EVALUATING PUBLIC ENTERPRISES

4.1. Collecting Data

Considerable work may have already been accomplished in classifying the public enterprises. Financial and micro economic data of the enterprises, the industries and their place in the competitive market may have already been accomplished. If not, the project team must collect data at the enterprise level, the sector level, the national level, and internationally as it relates to the firm under analysis. This data collection and analysis will allow a review of the current financial position of each public enterprise.

Appraisal of the enterprises and assessment of their potential for future profitable development requires a base of reliable financial and production information. Our recommended approach for gathering this information is described below. Many of the actual activities may be done by the line ministries, either directly or by means of consultants.

An important early task in the privatization process will be to identify and define the information requirements for each public enterprise. This will involve:

• Defining Key Data
• Collecting Data
• Developing a Financial Questionnaire, to be used as input for a computerised financial "spread"
• Identifying and Training Local Financial Analysts to assist. Financial data must be collected and input into the financial model. This will require several counterpart financial analysts (who will be trained accountants, bankers or economists). These local counterpart analysts can be identified quickly, trained in use of the Questionnaire and the computer financial model. This data will be entered into the financial model for spreading and subsequent analysis.

• Evaluating Existing Data. Each public enterprise will be studied as to financial results, strength, trends, etc. Data will be standardised to allow comparisons between enterprises in the same industry. To the extent that industry data is available on private sector enterprises locally and elsewhere, such data will be used for comparative purposes.

  This analysis will include Income Statement, Balance Sheet and Cash Flow items. Attachment 6 discusses essential items and presents a typical output on an enterprise analysed by us. Of course, the actual line items will vary, depending on industry type. The analysis and resulting implications will be discussed at the Executing Agency and enterprise level before proceeding.

  The financial modelling will produce a preliminary view of each of the enterprises mooted for restructuring or privatization. Certain enterprises will appear more likely candidates for privatization than others, based on financial performance. This evaluation will be compared with the Government's list of intended candidates for privatization. In certain cases, the view formed from this preliminary analysis will be enhanced by subsequent direct research of these enterprises.

4.2. Preliminary Analysis

4.2.1. Constraints Analysis

Section 7 discusses critical issues and constraints to a successful divestment and restructuring. These will be addressed and dealt with to the extent possible.

4.2.2. Appraisal and Valuation of Short listed Enterprises

Once agreement is reached on the enterprises to be privatized, restructured or liquidated and priorities established among them, selected enterprises will be analysed more thoroughly.

The financial analysis described in section 4.1 above, will be done on the basis of financial information provided. This will be supplemented by actual visits to short listed enterprises.

• On Site Visits
  Each short listed enterprise will be visited. These visits will allow a thorough technical and commercial appraisal of the enterprise. The results will be used to identify areas where action can be taken to obtain immediate improvements in performance. This will enhance both prospects for privatization and the price which the enterprises can achieve on sale.

  Aspects to be investigated in examining each enterprise will include (as appropriate):

  • background and history of the Unit;
  • details of administration and marketing:
  • administration costs and capability;
  • marketing costs and capability;
  • details of production
  • technical appraisal of plant and equipment (to ascertain current condition, operating performance and availability, utilisation, suitability, etc.);
  • plant layout, condition and efficiency;
  • type and number of employees (direct and indirect);
  • manufacturing and construction methods;
  • skill requirements and staff availability;
  • material usage and wastage;
  • maintenance management and practices;
  • production planning and control;
  • quality achievement;
  • inventory control procedures and physical distribution of products;
  • review alternative technologies;
  • examination of the availability and security of current and alternative sources of supply (including the type and characteristics of raw materials); and
  • other information, as appropriate;
  • situational issues (location; proximity to transport, power, water, etc.; other factors such as flooding, etc.).

  Among other things, this on-site visit will:

  • identify opportunities for improving productivity and cost effectiveness;
  • review existing staff skills and assess training requirements;
  • determine shortfalls in existing technical skills and education to meet current and future needs; and
  • recommend alternatives for meeting the shortfalls.
  • Valuation of Assets

  On site visits will allow valuation of assets will be made, using both the "going concern" and "as is, where is" scrap valuations. The valuation approach would use the "top down, bottom up" approach used in the New Zealand SOE corporatization process with which we have been extensively involved. This approach applies detailed calculation of individual assets. These value estimates are then checked against an overall business valuation. Monopoly issues, if relevant, will be also be considered, and issues of monopoly "rent" taken into account.

  The initial approach will be to apply known values to assets, where possible:

  • receivables and inventories will be valued at the lower of historical cost or market value;
  • items of non-specialised plant and machinery (ie. cars) will be valued at current market prices;
  • specialised plant and machinery will be valued at depreciated replacement value, unless a higher market value can be demonstrated;
  • land and buildings will be valued at current market prices;
  • unique impediments will then be considered.

  In each of the above cases, values will be referenced to book values. These preliminary accounting valuations will then be applied to each of the public enterprise's balance sheets.

  It will then be necessary to test these valuations against their potential earning capability as calculated in Section 4.2.2 below.

  For those Units to be sold, these valuations will establish basic floor values. This will prevent predatory buying strategies by investors who intend to asset strip at the expense of the Government, the public and the privatization program. For those Units which are not operating profitably, and may be better liquidated, we will have an idea of the liquidation or scrap value of each.

• Evaluation of Management
  Management's strength, depth, stability, integrity, dedication, and commitment to privatization will be evaluated. Local counterpart support can be used extensively in making these evaluations.

• Evaluation of Labour Issues
  Labour issues are critical to most privatization projects. Both the national labour movement as a whole, and the workforces of affected enterprises will have significant impact on the success of the privatization process. To the extent that enterprise's labour forces is sympathetic and supportive of the privatization, the national movement will be obliged to cooperate or, at a minimum, remain silent.

  Levels of overstaffing; quality of labour; workers' skills, productivity, experience, qualifications and level of ambition; loyalty; absenteeism and turnover; pilferage; commitment to privatization will all be gauged. Existing labour pool (size, education, stability, homogeneity, alternate employment options, etc) will be studied. Potential alliances with both formal and informal leadership structures within each enterprise will be developed.

• Value Enhancement Strategy
  When appropriate, a strategy will be developed for value enhancement. For those enterprises slated for privatization, such strategies may not be implemented in certain cases. For those slated for restructuring, the Value Enhancement Strategy will form the basis for restructuring.

Factors Determining Profitability

• Assessing Future Prospects
  Prospects for future profitable operation for each of the enterprises will be made. These assessments will be based on the results of financial analyses, information obtained during the on-site visits and from the value enhancing strategy suggested for certain enterprises.

  Determination of future prospects will require consideration of the factors identified in the graphic shown above, as appropriate to the circumstances of each selected PE:

  Because most industries are usually operating in a distorted market, adjustments must be made to anticipate performance in a "free market". It is recognised that some time will elapse before the market is free of distortion resulting from previous Government intervention. However, we believe that those enterprises which will perform best in a free market represent the best candidates for privatization.

  This adjustment of performance to take into account possible competition will be of a qualitative nature, as no reasonable quantitative paradigm seems appropriate. The adjustment will be based on the best judgement of the Project Team, after consultation with the Executing Agency and other appropriate parties.

4.2.3. Preparation of Business Plan and Cash Flow Projections and Finance Plan

For each enterprise, a business plan should be developed. This business plan should include projected income and cash flows. These projections are very important from a valuation perspective. For each enterprise, the steps involved in preparation of financial projections would be as follows:

• consideration of overall objectives and strategy;
• development or review of existing marketing plans, including an analysis of competition;
• identification of product groups;
• assessment of income and variable costs by product groups;
• analysis of suppliers
• analysis of distribution costs;
• calculation and analysis of overheads;
• analysis of gross profit margins;
• development of financial model;
• processing of information and testing of sensitivities;
• development of optimum capital structure and calculation of funding requirements; and
• projection of three year financial plans.

The capital expenditure budgets, income and expenditure projections, projected annual balance sheets and expected funding requirements will be incorporated. These plans will result in cash flow projections that will be generated on our own financial model, which uses sophisticated interactive computer software. The financial model will produce output similar to the financial spreadsheets displayed in Attachment 5.

The financial model is already developed. This represents a significant savings to any privatization project. Input will be undertaken by the counterpart financial analysts, thereby providing an excellent opportunity for skills transfer. These financial analysts would work in close association with the Executing Agency and the staff of the enterprises.

4.3. Diagnostics

Once the public enterprise has been evaluated, financial experts will preform a range of diagnostic exercises on the enterprise. These will relate to the health of the enterprise, its management, labour, resource and capital situation, its market, its position in the industry, prospects for the industry, etc. On the basis of this evaluation, a diagnostic exercise will be completed. This will provide for a. preliminary screening of enterprises. In many cases, the diagnostic will have a high degree of certainty and particular steps will seem obvious. In some cases, a more detailed evaluation will be unnecessary. This is especially true for enterprises which are obviously non viable and should be closed as soon as possible.

The diagnostic exercise can also identify enterprises which should be sold quickly. In some instances it is best to act immediately and sell off obviously saleable public enterprises rather than go through a long drawn out analysis process. This is advisable in cases where strong investor interest exists and/or where the public enterprise is profitable and well managed.

4.4. Evaluating Viability

Enterprises will be classified in one of four ways:

• Profitable, viable.
  These will make ideal candidates for privatization. A decision will be made on these as to timing of privatization, which will relate to capital market conditions, the timing and complexity of value enhancement measures, and the sales priorities of the Government. This group will typically consist of:

  • (i) Larger profitable companies, requiring core investors, which will attract potential investors and can go to the market quickly.
  • (ii) Profitable smaller companies, notably in the farming, trading and transport sectors, that are attractive to potential investors, but where concentration of ownership could impede success. These companies are often best privatized through the vehicle of investment companies/trust funds.

• Unprofitable, viable.
  These will represent enterprises with basic strengths which can be made profitable by certain means. They are candidates for restructuring. In most cases, these will probably be privatized after the value enhancement action plan has been effected, so that the Government can enjoy the benefit of the value added efforts. It is possible, however, that some of these could be privatized before coming into profit. This might occur in the event the Government feels compelled to keep to its agenda of privatizing a certain number of enterprises and no other units are suitable for sale, or in the event that the value enhancing steps are agreed by the capital markets or other potential buyer, and the enhanced value is already reflected in the sales price.

  This may be the largest group of enterprises. The inclusion of certain enterprises in this group derives from the difficulty in assessing their longer term financial viability. These enterprises tend to be in marginal or poor condition but are potentially viable and need to be turned around. In certain cases, turn around will be successful and the company go to the first group described above. In other cases, turn around will not be successful and they will go into the last group described below.

• Profitable, non viable.
  These enterprises represent the most difficult of all. They will be trading profitably, but may be in sectors for which no future is projected after completion of economic reforms. The Government must decide if it is prepared to sell these enterprises to buyers whose views of the future of the enterprise is more optimistic than that of the Project Team. In such cases, the sale should be prompt, before any deterioration in results occurs. Moreover, we would recommend selling such enterprises to a sophisticated and substantial private buyer, rather than risk spoiling the public market by selling it enterprises for which projected financial results are pessimistic. This is "selling a puppy", and would be detrimental to the Government's long term privatization interests. The public market should be reserved for the better enterprises with the brightest futures. This is the best way to ensure a robust and deep capital market.

• Unprofitable, non viable.
  In the case of enterprises for which no possible improvement can be foreseen, the method of divestment will be clear. These should be liquidated or merged with stronger enterprises (if a compelling reason for a merger can be developed).

  These classifications will be preliminary. Actual privatization strategies for each enterprise should not be made until a full appraisal of the capital markets, the investment environment and the socio/political environment and level of local political support have been made, resolution found for policy issues and impediments, linkages forged with potential buyers and investors, and the full range of privatization options for each enterprise is fully evaluated. At that time, a privatization strategy will be developed for each enterprise.

4.5. Review of Options

The full range of privatization and divestment options will be explored in the context of the local conditions and environment. In many countries, the likely range of options is limited by the lack of a robust capital market and other constraint. Nonetheless, possible options that must be considered would include:

4.5.1. Liquidation and scrapping of assets

Enterprises which are classed as "unprofitable and non viable" should be closed. Assets should be liquidated. In some cases, certain assets may be transferred to other enterprises. Care must be taken that assets are not "dumped" into the market, thereby injuring other enterprises which compete directly or indirectly with those being liquidated. Sale of inventory or capital equipment at extremely low prices will hurt other participants in the market.

4.5.2. Merger of Enterprises

It may be that a combination of certain enterprises or parts will maximise the Government's value. In some cases, functioning enterprises may be merged. In other cases, the better assets and personnel can be shifted to enterprises where they can be better employed.

4.5.3. Spin-off of operating units

Public enterprises may have operating units (especially marketing and service units) which may prove profitable on their own. Spinning these off is a good way to begin the process of privatization on larger, intractable and possibly unprofitable enterprises.

4.5.4. Corporatization

Corporatization is often an ideal transition phase in the process of improving economic efficiency of public enterprises and divestment. The New Zealand model successfully employed this route to privatization and has been recognised internationally to have been well executed. Corporatization however is not a necessary step to enterprise restructuring and eventual privatization. It has been omitted in the case of many successful privatizations. It is discussed here as a recommended approach and as a useful framework under which to discuss the process of enterprise reform.

The process of corporatization would typically take the following steps:

• Creation of corporations from public enterprises
• Creation of Establishment Boards
• Valuation of enterprises
• Agreeing capital structure of new corporations
• Appointing commercial Boards of Directors
• Appointing management
• Role of government as shareholder

Boards of Directors are constituted consisting of commercially minded, experienced individuals with a mandate to run the enterprises profitably. Incentives are structured to produce profit motivated decisions. The Boards of Directors, in turn, recruit suitable management teams to run the corporations for profit. Once again, incentives are put in place to ensure profitable operation of the enterprises.

Mechanisms must be put in place to ensure that the Government officials are not able to interfere in the operation of the enterprises.

4.5.5. Commercialising

Short of corporatization, it may be possible to create sufficient profit motivation in management by placing it on a commercial basis. Elimination of counter productive Government objectives relating to employment, price stabilisation, etc. often makes it possible for a well managed commercial government operation to operate profitably.

As with corporatization, mechanisms must be put in place to ensure that holding company or ministry level officials are not able to interfere in the operation of the enterprises.

This does not often appear to be a favoured (or even realistic) option, however, and is mentioned here for good order's sake.

4.5.6. Sale by tender

An enterprise may be sold by tender as a going concern. In this case, interested parties are induced to bid for the business. This technique has been favoured by the governments in the past. However, it is generally acknowledged that this is not a preferred technique in privatizing. It is nonetheless possible to put in place mechanisms which allow this option to work effectively.

4.5.7. Sale of shares

It is possible to sell up to 100% of the shares in a public enterprise through an Initial Public Offering, depending on the robustness of the capital markets and the quality of the enterprise being sold. In the case of the issuance of shares, the following specific issues will be investigated and analysed:

• Sale of 100% shares in the enterprise (total issue)
• Sale of less than 100% of shares (partial issue)
• The role of local development banks
• The role of commercial banks
• The role of other institutions
• The possibilities of Employee Stock Ownership Plans (ESOPs)
• Issues relating to Initial Public Offerings
• Issues relating to secondary market support

4.5.8. Granting of shares

Shares in public enterprises may be distributed to parties for little or no consideration, or at a deep discount to par value. In simple terms, shares may be given away or sold at a price below their true value. Employees, individuals in holding corporations, and the general public may be suitable recipients of a granting of shares. This technique was effectively utilised in Britain for both economic and political reasons. (Among other things, the Tory Government found that creating a nation of capitalists was beneficial to their political power base.) Discounted shares might be offered to labour, to management, to sector corporation officials, and to small investors among the public.

4.5.9. Joint venture arrangements

Multinational corporations or others (such as the IFC, CDC, etc.) may be interested in joint venture arrangements with public enterprises as part of the privatization process.

4.5.10. Performance and Management contracts

Contracts with existing management may achieve many of the benefits of privatization. Effective management incentives are possible for relatively minor economic adjustments. Part of the arrangement might be eventual management buy outs of the enterprises.

4.5.11. Leases

Assets of an enterprise may be leased to other public enterprises, to private sector manufacturers, to multinationals, or to others. As with management contracts, this option can be achieved with minimal political trauma.

4.5.12. Mothballing

A public enterprise may simply be closed. No fixed assets are sold. A skeleton crew is retained to keep assets from wasting. Mothballing a plant implies simply shutting the doors. None of the fixed assets would be sold. While this prevents the Government from realising any cash from these fixed assets, such a strategy is appropriate in several instances. If no international market for the assets is practical, and selling them into an already oversupplied local market would disrupt the local industry, the Government may opt to mothball, waiting for a better time to sell. Alternately, if the Government believes the assets will have a greater value in the future, as market conditions change, it may prefer to retain these fixed assets until then.

For each of the short listed enterprises, each of these options should be considered. The more appropriate strategies for each will be identified, others rejected.

4.6. Agreeing a Reform Strategy

4.6.1. Agreeing Priorities

Once the public enterprises have been classified and evaluated, it is possible to recommend a priority amongst them for privatization, restructuring and liquidation. From this, enterprises will be identified for priority treatment.

4.6.2. Determining a Game Plan

Thus far, our methodology will have established a benchmark by evaluating the present condition of each enterprise and examining options available to the Government for each. Depending on the classification of an enterprise and the priority assigned to it, the enterprise will be divested, restructured or liquidated. Our approach to divestment is presented in Section 5; our approach to restructuring in Section 6. Liquidations are discussed in Section 4.5.1, above.