Articles

Why Privatization is Not Enough

by Kevin McDonald

This article was published in the Harvard Business Review, on May-June 1993.

Most Western businesspeople believe that privatization is the key to salvaging state-owned enterprises in Eastern Europe and the former Soviet Union. According to this conventional wisdom, privatization invariably improves corporate governance, management, and performance. My experience with dozens of Eastern European companies, most of them in Poland, has convinced me that this is an incomplete truth and therefore, like a runway that is just a bit too short, extremely dangerous.

The reality is that most newly privatized companies need dominant, experienced shareholders to compensate for the weaknesses of managers never before exposed to best business practice. Without the support and prodding of such shareholders, Eastern companies tend to operate very much along the lines learned in the days of central planning, insider control, and relentless focus on production. Old guard managers simply lack the skills and experience to convert a company from its old communist predilections to a genuine market orientation. But when these same enterprises receive support from strong, capable - most often Western shareholders, they have shown that they can perform to international standards and even outperform some leading Western competitors.

Eastern European governments need to continue privatizing rapidly, if for no other reason than to create and attract the kind of strong investors who can work miracles. For that matter, when the long-term prospects for a company are promising, its shares are probably worth owning even if they are widely dispersed. But investors earn exceptional returns only when they themselves add value in the form of leadership and systems, experience and direction. The positive effects of privatization are far from automatic.

Two success stories from Poland Thomson Polkolor and Alima Gerber - illustrate the kinds of problems that investors typically encounter, the sorts of solutions that prove effective, and the stunning increases in sales, profits, and morale that good management can achieve.

TV Tubes and Low Morale

Thomson Polkolor is a joint venture between Thomson, the French electronics giant that acquired RCA in 1987, and Polkolor, a Warsaw based producer of picture tubes for color television sets. Thomson began looking for an acquisition in Eastern Europe in 1989. It chose Polkolor partly because Polkolor's factory was built in the 1970s using RCA technology and could thus provide a portion of the Thomson product line. The deal was completed in May of 1991. Although Polkolor it self was never sold, the transaction was in effect a privatization because the new joint venture controls virtually all the assets - and Thomson owns 51% of the joint venture.

At Polkolor, Thomson found business at a standstill. In fact, by the time the deal closed, the company was insolvent and had halted production. There were still 4,500 employees on the payroll, but there was no cash to pay them. Polkolor urgently needed capital, better management, better work attitudes, and an injection of basic business skills and procedures.

For example, although the plant did highly skilled work involving the clean, precise preparation and assembly of parts and materials work that required extensive quality control - the defect rate in final product was 12%. In the glass plant, the defect rate was one in every three pieces produced. There was no way the enterprise could emerge from its troubles without tremendous operational and financial restructuring.

As part of the agreement, Thomson agreed to invest $35 million and to pay one year's salary for the 1,000 employees whom the more efficient enterprise did not need. The Polish government agreed to convert old bank credit into equity in the joint venture and to allow Thomson to import components duty-free.

Kevin R. McDonald is a management consultant based in Newton, Massachusetts. In January 1990, he established the Task Force on Company Assistance, a Polish government-sponsored team of management advisers to Polish enterprises. In 1991, he founded ITCA Europe Ltd., a successor organization.

In 18 months, Polkolor's defect rate fell from 1 in 3 to 1 in 200.

Thomson's managers identified two sources of Polkolor's operational difficulties. One was cultural or behavioral: employees lacked any sense of responsibility to the organization or to themselves. They viewed their jobs as a necessary evil and felt no motivation to work productively or even carefully. Absenteeism was high. Concern for quality was obviously lacking. There was little interest in the health of the company as a whole - and no trace of team spirit.

The other source of trouble was structural or procedural: Polkolor lacked basic tools for measuring quality and tracking inventory. The extent of its problem-solving interactions with customers was to accept returned merchandise and write it off as unsellable.

Thomson attacked the problem of morale and lack of commitment by providing employees with enthusiastic leadership, exposure to Western business practices, and cash incentives. It installed Western managers in 8 out of 12 top management positions (7 of the 8 spoke Polish fluently). It sent Polish managers and workers overseas for 2,000 days of training. It conducted more than 10,000 worker-days of training in the plant, not counting daily, one hour English lessons for everyone. And, finally, it raised salaries by an average of 122% to a level 60% above the national median.

Thomson found itself preaching to a receptive audience, partly because workers liked their increased pay and responsibility, partly because they responded well to Western leaders, whose commitment, expertise, and 16-hour workdays contrasted so sharply with what had been the increasingly desperate befuddlement of the old-guard communist managers. (Another partial explanation may lie in the startling, though unverified, report that roughly one fifth of Polkolor's employees had at one time or other worked in Chicago as illegal immigrants.)

With regard to quality, Thomson addressed the problem in two ways. First, management introduced new quality control procedures, record-keeping, and technology (including simulation, which allowed testing of components without installing them in a television receiver). Second, the company adopted new productivity targets and began posting employees' accomplishments on company bulletin boards.

Results have been dramatic. The overall defect rate is now down to roughly 1 in 200, which is lower than Thomson in Europe, the United States, or South America, and comparable with quality rates in Japan and Korea. What's more, the plant has gone beyond its initial task of assembling imported components and now manufactures the most complex parts of the picture tube. The joint venture has upgraded product technology in general, introducing hard-to-make, square-edged tubes to complement the simpler, round-edged variety Polkolor had made since 1977. In addition, Polkolor is now Thomson's sole supplier worldwide of picture tube masks, which contain thousands of micro metrically precise perforations. The company has also improved product safety - there is no more x-ray leakage out the back of the tube, for example - and has greatly reduced inventory.

Still, there have been myriad problems along the way. Thomson had to replace more than 8,000 square meters of broken glass and 100 kilometers of pipe in the factory itself, and it had to scrap a $6 million furnace bought by Polkolor just one year before the joint venture was formed.

To make matters worse, the Polish state has not fully complied with its part of the joint-venture agreement. Specifically, the government failed to require banks to convert their debt to equity; the customs of fice still obliges Thomson Polkolor to pay duties on some imports; and the state bureaucracy has repeatedly changed the personnel assigned to interact with the company.

The Polish banking industry has been a thorn in the venture's side as well. A local, private bank took one year to make a $20 million loan that would have taken eight weeks in the West. (The bank deployed a series of four different loan officers on the project, not one of whom visited the plant.) A state-owned bank has delayed implementing a low-interest-rate loan from France for more than 18 months as a result of what one baffled Polkolor manager calls "in-competence, bureaucracy, and every week a different reason."

Nevertheless, the Thomson Polkolor joint venture has achieved impressive financial results in just 16 months of operation. Sales have doubled. Exports to the West have reached 60% of output, versus 0% two years ago. Production is now 1.2 million tubes per year, compared with a peak of 700,000 (12% defective) before Thomson came on the scene, and this despite a 25% reduction in personnel. The joint venture now generates an operating profit. Last year, it paid $10 million in taxes, whereas the former state- owned enterprise paid no taxes at all.

As a result of all these changes, morale is markedly higher. Employees are visibly cheerful for the first time in anyone's memory, and there is good rapport between managers and workers. By last fall, absenteeism at Polkolor had dropped to 3%, compared with 7% to 11% at Thomson's facilities in France and the United States.

"When Thomson arrived," says one of the joint venture's Western executives, "the people at Polkolor lacked any feeling of ownership, of belonging. Most of them thought such concepts were a joke. In the United States, we wear team jerseys, sing fight songs, and cheer the company's successes, but here, for 45 years, the successes and the belonging were all pretense. The state always maintained that Polkolor was a gem of Polish industry, though in fact it was a broken enterprise.

As a result of Thomson's changes, employees are visibly cheerful for the first time in memory.

When the lie was exposed, everyone got depressed. But now that success is real, everyone wants to be part of a winning team. They're starting to wear Thomson t-shirts in the plant and they're rooting for the soccer team that Thomson sponsors."

Thomson Polkolor's Polish work force is also breaking every production record and surpassing other Thomson plants worldwide - to such an extent that the company is thinking of transferring production to Poland from other countries.

Thomson is so pleased with progress that it has decided to surpass its original plan of investing $35 million in the joint venture and put in a total of $100 million over a period of three years. Also, the company will probably increase employment by another 600 workers in the next year, as sales continue to grow.

Baby Food and Bad Accounting

In February of 1992, Gerber Products purchased 60% of the shares of Alima, a Polish baby food producer in a small city in largely agricultural southeastern Poland. Gerber won a competitive bid against Heinz by of fering a slightly higher purchase price ($12 million) as well as by making a commitment to invest more capital in the company and help support Polish agriculture by exporting to the West.

Alima was in better shape at the time of the acquisition than Polkolor had been. Indeed, by Polish accounting standards, Alima showed a profit and so paid taxes to the state. In addition, the company employed only 1,000 workers, compared to Polkolor's 4,500, making it much easier to reshape.

Nevertheless, Gerber did find functional deficiencies that kept Alima from growing and becoming genuinely profitable. In fact, the company's deficiencies were so grave and, from a Western perspective, so rare, that they presented an exceptional challenge.

For example, Alima had an accounting department, but its clerks merely collected data on inputs and outputs and prepared statistical reports for the government. They did virtually no analysis of the statistics they compiled and no management accounting worthy of the name. There was no finance function at all, so factors like the cost of capital and the effect of inflation were ignored. Surprisingly, Alima did have a marketing department, but its two employees spent 90% of their time doing work for the personnel office.

Clearly, here was a company that lacked the structures and procedures for coping in a market economy, a consumer-goods company so oriented toward production that it lacked the ability, in any conventional Western sense, either to market or to measure profit.

On the positive side, Alima did not have the poor attitudes and work habits that plagued Polkolor. So Gerber's task consisted not so much in exposing workers to Western ways which it did by means of trips abroad and on-site training - as in establishing a functional market orientation where none had previously existed.

Accordingly, Gerber assigned fewer Western managers to the new acquisition than Thomson had sent to Polkolor. Gerber made professional staff from the West readily available on a consulting basis, and these experts came frequently to focus on such things as manufacturing, soil analysis, and pesticide use by local farmers, but Gerber installed only one full-time Western manager, a man named Jan Lower, as director of finance. Lower was an accountant by training, and his mission at Alima was not only to introduce change in a variety of functional practices, but also to build consensus for the changes he initiated. In most cases, his reasoned explanations led to the adoption of Western management techniques by common consent. In other cases, he had to press his authority and insist on changes against lingering opposition and the resistance of habit.

Lower was able to improve Alima's balance sheet and income statement tremendously without investing a dollar beyond the cost of his own salary. What's more, the gains came quickly. Within the first six months of Lower's tenure, Alima had put into place a long series of basic financial controls and cost-cutting measures.

Under Lower's guidance, Alima instituted a credit policy to replace the old practice of extending free credit to all customers. It began to manage exchange-rate risk, an essential activity given the company's need to import some raw materials. It installed a new management information system so that company leaders could analyze operations instead of merely subjecting them to bureaucratic overkill, as in the past. It eliminated suffocating controls like the six forms previously needed to requisition a pad of paper. It also rationalized its purchasing procedures. For example, it began buying bananas directly from Central America instead of through intermediaries in Holland, which saved some $600,000 per year.

Most important of all, perhaps, the company switched from first-in-first-out to last-in-first-out accounting, a change that produced lower paper profits, lower taxes, and solid cash flow - in contrast to negative cash flow earlier, when inflation was essentially ignored. This particular shift in policy came about by fiat after lengthy discussions failed to convince the old guard that the new system was logical, responsible, and beneficial.

While implementing these functional changes, Alima also purchased and installed a new production line for the Gerber brand of baby food, which it exported and sold domestically. It then reconfigured its older, albeit still modern, equipment into a production line for its traditional Bobo brand, marketed only in Poland. To complement this investment in production lines, Gerber also established new work proceures along such basic dimensions as cleanliness, neglected in the days when Alima could sell its output regardless of quality.

At Alima as at Polkolor, the results of change have been dramatic. When Gerber acquired Alima in February, 1992, its annual sales were approximately $25 million. By early 1993, they had reached an annualized level of nearly $50 million. Management believes this figure could triple within five yearsto $150 million, or 15% of Gerber's world-wide sales.

Exports will soon account for 20% of sales, up from negligible levels just one year ago. Profits are also up. Alima not only shows a paper profit but also generates cash. Morale too is at an all-time high. Gerber promised at the outset to maintain head count for 18 months and now enjoys great goodwill as a result. In any case, higher profits have made layoffs unnecessary.

As for debt, Alima owed $4.5 million when Gerber acquired it in February, 1991. Nine months later, its debt was less than $2 million, despite an autumn infusion of credit to support purchasing at the peak of the harvest season.

Breaking Even

Whereas privatization with a powerful dominant shareholder can yield dramatic improvements in performance and profits, privatization with weak or fragmented share-holders is more likely to produce a company that breaks even. Admittedly, breaking even is no mean achievement for an enterprise weighed down with antiquated equipment, outdated accounting practices, communist marketing know-how, and padded employment rolls, but the stark contrast between reducing losses and embracing gains underscores the enormous difference that a strong, motivated share-holder can make.

And that difference is in management. In companies privatized with widely dispersed or weak ownership, incumbent managers generally stay with the company, implementing turnaround strategies that are largely two-dimensional: find new customers; reduce head count. Communist-trained managers simply don't know how to maneuver along the various dimensions that have proved so important at Polkolor and Alima, where Western and Western-led managers changed corporate culture, transformed accounting, installed quality control, introduced new products, built marketing departments, and forged closer ties with suppliers. Without such initiatives, profits inevitably fall short of expectations, leaving old-guard managers with no recourse but to get rid of workers.

Sadly, even layoffs don't produce the results these managers are after. While large work force reductions might make these companies temporarily profitable despite the absence of real innovation, the labor unions resist big cuts. This impasse usually leads to just enough layoffs to let the company break even. These managerial shortcomings are not the product of intellectual limitations. Rather, they are the legacy of a communist system that forced enterprises to think only in terms of production and directed managers to maximize output with a shortage of inputs. Polish and other Eastern managers were highly skilled at this task but almost entirely unprepared for the demands of a market economy.

Against this backdrop, the owner ship equation in a privatized concern becomes critical, for incumbent managers need to be supported, motivated, or replaced. A board representing widely dispersed, individually weak shareholders may decide to replace management. But such boards have not demonstrated any ability to attract alternative managers with the necessary qualifications and experience, and they have generally failed to provide new management with the support it needs to overhaul a company's culture and operations.

The following three examples of less successful privatizations tend to follow the same pattern of relative failure: managers focus exclusively on revenues and layoffs; the company stops losing money but earns no profit; weak shareholders do virtually nothing to help. The variations in this pattern - in the second and especially the third cases, managers were at least aware of their limited skills and made an uneducated, unsupported, and consequently unsuccessful effort to adopt Western thinking and business methods - reveal the terrible difficulty of reforming a hidebound company without progressive corporate governance in the form of a strong shareholder.

Cables and Interest

Slaska Fabryka Kabli - Kabli for short - is a midsize industrial company manufacturing cable and wire primarily for the domestic market, with annual sales of approximately $30 million. The company is based in the industrial city of Katowice in southern Poland and employs 520 people. Kabli was privatized in 1991, and some 34,000 investors own shares. The largest block, 6%, is held by an individual with no ties to the industry. Another 1.5% is held by a state-owned bank. Employees hold 1.5%. The government owns no shares.

Management of Kabli has focused on sales growth while all but ignoring the equally crucial problem of high interest rates. The failure to recognize this problem reflects Kabli's historical indifference to financial matters. Real interest rates were negative under the communist government, so the company never developed a finance department that might now raise capital internationally. (Alima was in a similar situation before Gerber arrived.) In spite of this deficiency, Kabli's shareholders have taken no steps to improve company management.

Since privatization, management's principal sales initiative has been to introduce a sales commission. As a state-owned enterprise, Kabli could not afford commissions because of the excess-wage tax. (The government uses the tax to constrain inflation and encourage privatization.) Kabli has also added export and domestic sales departments, established a dealer network in Poland, contracted with consignment warehouses in the Czech and Slovak Federal Republic, Hungary, and Austria, and introduced a commission for the collection of cash from accounts receivable.

Gerber believes that its Polish acquisition may soon account for 15% of worldwide sales.

Despite the success of these measures - a 312% real increase in exports, for example - costs have risen so sharply over the past three years as to offset most of the revenue growth. The company's main cost problem is the interest rate on bank loans, currently around 50% per year. Largely as a result of these high interest expenses, Kabli is operating barely above the break-even point.

Kabli's inability to attract Western credit is its main barrier to growth and profit. The real rate of interest in Poland is approximately 10% per year, compared with 5% in the United States, and this 5% difference is greater than most cable manufacturers' profit margin. No Polish company can overcome such a large cost penalty after paying international prices for copper, especially when an excessive labor force effectively eliminates the apparent advantage of low Polish wages.

Western funds are available for companies like Kabli that export half their output to the West. But the present managers have not known where to look and lack the experience to write a suitable business plan. They have never had a finance department, so now they are trying to learn the profession on the job. It's proving an impossible task. Frustrated in its efforts thus far, Kabli has had to lay off employees in order to break even. The company has cut 50 jobs to date and hopes to reduce the work force still further.

Kabli's board of directors has not helped to fill the void. It has never proposed bringing in the kind of personnel recruited by Thomson and Gerber for Polkolor and Alima. Nor has it called for meetings with Western banks. The board has simply left managers to their own woefully in adequate devices. Kabli's managers may eventually learn to do business in a market economy, but they have spent three years trying to acquire capacities that a strong shareholder might have injected in three months.

Glass and Markets

Krosno Glass Works (Krosnien skie Huta Szkla) in southeastern Poland is another midsize company, though it has a larger work force - 4,800 workers in six plants - as well as more complex production and marketing than Kabli. Krosno produces a wide variety of glass - table glasses, exotic hand-blown bottles, fiberglass - and generates revenues of approximately $35 million per year. The company exports 50% of its output to 25 countries. Most exports go through Minex, a formerly state-owned foreign trade organization recently sold to its employees.

Krosno was privatized in November of 1991. The Polish government owns 35% of the shares; the Polish Development Bank, 15%; Minex, 10%; 7,000 current and former employees, 12%; and the final remaining 28% is widely dispersed among the public.

Krosno's revenues have fallen dramatically since privatization, due mainly to the worldwide recession. Sales have fallen for all products except hand-blown glass, which is now the company's only profitable product line. Yet management has made no significant effort to increase sales and still relies entirely on Minex for exports. The company does not even have a product catalogue, although it makes some unique merchandise.

Management's response to the sales drop has been to fire one-third of its employees - 2,400 of 7,200.

A former sales manager blames management for making obvious and unforgivable mistakes: "Management should have added capacity in hand-blown glass, but they do not know how to raise capital. So instead they laid off as many people as they could. Some of the people they laid off now make hand-blown glass in competition with their old employer. Meanwhile, Krosno did not fire enough workers to become profitable. The company still operates two plants that are clearly losing money. So management has continued losing money and has also put new competitors in business!"

Management's failure to expand its hand-blown glass business is reminiscent of Polkolor and Alima before a dominant investor directed each company to shift capacity - in-to picture-tube masks and the Gerber brand, respectively. At Krosno, unfortunately, there is no dominant investor with ample experience in a market economy.

On the contrary, the board's only response so far has been to replace the company president twice in two years - first with an outsider and then with a 30-year company veteran - to no visible avail. As several observers have pointed out, all three of the men who have led Kros no over the past two years were trained and seasoned in the communist marketplace, which disregarded profitability and valued production and labor peace above all else.

As it happens, this oldguard mentality may be more prevalent, and more problematic, on the board of directors than among Krosno's top managers themselves. For all its in-experience and mistakes, management at least understands the need for new ideas, partners, and capital. As one put it, "We need an owner interested in financial results, not in keeping the peace with employees."

A former official at the Ministry of Privatization agrees that corporate governance is inadequate: "At Kros-no you have dispersed share owner-ship and no stock options. There really is no market-oriented governance in those companies. Board members do not participate actively. The state doesn't even attend key board meetings. In these conditions, it is easy for workers to block attempts at more layoffs. You've got no strong third voice supporting management."

The former Ministry official sees a larger problem of governance -conflict of interest in the board room: "Since you don't have a strategic investor, you have the same old problem of insiders manipulating the company. In this case the insider is Minex, taking the profit by milking the company."

Sound and Inexperience

Tonsil makes speakers, micro-phones, headphones, and related electronic parts and has annual sales of $40 million. Since privatization in November, 1990, management has tried to create a Western company. However, it lacks the expertise to do more than look for new customers and cut costs. The company is deficient in marketing, finance, and cost accounting - much the way Alima was before Gerber came along, except that the management of Tonsil recognizes these deficiencies. The tragedy is that awareness alone has not enabled Tonsil to fill the managerial void and overcome the problems. And the company's board has done little to help.

Tonsil is located in western Poland, near Poznan, and employs 2,000 people. Its markets have traditionally been electronics manufacturers, Western (especially German) companies, and Polish consumers.

Like Krosno, Tonsil's shares are broadly held. The Polish state owns 47%; the Polish Development Bank, 18%; 3,500 present and former employees, 3%; and 32% is broadly dispersed in public hands.

Tonsil's sales have collapsed since privatization, due partly to the global recession. Sales fell 40% within months of privatization and have dropped another 50% since. Management has directed its marketing toward the makers of television sets and car stereos, with little effect. The company's signed sales agreements with Grundig in Germany and Thomson in France will not soon generate high-volume sales.

Management has tried to offset declining revenues by cutting payroll costs. The company has laid off 1,500 employees (42% of the work force), including most of top management. Tonsil has also reduced social assets and lowered finished goods inventory - though not raw-material or work-in-process inventories, both of which are high by Western standards. The effect of these cost reductions has been insufficient. Although Tonsil was highly profitable before privatization, it currently generates a net loss. The company's board has intervened only once. A year after the privatization took place, the board fired all but one member of the management team on the grounds that results were not satisfactory.

Unfortunately, although the new management team includes motivated and talented people, it still lacks basic marketing, finance, and accounting expertise. The board has taken no steps to add people with these functional skills and has done little to help the current team acquire them.

Unlike many other Polish companies, Tonsil's new management wants to create a Western, market oriented company and understands what it would take to increase profits - more direct distribution, for example, and pricing based on actual production costs. But these managers do not know how to make such changes and have no time to learn on the job. So they focus on the non-controversial task of looking for new intermediaries to sell their products. When the effort fails, they either lay off workers or get fired themselves.

Management would now like to acquire a strategic partner as share-holder and put an end to the old formula involving new customers and layoffs. Ideally, this partner would supplement its own product line by adding Tonsil products and provide the marketing budget that Tonsil cannot afford. Tonsil also needs instruction and assistance with implementation. Its managers don't know where they are making money and where they are losing it.

Swimming Lesson

Janusz Dabrowski, an economist at the Gdansk Institute in Warsaw, has carried out a thorough study of 11 privatizations. He has observed certain positive effects that seem to stem from all privatizations - more market re-search, for example, and greater sales promotion efforts. But he insists that dominant shareholders such as Thomson and Gerber are the key to improving corporate performance and governance. "The most positive effects are from capital privatization, especially if purchased by a foreigner. Why? Because there is new capital investment, access to new markets, and influence on management and the organization of the enterprise."

Western investors can work miracles in Eastern Europe if they add value both inside and outside the company in purchasing, marketing, and finance. As Polkolor and Alima show, the level of success can be truly phenomenal.

However, as Kabli, Krosno, and Tonsil demonstrate just as forcefully, companies without strong, capable shareholders are apt to perform no better after a public offering than they did as state-owned enterprises. Privatization alone, in the words of one of Tonsil's top managers, "is like throwing a person into the water and calling it a swimming lesson."

Author's note: The author would like to thank Professor Jeffrey Sachs for his contributions to the development of this article.

Principals

Kevin McDonald
25 years of experience in investment banking, consulting, private equity, and international business
Michael Lehner
In the high technology field for 30 years, as an operating manager, consultant, venture capitalist, and investment banker
Copyright © 2010 McDonald-Lehner. All Rights Reserved.