Key Stages of Privatisation

3. Methods of Sale

d)Flotation/Public offering

i) What type of situation it is suitable for

Flotations are generally more complicated and involve a higher level of risk than trade sales and their related processes. They have generally only been attempted successfully in countries which have a highly developed market economy with a robust stock market and a wide range of institutional and individual investors who are willing to participate in them. They are generally used for selling very large public enterprises, and in some countries have been used to privatize some of the public utilities, in a general opening of the market and ending of the monopolies of state institutions.

Flotations are also more expensive and time consuming to carry out than trade sales, but if done well they normally provide greater returns for the vendor in the long run. Governments have sometimes chosen to privatize enterprises by flotation rather than by trade sale if they have anticipated that there would be a large institutional and public demand for shares, and if they have desired to promote wider share ownership amongst the general public. The first flotation in a country has normally proved to be the most problematic due to scepticism and lack of confidence about its feasibility amongst investors and the public, but one of the Government’s top objectives in trying to make the first flotation as successful as possible has often been to increase investor confidence and public approval for the process in order to pave the way for future privatizations by the same method. They are therefore only likely to be carried out in a country which has a wide programme of privatization.

ii) Management

Due to the complexity of the process involved, and the importance of securing the confidence of investors, the vendor may consider making some changes to the management team of the enterprise which is to be privatized. This may only involve appointing some new members to the team, or it may also involve replacing some of the key members. The rationale behind this is that it is held that investors are likely to have more confidence in the success of the privatized company and hence be more prepared to invest in it if some of its managers have experience of operating within the private sector. So it is common at this stage for the vendor to bring in managers who have worked in the private sector before, and maybe ones who have worked on other flotations in the past.

iii) Capital structure

The vendor may wish to take steps to prevent the newly privatized company from expanding unwisely and diversifying into other high risk investments, which has happened on a number of occasions and ended up losing the company a lot of money, which is undesirable in any company but also of social consequence here, as the companies generally provide a public service. A way of doing this is by ensuring that the company will be in a certain amount of debt: not so much as to deter potential investors, but enough to prevent it from being able to risk its capital in risky investments. If the enterprise was in heavy debt to the Government as a public institution the government may have to write off a part of its debts in order to make it attractive to investors, but it may wish to consider leaving the enterprise in some debt.

iv) Reforms and restructuring

As with a trade sale, it may be necessary to undertake some internal reforms and restructuring in an enterprise which is to be privatized by flotation, and the vendor may wish to consult external advisors about which course to take. The most likely kinds of reforms are outlined in Part One 2 (c) and Part One 3 (a) iii) above, but considering the likely large size of enterprises which will be privatized by flotation, any reforms carried out are likely to be accordingly large, complicated and time consuming.

v) Strategy and timetable for sale, including percentage to be sold

There are various ways of conducting a flotation, and before carrying out the sale the vendor will need to consider which strategy to adopt. One of the most important aspects of strategy is the timetable by which the sale team carry out the sale.

The timetable should obviously allow time for advertising the flotation widely before opening the sale, designate a set time period in which to accept requests for shares etc. but the vendor may also wish to consider selling the shares of the enterprise in more than one stage. This technique has briefly been mentioned in Part One 3 (a) ix) above (“residual shares”) with reference to trade sales but it is much more applicable to flotations than trade sales.

Experience has shown that the value of shares of newly privatized enterprises generally began as quite low on the stock market (especially when it was the first flotation in a country) but increased significantly a short time later, and so those who had bought shares in the beginning at a very low price could make a large profit from selling them a few months later, but the Government gained nothing from this rise in value as it had already sold all the shares at a low price.

When selling the shares initially the Government may be forced to sell them at a fairly low price, but one way to mitigate this is by only selling a certain proportion of the shares when the company is first floated (say 60%) and waiting some time until the share prices have risen (which they are likely to do if the flotation is well organized) before selling the remainder. In this way the vendor will receive a much higher price for the sale of the whole enterprise than if all the shares are sold in one go, most likely at a low price.

If the vendor intends to employ this technique then they need to consider carefully what percentage of shares to sell in the first stage. If they sell a very large percentage initially then they will not be able to capitalize so much from the higher share prices later on, but on the other hand it is probably necessary to sell more than 50% of the shares initially or the company will not be considered to be private.

vi) Valuation and pricing

The first stage of pricing is the pre-sale valuation as in other methods of privatization, and as with other methods, the valuation should be conducted by independent external advisors. After this the vendor will need to decide how many to shares to create and what price to sell them at.

The question of pricing is difficult. The vendor does not want to underprice the shares as this may create a level of demand for shares which cannot be satisfied, and also discredit the process in the eyes of the public, as it will seem to them that a minority are profiting at the expense of the state and the taxpayer. On the other hand, if the price is too high it will be hard to get participation from a wide range of institutional and individual investors, as many will be put off. The vendor naturally wants to get a good price but considering that one of the reasons for choosing this method of privatization is normally to increase share ownership amongst the general public it wants to encourage as many of them to participate as possible.

The vendor will be selling the shares to a mixture of individual, institutional and foreign investors, and probably the best way that they can seek to sell all the shares intended for sale at the best price is by building up competitive tension between the these different groups. Some techniques have now been developed which can ascertain the likely demand for shares at different prices, the knowledge of which then allows the vendor to set prices which are likely to bring the highest proceeds.

One of the most successful of these techniques is called bookbuilding, in which investors indicate how many shares they would be prepared to purchase at various prices. The shares are then priced at the end of the offer period, taking account of both the demand and enthusiasm of investors, as well as the general movements of the stock market up to the close of the flotation. In this way the vendor can be reasonably sure of getting the highest price possible for the shares at which they will all sell successfully.

Techniques such as bookbuilding have proved to be much more successful than the practice known as underwriting, which was often used some years ago but is not practised anymore, because it is extremely expensive for the vendor and basically allows large financial investors to dictate the price of shares. The use of this technique is discouraged nowadays.

vii) Marketing the enterprise

The key to success in a flotation is effective marketing of the enterprise which is being sold to potential investors, with a view to achieving as wide a participation as possible. The vendor will wish to target both institutional and individual investors, (that is companies and the general public respectively), possibly in foreign countries as well as domestically. But apart from this the vendor may well wish to encourage the management and employees of the enterprise to buy shares in it, and may consider providing them with incentives to do so. Let us consider each in turn:

To institutional investors

The enterprise can be marketed to institutional investors using much the same kind of media as in a trade sale (see Part One 3 (a) v) above), such as trade journals and the financial press. The vendor will hope to find investors who are likely to retain hold of their shares as this increases general confidence in the enterprise’s prospects, and hopefully will ensure an air of calm and stability in the aftermarket.

If the vendor thinks that the domestic capital market (including both institutional and individual investors) may not be able to absorb all the shares, they may consider selling some of them on the international market. If the vendor wants to make shares available to the international market they will need to decide what proportion of shares to open up to international investors, and what proportion to save for local ones. If a large number of shares are being sold on the international market the flotation is likely to need a global coordinator to oversee it.

To the general public   

One important objective of the Government in carrying out a flotation is often to increase share ownership amongst the general public, and so it is likely that marketing the enterprise to individual investors will be an important part of the process. Maximizing participation of individual investors also allows the vendor to tap a source of funds in addition to those available from financial institutions and provides a source of competitive tension in pricing the shares. Indeed, high demand from the public to buy shares allows the vendor to charge institutional investors higher prices for shares than they would able to do otherwise. The increase in competitive tension allows vendors to tell institutional investors that if they do not show enough enthusiasm during bookbuilding, for example, then more shares will be allocated to individuals.

The best way to market the enterprise to individual investors is through a public information (advertising) campaign. This will allow as many people in the country as possible to be aware that shares in the enterprise are being sold. However, there are often strict regulatory restrictions about what potential investors in a flotation can be told, and the vendor must take these into account when marketing the enterprise.

Marketing to individuals may involve giving individual investors certain incentives to buy shares which are not available to large scale investors, such as free bonus shares, or special terms for purchase such as staged payments (e.g. three payments over the period of a year or 18 months). Another possible incentive is offering reduced charges to shareholders for services provided by the enterprise, and this will encourage individual investors to hold onto their shares in the long term rather than selling them on soon after the price begins to rise. However, the vendor should be careful that in granting such incentives to individual investors they do not lose more money than they gain from the public’s participation.

The vendor’s hope is, of course, that share prices of the privatized company will rise rather than fall after its flotation. Persuading individuals to buy shares could backfire if the value of shares declines.

To management/employees

In any privatization it is useful to obtain the cooperation of the management of the enterprise, as well as the other employees and their union representatives, and the success of the enterprise in the future also depends on them. Many members of the management and other employees may have worries about the role they will have in the privatized company, and may fear for their job security.

Allocation of part of the shares, either free or at a reduced price, might win the goodwill of the workforce, and also provide them with a feeling that they have some kind of stake in their company in the future. Potential offers that could be made to the employees include free shares (up to a limit), free shares in proportion to shares bought by the employee, a discount on the share price, or priority in the allocation of shares.

In a similar way to incentives to the general public, the vendor should be careful that financial privileges given to the workforce do not actually lose the state money, and should also be aware that a policy taken in any specific flotation could become a precedent. It is especially important that the existing management of the enterprise are not allowed to contribute to decisions regarding the share options to be allocated to themselves.

The issue of granting shares or concessions to the employees of the enterprise may also arouse public interest and controversy, especially if it is a large state institution. In order to reduce the chance of public indignation it is probably best to keep the public as informed as possible on these matters and announce publicly the full details of any plans to provide financial concessions to the management or other employees, before the offer is actually made to them.

The vendor must take care that such plans are fair and seen to be fair by everyone, as if they are not this may well turn the employees and the public against them and maybe against the whole privatization. The management may also want to secure benefits for employees in hope that this will keep their morale high after the sale, but the question must be raised whether the vendor (and hence the state) should have to bear the cost for this.

So the vendor needs to strike a careful balance between offering some incentives to the workforce to take an active part in the future of the company, and ensuring that doing this doesn’t cost more money to the state than is acceptable to the general public.

viii) Allocating the shares

There will be basically three main groups of potential investors in a flotation: institutional, individual and foreign. The proportions by which the vendor allocates the sale of shares to these different groups will depend on their sale objectives. For instance, as flotations are often intended to provide an opportunity to encourage more members of the public to buy shares, it is likely that a significant percentage will go to individual investors, so long as there is demand from them.

A healthy demand from individual investors is also a good way of obliging institutional investors to make offers which are attractive to the vendor, and the vendor will secure higher proceeds from the privatization as a whole if many individual investors are involved, thus creating high demand and competitive tension. The vendor may also give priority in its allocation of shares to investors who are likely to be long term investors, as this can reduce the perceived risk that shares will be sold for a quick profit immediately after the sale. If there is a high enough demand in the domestic market the Government may decide not to open up the shares to foreign investors, but they may do so if they wish to increase demand and competition between different investors.

Whatever the vendor’s policy of allocation of shares may be, it must be seen to be fair and transparent by all involved, or the credibility of the vendor may be undermined. When allocating the shares, the vendor should announce publicly who is getting what so that all can be assured that no one is being granted special concessions.

It is in the vendor’s interest for the offer to be oversubscribed, as this will create the most competition and secure the best price for the vendor. However, in such a situation some investors will be disappointed when they do not receive all (or maybe even any) of the shares they bid for, and so it is a good idea for vendors to state their allocation policy clearly in advance of the sale, to ensure that investors understand the basis on which shares will be allocated, and hopefully reduce the chance of disaffection on the behalf of investors.

ix) Stabilizing the share price

In order to get the highest possible prices for shares, the vendor needs to be able to give investors a reasonable degree of assurance that the share prices will not fall in the immediate aftermarket.

Such a fall could be brought about by widespread selling of shares soon after the sale. The vendor can guard against this eventuality to some extent by doing their best to allocate shares to investors who they believe will keep the shares for some time rather than sell them. Another safeguard which can allow the vendor to stabilize the share prices in the aftermarket is a mechanism which allows the vendor or agent of the vendor to purchase a proportion of the newly-issued shares on the stock market at the vendor’s offer price for a certain period after the sale. This will mean that if some shares fail to sell the vendor can buy them back without making a loss, and retain them for sale when the shares have stabilized on the market and the price has begun to rise (the hope is that this will happen). The vendor must make sure, though, that any such measures comply with local stock market and other legal requirements, in order to avoid risking accusations that the market has been rigged.

There are various other stabilization mechanisms that the vendor can use. These include getting the institution handling the sale on the vendor’s behalf (known as the global coordinator) to support the issue price in the aftermarket in return for a percentage of the offer, or granting them the right (but not the obligation) to purchase additional shares from the vendor at the offer price for a specified period after the share allocation date, in order to take up left-over shares.

Thus there are various ways in which the vendor can hope to stabilize the share price and guard against loss in the aftermarket, which could have serious consequences for a large and important institution. However, the vendor should be aware that the stock market is ultimately something which is beyond their own control and if they have serious doubts as to whether the company will be able to stand a flotation on the stock market without considerable financial protection and aid then the question arises as to whether it is sensible to carry out the flotation at all, particularly if public services stand to suffer.

x) Safeguards and regulation

What is probably the most important safeguard the vendor needs consider, the stabilization of the share price in the aftermarket, has already been discussed in section ix) above. Also, the matter of holding residual shares, in order to sell them later on for a higher price than could be obtained in the first offering, has been discussed in section v).

These are the main considerations of the vendor with regard to getting a good price for the shares and doing their best to ensure that their value will not be lost in the aftermarket.

Needless to say, the process of the flotation needs to be transparent, and the shares allocated according to a fair and justified policy, with no conflicts of interest for anyone involved.

The issue of regulation may arise if the enterprise which has been floated is a utility which provides an important public service. If it is such an institution, then one of the objectives of the privatization, apart from widening share ownership in society etc. should be to guarantee a high level of service to customers, particularly if the enterprise is in an essentially monopolistic position. It is likely that the enterprise will only be able to sell shares easily if it had been performing reasonably well in the run up to the sale, and so it is unlikely that a flotation will be carried out in order to raise the quality of service of a struggling state institution.

It is hoped that an important position will be given to customer service in a private company as well as maintaining a good share price on the stock market. However, it would be wise for the Government to continue to monitor the company’s performance after privatization in the same way that they did when it was still a public institution, and set performance targets if the quality of service seems to be poor. Poor service should not be tolerated in any institutions which provide public services, and the Government may wish to consider fines for companies whose level of service is judged unacceptable.

Such measures are discussed elsewhere in Safeguards and regulation.

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