by Ajay Shah
In the past, we have seen privatisation as a sale of equity shares. As an example, consider the VSNL privatisation. Everything else about VSNL was held intact; there was just a change in the owner of the equity shares.
This works for a firm like VSNL, where there is positive value after paying off all the liabilities. What about a firm that is so far gone that there is no bidder if we put up the shares for sale? What about the situation where the prospective cashflows from the firm don't pay for the liabilities that are in place.
As an example, consider a firm that has Rs.100 of equity that is all owned by the government, the firm has Rs.200 of debt, and the firm is worth Rs.50 if it is sold as an all-equity firm. If we simply try to sell this firm, buyers will worry about having to take responsibility for Rs.200 of debt.
India has not done a privatisation in such a situation so far. There are two ways out, one that was always possible, and one that is now possible using the Insolvency and Bankruptcy Code of 2016.
As an example, in Germany, in 1990 a government agency was created which was put in charge of all the property of the previous German Democratic Republic (GDR). It led the privatisation of 8,500 state owned firms with over 4 million employees. Many of those firms were in deep trouble. A key ingredient which made the privatisation strategy work was that negative bids were permitted.
In our example, the auction will reveal a price of -150. The government will pay the buyer Rs.150, who will augment it with Rs.50 of his own, and pay off the debt of Rs.200. At the end of this, he is holding an all-equity firm which has cashflows worth Rs.50.
In this case, the lenders get Rs.200, and the government gets Rs.-150. The payment of Rs.150 is an ordinary fiscal expenditure for the government.
This is a method for privatisation that can now be used in India, when we face firms which have a negative net worth and the creditors will cooperate with the government.
In this case, the lenders get Rs.50, and the government gets 0.
Financial engineering cannot create value. The fact, in our example, is that the NPV of the cashflows of the company are worth Rs.50. The two solutions address this problem in two different ways. If we do a pure transaction involving equity shares only, then the government has to pay Rs.150, and the lenders are fully protected. If we put the firm into the bankruptcy process, the government (i.e. the equity shareholders) walks away with nothing, and the lenders walk away with Rs.50.
In the past, we have seen privatisation as a sale of equity shares. As an example, consider the VSNL privatisation. Everything else about VSNL was held intact; there was just a change in the owner of the equity shares.
This works for a firm like VSNL, where there is positive value after paying off all the liabilities. What about a firm that is so far gone that there is no bidder if we put up the shares for sale? What about the situation where the prospective cashflows from the firm don't pay for the liabilities that are in place.
As an example, consider a firm that has Rs.100 of equity that is all owned by the government, the firm has Rs.200 of debt, and the firm is worth Rs.50 if it is sold as an all-equity firm. If we simply try to sell this firm, buyers will worry about having to take responsibility for Rs.200 of debt.
India has not done a privatisation in such a situation so far. There are two ways out, one that was always possible, and one that is now possible using the Insolvency and Bankruptcy Code of 2016.
One way is to permit negative bids
As an example, in Germany, in 1990 a government agency was created which was put in charge of all the property of the previous German Democratic Republic (GDR). It led the privatisation of 8,500 state owned firms with over 4 million employees. Many of those firms were in deep trouble. A key ingredient which made the privatisation strategy work was that negative bids were permitted.
In our example, the auction will reveal a price of -150. The government will pay the buyer Rs.150, who will augment it with Rs.50 of his own, and pay off the debt of Rs.200. At the end of this, he is holding an all-equity firm which has cashflows worth Rs.50.
In this case, the lenders get Rs.200, and the government gets Rs.-150. The payment of Rs.150 is an ordinary fiscal expenditure for the government.
The other possibility is to utilise the bankruptcy code
- The firm defaults on one payment.
- One creditor initiates the Insolvency Resolution Process under the Insolvency and Bankruptcy Code, 2016.
- The creditors committee is formed.
- The bidder comes in with a plan which offers Rs.50 for control of the company.
- The creditors committee agrees to wipe out the debt, take the Rs.50 in the bargain, and walk away.
- In the end, the bidder gets a clean all-equity firm for the price of Rs.50.
This is a method for privatisation that can now be used in India, when we face firms which have a negative net worth and the creditors will cooperate with the government.
In this case, the lenders get Rs.50, and the government gets 0.
Conclusion
Financial engineering cannot create value. The fact, in our example, is that the NPV of the cashflows of the company are worth Rs.50. The two solutions address this problem in two different ways. If we do a pure transaction involving equity shares only, then the government has to pay Rs.150, and the lenders are fully protected. If we put the firm into the bankruptcy process, the government (i.e. the equity shareholders) walks away with nothing, and the lenders walk away with Rs.50.
The flow of logic in case 2 (i.e. bankruptcy process initiated by creditor) implies that there is no legal necessity for the government (implicit guarantor) to compensate the loss of the creditor.
ReplyDeleteThe creditor is making a loss of 150 in this case. His only motivation in this case to initiate the bankruptcy problem would be an explicit denial from the government to go for option 1 (negative bid). In other words, there is no illusion of any activity by the implicit guarantor and hence option 2 would be a dominant strategy for the creditors.
Do laws allow for such denial of any activity on the part of the government (in case of public sector bankrupt firms).
Even if there is any chance of implicit guarantor opting for options 1 (may be due to social pressures), option 2 just looks like an academic option.
Once default takes place, value destruction is pretty fast. Some creditor or the other will find it efficient to file for IRP.
ReplyDeleteThe creditors as a group get 50 which is a loss compared with their face value of debt of 200. But this is better than waiting and doing nothing.
As a side effect, in this illustration, we get privatisation.
It could work, for some situations.
On happening of the default, there is no need to wait for a creditor to file IRP. Even the corporate debtor itself can file for IRP under section 10 of IBC. So, the steps could be: (1) The Government Company intentionally defaults on a loan; (2) The Government company files for IRP. Step 3 onward follows.
ReplyDeleteThe concept of intentional default to be easily privatised sounds too easy to be true. On a straightforward intuition, this seems more like an abuse but not a benefit of IBC. There would be surely some laws in the IBC to prevent such intentional default just for the sake of privatisation.
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