Governments are under pressure to speed up privatization. In western Europe the need to reduce public debt to levels that will qualify countries to join the EU’s single currency has brought a new urgency to stalled programmes. In emerging economies the IMF is pressing governments to rid themselves of state dinosaurs. Market prospects are not propitious, adding to the urgency – governments are aware that the bull run in equities may be drawing to a close. There are also signs that strong investment inflows from the US are drying up, with reports that US investors are redeeming holdings in mutual funds.
Under these circumstances governments must get assets to market soon or find they have to sell them off more cheaply than expected. In western Europe (including Turkey) this means, according to a recent report by JP Morgan, that governments are expected to set a privatization record this year, raising an estimated $53 billion and thus dominating global privatization programmes. The privatization goals have been set at a time when there is little room for mistakes. At worst there may be delays and even a secondary market crash, but the show must go on. “Privatizations must take place, and unfortunately it’s now or never even if the conditions are not ideal,” says one equity analyst.
If JP Morgan’s estimate for 1997 is achieved, western European privatization receipts will be 23% up on last year’s $43 billion. Italy has the most ambitious programme for 1997, with nearly $20 billion of sales planned, followed by France with $11 billion, Spain with $8.6 billion and Germany with $5 billion.
Last year’s record figure was already 30% higher than the previous peak, in 1994, bringing the total value of European privatization sale proceeds to $230 billion. JP Morgan estimates that privatization receipts will decline to $42.4 billion in 1998 and $22.4 billion in 1999.
“The increase in anticipated 1997 revenues is not only the result of postponements from 1996,” the JP Morgan report says, “but to a great extent a reflection of the urgency to complete some of the privatization programmes ahead of European monetary union.” In the run-up to Emu, European governments feel under increasing pressure to accelerate programmes to meet the Maastricht criteria for debt and deficit. Privatization proceeds cannot be taken into account when calculating the deficit, but they can be used to reduce governments’ financial debt.
There are few novelties in the 1997 programmes to enhance investor interest. Privatization will remain focused on such sectors as telecoms, utilities, energy companies, banks and industrials. Telecoms and utilities are likely to account for 56% of 1997 sales proceeds and equity values may well be adversely affected by the high level of supply of stocks from a limited number of sectors.
Large deals in hand
Even in January, traditionally a quiet month, preparation had begun on several large deals, including Spanish telephone company Telefonica. The first sale of Telefonica stock in 1995 was not a success – the share price fell 6% in the first month of trading.
“Things are very different now,” says one banker. “Despite some wobbles in the market in late March, demand is strong enough to support the issues. All of the recent privatizations have been successful, so we’re just praying that the market will stay kind.”
The rush means conditions are far from optimum. “Large global multi-market privatization transactions are not as rare today as they were in the late 1980s and early 1990s,” says Lucas Wilson, executive director of capital markets at SBC Warburg. “However, against the background of generally strong world equity markets and increasing retail equity ownership through Europe, there still appears to be demand for these issues. And of course in some of the less developed markets of central and southern Europe, where privatization programmes are still in their early phases, there is still some true rarity value.”
The emerging markets are also expected to produce a wave of privatization activity this year, with deals from Russia, other former Soviet republics and eastern European countries finally coming to fruition after two years.
Turkey is finally to set the ball rolling, after delays on its big-ticket privatization programme. Prime minister Necmettin Erbakan plans to raise nearly $6 billion to meet the budget deficit this year by selling 55 companies, including Turkish Telecom, the Edmir iron and steel plant, petrochemicals complex Petkim, the three Tupras refineries and petroleum distributor Poas.
The scope of Turkish sell-offs is perhaps unrealistically large. The biggest hurdle is political opposition. However, the constitutional court, which had stalled the programme, ruled the sales could go ahead.
“The chances are good and the government seems to be committed,” says one equity manager in Istanbul. “As long as the constitutional court doesn’t pull the rug out it will be a good year. But we’ve missed the boat to make serious money on the deal.”
There remains doubt about the possibility of western European privatizations being accomplished in the time decreed. In 1996 only 20% of expected privatization receipts were raised. Offerings in Italy and Spain worth some $7 billion were postponed, with the biggest slippages in the utility sector.
Although the Italian treasury says the success of privatization tranches of oil and gas group ENI in 1995 and 1996 will enable the country to accelerate privatization, this may be easier said than done. Any slippage could cause problems for state holding company IRI, which is relying on the sale of its holding in Stet to reduce its debts in line with EU directives. “The Italian government has indicated to the EU that it will deregulate telecoms,” says Jonathan Adams, telecommunications analyst at JP Morgan. “It’s been timetabled for January 1988 so they are doubly intent that privatization will occur. The pressure is on.”
Parliamentary delays
The delays have been caused by the government’s opponents presenting amendments to the draft legislation establishing a telecommunications regulatory body to facilitate Stet’s privatization. The Italian government hopes draft legislation to create an industry watchdog will become law before the summer recess in August. If parliamentary problems are not overcome, timetabling the privatizations will become more difficult given the congested calendar of sell-offs planned for this year.
This sprint for Emu qualification poses an Olympian task for Italy, which has a fragmented, inefficient banking system still 60% controlled by the state. The industry’s average return on equity was a dismal 0.3% in 1995. Last year it improved, but only to 2.2%. Forecasts are for 2.3%, 2.4 % and 3.1% for 1997, 1998 and 1999, respectively, compared with 20% in the UK and nearly 15% in Spain. Even the troubled French banks manage 6.5%.
The French government wants to raise between $5.29 billion and $8.82 billion in May’s partial privatization of France Télécom, the state-owned telecoms operator. The first tranche of shares may be the biggest French privatization since that of oil group Elf Aquitaine in 1994, and possibly the biggest. The French finance minister originally wanted to generate Ffr25 billion ($4.5 billion) from the sale; indications of strong investor demand are thought to have caused the revision.
While offerings will continue to rely on international investors, domestic buyers are expected to take up about 60% of this year’s privatizations. In Europe, domestic investors took up close to 64% of issues in 1996. More than two-thirds of the Spanish government’s sale of the remaining 21% stake in Telefonica was bought by domestic investors. The scale of domestic interest is hailed as a sign of a new equity culture emerging in European equity markets. Bankers compared the Telefonica sale with Germany’s flotation of Deutsche Telekom last year, seeing a turning point in demand for equities in countries where fixed-income investments have dominated.
“Domestic issuers will play an increasingly important role, ” says Caroline Meroz, European equity strategist at JP Morgan. “The equity culture is growing rapidly and this is likely to continue.”
The strength of domestic demand was the overriding factor in the success of recent European privatizations, but analysts point out the buoyancy of world markets and the high levels of liquidity among institutional investors also played a key role. A strong performance in the region’s equity markets underpinned the privatization record last year. The FTA Europe index – excluding the UK – rose 25.7% in 1996 against a 9.35% increase in 1995.
“Sentiment is just as fragile as it was at the start of the year,” says one banker. “But when there is domestic demand like this, no government is going to ignore it.”
But despite strong underlying markets some countries’ programmes could not be completed. In Spain, although the equity market was the strongest performer in 1996 – the Ibex index rose 42% – only 51% of the programme was completed, slowed in part by general elections for a new government.
The prospect of two or even three big Italian privatization offerings in the next few months is daunting, especially in view of the congested calendar of international equity offerings scheduled for the autumn. Spain’s Telefonica and Dutch telecoms company KPN have already had problems arranging launch timetables that avoid clashes.
The size of the Italian offerings is also asking a lot from both domestic and international investors. “There is a bigger risk in Italy as conditions for equity are more hostile,” says Peter Sullivan, European investment strategist at Goldman Sachs. “They are substantially behind the rest of Europe in terms of domestic economic growth. Even if there were the economic conditions it is not certain that the new issues can be done.”
Although institutional and retail buyers have plenty of cash to invest, there is a fear that a secondary market adjustment could put a lid on the equity bonanza. “There is a feeling that share markets are at their tops,” says one London equity analyst. “Stocks can’t go up much further. It’s more likely that they’ll fall back. Given the volumes of new issues expected this year the potential for blunders is huge.” Prospects for the US equity market do little to dispel fears. Analysts expect a 10% price fall this year. A poor performance there might damage other big markets.
“The Federal Reserve has been playing a tune which they’re not going to play forever,” says Alex Graham, director of equity capital markets at Salomon Brothers in London. “If this changes more than the markets currently expect, we could be in for another 1994.”
Many believe that investors’ propensity to buy is stretched to its limit. If investors believe stock markets cannot go on performing so strongly, they will start to build up cash. The ability of these privatizations to retain interest cannot go on forever. The 1997 privatization programme will focus on the same seven sectors that have dominated over the past few years. The telecoms sector will continue to dominate, followed by the utilities sector. Together they are expected to account for over half of this year’s sale proceeds.
Says one equity analyst: “One of the risks is asset oversupply for domestic investors. Home country oversupply was a big problem in 1995 and 1996. International investors are affected less but they could face regional oversupply from western Europe in 1997.”
These fears should be put into context. “Last year was a record year and 1997 is likely to be another record year,” says Warburg’s Wilson. “However, the delay of one large $10 billion transaction can make a big difference to the trend line.” So far 1996’s equity supply has been absorbed relatively easily. Schemes such as long-term employee ownership as incentives to encourage employees to participate in big offerings will certainly help.
“The flood of issues does add an element of risk,” says Goldman’s Sullivan. “But to the extent that markets are dominated by large institutions you tend to get increased interest.” One effect of the privatizations will be to change the composition of the major indices, as was the case with Deutsche Telekom entering the DAX (4.5%) and ENI entering the MIB30 (22.1%). The size of the offerings means they constitute a big part of the indices so investors wishing to maintain their weightings will increase their positions on these stocks.
Increased investor interest
“People don’t issue in a vacuum,” says Sullivan. “The amount of issuance does depend on market conditions and perceived investor appetite. There has been a natural increase in interest in equity investment and a realization of the need for pensions from an ageing population.” UK pension funds have increased their exposure to European equities and France will soon start private pension funds with a minimum investment into equity set at 60%.
Lead underwriters feel squeezed between demands for good investments of increasing sophistication with a wide number of stocks to choose from, and those of experienced vendors keen to extract the highest possible valuations from the market at least expense.
French treasury strategies show how issuers are becoming increasingly aggressive with bankers. Most French privatization secondary sales of stock are now conducted as block trades or bought deals. Instead of long marketing campaigns that enable the orders to build up, the French treasury asks banks to bid at short notice for large blocks of stock, forcing them to bear the risk of a share-price collapse.
Bankers agree the financial rewards for these unwieldy block deals do not compensate for the risk. Privatization fees have fallen from 4% in 1994 to 2.5% and 3% on certain high-profile European secondary sales. Efforts to compensate for the low fees with high-issue volumes may tempt banks to overstep the limits of a saturated market. With investor fears that the market has reached its top, there is the potential for a disaster.
“Sooner or later, one of these trades is going to blow up in somebody’s face,” says one banker. “When bought deals go wrong they tend to go very wrong. You can lose a lot more money than you could ever make if things go right.”
