- There are sound reasons to seek strategic partner for airline
- Government must decide if it’s offering investors monopolies
- Stock market would help value SOEs and divide equity stakes
However, the need for more infrastructure to boost growth combined with a growing debt problem suggests an alternative conclusion: perhaps the government is correct that it can’t continue to pump borrowed money into SOEs and should seek private capital and expertise instead to try and maintain the momentum.
And in the case of Ethiopian Airlines, assessments of its balance sheet and the aviation market offer a rationale for the move.
Still, many worry the proposed privatizations will be rushed and only temporarily ease the country’s dire foreign currency shortage. Their fear is that the cost of servicing returns on investment will eventually exacerbate the problem it is trying to solve. The stated reasons for the policy are to boost growth, jobs, and exports. But the government must clarify how opening-up will address the recurring budget deficit and the challenge of ballooning debt repayments.
Privatizations will indeed generate much-needed hard currency, although it will take time before the investments enter the economy, and it is unlikely that the foreign exchange shortage will vanish over the next few years. But there is a silver lining, as this period also gives the authorities an opportunity to improve their financial sector policies and regulatory frameworks.
many worry the proposed privatizations will be rushed
Despite overall enthusiasm, there are reservations within the business community regarding not only the time needed but also the expertise required, as well as the sequencing of the new model privatizations and financial sector development. Hitherto, privatizations have been conducted through a straightforward bidding process. With the new desire for participation from Ethiopians and the Diaspora, there is a need for a quasi-IPO process: a form of taking the SOEs “public” while also allocating a large minority stake to a strategic investor.
Capital markets could play a role in facilitating the listing of shares and would also allow trading. Former Prime Minister Meles Zenawi once said that he did not see the need for capital markets in Ethiopia, and officials have often argued the government does not have the regulatory capacity. The announcement of the privatization of the largest SOEs is hopefully an indication that the nation will finally start working towards a stock exchange.
The telecoms, airlines and electricity enterprises were considered strategic assets and keeping them in government hands was seen as in the public interest. A common argument was that if they were private, the public would not be able to afford essential services such as power and telecoms at rates charged by private providers. Now, with a shift of focus from state-led development, those arguments are fading, and the need for new capital and new impetus has arrived. While it is true that more should have been done to prepare the institutions for this future, now is the time to look forward—although first, it is time to look to the skies.
Ethiopian Airlines, the leading African carrier, will likely be the darling of strategic investors from the Middle East. Albeit well-intentioned, the negative reaction from the public to the proposed partial privatization of the airline runs counter to economic realities.
Although it has strong earnings, Ethiopian Airlines’ financing model is partly a function of the nation’s creditworthiness. The airline’s debt from equipment acquisitions, which in recent years has soared, and its ability to negotiate preferential terms via large orders, is increasingly relevant to profitability. If Ethiopian were to grow steadily and re-invest last year’s profits, it would just add one Airbus A350 to its fleet. Total re-investment of free cash flows would allow it to buy a couple more jets. Without the backing of strategic investors, the airline’s current rate of equipment acquisition would rely to some degree on continued government backing.
Arguments for seeking strategic investors should focus on what competitors might potentially do. The two other main sub-Saharan carriers, South African and Kenyan, are struggling and are actively preparing themselves as acquisition targets for larger airlines in an industry where scale is critical.
In Ethiopian’s advantage is that successful global carriers are not generally interested in acquiring struggling African airlines. However, this doesn’t mean they are not monitoring Ethiopian’s success and considering a challenge. Global carriers will eventually find a new way of combating Ethiopian’s dominance in Africa, even if it means going after similar small-scale acquisitions to Ethiopian, or seeking strategic partnerships to gain a foothold. But what this announcement should do is make the big carriers pause in their consideration of the Kenyan or South African acquisitions, allowing Ethiopian to extend its lead.
The general public gave an overwhelming thumbs-up to the proposed semi-privatization of Ethio Telecom. Opponents argued it generates significant revenues and so not only will the country lose out on those, but it will also require large sums of foreign currency to finance the return on investment to strategic investors. This argument misses the point. Safaricom in Kenya generates nearly twice as much revenue from about half the number of subscribers of Ethio Telecom, and it is not the only telecom company in Kenya.
Ethio Telecom is notorious for charging high rates for spotty services. The justification for the privatization of tele should focus on how internet-dependent services can propel economic growth. But it will be unfair to expect the telecom sector to deliver on lofty promises if it continues to be inefficient and run as a monopoly post-privatization. Gradual opening up of the sector to competition is one way to realize higher levels of service and efficiency.
The government’s monopoly of the “commanding heights of the economy” was directed at ensuring the expansion of basic services. Profit-making, or even full cost recovery, was not deemed a priority for some enterprises. For instance, Ethiopian Electric Utility (EEU) charges one of the lowest rates in the world, while Ethiopia Electric Power is heavily indebted due to intensive investment in generation.
Everyone should understand that investors buying a stake in EEU will expect a return on their investment. Inefficient SOEs that are not charging market rates will therefore have to wait before investors consider them. The recent cabinet decision to allow EEU to increase electricity rates four-fold is a step in the right direction. This makes EEU a more attractive proposition, and will also encourage further private sector interest in building and owning power stations, which the government has already shown openness too.
Now that we have addressed the reactions to the proposed privatizations and the underlying justifications, let’s look at some key challenges.
The government indicated its intention to maintain majority control in large enterprises like Ethio Telecom, while selling larger minority stakes to strategic investors and the remaining portion to Ethiopians and the Diaspora. The exact division of equity between investors and citizens will likely be driven more by politics than market forces. And it should be noted that even the smallest minority stake from Ethiopians will reduce potential funding for other projects.
The government will likely favor a structure that removes the debt and guarantees of SOEs from its books to improve its credit rating. However, lenders will push back on such conditions while majority stakes remain with the government.
Ethiopia’s banking sector is limited to collateral-based lending, often referred to as retail banking. Banks do not provide investment-banking services and lack the capital markets expertise and regulatory framework needed to underwrite IPOs of SOE shares.
Without a stock market, Ethiopians will continue to rely on the existing system of selling shares in disorganized and unregulated markets. Lack of capital markets also means difficulties in liquidity and price discovery of SOE shares. It is important to note that investors invest in SOEs because of the expectation that the value of their holdings will outperform other investments and that they have viable exit options.
Monopoly or competition?
The biggest unknown is if and when these sectors monopolized by SOEs will be opened to competition. As with Japan Tobacco International’s purchase of a stake in the National Tobacco Enterprise, a promise of continued monopoly to strategic investors will yield higher valuations, as they will be allowed to set prices. However, continued monopolies will not address inefficiencies.
A practical approach would be introducing oligopolies and then gradually opening up those sectors with lingering inefficiencies to more competition. The worst outcome of privatization is to agree to an indefinite monopoly that creates huge ‘rent seeking’ opportunities for private companies. Decisions on proposed market structure are absolutely critical and the primary policy challenge.
A typical outcome of retaining majority control is the desire to continue dictating management. Most of the top management of SOEs are currently political appointees. It is widely accepted that these appointees have limited knowledge of the businesses and industries they are tasked with governing. Public enterprise staff are considered government employees, albeit on a slightly better pay scale than the rest of the civil service. This management structure and governance system cannot hold post-privatization.
For the large enterprises that are being offered for partial sale, strategic investors’ demands are likely to include operational control and the ability to appoint top-level management by offering globally competitive incentive packages. In an attempt to improve efficiency and services, investors will also want to restructure, which may result in mass layoffs and hiring of skilled staff, along with market-driven compensation and incentive structures.
The government will want to continue appointing politicians onto the boards of privatized SOEs to ensure public interest is protected and to have a direct say on strategic decisions. Governance issues will likely cause rifts between investor-appointed and politically appointed board members. This may necessitate appointing independent directors from the business community and elsewhere to bridge potential impasses.
A very tricky part of the privatization process will be valuing the SOEs. Valuation is a double-edged sword: set too high, interest from the best investors is lost; set too low, the nation risks losing out. Past Ethiopian privatizations have led to some skewed valuations. A typical use of valuation is to establish floor equity prices for SOEs when investors in the private placement bidding process make offers. Given the wider interest and participation, a more structured process will now be needed to produce a consensus market value. That is easier said than done.
The theory and practice of valuation is established, yet it is challenging when it is not backed by price discovery by participants in organized markets. The difficulty of equity valuation in the Ethiopian context is compounded by the only recent introduction of International Financial Reporting Standards-compliant financial statements, the history of SOEs, and the general lack of understanding of the methodologies used by investors to value equity.
international consultants and the big four are hardly disinterested advisors
The most common misconception in Ethiopia is equating asset appraisal values with business valuation. Typically, strategic investors focus on the values derived from future cash flows and are generally less interested in asset values, which may also include non-operating assets. Distressed assets attract different types of investors and are assessed differently. Another misconception is focusing on enterprise value, including debt, as opposed to the equity value that is of utmost interest to investors.
Often, retaining the services of big four accounting firms is considered a panacea to the challenges of valuation when there is no clear understanding of the output, methodology, capacities, and risks. It is important to ensure that whichever firm is retained is managed with utmost care. After all, international consultants and the big four are hardly disinterested advisors.
A successful execution of this phase of Ethiopia’s privatization requires strong institutions, capital market expertise, and a firm yet enabling regulatory framework. Although the formation of an advisory council to oversee the process is commendable, the government must learn valuable lessons from previous privatizations, as the current issues pose challenges that require an improved approach in order to satisfy both investor and public interest.
Main photo: From left, Prime Minister’s special advisor Arkebe Oqubay and Tewolde Gebremariam, Ethiopian Airlines CEO, June 28, 2018, Ethiopian Airlines
The opinions expressed are the author’s, although Ethiopia Insight is responsible for factual errors.
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