Bridge over ocean
1 August 2013 CFA Institute Journal Review

Ownership Change, Institutional Development and Performance (Digest Summary)

  1. Nicholas J. Handley

Successful privatizations require strong property rights and private-contracting rights; effective government is a less important factor. The best-performing enterprises are most likely to be privatized first, and institutional quality seems to be more important than the choice of private or state ownership in determining operating success.

What’s Inside?

The authors study privatizations, focusing on the effects of property rights, the legal and institutional environment, and general government effectiveness on operating profitability. They use a selection model to characterize which enterprises are privatized; the model acts as a control in the study. The telecommunications sector is considered separately because of its sensitivity to expropriation risk and the proliferation of privatization deals. A cleaner efficiency metric of phone lines per employee is used.

How Is This Research Useful to Practitioners?

All measures of property rights appear to be positively related to privatized entity operating performance at a significance level of 1%. Such rights provide a buffer against government rent-seeking behavior or opportunistic renationalization. Private-contracting rights measured as legal formalism—that is, the ease of enforcing contracts or collecting on debts—are found to significantly boost operating performance as well. This finding is consistent with the notion that privatized firms interact mostly with their private-sector peers. General government effectiveness and stability, although desirable, does not significantly raise operating performance. Quantitatively, an improvement of one standard deviation in the measures of property rights and private-contracting rights increases profit margins by 1.3–1.7 and 1.45 percentage points, respectively.

A selection model confirms that governments tend to privatize their better assets, possibly because such action raises cash most quickly. The authors’ results are robust to this finding, to excluding financial firms, to the choice of an IPO or privately negotiated privatization, and to including non-European deals.

In cross-border transactions, the acquirer’s domestic property rights relate to post-privatization performance at a significantly positive level, which is consistent with the notion that firms only invest when all sources of expropriation risk are mitigated. Property rights boost operating performance even among nonprivatized firms, suggesting that expropriation risk is not the only factor at work. High-subsidy firms take a decade to realize the benefits of privatization because they have to adjust to the subsidy loss. Low-subsidy firms see immediate benefits, despite still experiencing disruptive restructuring.

With regard to telecom privatizations, property rights and the presence of an independent regulator are important to the company’s performance. More competitive operating environments improve the efficiency metric but lower the operating performance metric.

Finally, property rights tend to be well matched between the acquirer’s and the target’s countries. The authors conjecture that acquirers from countries with stronger rights are not adept at managing expropriation risk, whereas acquirers from countries with weaker rights do not pay full market value because of their own domestic expropriation risk.

How Did the Authors Conduct This Research?

Privatizations are identified by using the Privatization Barometer within Europe and the Securities Data Company acquisitions of government-owned enterprises by non-government-owned enterprises outside of Europe. Accounting data are from Compustat. The sample period is from 1985 to 1990 and 2009 to 2010, depending on the exact regression specification. Telecom operating efficiency data are from the International Telecommunications Union.

The authors follow the corporate finance literature by using the ratio of operating income to assets as the performance metric and dependent variable. Many other factors may influence firm success, so controls are used for firm size, growth opportunities, income per head, industry competition, and extent of privatizations. They use aggregate property rights data from the Investment Country Risk Guide and World Bank Governance Indicators, and the three most relevant components—control of corruption, rule of law, and political stability—are considered independently.

A selection model and a treatment effects model are used to account for the nonrandom choice of which enterprises end up being privatized.

The telecom sector is considered as a separate study; it is rich in tangible assets and thus particularly sensitive to property rights because of expropriation risk. Phone lines per employee is used as an alternative measure of operating efficiency that is independent of accounting choices and regulatory environments. The authors also consider a number of telecom-specific and demographic control variables.

Abstractor’s Viewpoint

The authors make a clear-cut case for the importance of property rights and contracting rights for the success of newly privatized enterprises. They offer equity managers insights about which privatizations might be attractive as well as which acquirers may be well matched in cross-border transactions. Their findings support the gradualist approach to privatization, which demands that high-quality institutions be established prior to privatization because quality will not necessarily naturally follow privatization. My one concern surrounds the quality of accounting data on state-owned enterprises, which may conceal explicit or implicit subsidies and make comparisons with newly private enterprises more challenging.

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