Corporate Governance and

Privatization

Shubham Ahuja
 Introduction
Privatization programs have dominated public policy debates
and transformed the economic landscape. Over the last 15
years close to $1 trillion in assets have been passed from the
government to private hands.1 Billions more in assets await
future privatizations. This shift of responsibility from the state
to private hands has clear benefits. Analysts of privatization
report macroeconomic and political benefits ranging from
increased state revenue to a reduction in the states role in
provision of goods and services, while academic research has
documented significant operating and performance
improvement.
Transfers of assets from the state to private hands have not
stopped ‘grabbing hands’ of the state.
Policy makers that adopt a corporate governance
perspective will have more effective privatizations with
fewer problems, particularly in the long-term. The steps
required to bring together those with resources to invest
and managers with strong investment projects that they
can implement in privatized firms are deceptively simple;
give management free hands to pursue strong investment
projects but constrain ‘grabbing hands’ of public and
private parties by providing information and
accountability to investors. I say deceptively, because it is
difficult to put such ideas into practice because of the
variety of institutions that affect information and
accountability.
To simplify thinking about privatization and governance
the concept of governance chains is introduced which can
constrain grabbing hands and provide benchmarks as to
the use of different governance chains in established
firms. There are two types of chains, the first being a
private governance chain where there are few institutions
and each provides both information and accountability.
The second governance chain is formal, and the
specialization of information and accountability increases
the length of the chain and the demand for institutional
depth. The framework and evidence from established
firms helps to interpret past privatization evidence, and
offers insight into how to make future privatizations as
effective as possible
 Sizing Up the Corporate Governance
Challenge
• Investment in exchange for a promise
In a well-functioning economy there is specialization in
investment and management. Investors delegate decision
making over investments to those with the information
necessary to make the right business decisions. Resources
are matched with those with good investment projects
and the ability to implement. Suppliers, workers,
managers, and financiers are all investors of a sort as they
entrust their resources to those in control of an
enterprise. Each, as an investor in a long-lived collective
enterprise, awaits promised returns to these
contributions.
• Grabbing hands undermine promises and
produce social costs
A major obstacle to securing such investments is
the prospect that those delegated with decision-
making power will not use that power as they
promised. The fear is one of ‘grabbing hands’
diverting returns rather than helping hands
delivering what was promised. Some diversions
are obvious, such as outright theft. Others are
less obvious but equally costly from a societal
perspective such as the continuation of
investments that reward those in control.
• Governance institutions constrain grabbing hands by
improving information and accountability
Most simply, the institutions of corporate governance are
those socially defined factors that influence the expected
returns to investing and giving control to delegated
decision makers. Governance institutions alter the
payoffs to strategies of insiders and outsiders and
consequently the actions that will be observed.
Governance institutions facilitate or constrain the
grabbing hands of public and private actors.
Effective governance institutions improve information
flows and are always being targeted towards their most
efficient uses.
 Governance Chains
• Recognizing that effective governance requires constraining
both private and public grabbing hands calls for a broad
characterization of corporate governance institutions.
• The most formal solutions have many more links in their
governance chains. Separate entities specialize in providing
information and accountability, in addition to those that
combine provision of these tasks. The three principal links
are legal institutions such as laws of incorporation that hold
political actors accountable, internal institutions devised by
insiders and outsiders to provide both information and
accountability such as the board of directors, and legal
institutions like corporate and disclosure laws that ensure
that information and powers of accountability are held not
only by the board, but by minority outside investors more
generally.
Two Governance Approaches and the
Keys to their Effectiveness
• Private Governance Chains
Thinking through the main components of governance chains
helps an advisor to recommend a governance approach in
privatization and helps to make a given approach as strong as
possible.
Self-enforcement of promises is important where there is no
effective state, and reputation is central to self-enforcement.
One way investors can increase the security of their
investments is by repeatedly interacting with the same party
and allowing ‘the long shadow of the future’ to discipline
against grabbing hands. Insiders will maintain their promises
so long as the discounted losses from losing the continued
relationship exceed the short-term gains associated with the
breach of promise.
• Linking insiders to an ‘ordering agent’
• Adjusting ownership and control to facilitate
private information flows and enforcement
• Formal governance chains
To determine if formal governance chains can be used
instead we need to understand how formal governance
chains function and whether they exist or can be
introduced at the time of privatization. This section
describes and provides some estimates of each of the six
links in formal governance chains.
• Legal institutions to constrain the grabbing hands of
the state
• Independent boards to constrain insiders
• Legal institutions that constrain the grabbing hands of
insiders
• Institutions that complement ‘formal’ governance
institutions
 Evidence on Governance Chains in
Privatization
• Governance approaches and privatization outcomes in transition
countries
The difference is that corporate structures introduced at the time of
privatization are devised by political actors and unlike corporate
structures in established firms, have not stood the test of time. The
index of concentration is whether the EBRD (1999) classified
economies predominant privatization method as direct asset sales,
management and employee buy-outs or voucher privatization. A
voucher privatization is a share issue privatization that results initially
in disperse ownership. Direct asset sales result in more concentrated
ownership. Management and employee buy-outs are somewhere in
between direct sales and voucher privatization at creating
concentration at the time of privatization. This is a crude measure but
it captures cross country differences.
• Global evidence on governance approaches
and privatization outcomes
To a great extent, privatized firms around the
world stick to established benchmarks. Among
countries with relatively weak formal
protections, there are very few countries that
use share issues for a large proportion of
privatizations. This pattern is closer to that of
established firms than privatization in transition
economies.
 Making a Given Governance Chain as
Strong as Possible
To many advisors, the question they face is not what governance approach to take in
privatization, but rather how to make the given approach as effective as possible.
There are many factors driving the choice of privatization method in addition to
governance concerns. Political factors, including such issues as concerns about foreign
domination or concentrating too much economic power in the hands of already
powerful domestic groups.
• Making the most of formal governance chains
First, one can make up for weaknesses in domestic information disclosure laws by
releasing more information, or better yet, tying the privatized firm to foreign
institutions through cross listing. In addition to the benefits of increased liquidity and
lower cost access for foreign investors, foreign listing requirements increase the extent
of information, and the involvement of foreign stock exchanges and foreign regulators
increases the credibility of that information. The presence of a foreign listing also
helps to constrain the state by engaging powerful institutional investors which the
government might be relying on in for future plans. The use of a foreign listing is likely
to be 30 Particularly useful in providing information and accountability if the
company’s strategy calls for continued turning to international markets for financing
• Making the most of private governance
chains
The framework also has implications if simpler
private governance chains are used, for these
approaches also have their governance dangers.
To reiterate, what is most important is to
produce information and accountability by
leveraging identity of owners and concentration
of ownership, while limiting agency problems in
controlling shareholders and/or the ordering
agent.
 Conclusions
• Privatizations have produced significant improvements but also
some disappointments. Advisors that take a governance perspective
at the time of privatization will see more effective privatizations,
particularly in the long run. At one level, taking a governance
perspective is incredibly simple – the advisor needs to find a way to
tie grabbing hands of public and private parties by providing
information and accountability. At another level it is difficult, for
there are a variety of institutions that can provide information and
accountability
• To simplify thinking about privatization and governance I have
introduced the concept of governance chains to tie grabbing hands.
I introduce two types of chains, the first being a private governance
chain where there are few institutions and the institutions assume
the responsibility of both providing information and accountability.
The second governance chain I call formal, and the specialization of
information and accountability increases the length of the chain
• Where each of the links is strong formal
governance chains will be more effective, but as a
matter of fact in most countries many of the links
are weak. The key to effective privatization is to
employ the governance chain that has the
greatest probability of success in the first instance
and, barring this, to strengthen each link as much
as possible. Privatizations that attempt to use
formal governance chains without initial
development of the links of the governance
chain, or concerted efforts to make up for existing
weaknesses, will disappoint
Thank you