Privatization of real options

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Many privatization objects have characteristics of real options in the sense that a substantial investment is required in order to make the asset productive while at the same time there is uncertainty about the future value of the asset. This paper explores several auction designs for the privatization of such assets and shows how government revenues depend on the auction designs. As a benchmark, the paper analyzes revenues from an auction with cash only. It is demonstrated that a bid that includes a bidding firm's pledged investments at the time of investment as to stimulate regional development is inferior to a cash only bid. Investments which are made compulsory by the government at the time of the actual investment or retained shareholding by the government, both announced before the auction, can augment the government's payoff. Journal of Comparative Economics 36 (3) (2008) 489–497.

Introduction

Privatization, the process of government divestiture of its holdings in state-owned companies, has received enormous attention by both scholars and policy makers with the goal to determine its effect on both individual companies and on governments (Megginson et al., 2004). There are three main methods of privatization: share issue privatization, voucher privatization and asset sale privatization. The main reasons to opt for privatization are:

  • (i)

    the belief that private firms can make more efficient use of an asset than a government can, and

  • (ii)

    the revenues that it generates for the government (Lopez-de-Silanes, 1997).

An auction is generally perceived as an efficient instrument to allocate a former state owned firm to the firm with the highest valuation and to extract as much revenue as possible (Schmidt and Schnitzer, 1997).1 Lopez-de-Silanes (1997) reports that auction revenues from the privatization of 65 enterprises in Mexico contributed to almost 3% of GDP in 1991.

Though some governments opt for gradual transitions to market economies with structural and enterprise restructuring actions prior to privatization, almost all transition governments decide to rapidly privatize through a so-called Big-Bang approach (Svejnar, 2002). Under the latter approach, the state-owned assets are privatized without any enterprise restructuring, meaning that firms acquiring the state assets need to undertake the necessary restructuring themselves. A famous example is the Treuhand privatization agency for Eastern Germany who started its activities in July 1990 and managed to privatize nearly three-quarters of the Eastern German enterprises by the end of 1992. As the payoffs to these restructuring investments are subject to high uncertainty and the cost of investment is typically sunk (making the investment irreversible), these investments have the characteristics of real options (Dixit and Pindyck, 1994).

Real option theory basically says that a firm with the flexibility to postpone an irreversible (real) investment should invest only if the present value of future cash flows exceeds the cost of investment by the value of keeping the option alive. As uncertainty increases, the value of waiting for more information before ‘executing the option’ increases and hence, analogous to financial options, the value of the real option increases.2

Considering the actual restructuring of former state owned firms in Central and Eastern Europe, it has been argued that private investors have been unwilling to invest due to the high uncertainty about future policy. Within former state-owned firms, employment fell sharply while there was no significant change in total factor productivity. Defensive restructuring in the early years of transition, characterized by the downsizing of unproductive inputs and underinvestment in productivity-enhancing technologies, may account for these observations (Grosfeld and Roland, 1995). The result indicates that many privatized firms waited until uncertainty resolved before undertaking the necessary restructuring investment.

Theory on real options has developed rapidly whereas applications and empirical evidence of real options are still rather scarce. Arguably, one of the most famous real option cases is on the privatization of the Peruvian Antamina mine, published by Moel and Tufano (1997) as a Harvard Business School case. The valuation of mines has been among the first applications of real option theory as the mining industry produces a relatively homogeneous product with observable output prices and predictable cost of development (Brennan and Schwartz, 1985). The implications of the real option theory have been tested and confirmed in later empirical studies; for example Slade (2001) and Moel and Tufano (2002) examined real options in mining while Quigg (1993) and Cunningham (2006) studied options in the real estate market.

The novelty in the privatization program of the Peruvian government was the type of bid requested for the copper-mine. In addition to an upfront cash bid, the bidding rule included investment commitments pledged by the bidding firm. As these pledged investments by the bidding firm are conditional upon mine development, they are part of the exercise price of the option. In fact, the winning bidder would be the firm proposing the largest total bid, which equals the sum of the upfront cash payment plus 30% of the promised investments, indicating the government's preference of upfront cash payments to later investment commitments. As the winning firm can simply withdraw from the project at the end of the exploration phase without developing the mine and realizing the investment plans, the pledged investments affect the option value. As explained in the case, a firm can make a bid consisting of only a promise to invest an extremely large amount (so no upfront cash).3 As a consequence, such a bid would be equivalent to an infinite cash payment upfront and could never be beaten by any other firm, even if the other firm's efficiency is much higher. Though the case gives an interesting example of how real options can affect bidding behavior, another model framework is required to rule out these infinite pledged investments. By modeling the option as an American (perpetual) instead of an option with a fixed exercise date (European option), bids with very large pledged investments have an option value of zero in our model and will therefore not be preferred by the government.

Asset sales through such a combined bid of pledged investment and cash offer is just one example of a possible auction rule where the bidding rule affects the option value of the privatization object. In this paper, we consider two other bidding rules:

  • (i)

    a cash bid combined with additional investment requirements imposed by the government, and

  • (ii)

    a cash bid with retained shareholding by the privatizing government.

As a benchmark, we analyze the revenues from a cash only bid, which is most common. The latter auction is straightforward to analyze as the bidding rule and the option value are independent.

We simplify all auctions by assuming complete information and just two bidding firms with possibly different cost of investment. Eliminating any uncertainty about the other firm's investment cost allows us to concentrate on the effect of uncertainty surrounding the value of investment, which is observed by, and the same for, both firms. So, the outcome is simple: the low-cost firm bids slightly more than the value of winning the auction for the high-cost firm. Theoretically, the information structure implies that the government can bargain with the most efficient firm. Under the assumption that the cost of negotiation is high, an auction will achieve the efficient outcome at a lower cost than negotiations. But even in the case of negotiations where the government has all bargaining power in the sense that it makes repeated offers, negotiations and auctions yield the same results.4 In this case, the Coase (1972) conjecture implies that the low cost firm rationally expects the government to reduce the price for the firm up to the price for which the project becomes attractive for the high cost firm. In a bilateral bargaining game where the government and the firm make alternating bids, Rubinstein (1982) showed that the low price equilibrium outcome also prevails when the cost of bidding just slightly greater for the government than for the bidding firm.

The assumption on the information structure generates an additional advantage in that we can abstract from the question whether the government should focus on revenue or efficiency. Many studies have looked at the trade-off between the revenue and efficiency objective in privatization auctions where information is incomplete; see Cornelli and Li (1997) and references therein. In our paper, efficiency and revenue maximization are equivalent.

Our setting allows us to compare the impact of real options in the different auction designs and rank the revenues that they generate with the Antamina mine as a stylized example. It is proven that pledged investments as part of the firm's bid never improve revenue as compared to a cash-only bid. A fixed amount of investments, made compulsory by the government and announced before the bidding, does increase revenue, but only if the cost of investment is different for the investing firms. Finally, we prove that retained share ownership by the government also improves government revenue under the same condition of different investment costs.

Previous studies also identified retained shareholding as a way to improve auction revenue. In McAfee and McMillan (1986) and Riley (1988), retained ownership improves seller's revenue because of information asymmetry. Demougin and Sinn (1994) explain retained shareholding as a means to generate more revenue and greater investment through risk sharing with the firm. As our paper does not rely on information asymmetry nor on risk aversion, we provide a new channel of how a retained government share can increase the government's revenue.

Our paper also builds upon Baldwin and Bhattacharyya (1991) who examine the method of sale and the impact of contingent claims embedded in the sale. In addition to their contribution, we explicitly derive the government revenues for the different bidding methods of privatization. The results we derive are only interesting when there is an option value of waiting. When the value of the investment project is relatively high or uncertainty is relatively low, the option value is negligible and a straightforward cost-benefit analysis suffices. In that case, we show that the different privatization methods basically have no impact on the revenue for the government.

This paper is organized as follows. Section 2 discusses the basic setting with a cash only bid. Sections 3 Pledged investments, 4 Compulsory investment examine pledged investments and compulsory investments, respectively. In Section 5 we consider retained shareholding of the government. Section 6 examines the impact of the different auction rules on the total government payoff with the Antamina case as stylized example. Finally, we conclude the paper and suggest some further research in Section 7.

Section snippets

Privatization through a cash only auction

There are many factors affecting a firm's optimal bid for the previously state owned enterprise, some related to the structure of the auction and the number of bidders, while others relate to option valuation. Considering the structure of the auction, we examine, for ease of exposition, a first-price sealed bid auction5

Pledged investments

Suppose that the government's aim is not only to raise cash but also to stimulate investment in the region. Therefore, the government sets up an auction that not only considers an initial payment but also a firm's pledged investment commitments into the region as part of the total bid. These pledged investments can be thought of as a contribution by the firm to a regional development fund. In the case of the Peruvian privatization of the Antamina mine, pledged investments had a weight of 30% of

Compulsory investment

The challenge is to find an auction design that increases the revenue for the government. This section shows that a fixed compulsory contribution to a government owned investment fund can improve the revenue for the government. The idea is as follows. Suppose that the costs of investment differ substantially across both firms with, as before, firm 1 having the highest efficiency. Then, firm 1 will bid the maximum option value of firm 2, taking into account the fixed contribution to the

Retained share

In his survey on corporate governance in transition economies, Estrin (2002) indicates that a participation contract where the government retains shares is frequently used. The fractional ownership entitles the government to receive a small percentage of the firm's future profits after a firm's investment in restructuring or development. This section shows that a retained share in a direct sale auction can also increase revenues in our model as compared to the all-cash auction. With investment

Implications

The winning bid in the privatization of the Antamina mine was made by the relatively small Canadian partnership between Rio Algom (taken over in the year 2000 by Billiton) and Inmet (who later sold its stake to Noranda) with an upfront payment of $20 million. and pledged total investments of $2500 million. Necessary capital expenditures to develop the mine are estimated at $1200 million, so management promised to make considerable extra investments. Various sustainable development programs were

Conclusion

Merging real option theory with auction theory is not particularly interesting unless it leads to insights beyond the standard insights from option theory and auction theory. The Antamina case, where the bidders assign a value not only for the object but also promise to make additional investments, is a case where the bidding rule and the option value intertwine. Similar interactions exist with a compulsory investment and retained shareholding by the government.

As privatization usually comes

Acknowledgments

I would like to express my gratitude to two anonymous referees, seminar participants at Universidad Carlos III and Kirsten Rohde for valuable comments and suggestions.

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