Privatisation in Ukraine: high jump after years of crawling?

Original on Laender-Analysen

Ukraine’s government aims to privatise at least 300 small state-owned enterprises this year and to make 5 large companies ready for sale to receive up to $ 500 mln (UAH 12 bn). Are these numbers realistic? Why is successful privatisation of thousands of enterprises crucial for the overall economic success of the country? 

Privatisation objectives

Privatization revenues remain among the most important objectives for some policymakers and in the public perception. In reality they do not matter that much, especially in Ukraine. According to the international experience and the previous CES research, transferring ownership to private hands is important for new market economies due to the following reasons:

  1. Private owners are generally more efficient than the state.
  2. Privatisation of SOEs eliminates the need to fight corruption at them.
  3. The state usually has no incentives to grant preferences for private enterprises if the sector is competitive. 
  4. Privatisation can bring new direct investments if institutional investors are attracted.

These four objectives were not always met in Ukraine as the country has not yet fulfilled the important privatisation prerequisites:

  1. Active involvement of foreign investors.
  2. Reducing the level of information asymmetry by involving independent investment advisers.
  3. Linking financial and non-financial incentives (KPIs) of SOE top management to readiness of SOEs for privatisation – to prevent then from sabotaging privatisation efforts.
  4. Priority privatisation of enterprises operating in competitive markets.
  5. Zero state share in privatised enterprises. 

Almost three decades after the start of market transformations, Ukraine is still the country with ca. 3.7 thousand state-owned enterprises. In the next sections we will briefly describe the stages of privatisation and to what extent the above mentioned objectives were met during each stage.

Privatisation stages and their outcomes

As a post-Soviet country, Ukraine has the legacy of a command-and-control economy. It led to the absence of the private capital in the economy. In the early 1990s, the country was not ready to jump into the free market economy.

The international experience and evidence from Ukraine have demonstrated that the method of privatisation is crucial. Ukraine started from preferred share allocation mechanism in 1993, through voucher privatisation at the end of 90’s, and ended up with direct privatisation to institutional investors, looking forward to launching the IPO of the state railway in 2020s.

Source: State property fund of Ukraine, state budgets

1. 1992-94: ill-designed start with no foreign investors

The first Ukrainian privatisation law was adopted in March 1992. Until 1994, the privatisation was often based on the preferred share allocation mechanism, when the employees (effectively, the incumbent management) were buying out the company on preferential terms. 

The goal was to transfer the ownership to private hands: (1) fast (while lacking domestic capital market) and (2) with the public support (not “selling out the national wealth” to foreigners).

As a result, strategic investors rarely became owners of high-quality assets, while the shares of most citizens lingered in trust funds. Such privatisation had cemented the position of so-called “red directors”, providing politically connected individuals access to the state assets. Out of nearly 12,000 companies privatised in 1992-94, some 80% were privatised in this manner, providing no room for foreign institutional investors.

At the end of the period, it was the parliament that slowed down the process of ownership change. It meant two things:

  1. The parliament shifted the focus to the fiscal role of privatisation, rather than other objectives. Contradictory to a clearly defined norm in the privatisation law, it adopted the Law on the Budget of Ukraine for 1993, according to which 50% of privatisation proceeds were to be directed to budget. 
  2. The parliament had to vote for the lists of privatisation objects (so-called Privatisation programmes) each year. However, in July 1994 it imposed an 8 months long moratorium on the compilation of a list of enterprises forbidden for privatisation. In March 1995 the list was finally approved. It included 6,102 enterprises, among them many that were attractive to investors (shipbuilding, maritime transport, oil refining, fuel and energy complex, etc.). Many were, however, subject to political interests of the line ministries.

The combination of the above has led to the foundation of the oligarchy in Ukraine.

2. 1995-98: Voucher privatisation by the State Property Fund

The voucher privatisation mechanism came from the legislature amendment in 1994. 

That year, two changes took place. First, mass privatisation through vouchers (privatisation certificates) was launched by a presidential decree. Second, the law was changed to shift the policymaking powers to the State Property Fund. In 1995-1998, nearly 50,000 objects were privatized, including more than 11,000 medium and large enterprises.

Due to the emergence of Ukrainian financial system and introducing the national currency in 1996, selling blocks of shares for money started developing (instead of privatisation certificates). An increasing share of stocks began to enter the stock market. The largest demand was for energy companies (54% of total cash flow), mechanical engineering and metalworking enterprises, enterprises in chemical, petrochemical and food industries.

However, the actual change of ownership (transfer of more than 70% of ownership into private hands) only took place in a third of these companies and the state remained a very significant owner in the rest of the entities nationwide.

3. 1998-2017: selective privatisation by cronies: showcasing “the good, the bad and the ugly” examples

In the beginning of the 2000’s, private sector finally began to play a significant role in the economy. As of 2002, it’s share reached 57.7% in manufacturing, slightly more than 50% in textile and sewing, food industry, processing of agricultural products.

Propelled mostly by the vested interests of the selected few, the parliament shortened the list of enterprises that were not subject to privatisation significantly. In 1994, it consisted of 6,102 enterprises, while in the beginning of 2000, there were only 1,307.

Starting in the 2000’s, crony capitalism has been strengthening in Ukraine. The major fossils and energy objects were transferred to the hands of selected few using the special laws adopted by the parliament. For example, the method of selling 10 enterprises of the state JSC Ukrrudprom was determined by a separate law. The law provided for the right to purchase shares of enterprises belonging to Ukrrudprom to shareholders owning at least 25%+1 share.

Thus, the largest oligarchs (Akhmetov’s SCM and Novinsky’s Smart Group and Kolomoisky’s Privat Group) bought Ukrrudprom enterprises

Furthermore, privatisation gradually began to turn into a source of funds to cover budget deficit rather than investments. Since 1997 (except for the short period of 2006-2007), the state budget envisioned higher privatisation inflows as a source of revenues.

a. The good: Kryvorizhstal case

In October 2005, Mittal Steel purchased 93.02% of metallurgical giant Kryvorizhstal’s shares for UAH 24.2 billion ($ 4.79 billion) at a starting price of UAH 10 billion. Bidding was broadcasted live. The President and former Prime Minister were present to celebrate the transparent re-privatisation of the factory.

This package was originally sold in June 2004 to the Investment and Metallurgical Union Consortium (IMC) for UAH 4.26 billion (about $ 800 million). The founders of IMC were SCM (Rinat Akhmetov) and Interpipe (Victor Pinchuk).

The new president and the prime minister urged Ukrainian courts to cancel the results of the auction. After the resale, the State Property Fund returned UAH 4.26 billion to the consortium.

Thus, Ukraine attracted high quality foreign direct investment and increased competition in the metallurgy, historically divided by the cronies.

b. The bad: Ukrtelecomcase

In the early 2000s, as the rapid replacement of landline telephony by mobile was taking place, the state telecom giant was foredoomed to lose its monopoly position in the communication sector.

The way to minimize its value before privatisation in 2010 was through discriminatory competition conditions. At that time, privatisation laws required the sale of “strategic objects” to an investor that already had a stake in a similar foreign or domestic market and was interested in expanding it.

Another discriminatory condition for domestic and foreign competitors was the restriction to take part for the companies with a share of any government or SOE (in the entire chain of ownership) exceeding 25% capital. Because of this, some majors like MTS Ukraine PJSC were not admitted. Kyivstar was then owned by the Norwegian state-owned Telenor Group; of Deutsche Telekom, 15% belonged to the German government and 17% to the KfW state development bank, etc.

As expected, only one bid was received from the predetermined winner ESU LLC, a subsidiary of the Austrian company EPIC. At that time it was believed that it was close to a former president Yanukovych or the major oligarchs. EPIC paid UAH 10,6 bn ($ 1.33 bn).

In 2018, seven years after the privatisation, litigation in London shed light on the primary buyer. It seemed to be the former head of the Security Service Valery Khoroshkovsky, who acted with the financial support of Dmytro Firtash. In 2013, the control over Ukrtelecom was transferred to Rinat Akhmetov, who bought ESU for $ 860 million.

с. The ugly: Odessa Portside Plant case

The sale of the Odessa Portside Plant (OPP) after the Revolution of Dignity could have become a new success story for the new pro-Western government. However, the last two attempts to privatise it in 2016 were unsuccessful.

Initially, no one was willing to pay the starting price of $521 million, bearing in mind the dispute on $250 million of the OPP debt to Dmytro Firtash’s Ostchem. Later, potential investors were not interested in the decreased price of $202 million. When the debt was confirmed by the Stockholm Arbitration in 2019, the prospects for the sale only worsened.

In 2009, before the appearance of toxic debt, Ihor Kolomoisky was ready to pay $600 million for the enterprise. The plant is one of many typical examples of how the state, whether hiding behind the strategic value of the object, or fearing price decreases, has been refusing privatisation until the enterprise burdened its value with debt losses.

Now OPP may become the success story of the Zelensky’s government – but not earlier than in June 2020, as the privatisation process will take around half a year.

Overestimated expectations after Euromaidan

а. Government policy amendments

After the Revolution of Dignity in 2014, the new government promised an effective privatisation process of the significant share (more than 800) of the remaining 3.5 thousand SOEs.

In February 2016, the law  on improving the privatisation process by introducing the “privatisation advisors” institution was signed. This enabled the government to launch the privatisation of strategic enterprises. 

In 2018, the law “On the privatisation of state and municipal property” was adopted. It changed the process of large-scale privatisation. One of the key points was the right to sign all the privatisation agreements under English law until January 1, 2021. It ensured a greater transparency of privatisation procedures and protected the investments.

The new law significantly limits participation in Ukrainian privatisation of buyers from Russia (the country aggressor). Companies with 10 or more percent of shares held by a resident of Russia will not be admitted to auctions. The participation of companies with 50% of shares owned by offshore companies is also limited.

It also formulated the criteria for objects that cannot be privatised (the property of state agencies and local self-government, military objects, enterprises in nuclear and space industries, monuments, the subway and many more). Following this decision, a special law cancelling the old list of entities prohibited from privatisation was adopted by the new parliament in 2019.

The law also effectively launched small-scale privatisation (objects with starting price of less than UAH 250 mln / $10.6 mln) auctions at the electronic platform “Prozorro.Sale”. 

b. How Prozorro  pushed the reform

By the end of 2019, 3.95 thousand objects have been registered for small-scale privatisation through Prozorro.Sale, however, less than half of the auctions had been scheduled. 1,5 thousand objects are already sold, most of them at the first attempt. 

One of its most effective tools is Dutch auction if a small privatisation is not sold at the second attempt. The main difference of a Dutch auction is that during the auction, the price is automatically reduced until one of the bidders stops it when ready to buy. After that, if more than one participant is involved in the auction, other participants have the opportunity to raise the price, and at this stage the auction proceeds according to the usual rules.

“New law” + “new government” – “corruption”: why this time privatisation in Ukraine may be a success

Ukrainian Prime Minister Honcharuk (aged 35) is currently the third youngest PM in the world, and the ruling “Servant of the People” faction (average age 37.6) is the youngest in the Ukrainian Parliament. They were growing up in the market economy and (apparently) do not have vested interest in state owned enterprises – and subsequently were pushing for a fresh privatisation attempt.

During last four months of 2019, 5 major companies were  set for privatisation in 2020 by the Ministry of Economy, while 530 entities were transferred to the State Property Fund for pre-privatisation preparation. Overall, according to a draft law that was directed to Rada recently, the state intends to retain 219 out of 3,663 state-owned enterprises. Among them:

  • 9 enterprises where the state should remain the major shareholder (including Naftogaz and Ukrainian railways);
  • 101 companies where state should retain 100% ownership (the majority of them are defence companies and natural monopolies);
  • 109 culture and sport objects.

SOEs that are in the pipeline for privatization, could be divided into the following groups:

President’s Office. Out of 47 entities controlled by the subsidiary of the President’s Office five have been already transferred to the State Property Fund for privatisation process, nine more are to follow. Among them: a distillery and two hotels in Kyiv’s main street, Khreschatyk.

State Property Fund. One of the first decisions of the new management was toshift the Fund’s functions from property management to actual privatisation. The new law on lease of the state and municipal property came into force in February 2020, meaning that all the property is leased through Prozorro. Sale platform.

State owned banks (SOBs). Two state-owned banks (SOBs) – Ukrgasbank and Privatbank – should have been privatised by 2020 and 2022 respectively according to the government strategy. The government also plans to sell 45% of Oschadbank. SOBs – both intended for privatisation and those remaining in the state ownership – have been introducing proper governance structures. Corporate governance reform is an important milestone in preparation of SOBs for the privatisation and private capital injection

Ukrspirit. From July 2020, the law on de-monopolisation of spirit manufacturing will come into force. It means that private actors will be able to run their own refineries and for them there will be no need to rely on the state monopoly Ukrspirit. At the same time, 35 of the state-owned Ukrspirit’s 41 refineries will be set to privatisation

Potential IPOs: UZ and Naftogaz. On October 29, 2019, Ukrzaliznytsya, the Ministry of infrastructure and the EBRD signed the agreement on the preparation for IPO. Although it does not seem to be a short story (the pre-phase is about to take at least three years), the process itself may increase the company’s transparency and the cost of future loans. The total amount of investment to be attracted as a result of IPO is assumed at $3 bn. 

Ukrainian oil and gas monopoly’s “Naftogaz” CEO, Andriy Kobolev, “…conducted a series of consultations with investment banks and potential investors on the prospects of Naftogaz Group’s IPO and received a very positive feedback” on February 17, as he announced on Facebook. Three years earlier, in 2017, Mr. Kobolev had already announced a potential IPO of 15% of the company’s shares for ca. $ 10 bn. 

SUMMARY / Outlook

Ukraine has been struggling with privatisation and transformation to an actual market economy since independence. As the whole process was ill-designed from the beginning, the class of oligarchs emerged instead of strong local owners of companies and foreign investors. Ukraine so far has a few big privatisation success stories. Among them, privatisation of Kryvorizhstal in 2005 and small-scale transparent privatisation in recent years. However, the strategic view and recent decisions of the new Ukrainian government promise more success stories to come – either as full privatisation in competitive sectors or IPOs for the monopolies.

Therefore, now the chances that Ukraine will succeed in privatisation are higher than ever before. Privatisation will bring in more effective owners and FDI inflow, diminish corruption and restore a level playing field.