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The Challenges of PrivatizationAn International Analysis$

Bernardo Bortolotti and Domenico Siniscalco

Print publication date: 2004

Print ISBN-13: 9780199249343

Published to Oxford Scholarship Online: April 2004

DOI: 10.1093/0199249342.001.0001

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(p.132) Appendix 2: Importing Investor Protection

(p.132) Appendix 2: Importing Investor Protection

The Challenges of Privatization
Oxford University Press

Inefficient regulation hinders the development of financial markets and, as a consequence, lowers the chances of a successful privatization programme. The problem is particularly severe in developing and emerging countries where profitable companies may exist but a company's growth potential is limited by the difficulty of attracting external finance, be it debt or equity. International organizations have tried to cope with this market failure by the financing of infrastructure through ‘Build-Own-Operate’ (BOO) schemes.1

A look at more recent operations, however, shows that governments from poorly regulated countries are more often tapping international capital markets as a source of capital. A placement on highly developed markets—like NYSE and NASDAQ or the London Stock Exchange—is now a common practice for the best performing companies. In the majority of cases, the flotation is split into an international and a domestic tranche, sometimes in conjunction with a private equity placement to a core of strategic investors.

The benefits of floating shares in a foreign exchange (the so called ‘cross-listing’) have been analysed in the financial literature in terms of improved diversification opportunities, enhanced liquidity, and reduction in the cost of capital. However the most convincing explanation seems the one based on improved investor protection. Indeed, by cross-listing shares, national governments ‘import’ the rules of more advanced markets in that the shareholders of privatized companies benefit from the legal and institutional apparatus that protects foreign investors. Clearly, this binding mechanism has a cost for the controlling shareholder as it limits the possibility of extracting private benefits of control. But projects that require large amounts of outside capital can only be funded if the incentives of controlling shareholders are aligned with those of minority investors. Therefore, cross-listing shares is fundamental for privatized companies that have substantial growth opportunities.

The available empirical data confirms this hunch. Doidge, Karolyi, and Stultz (2001) show the existence of a cross-listing premium for companies listed in the USA, i.e. a valuation differential of 16.5 per cent between the companies listed in the USA and companies from the same countries listed only in the domestic market. Interestingly, the differential increases as firms choose more stringent and prestigious listing mechanisms, as we will describe below.

1. Cross-listing Procedures

To illustrate the economic implications of cross-listing, it is useful to analyse first some technical and institutional aspects of this type of placement. When a company decides to launch a global offer on a major stock exchange, such as NYSE, it usually structures a (p.133) Depository Receipt (DR) Programme. DRs are representative securities held in deposit by the country of the issuing company. They are traded in the currency of the host country and subject to its rules regarding clearance, settlement, and the transfer of ownership. These characteristics facilitate the evaluation of stock by international investors and, above all, reduce the transaction costs of investment in a foreign company, bypassing most of the paperwork and tax problems associated with the acquisition of foreign stock (Mustafa and Fink 1998).

There are different types of DR entailing different levels of complexity and disclosure. Global Depository Receipts (GDR) are usually traded in major stock exchanges outside the US—above all on the London Stock Exchange (LSE)—and in over-the-counter markets in the US. A company that issues GDRs is not subject to the General Accepted Accounting Principles (GAAP) nor must it wholly abide by SEC regulations. As a consequence, the issue of GDRs allows a company to enjoy the benefits of international trading without modifying its reporting practices. This may, however, displease some investors.

Companies that intend to offer their shares to American institutional investors and be quoted on US stock markets must use American Depository Receipts (ADR). These entail the same obligations as American shares, ranging from GAAPs to full compliance of SEC rules on transparency.

ADR and GDR programmes are not the only ways in which a foreign company can have access to the American market; one possible alternative is the private placement of DRs under SEC's Rule 144a. This method is the cheapest in that it allows the issuing company to avoid SEC authorization. The rationale for this exemption is that stock issued under Rule 144a is traded in upstairs markets by large institutional investors (the so-called Qualified Institutional Buyers, QIB). QIBs are, in fact, primary financial institutions that, in most cases, are in the position to obtain autonomously key information about stock. Therefore they do not need the same protection that SEC warrants to the public (Rovinescu and Thieffry 1996).

It often happens that global offers are structured using a combination of the above methods. The choice of DR depends on the operation's goals in terms of visibility and on the financial solidity of the issuer. Obviously, ADRs are the most attractive and secure method for foreign investors, but they are also the most costly. Companies for which transaction costs associated with ADRs are deemed excessive can opt for stock market placements under less stringent regulations, such as Rule 144.

Looking at the details of DR operations, the offer usually begins with the appointment of a financial adviser—typically an investment bank—given the task of establishing the number of shares corresponding to one DR (the DR ratio). The aim is to make the nominal value of the security comparable with those quoted on international markets. The consultant then appoints a depository bank to take custody of the securities in the country of the issuing company.

The number of shares and the sale price is usually determined through book-building. Book-building begins with a dialogue between the lead manager and a representative of the underwriters. Potential investors indicate the number of shares they may want to buy within certain price ranges. The offers are not at all binding, but indicative; final prices and quantities are determined considering the intrinsic value of the company and investors' offers. According to traders, book-building is an efficient auctioning method as it allows for a more precise evaluation of the company. In reality, it is not the procedure which guarantees the success of the operation, but the competitiveness of the auction and the choice of the pricing strategy.

(p.134) Some theoretical and empirical contributions have shown that competitive auctions have a positive impact on prices (Brannman, Douglas, and Weiss 1984; Milgrom 1987). In the context of privatization, recent studies on 236 Mexican operations have further confirmed these results: a high number of bidders generates a significant premium, as does the absence of limits on the participation of foreign investors (Lopéz-de-Silanes 1997).

Some important sales in India clearly show the importance of pricing strategy in the success of placements (Mustafa and Fink 1998). BPL Cellular Holdings is a company that operates in the Indian cellular phone sector. The first ADRs issue at a price of sixteen dollars per share was, in fact, halted only a few hours before the established placement date due to a lack of buyers. Analysts came up with different explanations for this débâcle: first, the majority of investors maintained that the price was too high, only subscribing partially to the offer. To absorb what was left over, the price was dropped to twelve dollars and subsequently to ten dollars per share. These sudden price reductions were read negatively by analysts, and confirmed their concerns over the entire operation. Similarly, the placement of another Indian telecommunications sector group, VSNL, was cancelled on 3 May 1994, following the negative reaction of investors to a sale price of 1,500 rupees when analysts had valued them at 1,000 rupees. Five months later, the government resumed the offer at a price closer to fair value, but the offer was again halted (Guislain 1997). Finally, in March 1997, VSNL managed successfully to place GDRs for a total value of $448 million. The offer was many times oversubscribed. The reasons for the success of the final operation were many, but were mainly due to the effectiveness of the road-show (attracting over 650 institutional investors from twenty-eight countries) and in the choice of a particularly competitive book-building method.


(1) For a comprehensive analysis of the costs and benefits of these schemes, see Sheshinski and Lòpez-Calva (2000).