Getachew Beshahwred
The government is in the early, and in some cases advanced stages, of privatisation which has led a limited number of private organisations and individuals to organise a conference or a forum to discuss the advantages and disadvantages of privatisation and its implications for the wellbeing of the economy, the country and its citizens. Government representatives have participated, (though limited) at these meetings. It seems the government is in a listening mode which is quite a pleasing change. However, I do believe the government should be more active in this respect before embarking upon the process of privatisation which is quite complex and sometimes irreversible. It needs to do its homework properly before agreeing to sell any parts of the publicly held companies. It is quite important for the government to continue with its listening exercise by organising its own conferences, discussion forums and advisory groups in a more structured way. It should consider forming an advisory or a steering group consisting of professionals (young and old) academicians and most importantly people with relevant experience. I believe a balanced view or advice could come from such a group.
In any case I would like to congratulate the government and the ministers who have at least opened up the door for comments and discussions about a major government policy. Today I deal with the issue of Debt and equity. It seems there is an expectation that privatisation would lead to less debt and higher equity. There may be a huge expectation gap.
At one of the recent conferences on privatisation, a government advisor stressed that one of the main reasons for privatising some of the biggest publicly held companies is the huge debt in their balance sheet which, according to him, has to be repaid. The reasoning behind this thinking is obviously the distinct possibility of using the proceeds from privatisation to repay the lenders and creditors thereby eliminating or at least reducing the debt of the companies. Moreover, the expectation is that the new private owners would then invest in the company in the form of equity rather than debt. The implicit assumption in all of these is that equity is always better than debt. Really?
let us examine the following:
Is debt bad?
Would private investors take on a publicly owned company with all of its debts? If they do, what would they require in return?
Would the new private owners make more equity investment in a publicly held company after it is privatised?
Is debt bad?
Almost all companies are financed through a combination of debt and equity. It is just a question of balance which depends on a number of factors. However, the generalisation, like many other generalisations, that ‘equity is better than debt’ is wrong. It is the QUALITY rather than the quantity of debt that matters. Borrowing for investment could be even be less costly than equity investment especially in time of low interest rates. In addition, interest can be used to reduce corporation tax since it is an allowable expense. Moreover, governments could obtain favourable terms due to the security they can provide.
Would private investors take on a publicly owned company with all of its debts? If they do, what would they require in return?
They may; but at a price; the proceeds from privatisation would reduce accordingly. It is not unusual to hear that a company has been sold for £1. This is not because the company is worth just £1 but because it is hugely in debt and the new owners would agree to take over the company with all of its debts. But in some cases, new investors may not be keen to take over a company with huge debts as it happened during some of the privatisations in the United Kingdom. For instance, in 1989, the UK government took on all debts of the water companies (£4.9 billion) before they were privatised leaving the companies debt free at time of privatisation. This could happen in Ethiopian privatisations too.
Would the new private owners make more equity investment in a publicly held company after it is privatised?
You would think so. But that is not the case. In the United Kingdom some investors borrowed to acquire a publicly held company and then took on more debt, using the assets of the newly privatised company as a security. For instance, the former owners of Thames Water, the Australian bank Macquarie took a loan of £2.8 billion to buy the company and then loaded £2 billion Cayman Islands debt onto Thames water and its customers. Now Thames Water is more than 50% owned by a Kuwaiti investment fund, Abu Dhabi Investment Fund, China Investment Corporation and a Canadian pension fund.
As the graph above shows the UK government, at the time of privatisation, took on all debs of the water companies. However, with in just four years the debt level has returned to Pre-privatisation level and by 2014-15 the total debt of the water companies was £47 billion. A report from the University of Greenwich has found that the 40% real increase in English Water bills between 1991 and 2015 was not as a result of higher investment but due to the huge interest on debt. The report also found that in the same period a total dividend of £50 billion was paid to shareholders.
Hence, debt of a publicly held company by itself is not a valid reason or justification for privatisation. As long as the company is earning a return on its investment which is greater that its cost of capital (especially the interest its pays on its debts) and it has a healthy cashflow to repay its debts, the level of debt should not matter.
Getachew is the Managing Director of GB & CO. London. He can be contacted at getachew@gbandco.co
