make more detailed information available: a computer program developed with NM Rothschild lifts data for the index from financial information providers such as Datastream and Extel.
The project isn’t going to generate large profits for NM Rothschild – there are few dedicated privatization funds – but supporting the index underlines the bank’s continued involvement in this area. Since the sale of its stake in Smith New Court to Merrill Lynch last year, NM Rothschild has lost its link into the daily rough and tumble of international equity trading. In compiling the index, it hopes to position itself as an advisory firm that is also attuned to the secondary markets.
Privatisation International believes the index will do more than just aid fund managers. It might be important to governments trying to overcome “increasing investor resistance to big privatization issues”, says the magazine’s publicity material.
Early privatizations were popular because the share sell-offs blatantly undervalued the enterprises. A look at the appreciation in share prices for some 1980s privatizations confirms this: British Aerospace: +405%; British Telecom: +167%; Krung Thai Bank: +767% (all figures as at January 1996).
Now, fewer bargains are on offer. Although a few privatizations, such as SGS Thomson (+51%) and Nordbanken (+22%), have done well, the share price of 37 of the 62 indexed companies privatized since 1994 – including Japan Tobacco (-38%), Renault (-17%) and Portugal Telecom (0%) – is either down or unchanged. It’s not surprising that investors’ memories of earlier stock-market successes are fading fast. Dylan Drummond
