Buy-outs in Hungary, Poland and Russia: governance and finance issues

Economics of Trunsition, Volume 4 (I), 67-88, 1996

Buy-outs in Hungary, Poland and Russia: governance and finance issues' Igor Filatotchev', Irena Grosfeld**, Judit Karsai, Mike Wright, Trevor Buck2

* Centre for Management Buy-out Research **DELTA School of Management and Finance Joint Research Unit CNRS-EHESS-ENS

Nottingham NG7 2RD France TEL: 01 15 9515265 TEL:331 4581 4302

University of Nottingham Paris

Abstract

The governments of Hungary, Poland and Russia have used buy-outs as an important privatization strategy which can be viewed as forming a continuum from straightforward sales where management and employees generally achieve significant ownership, as in Hungary, via intermediate approaches as in Poland where both payment and free distribution of shares are involved, to the Russian case where state-owned enterprises were effectively "given away" through a voucher privatization scheme. This paper, first, presents preliminary evidence on the extent and nature of post-privatization restructuring in buy-outs in these three countries, which highlights the transitory nature of this form of organization. Second, in the light of these findings, the paper analyses the possibilities and difficulties associated with enhancing corporate governance and finance.

JEL classification: (330, L33 Keywords: Employee and management buy-outs; corporate governance; finance; privatization

1. Introduction

Extensive privatization in Central and Eastern Europe (CEE) is now being implemented through various mechanisms but the relative importance of buy-outs varies between countries. As will be seen in detail below, in Russia privatization has largely been effected through buy-outs, whereas in Hungary and Poland, whilst there have been substantial numbers of such transactions, they do not play such an important role in the transfer of enterprises to the private sector.

The governments of Hungary, Poland and Russia have implemented privatization in quite different ways. These approaches can be viewed as forming a continuum from straightforward sales where management and employees generally achieve significant ownership of former state enterprises with the use of preferential credit, as in Hungary,

68 Buy-outs in Hungary, Poland and Russia

via intermediate approaches as in Poland where both payment and free distribution of shares are involved, to the Russian case where state-owned enterprises were effectively "given-away'' through a voucher privatization scheme.

Political factors played a major role in the form of initial privatization which was adopted in the three countries examined here. In Russia buy-outs were a conscious strategy aimed at ensuring the political feasibility of the privatization process. In Poland, the popularity of lease buy-outs was not anticipated by the legislation and its extent came as something of a surprise to policy-makers. In Hungary, buy-out through the self- privatization process was introduced as a means of achieving rapid but regulated privatization, after the problems faced by earlier programmes.

As the process of transformation has become more advanced, the emphasis of policy is beginning to shift. In particular, increasing attention begins to focus on the issue of ensuring enhanced enterprise efficiency, though of course political factors may still place severe constraints on actions designed to deal with this problem.

In the West, a distinction is made between management and employee buy-outs. Employee buy-outs are most often used in troubled firms as a means of obtaining workers' acceptance of restructuring which may not otherwise be forthcoming (Bradley, 1986; Long, 1978; Wright and Coyne, 1985). Management buy-outs are usually designed to realize efficiencies due to better incentives (Jensen, 1986). However, equity ownership is only one part of the overall governance process in a buy-out. Corporate governance also involves the control of the dominant decision-makers in an enterprise by other stakeholders. A crucial role is thus assigned to the provision of investable funds, direct monitoring by active investors (buy-out associations, banks, venture capital firms, efc.) and the indirect control exerted by creditors.

In general, enterprises involved in buy-outs in Hungary, Poland and Russia differ markedly from those in the West with consequent implications for their ability to effect efficiency improvements. First, they are typically management-led employee buy-outs rather than pure employee or management buy-outs. If employees are majority equity holders and managers own only minority stakes, they may have little incentive to effect enterprise restructuring. In the absence of other forms of external control managers and employees may form a coalition of entrenched interests resisting reform. Unless managers in a particular enterprise are dominant and employees are correspondingly compliant, the extent of market-based transformation may be limited. The simple transfer of ownership lo the private sector may do little to improve corporate governance mechanisms. Second, in CEE there are generally likely to be high demands for investment finance which may be difficult to obtain because of high aggregate uncertainty. Third, in those Western buy- outs which do require significant new investment finance, this is usually introduced from the outset through new capital injections by external financiers. In contrast, buy-outs in Hungary, Poland and Russia often involve only insignificant amounts of extra capital, and amount to mere transfers of ownership in their early stages. Given the importance of incumbents in privatized enterprises in CEE, external finance only becomes desirable when employees recognize the need for restructuring and investment for survival, notwithstanding the problems of the availability of appropriate finance. Transformation of the financial system in the region has been slow, although in Hungary and in Poland significant progress has been achieved.

Thus, corporate governance mechanisms and finance in buy-outs in CEE may be closely linked. Access to finance may be necessary for effective governance, but effective governance may be P condition for access to finance. Moreover, the initial form of privatized enterprise in CEE may be only a transitory one. Some buy-outs will become (or are already becoming) conventional privately held firms or publicly listed companies.

Filatotchev et al. 69

The longevity of buy-outs may depend upon the pressures to introduce effective governance mechanisms and external finance.

In the context of this discussion the paper has two principal aims. First, after outlining the nature and importance of buy-outs in each of Hungary, Poland and Russia, evidence is presented on the extent and nature of post buy-out restructuring. The findings, which are drawn principally from studies conducted by the authors and supplemented by other research, show both changes in various aspects of operating performance as well as substantial changes in ownership and finance, which includes evidence of an increased role of managers in a shift from employee buy-outs to more closely held management-led employee buy-outs. This evidence highlights the growing perception that buy-outs, which have been a highly pragmatic means of effecting initial privatization, increasingly need to be viewed as a transitory form of organization. The second aim of the paper, in the light of these findings and continuing political constraints, is to analyse the possibilities and difficulties of improving corporate governance and finance. In general three types of outside investor can contribute to enhancing governance and finance: banks, other firms or wealthy individuals, and non-bank financial intermediaries such as investment funds and venture capital firms. The discussion emphasizes the CEE-specific issues concerning the effectiveness of mechanisms for enhancing corporate governance and the differences which may be expected to arise between Hungary, Poland and Russia. The final section presents some conclusions.

2. Privatization buy-outs in Hungary, Poland and Russia

For each of the three countries examined in this paper, this section first reviews the development of privatization as it relates to buy-outs and secondly presents evidence on post-privatization changes in the enterprises concerned.

2.2. Hungary 2.2 . I . Privatization buy-outs Early experience of "spontaneous" privatization in Hungary emphasized the need for some form of regulation to deal with abuses arising from incumbent management obtaining state-owned assets on highly advantageous terms (Branyiczki et af., 1992; Mizsei. 1992). A highly regulated approach was then introduced where, although investors, managers or the State Property Agency (SPA) could initiate a sale, approval was strictly controlled by the SPA. The problem with this approach was that there was still scope for managers to dissipate state assets. As a result, in September 1991 a further measure was adopted based on self-privatization and "automatic" clearance by the SPA provided the transaction was prepared by independent advisors from an approved list (Karsai and Wright, 1994). The enterprises covered by this programme had either been sold or were in the process of sale by the end of December 1993. Remaining enterprises in state ownership were required to transform themselves into corporations, and could submit a privatization proposal for approval by the SPA. In 1992 the MRP law, that is the law concerning Employee Share Ownership Plans (ESOP) was introduced, whereby employees can purchase part of an enterprise if at least 40 per cent of them express their wish to establish the organization at the founding general assembly.' It is also considered to provide special incentives for managers undertaking a buy-out which would include the company to be purchased assuming liability as principal guarantor for up to half of the loan required to fund the purchase, as well as direct support in the form of a given quantity of shares, and the right of purchase of other shares on favourable terms.


In Hungary buy-outs can make use of the so-called Existence (E)-credit, which is credit on favourable ternis guaranteed by the National Bank. The terms of the E-credit have been progressively relaxed. By the end of 1993, management were required to pay at least 2 per cent of the purchase price from their own resources if the whole sum is below HUF 5 millions, while 15 per cent is to be paid if the sum exceeds this amount. The rate of interest paid is below the market rate and is based on a rate determined by the National Bank of Hungary plus a commercial bank margin. The maximum period of the loan is fifteen years, although most fall in the range of five to eight years, with a maximum of three years’ grace before repayment of capital. Banks typically require collateral in the form of the company’s shares if there is a sound business plan or the company has significant assets in the form of real estate. If managers and employees undertake a buy-out following this route it is possible to obtain tax relief on the interest and capital repayments. Employees can also obtain shares at a fifty per cent discount up to a maximum of their annual average wage.

Of approximately 700 companies included in the self-privatization programme, 4 I2 had been sold by the time the programme was ended in December 1993. Precise data are not available, but it.is estimated that about a third were sold as buy-outs. According to SPA officials and directors of consulting firms there were about 30 firms sold to employees prior to the passage of the ESOP law in 1992. Data published by the SPA show that between midJuly 1992, when the law came into force, and the end of March 1994, 148 firms were sold to employees under the ESOP framework with a total value of HUF 29.85 billion (Privinfo, 2 May 1994). Some 45 per cent of these enterprises had two hundred employees or less and only eight per cent had more than a thousand.

A survey by the SPA of 64 ESOP buy-outs shows that the average holding by the employees was 56.1 per cent (SPA, 1994). The remaining ownership stakes comprised the SPA (24.5 per cent on average), municipalities (6.7 per cent), companies (5.5 per cent) and other Hungarian owners (7.3 per cent). In contrast the average shareholding by employees within all firms privatized by the SPA up to August 1993 was 3.4 per cent, although the introduction of ESOPs meant that more recent transactions had much higher employee stakes.

Banks providing finance have rarely taken equity stakes, and when they have, their shareholdings have generally been modest. Ownership involvement of foreign firms has often been in cases where the foreign partner had taken part in the initial transformation of the company. Where there was wider employee ownership, shareholdings have tended to be concentrated amongst management, since the rules for share subscriptions tend to favour ownership by managers and long-serving employees through a system of points reflecting the number of years at the company, position and salary, or simply the amount of money the person is willing to invest. Evidence also indicates that the ability of employee shareholders in buy-outs involving ESOPs to engage directly in governance was constrained since supervisory and management bodies were typically dominated by the firm’s managers (Karsai and Wright, 1994).

In addition to these measures, a certain number of buy-outs have been effected since the bankruptcy and liquidation legislation was introduced in 1992. According to the legislation an enterprise which was overall a net creditor could be forced into bankruptcy if i t were unable to meet one of its debts due to short-term liquidity problems.’ Such a route to buy-out may, however, be cumbersome because of delays in processing transactions due to limited capacity in the courts and among the 135 authorized liquidators. These delays can have adverse effects on enterprises because of ineffective or non-exisient corporate governance during the bankruptcy procedure and because of the effect of uncertainties about the enterprise’s future on trading partners.

,

Filatotchev et af. 71

2.1.2. Hungary - Post-privatization changes The ESOP law places severe limitations on the transfer of shares in Hungarian buy-outs. The authors conducted detailed case studies of seventeen Hungarian buy-outs in early 1994 through face-to-face and telephone interviews as well as desk research.' In most of the companies, management actively promoted employee share ownership, with on average 70-80 per cent of employees acquiring shares on privatization. In four enterprises, after the buy-out, management bought back shares from employees who had left, and in about half of those cases which had not encountered severe difficulties, there had been a modest reduction in the percentage of shares held by outsiders.

Though employees as a group had significant equity stakes, management played the dominant role. A relatively small group of between 15 and 25 managers frequently acquired a majority stake or one in excess of 25 per cent, ensuring a power of veto, sometimes reinforced by special regulations on voting rights. Employee-owners, because of their low and diffuse equity stakes together with lack of expertise, were typically unable to exercise an effective supervisory role. It was also frequently the case that the leaders of the ESOP were senior management. The banks, which provided finance to most of the case study companies, also preferred management to occupy a dominant position in the buy-out group as a condition of extending the loan. However, this stance to some extent conflicted with SPA practice, which attempted to screen out those ESOP buy-outs which were actually management as opposed to management-employee buy- outs.

Average employment in the firms in the sample was 694 employees, with the smallest employing 45 people and the largest 3,400. Employment was known to have increased in only one enterprise. In the seven cases where redundancies occurred, the reduction in employment varied between I0 per cent and 3 1 per cent. In five cases there was no change in employment.

As the share of employees' incomes made up by dividends and any capital gains was insignificant, the focus of employees' attention was on receiving higher wages and keeping their jobs. However, as the firms generally had substantial debts and little funding available for investment, employees generally accepted relatively low wage increases. Management tended to refrain as long as possible from enterprise restructuring which would result in resistance from employees. In two companies in the sample, where the financial situation deteriorated to such a degree that large-scale dismissals became unavoidable and which have now failed, management kept the employee-owners on the payroll as long as possible. A third company which was experiencing performance difficulties was sold to a third party for a very low price. Upon buy-out, all three firms had very high debt burdens.

There was little evidence of significant capital investment. In six cases no investment expenditure had occurred and in a further six it was qualified as small in relation to the size of the enterprise. In only four cases was investment expenditure classified as significant. Since the borrowing capacity of the enterprises was typically fully utilized to finance the initial buy-out, internally generated resources were the main source of investment funding.'

The vast majority of the seventeen firms in the sample were profitable at the time of privatization. Reflecting this position and due to the favourable E-credit terms and scrutiny by the banks extending loans, there were no financial problems in twelve of the seventeen buy-outs after privatization. As already noted, two firms had gone into liquidation and one was the subject of a forced sale following serious financial problems. Two buy-outs had experienced minor problems necessitating the negotiation of further loans.


It may be expected that financial problems will increase following the end of the three years' grace period allowed under the E-credit scheme and that at this point a greater shift in ownership structures will also begin to occur.

2.2. Poland 2.2.1. Privatization buy-outs In Poland, the employees can become owners of privatized companies in three different ways. First, according to the privatization law of 1990, if a state enterprise is transformed into a joint-stock company and its shares are offered for sale, employees can buy up to 20 per cent of shares at half price (the value of shares per employee cannot exceed the average wage in the previous year). In addition. the employees can buy shares in their enterprise according to the same rules as "outsiders". In the joint-stock company, the workers' council is dissolved and a supervisory board and a board of directors are appointed. In the new bill on privatization it is proposed to give employees 10 or I5 per cent of shares for free. In several large enterprises, by a special decision of the Council of Ministers, 10 per cent of shares have already been given free to employees.' Among 100 enterprises privatized through the so called "capital route" there are two cases of pure employee ownership (these are Zh4 Innowroclaw, which was the first privatized enterprise in Poland, and Krakbud) and several firms with dominant employee ownership (for example, Rafako, which is listed on the Warsaw stock exchange, and Budokor).

Second, according to the same law (Article 37.1) a company established by employees can buy the enterprise according to the same rules as other bidders (through a publicly announced tender offer). Of 140 enterprises sold by this route, 9 have been taken over exclusively by employees and in a further 20, employees are the dominant shareholders (Przeglad Rzadowy, April, 1994).

Third, according to Article 37.3 of the privatization law an enterprise can be "liquidated" and its assets leased to a new company if at least 50 per cent of the employees participate.' Such a company signs a contract with the Treasury represented by a founding organ (a ministry or local authorities) stipulating that it will lease the assets of the previously state-owned enterprise against the quarterly or monthly instalment payments determined by the agreed price.

This method of privatization, in principle designed for smaller firms, has proved the most popular. To the end of 1994, buy-outs involved 764 state enterprises (Ministerstwo Przeksztolcen Wlasnosciowych, 1995). i.e. about 70 per cent of all "privatized" firms (inverted commas indicate that leased firms are not really privatized until the whole capital and interest has been repaid). Total employment in these firms reached about 150,000 people, i.e. about 52 per cent of total employment in privatized enterprises (cf. Prywatyzacja Przedsiebiorsw Pansrwowych, 1994).

In lease buy-outs the initial capital necessary to meet the down-payment of 20 per cent of book value has been financed from various sources: savings of employees, outside investors and, last but not least, firms' profits feeding into special funds created to support employee ownership. Evidence suggests that 30 per cenr of initial finance came from such special funds (see the study of 142 companies reported in Zycie Gospodarcze, No.12, 1994). Dabrowski et al. (1993) and Szomburg (1994) also find widespread financing of employee stakes in lease buy-outs from surpluses of the enterprises concerned.

2.2.2. Pos t-priva tiza tion changes The evaluation of post-privatization changes in Polish buy-outs in comparison with other enterprises must take into account the fact that enterprises that have chosen this

Filatotchev er af. 73

privatization method were in good financial condition. This factor at least partly explains why the overall results for buy-outs, as measured by the percentage of loss-making firms and the ratio of gross profits to costs, appear to be slightly better than for the enterprise sector as a whole (see Table 1). However, there are indications that performance is declining as the proportion of loss-making buy-outs increased sharply from 4.4 per cent in 1991 to 13.2 per cent in 1992 (IBD. "Zmiany", 1993).

Table 1. Profitability' of Polish enterprises ~~ ~~~ ~ ~~~

Type of enterprise 1992 1993

Lease Buyout 7.2 7.4 Corporatized enterprise 2.7 2.8 Total 1.6 2.5

a. ratio of gross profits to costs Source: Rocznik Starystyczny, GUS, 1994.

Various surveys and case studies of leased firms (Jarosz, 1994a, b; Dabrowski er af., 1993; Szomburg, 1994) show that in this group ofenterprises, as in other groups, we find a great variety of behaviour, adjustment and performance. Some firms are very dynamic (four of which are already listed on the Warsaw stock exchange), others perform poorly and may not survive in the longer term (7 leased firms went bankrupt, cf. Nuwa Europa, 10-1 I . 11.1994). In the middle there are firms with financial problems which need a profound restructuring to survive.

Table 2. Changes in ownersh ip structure in Polish enterprises leased by t h e employees Type of owner Average holding end-1991 Average holding mid-1993

(%I (%I Employees 75.4 Managers 9.8 Outside investors 14.8

66.9 12.0 21.1

Source: Jarosz ( 1994a)

It clearly appears that the ownership structure of leased firms becomes more concentrated with time, mainly in the hands of outsiders but also in the hands of managers who often buy shares from employees (Table 2). However, the tradability of shares is usually limited. In eighteen enterprises monitored by Dabrowski el al. (1993). the founders and employees had priority in buying shares and sales to outsiders had to be approved by management, supervisory boards, erc. Nevertheless, this monitoring of a group of enterprises observed some increase in the extent of share trading over time, primarily because of the termination of employment," with outside investors becoming more involved. According to another survey of 142 enterprises (IBD, "Zmiany", 1993), up to December 1992, 13.5% of all shares changed owner. Generally, the increasing share of outside investors and that of managers indicate that constraints on the tradability of shares are being progressively eased.

Interesting evidence on post-privatization changes in Poland is available from a survey of 110 of the 200 enterprises established prior to the end of 1991 and which had leased since then the assets of previously state-owned enterprises (see Jarosz, 1994a, b for full

74 Buy-outs i n Hungary, Poland and Russia

details). This evidence shows that, as compared with the period before privatization (i.e. at the beginning of 1990), employment by June 1993 had been reduced significantly. In 21 per cent of companies employment was more than halved, in 40 per cent of companies it fell by more than 31% and less than 50 per cent and in only 9 per cent of companies it increased. The extent of lay-offs in these leased firms exceeded that for the economy as a whole. Between January 1992 and June 1993 employment in the Polish economy fell by 6.9 per cent whereas in lease-buy-outs it fell by 10.9 per cent."' The study also shows that from the end of 1991 real wages in leased enterprises first rose by 4.6 per cent and then fell to ten per cent below the starting level by the first half of 1993. In contrast, the enterprise sector as a whole saw real wages initially increase by 18.1 per cent before falling to finish the period an eighth below the level seen at the end of 199 1. The same survey shows that wages increased more in those companies where the reduction of employment was greater.

The financial situation of the firms post-privatization appears to depend upon the time at which the lease was agreed. In the early stages of privatization the value of assets was estimated to be higher than book value (which implies higher instalment payments), whilst over time the value of state enterprises was estimated to be lower than the book value.

The authors of two major recent surveys, Jarosz (1994a, b) and Szomburg (1994), differing in their general assessment of buy-outs, agree on one point: firms for which this privatization method has been designed, i.e. small firms (less than 100 employees) operating in a very competitive environment, such as trade, have serious financial problems; medium-size (over 300 employees) industrial firms less exposed to competition are the most efficient. The main weakness of the Polish leased enterprises seems to be lack of capital and low propensity to invest, and their main strength the strong support from their employees. Unfortunately, trying to deal with the former, e.g., by letting in outsiders, may destroy the latter.

2.3. Russia 2.3.1. Privatization buy-outs In Russia the principal routes to effecting a buy-out have been the lease and voucher methods. Significant numbers of enterprises which were leased by their workers' collectives under the provisions of Article 7 of the 1989 Principles of Leasing Legislation of the USSR are now exercising their option to buy out the assets using instalment payments to make the purchase. When options to buy are exercised, this may be an appropriate stage at which to introduce new investors to enable new investment to take place as well as for restructuring to be effected. The second and most important route, following the introduction of the Russian Privatization Programme in 1992, involves buy- outs which are effected through the use of vouchers issued to the wider population (Chubais and Vishnevskaya, 1994; Boycko et al., 1993)."

In the voucher privatization of medium and large enterprises, a proportion of the shares in an enterprise were made available to employees through a closed subscription either in return for vouchers or at a preferential rate for cash, or both. The remainder of the shares were then typically offered for open auction with buyers paying in vouchers or in cash or a combination of both. Management and employees could participate in the auction so as to increase their shareholdings. Such buy-outs may be used to help satisfy public demands for an equitable distribution of the ownership of assets to be privatized, but may introduce problems of diffuse shareholdings and control. Of the three variants available under the privatization programme, the second and most popular enabled employees and managers to buy out 51 per cent of the shares of the enterprise at their


face value in the closed subscription (see, e.g., the cases of Bolshevik and Uralmash in Wright, Filatotchev, Buck and Robbie, 1993).12

Another means of effecting privatization is a combination of a buy-out with a public offering and a private placement of shares. An example of this kind of combination is the privatization of the Red October confectionery company, which is part of a broader government-sponsored effort to encourage industrial companies to raise equity finance through primary equity markets. Of the 3.5 million shares being offered, one million are allocated to private Russian investors, 1.5 million to domestic institutional investors, with the rest being marketed to international investors."

During 1993, the first year of the Russian privatization programme, almost one thousand medium- and large-scale enterprises a month were transformed into joint-stock companies and privatized through the combined buy-out and voucher auction procedure. As a result, from the end of December 1992 up to June 1994 more than 13,000 medium and large state-owned enterprises in Russia became private companies. Total employment in these enterprises amounted to 15.7 million people or 76% of total industrial employment in Russia (Obzor economiki Rossii. Osnovniye tendentsii razvitiya, Moscow, 2, 1994, pp. 125-126). Within the total of enterprises using the voucher route, about four- fifths chose variant 2 (State Property Committee, 1993).

2.3.2. Pos f-priva f iza tion changes The results of 171 face-to-face interviews of buy-outs using a questionnaire designed by the authors carried out in St. Petersburg. Moscow, Yekaterinburg and Nizhny Novgorod regions of Russia between March and September 1994 provide evidence of extensive post-privatization changes in respect both of the restructuring of activities as well as governance and finance.

Table 3. Changes in Russian buy-outs post-privatization (percentage of totul number of responding companies in each row)

Variable Increase Increase No Decrease Decrease Total more than up to change up to 10% more than respond-

10% 10% 10% ents(%)

No. employees Sales volume Investment in plant and machinery as a proportion of sales Trade credit as a proportion of sales Trade receivables as a proportion of sales State subsidies as a proportion of sales Inventory as a proportion of sales General wage rates as a proportion of Sales

1.8 10.5 7.2

4.7 28.7 7.6 22.8

16.2 38.9

26.9 15.8 8.4

38.0 100.0 43.3 100.0 29.3 100.0

21.4

18.9

I .2

16.5

24.7

10.1 44.6

13.6 37.3

1.2 73.5

15.9 34.7

22.4 33.5

11.9

8.9

1.2

12.9

9.4

11.9 100.0

21.3 100.0

23.1 100.0

20.0 100.0

10.0 100.0

~ ~~~~~ ~~

Source: Authors' survey; sample size = 171


One year after privatization there had been an increase in employment in 6.5 per cent of enterprises, with a fall in employment exceeding 10 per cent in 38 per cent of cases (Table 3). In contrast, in the year prior to privatization employment had remained unchanged i n 46.8 per cent of the sample and had increased in 9.4 per cent. Post- privatization, almost a half (47.1 %) of Russian buy-outs reported an increase in general wage rates as a proportion of sales revenue. Almost a fifth reported a decrease.

Evidence of changes in the distribution of managerial and employee share ownership is beginning to emerge." The survey shows that between privatization and one year afterwards, the average share of the equity held by non-senior managerial employees had on average fallen from 47.4 per cent to 46 per cent. The average stake held by the State Property Fund fell sharply from 22.8 per cent to 14.1 per cent, though it remained one of the most significant shareholders. This increased the stakes of management (from 19.4 per cent to 21.3 per cent), of private and institutional external investors (from 6.2 per cent to 10.8 per cent), of industrial groups (6.3 per cent to 10.4 per cent) and of banks (0.2 per cent to 0.7 per cent).

Some of these changes arise from reductions in the stakes held by the State Property Fund. However, despite managements' attempts to frustrate share sales by workers it is becoming clear that this is happening. Evidence from other surveys indicates that workers are selling shares to voucher funds.'' Our survey provides evidence that managers are acquiring. shares from employees. Indeed, in 27.6 per cent of enterprises, managers claimed that they had already purchased shares from employees. Some 62.1 per cent of enterprises said that they still intended to purchase shares from employees. Notable examples of the changing relative positions of management and employees are as follows. In the case of "The Boiler and Turbine Production Plant", a 200-employee company in St. Petershurg privatized using variant 2, the equity held by management rose from 40% to 52% between privatization and the time of our survey. The stake held by employees fell from 60% to 38% in the same period. In the case of the 400-employee "Nadezhda" textile factory in Moscow, wholly owned by managers and employees, the former held 25% of the equity on privatization whilst the latter group held 75%. By the time of our survey, these relative positions had been exactly reversed.

Employees are reported to be relatively uninvolved in governance. Active board representation by employees fell after privatization to only a quarter of cases, from being present in three in ten cases beforehand. Formal consultation on strategic issues rose slightly after privatization and was found in 58 per cent of cases. Informal consultations on these issues showed a modest rise from 45 per cent of enterprises prior to privatization to 49 per cent afterwards. Only 15 per cent of enterprises reported that employees constrained managers' ability to manage the company.

Table 4. Post-privatization outside shareholdings and channels of control (percentage of total number of responding companies)

Outside investor Chairman Director Otherwise Passive None active

Private individual 5.9 11.2 5.3 14.2 70.6 Investment fund 2.4 9.5 2.4 7.1 80.5 Another firm 2.4 11.2 8.9 7.7 76.9 State Property Fund 3.5 21.3 5.3 13.5 65.9 Bank 1.2 4.1 5.9 11.2 79.4

Many firms responded positively to more than one category, so that percentages in the rows sum to more than 100 per cent. Base of percentages is 17 1.


Despite their low levels of equity holdings, the evidence suggests that outsiders are represented on boards or are otherwise present as active investors to a greater extent than their shareholdings would indicate (Table 4). In most of the sample there are no active or passive outside investors, but in three-tenths of cases, private individuals are involved in control, and in almost a quarter of cases other firms. Banks and the state property fund also fulfil an active role, notably as directors and to a lesser extent as chairmen of the privatized enterprises.

Marked changes in the financial situation of enterprises in the Russian sample can be identified. One of the most notable is a fall in sales volume in 59.1 per cent of firms in the sample (Table 3). It appears that increasing the value of outstanding creditors continues to be an important source of finance. Over a fifth had increased their creditors/sales ratio by more than ten per ccnr post-privatization. There was a relatively even spread in the direction of movement of funds tied up in debtors and inventories, with some enterprises displaying marked reductions in debtors and stocks.

The extent to which more direct sources of finance have been used is shown in Table 5. In the majority of firms in the sample, the most important sources of finance were funds raised through the sale of assets and new bank loans. In 40% of firms the extent of new borrowing was considerable in relation to the size of the enterprises' sales. In 15% of cases the new loans raised were equivalent to more than a quarter of the enterprises' sales.

Table 5. Sources of funds raised post-privatization in Russia Source of funds Percent. of Percent. of sample Percent. of sample Total

sample not deriving funds deriving funds from (%) using each from each source each source (over

source of (up to 25% of 25% nf sales) funds SaleS)

Sale of land 93.4 6.0 Letting of land 62. I 34.9 Sales of surplus 56. I 42. I equipment New loans 44.8 40.2 Existing shareholders 87.4 10.8 New shareholders 87.4 12.6 Increased trading 45.2 44.6 revenue

0.6 loo 3.0 I00 1.8 100

15.0 loo 1.8 100 0.0 loo

10.2 loo

Source: Authors' survey

The largest single use of finance involved short-term factors, particularly to increase working capital (Table 6). A further tenth of finance was used for primarily short-term purposes such as to pay dividends and wages. Nevertheless, a significant proportion of funds, approaching a quarter (21.4 per cent) was being used for investment in capital equipment and some 12.4 per cent for R&D and new product development.

The Russian financial system was previously characterized by large state subsidies, huge inter-firm debts and banks doing little to enforce the repayment of loans. In almost three-quarters of Russian cases state subsidies as a proportion of sales remained unchanged post-privatization,'" but almost a quarter of firms in the sample reported that subsidies had fallen. If the state gradually hardens budget constraints by refusing to bail


out firms which are heavily indebted, the level and extent of inter-company trade credit is expected to fall.

Table 6. Uses of funds post-privatization

Type of use of funds Proportion of funds in each use (%)

Investment in plant and machinery Working capital Buying shares in other enterprises Buying out external shareholders Research and development Dividends and wages Other Total

21.4 48.5 0.9 0.6 12.4 10.2 6.0

100.0

Source: Authors’ survey; based on 131 companies who provided full information

Managers expect financing constraints to be hardened. In the year before privatization only a quarter of enterprises (27.5%) experienced increased pressure from banks to repay loans. After privatization, three-fifths (60.9%) anticipate that banks would increase such pressure over the coming two to three years. These results indicate that Russian enterprises are still exposed to relatively soft budget constraints, though these are getting harder as the pressure to repay bank loans is growing and state subsidies are diminishing.

2.4. Summary The privatization process and post-privatization changes in the three countries outlined in this section show that buy-outs are very important in Russia, but less so in Hungary and Poland. In Russia, some four-fifths of enterprises privatized using vouchers have adopted variant 2 which allows management and employees to obtain a majority equity stake. In Hungary about a third of enterprises privatized under self-privatization involved buy-outs. In Poland, two-thirds of privatized companies were leased to employees.

The initial post-privatization experience of bought-out enterprises discussed in this section shows, counter to expectations, widespread reductions in employment and control of real wages, particularly in Hungary and Poland. It also highlights several governance and finance problems. There appears to be relatively little investment being undertaken; in Poland and Hungary commitments to instalment payments and borrowings, respectively, leave little funding for such actions and make external finance difficult to obtain.

A common feature across the three countries was the decline in share ownership by employees as a whole with a corresponding increase in managements’ and outside investors’ stakes, though the change in the comparative holdings of outsiders varied between countries. In Russia in a comparatively short time since privatization, acquisitions of substantial equity stakes by management and by outsiders, especially private and institutional investors and industrial groups, was evident. Investment funds do not seem to be active in monitoring. In Poland the decline in employee ownership was accompanied by the rise in share ownership by external investors and managers. In Hungary, in contrast, little movement in ownership structures was observed, though there appeared to be a modest increase in the concentration of managerial shareholdings and a corresponding reduction in employee and outsider holdings. Increases in management equity holding may have some positive impact on corporate governance, especially if


managers have to borrow to fund the purchase of shares and are constrained to improve performance in order to be able to repay loans. However, i t needs to be borne i n mind that increasing managerial share ownership does not involve the introduction of new finance for investment.

3. Post-privatization governance and finance

The evidence in the preceding section suggested that the initial ownership structure upon privatization has shifted in favour of external ownership. There are four types of potentially active investors in CEE: banks, domestic and foreign companies and wealthy individuals, and non-bank financial intermediaries (such as investment funds and venture capitalists). In the case of small firms wealthy individuals may also be an important source of management oversight. We now discuss their ability to monitor management and to provide finance for investment.

3.1. Banks Conventional buy-out theory in the West places considerable emphasis on the role of the providers of finance for the buy-out itself and the need to service this form of finance as hard constraints on the behaviour of managers (Jensen. 1986). Failure to meet interest payments gives an early warning signal that remedial action is required. In the classic US-type leveraged buy-out model, the appropriate candidate for such a transaction is an enterprise in a mature industrial sector, with stable and significant cash flow and with low investment needs. Creditors are viewed as introducing mechanisms such as debt covenants and requirements for the supply of regular financial information which places pressure on management to engage in value-enhancing actions. Evidence suggests that in this type of buy-out such actions are indeed successful, at least in the short term (see, e.g., Palepu, 1990 for a review). Whilst these mechanisms help minimize the risks of default, after meeting debt repayments there may be little cash flow available to engage in new profitable investment.”

In both Poland and Hungary, buy-outs involve considerable commitment either to service external borrowing or meet instalment payments. In this sense they might appear similar to the classic US-type buy-out described above. However, there are differences in a number of areas. The main difference is due to the fact that the party which contributes in a significant way to finance buy-outs in Poland and Hungary is the state, the same party which is the seller and which sells because it has proved to be unable to monitor these enterprises in the past. Moreover, income streams in these enterprises may be considerably less stable than in mature sectors in the West. At the same time their investment needs are much higher because of the extent of necessary restructuring (Grosfeld and Roland, 1995).

However, in most countries in transition, real interest rates are prohibitively high and enterprises are not keen to use long-term debt. On the other hand, the attitude of creditors is also very cautious. Although employee-owned firms always have problems with raising outside capital for investment, in a period of profound economic transformation such financing may even be more difficult. In Poland and Hungary banks initially burdened with bad loans have improved their financial health and have become more careful in extending new credits. They are unlikely to engage in new lending and provide fresh cash for investment and restructuring purposes without considerable collateral. Problems with obtaining reliable financial information on which to base a decision, doubts about the value of assets and uncertainties concerning the property rights make banks cautious in


their assesment of the amount of collateral available. In Hungary, evidence from the authors’ survey of buy-outs, as noted earlier, suggests that the value of the security demanded usually amounted to one-and-a-half times the total value of the loan.

Even within these generally problematical conditions. pure buy-outs may be viewed by the banks as a greater credit risk than other enterprises. Evidence from a survey of the nine main commercial banks in Warsaw shows that management and employee buy-outs with exclusive insider-ownership are generally rated as greater credit risks than those buy-outs which have been able to attract foreign or strategic investors (Solarz, 1994).

There are, however, attempts to alleviate these problems. In Hungary, for example, the need to provide collateral has been reduced by a change in SPA policy in 1993 which meant that only 50 per cent of the shares plus one could be sold to incumbents in a buy- out. With the passage of the MRP (ESOP) law, collateral requirements also became more regulated as it contained detailed rules concerning the bank lien over the property of ESOP groups. In early 1993, a new institution was established to offer guarantees for ventures which, though promising, could not provide the necessary guarantees. The Credit Guarantee Co. Ltd. was authorized to assume risk up to HUF 100 million and up to 80 per cent of the required collateral. Since this institution became involved, the level of collateral has dropped from one-and-a-half times the size of the loan to just 70 per cenr. Although a generally available scheme, most of this new institution’s early clients were employee groups, the introduction of the scheme removing one of the largest obstacles to the granting of finance for buy-outs. There is a danger, however, that this process will reinforce the practice of using personal contacts and political influence in obtaining finance, with less emphasis being placed on an enterprise’s income-earning potential or its ability to provide property guarantees (Voszka, 1992).

In Poland, the leasing procedure requires that the down-payment on a buy-out cannot be lower than 20 per cent of the capital of the privatized state enterprise. Transfer of ownership occurs after all capital and interest have been repaid. As a result, companies have been deprived of the possibility of using assets as collateral in taking long-term credits. In the new bill on privatization it is proposed, however, to allow for the transfer of ownership rights before the full value of the capital has been repaid.”

Russian enterprises, in contrast, are not exposed to any significant additional debt as a result of the buy-out. Although the voucher auction does not bring any fresh cash into the company, the banking system may f i l l this gap in the future and provide much-needed finance for restructuring purposes. However, Russian banks are aware of the problems with corporate governance within newly privatized companies. Consequently, banks may be reluctant to provide privatized Russian companies with long-term credits as long as corporate governance problems have not been solved and will focus on short-term lending. In addition to the problems emanating from high interest rates already noted, the provision of long-term financial resources to industrial organizations with governance structures which are inadequate in the new market environment will inevitably increase the systemic risk within the fragile system of Russian commercial banking.

3.2. Domestic and foreign companies and individual shareholders Whilst much attention has focused in the West on highly leveraged buy-outs, a common feature of some buy-outs also involves the retention of an equity stake by the vendor or the taking of a share of the equity by another industrial company. If such arrangements arise in CEE they may have important governance and finance implications. In respect of finance, such equity stakes can be linked to commitments to contribute towards investment financing and, thus, can reduce the need for raising external finance.


In respect of corporate governance, the presence of an outsider with a significant equity stake provides for direct influence on the direction of the company. However, an important pre-condition for a long-term commitment is the existence of mutual trust between the parties involved. Foreign firms may be reluctant to become involved unless they can obtain majority control, which insiders may be unwilling to cede. Employee- owners may be unwilling to enter such a relationship where they perceive that the other party may want to close capacity, etc. Similarly, the incoming party may be reluctant to become involved where an unacceptable level of uncertainty exists about conditions inside the enterprise. There are also indications, for example, from Hungarian experience, of the vulnerability of CEE enterprises to exploitative behaviour by enterprises from outside the region. For example, while i t may appear attractive to sign a bilateral agreement according to which a foreign firm takes an equity stake and agrees to buy a given level of orders at a guaranteed price and a CEE enterprise purchases foreign capital equipment, enforcement of the foreign enterprise's commitment may be difficult. In Poland, foreign firms and domestic legal persons are not allowed to participate in the initial buy-out transaction, except in the regions with high unemployment.

It is perhaps not surprising that in the few cases in Russia where employee owners and outside firms have become involved in joint ownership, there existed previously a long-standing relationship between the parties involved (Khaykin. Lindquist and Ackerman, 1993). Similarly, in the buy-outs interviewed by the authors in Hungary, external firms which had become involved in equity ownership had frequently had a relationship with the buy-out at least since the time of corporatization. A further route to develop trust is provided by the Russian privatization legislation whereby 20 per cent of the shares of an enterprise can be acquired through an investment tender rather than an open auction. Hence, it is possible to achieve a joint buy-out whereby a prospective outside investor reaches an agreement with incumbent management and employees on issues concerning job security, salary levels, distribution of ownership and profits, and amount and type of investment to be contributed by the outside investor. Having established a relationship at the privatization stage, the outside investor may subsequently be able to secure agreement to increase its shareholdings either by direct purchases from incumbents or, perhaps less threateningly, through increasing the capital of the company. Over time the proportion of shares acquired in this way may become a controlling one, though for the time being the continued importance of incumbents indicates that they are likely to retain a significant equity stake.

The efficiency of such joint buy-outs would depend upon the degree of product market competition. Contrary to Hungary and Poland, in Russia i t proved impossible to inject a significant degree of competition at the start of the privatization process." As a result, governance structures which develop in buy-outs and which involve industrial partners may serve to rigidify the existing inefficient structures rather than to restructure them. There is also a fear that the creation of such joint buy-outs may hide questionable financial interests of the old nomenclature and even criminal connections.

Individual shareholders initially external to the enterprise may also have a role to play in the governance and finance of buy-outs in CEE. They may become involved either in a main controlling and ownership capacity (a management buy-in) or as minority active investors (so-called informal venture capitalists or "business angels") (See Robbie er al., 1992, for a general discussion).

As seen earlier, private individuals do have an active governance role in a significant minority of Russian buy-outs. In the Uralmash Heavy Engineering Amalgamation in Russia, where the workers collective acquired 50% of the shares on privatization, a fifth of the shares were unexpectedly acquired by the private company "Bioprocessor", owned


by one of Russia's wealthiest individuals. It was agreed that "Bioprocessor" would not interfere in operational decision-making in Uralmash but that its senior managers would take seats on the board of directors of Uralmash. In Poland, the Ministry for Ownership Transformation has proposed to modify the privatization law by imposing an additional condition on companies privatized through liquidation and leased to the employees: at least 20 per cenf of capital should be made available to outside investors (Ministry for Ownership Transformation, 1995).

3.3. Non-bank financial intermediaries Non-bank financial intermediaries include a number of institutions, such as pension funds, investment funds and venture capital funds. The way in which these institutions become involved in corporate governance varies considerably depending upon regulatory frameworks, incentive schemes and the skills of fund managers (Frydman e f al., 1993): they may choose long-term relationships and constructive intervention or prefer passive trading of shares in order to maximize short-term returns.

Evidence in section two showed that investment funds may play in Russia, but not in Poland and Hungary, a potentially important role in enterprises privatized as buy-outs. Control by a private investment fund introduces the opportunity to split up an enterprise or to strip it of its assets, and may be especially attractive where there are substantial city centre land and buildings which can be redeveloped. Such a prospect may become feasible as markets in land and buildings become established and make assets of this kind valuable after a long period in which they have been ignored or undervalued in accounting statements. Such restructuring may perform an important function in reallocating them to more productive uses than previously.

It is premature to say, however, whether investment privatization funds will exert effective corporate governance. According to a preliminary assessment by Frydman e f al. ( I 994), the behaviour of investment privatization funds appears, for the time being, very heterogeneous. There are funds that have been captured by managers: funds closely supervising and exercising pressure on management; opportunistic and rent-seeking funds striving for various exemptions and privileges from the state and which may benefit if the government maintains soft budget constraints; funds passively trading shares; and finally funds that show a combination of these characteristics."

The extent to which investment funds in Russia can contribute finance for investment in the companies in which they have an equity stake is also debatable. Though in principle the typically significant shareholdings held by banks in voucher funds means that they could be important agents for channelling investment funds into Russian firms, in practice share sales may be encouraged by severe cash constraints on the funds, raising doubts about their ability to set aside adequate amounts for the follow-on finance which will often be required for post-privatization enterprise restructuring. Hence, at present there appears to be at best little evidence that investment funds are actively contributing to the long-term growth of enterprises.

Given an urgent need for investment finance and the weakness of managerial skills, it seems that the emphasis of the process of external funding of buy-outs in CEE has to be shifted from debt to equity financing with core investors exercising a higher degree of monitoring and control in newly privatized enterprises. Problems of these companies could be alleviated by the emergence of investors closely involved in the process of strategic and operational decision-making and with a serious financial commitment to the business.

For the majority of management buy-out transactions in the West, venture capital funds fulfil this role in the market. In the case of such intermediaries the provision of


capital, through various types of instruments with greater or lesser commitment to make dividend payments, is correlated with managerial expertise which goes beyond purely financial analysis to marketing, industrial management, strategic search, etc. (Sahlman, 1990; Jensen, 1993). Managers of venture capital funds typically have high-powered incentives to monitor closely the performance of enterprises.

Venture capitalists can help to solve the dual problem of an inadequate system of corporate governance and a lack of long-term finance for restructuring and investment in CEE. They offer a form and style of financing which is not provided elsewhere in the spectrum of financial services available in CEE so far, in respect of its combination of a certain length of commitment with greater involvement and a degree of influence over the companies in which equity stakes are taken (Beecroft, 1994). Unlike existing investment funds in CEE, the venture capitalists’ commitment includes helping companies in restructuring during the process of transition. helping to find suitable management and assisting in rescue packages.

However, few venture capital funds have yet appeared in CEE: for the time being the major source of venture capital seem to be Western institutions such as the EBRD, IFC and American pension funds (Grosfeld and Roland, 1995). The largest funds in most countries are American Enterprise Funds which have been established by the United States Congress’ Support for Eastern European Democracies Act and which invest US government and private money. Because of high aggregate uncertainty they face serious adverse selection problems in investing in enterprises and may be even more reluctant to invest in buy-outs. In Poland evidence indicates that the bottleneck in financing investment projects may not be lack of capital but the scarcity of good ideas with reasonable prospects for success (Grosfeld, 1994). Also in Hungary it appears increasingly difficult to find good investment opportunities: venture capital funds have been mainly involved in the funding of joint ventures with some level of foreign participation rather than buy-outs where there are concerns about the returns available (Kocsis, 1993). Moreover, it is also important to bear in mind that incumbent management may wish to choose an investor who does not want to exert close moni toring.2’

4. Conclusions

This paper has examined the interrelated problems of governance and finance in privatization buy-outs in three countries of CEE with contrasting experiences. In each of Hungary, Poland and Russia, buy-outs have accounted for a significant proportion of enterprises which have been privatized. Post buy-out changes have generally focused on the restructuring of employment and controlling real wages, especially in Hungary and Poland but to a lesser extent in Russia. In all three countries, buy-out firms have difficulty in financing investment.

Employees and management buy-outs have proved to be an efficient mechanism of transfer of a substantial share of assets from the public to the private sector. The results of mass privatization are numerically spectacular in Russia, where many thousands of state-owned companies have been taken over by insiders in less than two years. In the long term, however, buy-outs may not necessarily prove to be a permanent feature of the emerging economic structure.

Newly privatized companies are suffering from the combination of two problems: an inadequate system of corporate governance and a lack of external finance. The longevity of buy-outs will largely depend on the degree of product market competition, the

a4 Buy-outs in Hungary, Poland and Russia

particular shape of evolving financial systems and on the strength of newly emerging institutions (investment funds, venture capitalists, etc.). The emergence of venture capital firms capable of providing capital and managerial expertise can be seen as a particularly desirable means of bringing in adequate corporate governance and finance. Now the role of the state is to create an adequate regulatory environment ensuring that the newly established relations between recently privatized companies, financial and non-financial stakeholders and lending institutions will favour economic efficiency improvements and will promote corporate restructuring and technological modernization.

Endnotes

I .

2.

3.

4.

5.

We are indebted to two anonymous referees for helpful comments and to Jacek Bukowski for interesting discussions. The following sources of financing for this research are acknowledged: Filatotchev, Wright and Buck thank the European Bank for Reconstruction and Development, Economic and Social Research Council grant no. R000221142, Touche Ross Corporate Finance and Barclays Development Capital Limited; Irena Grosfeld thanks Commissariat General au Plan and Ministtre de Recherche et de I'Espace; Judit Karsai thanks the Hungarian National Scientific and Research Foundation grant no. T 4583, "Domestic and foreign experience in management buy-outs". Judit Karsai, Research Institute in Industrial Economics, Budapest, Hungary; Mike Wright and Trevor Buck, Centre for Management Buy-out Research, University of Nottingham. A feasibility study is required to be prepared by the organizing committee of the ESOP, and countersigned by the company, to establish that the financial situation of the company makes the operation feasible and to determine the proportion of shares to be made available to employees. The law obliged an enterprise to file for bankruptcy within eight days if payment arrears exceeded 90 days. The law allowed for financial restructuring where each creditor agreed on a proposed restructuring plan submitted by the debtor within 60 days of filing for bankruptcy. If an enterprise had undergone a restructuring procedure in previous three years it was obliged to file for liquidation. In July 1993 the law was eased, replacing automatic filing for bankruptcy with a requirement that a majority of creditors had to agree to such action and introducing the need for a simple majority of creditors representing 75% of the outstanding debt to agree to a restructuring rather than unanimous consent. Between January 1992 and October 1993 there were 5,130 bankruptcies out of which 1.963 were completed, of which 53% were settled by agreement between creditors and debtors. In the same period there were 16,031 liquidations filed out of which 1.462 were completed (Privinfo, 1994. VI.1, pp.37-38). According to estimates prepared for the Ministry of Finance in early 1995, a quarter of the enterprises owned by the state in 1990 and transferred to the SPA had been liquidated and dissolved by the end of 1994. The interviews lasted between one-and-a-half and two hours and were conducted on the basis of a detailed questionnaire with at least two senior managers and one representative of the ESOP in each enterprise. The enterprises cover the entire period of self-privatization and reflect the relative proportions of the industrial sectors which have been privatized.


9.

10.

1 1 .

12.

13.

14.

15.

Indeed, eleven of the fifteen firms which received credits financed more than seventy per cent of the purchase price from loans. E.g., Gdansk and Szczecin Shipyards, Wedel, Gorazdze, Polifarb Cieszyn, Kwidzyn, Strzelce Opolskie and Tonsil. Confusion is often made between privatization liquidations and liquidations according to Article 19 of the law on state-owned enterprises. The latter applies to enterprises in poor financial condition and aims at satisfying creditors. Only 9 enterprises liquidated according to Article I9 have been bought by (or leased to) the employees, cf Prywatyzacja przedsiebiorstw panstwowych, 1994. Such transfers of shares are voluntary (an employees' shares need not be sold upon termination of employment). It should be stressed, however. that buy-outs studied by Jarosz er al. (1994a, b) were established before 1992 and, as other Polish enterprises, adjusted mainly by reducing employment. In firms leased after 1992 the extent of lay-offs is probably more limited. Large enterprises employing more than 1,OOO people or having a nominal capital of more than Rbs 50 million at the beginning of 1992 were to undergo compulsory privatization. Medium-sized firms with between 200 and 1 ,OOO employees could choose to be privatized through this route. Small-scale firms with less than 200 employees and/or with a book value of less than Rbs 10 million are subject to privatization through auctions and tenders with management and employees having the right to bid and the right of first refusal if they can match the bid of outsiders. For the purpose of the buy-out, managers and workers may create a so-callcd "Enterprise Workers' Share-Ownership Fund" using a maximum of 10 per cent of the previous year's profits and 50 per cent of non-distributed wages and bonuses also from the previous year. Employees can use this fund to buy-out up to 10% of all shares of their enterprise. The issue has been underwritten by Russian companies and financial institutions and part-financed by the UK Know-How Fund (Financial Times. 30.1 1.94). Other surveys of ownership, which include some post-privatization trading of shares, show that managers and employers own on average between 60 and 70 per cent of the shares, of which about 17 per cent is owned by the management team (see discussion in Boycko et al. 1993). Outsiders own on average about 14 per cent and the property fund the remaining 16 per cent. See Frydman er al. (1994), who show that in 55% of the funds in their sample workers are active in selling shares to them. They also report, however, that actions by managers constitute a substantial harrier to workers selling their shares to outsiders. Our own evidence shows that in the specific case of Bolshevik Biscuit, a 2,200-employee company with generally sound performance and a spacious office building and workshops close to the centre of Moscow, the workers' collective bought about 70 per cent of shares through the closed and open subscriptions available under variant 2 with management obtaining only five per cent. A quarter of the shares were acquired by the private investment fund Alfa Capital. some of which were bought at the time of the auction and the remainder through a concerted campaign to persuade employees to sell their shares at prices which represented a very significant real gain on their nominal value. The General Director and Alfa Capital have contlicting objectives. The former wants to use all net profits for reconstruction and modernization of old workshops, whilst the latter is primarily interested in dividends on its investment. The General

86

16.

17.

18.

19.

20.

21.

Buy-outs in Hungary, Poland and Russia

Director initially survived only after promising shareholders that dividends would be distributed at the end of the financial year, although subsequently outsiders obtained majority control. This also includes companies which have not been receiving any kind of subsidies even before privatization. In larger US leveraged buy-outs evidence generally shows that capital expenditure and research and development expenditure fall immediately following the buy-out and that there are significant levels of asset disposals, though R&D-intensive buy- outs on average increase bank debt on buy-out and maintain expenditure on the most productive R&D projects. Evidence for the UK, where venture capitalists have a more significant role to play, and where the degree of leverage is generally lower, suggests a much lower level of asset sales which is more than offset by new capital investment (see Wright, 1994, for a review of the international evidence). One of the proposals of the Ministry for Ownership Transformation is to allow for the transfer of ownership after two years if at least 30 per cent of the capital has been paid back. However, given the fact that interest rates applied to leased capital are half of those applied by the National Bank of Poland, it may be expected that firms will prefer to locate their surpluses on bank deposits rather than pay back the debt. Though attempts are being made with the help of foreign antitrust agencies to establish such a working regime. They find little evidence that investment funds have been proactive in effecting dismissals. Ejecting insiders may be difficult unless funds can persuade the body of employees to reject incumbent management. Hence, it is possible that by working with management rather than adopting a hostile stance changes can be effected. The problem, however, is that funds may become more concerned with bolstering managerial entrenchment than effecting independent corporate governance. A high degree of trading by certain investment funds may be the result of substantial windfall gains which may be available from selling the stakes acquired on privatization. In turn this raises the opportunity cost of restructuring and reduces the incentive to become an active investor. Moreover, if individual managers in intermediaries do not have their own wealth exposed to loss, they may not be particularly concerned about value maximization. There are, however, examples of the involvement of venture funds in buy-outs:

. Polish-American Enterprise Fund has invested in two leased firms: ESPEBEPE, listed on the stock exchange, and Gdansk textile firm "Fala" (Rzeczpospolifa, 4.1 1.1994).

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Buy-outs in Hungary, Poland and Russia: governance and finance issues

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