Governments are bad negotiators, because democracy demands they tip their hand before going to the bargaining table. That means governments get the short end of asset sale deals

A common claim in favour of asset sales is that the sale price is usually the “net present value of future profits”, which means that the sale price plus the interest you save on your lower debt is about the same, over the long term, as the dividends you would have made from keeping the asset. Where does this claim come from?

It comes from basic microeconomics, where if these two things weren’t more or less the same then one of the parties would not rationally want to make the deal. The idea is that asset sales are a way for the government to make all the money they would have made owning the asset, without the hassle and risk and inefficiency of being in the power / telephone / airline business.

The problem with that way of thinking is that governments are not rational profit-maximizing economic actors.

The thing politicians care about most of all is votes, not money. Sometimes being prudent with public money brings in votes (e.g. promising to scrap hip-hop tours), and sometimes it does not (e.g. Labour’s debt-reducing surpluses). Asset sales are a case where the government has strong political incentives to make a sale, even when the sale price represents a poor financial return.

Here is how it works in the two most common forms of state asset sale:

Sales to “Mums and Dads”

When governments sell assets to everyday folk by way of a share float, their incentives are convoluted. They have an obvious financial incentive to reap as much from the sale as possible, but they also have strong political incentives to make sure the float is oversubscribed (so that the asset sales policy appears popular) and also to avoid the impression of pricing Mums and Dads out of the market (so as to avoid their ire at the ballot box).

Both of these political incentives serve to lower the price the government is willing to charge for its assets. An over-subscribed float is a sign of a lowball float price, because the government could have increased its sale revenue by raising the share price so that a few potential investors no longer register for shares. A share price that increases immediately post-float is another sign of a government ripping itself off. Yet these are also two things that governments work **towards**, as they politically signal a popular policy and bring quick gains for the lucky "Mums and Dads."

Sales to firms

The other way to sell assets is directly to large firms. New Zealand’s government says it isn't doing that this time (at least directly), but it is worth considering the dynamic anyway. Firms, simply put, care only about delivering financial value to their shareholders. Governments, on the other hand, care about much more – especially perceptions of political competence and ideological coherence. This provides a massive negotiating advantage to the kinds of firms that purchase state assets such as utilities.

Firms know that asset-selling governments have large amounts of political capital tied to the act of making a sale, and that the government has some wiggle room with the public (who are not all utilities analysts) in terms of spinning what a fair price would be. Governments are the classic “motivated seller,” a position that invariably brings in a low sale price.

Some may think that this problem does not arise if there are multiple firms bidding on the asset, because they will competitively bid it up to its fair price. Not quite.

If there are multiple firms bidding on a government asset, they will indeed bid it up – but the end point to the competitive bidding is not fair market value for the asset, it is the cost of the next best opportunity for the firm. If there are even a smattering of opportunities around to purchase some government’s assets without paying full market value, then that will bring down the sale price on all the other asset sales. Do those few opportunities for monopoly buyer profits exist?

Yes. The number of firms prepared to place large investments in heavily regulated sectors in the far south west Pacific is sometimes disturbingly small (especially in the current context of an overvalued currency). Exhibit A: The Great New Zealand Radio Frequency Debacle, where a firm was willing to pay $100,000 for a frequency, but the government only charged them $6 for it. Yes, $6.

Think about selling a home. When you sell your house, everyone knows that you should posture as a reluctant seller, because that it how you induce higher bids. Buyers who smell a desperate seller make low offers.

Asset-selling governments publicly showcase their almost giddy excitement at the prospect of selling up, portraying themselves as overly eager sellers. That brings unfairly low prices for governments and, through them, for everyone.

Comments (10)

by Andrew R on September 13, 2011
Andrew R

It comes from basic microeconomics ... and the microeconomics it comes from is seriously flawed; e.g. underlying assumptions about utility maximising and rational economic beings lack any proof (are just assertions or statements of faith); Keynes dealt with the absurdity of the accuracy of any net present value of profits approach years ago.

by alexb on September 13, 2011
alexb

So basically we would be stupid to sell our assets at a time when we desperately need long term planning. The profits from these assets will sustain the country for generations, or the assets will be sold now, below price and at a time when the market is weak. Why is this still being debated? Can't National just decide not to sell? Its economic lunacy, and not at all conservative.

by Rob Salmond on September 14, 2011
Rob Salmond

@Andrew R: You are right about the heroic assumptions that lie behing these long-horizon NPV calculations in the general case. My point is that, even if you accept every one of those heroic asumptions, assets still will not sell for NPV(future profits) when a government is one of the parties to the deal. There are particular problems, even beyond the general problems, when a government is involved.

by on September 14, 2011
Anonymous

I'm sorry but you could use very similar logic to argue that governments often over pay for assets in the market. E.g. the purchase of Kiwi rail. Governments in general are not very good at major purchasing or selling decisions because they typically have muddled and unclear objectives whilst the counter parties that they deal with are in most cases extremely focused upon achieving the best possible return on their buy / sell decision.

Whether or not it makes sense for the government to sell the particular assets (as currently planned) it certainly makes sense for a government to make rational choices about how they should maintain their balance sheet. For the portion of the government's balance sheet that is deemed to operate on a commercial basis is makes entire sense to make investment choices made on views of return on capital. The particulars over discount rates and periods can be debated however the base calculations are sound. If you disagree and believe that there are better methods of calculating return I suggest that you put you money where you mouth is as you should be able to make large amounts of money bucking the market orthodoxy.

The idea that a government should never sell a commercial asset is as equally absurd as the argument that it should never buy anything. Both options should be looked at in the context of the overall best return on the total capital invested in commercial assets on the government balance sheet. If I recall correctly the total average return on capital for the government SOE portfolio has been around 4%. On the face of it this represents a massively suboptimal use of public resources, especially considering the risk associated.

There is another point to consider. When governments attempt to perform the roles of shareholder and regulator for the same asset inevitable conflicts of interest arise. When the government owns a company like Solid Energy whilst at the same time attempting to regulate the environmental impacts of mining is torn between two competing objectives, and consequently does not do a particularly good job in either direction. This logic even applies to natural monopolies / duopolies that they government may own e.g. the power companies. In this case the government maybe strongly tempted to let these organisations achieve super normal profits, often hidden in their balance sheets. If they were sold the government maybe more prepared to properly regulate these companies and give consumers a better deal.

 

by Rob Salmond on September 15, 2011
Rob Salmond

@jm: Indeed my argument does suggest that governments are in a bad negotiating position when it comes to both buying and selling assets. That does not make the analysis incorrect. My point is not that govenrments should never buy or sell anything, but rather that the public needs to be realistic about the calculations that are being made. Right now, plenty of folk are saying that current public assets will be sold for NPV(future profits) - I argue that is an overestimate. For some, the degree of that overestimation will be immaterial, as they are willing to have the public purse pay that price in order to get the ownership model they want. For others, it may change their conclusion. The important thing is to think about these tradeoffs on the basis of information that is accurate, not information that is slanted.

by Rab McDowell on September 15, 2011
Rab McDowell

Would it not be better to sell into a competitive market. If sufficient buyers are bidding then, presumably, they will bid against each other till they reach the limit of what they can pay. That way it does not matter whether the Govt is or isn't a good negotiator. The best price will be received.

by Rob Salmond on September 16, 2011
Rob Salmond

@Robert - See article above for why that is not necessarily: (1) true; or (2) relevant to the case of selling New Zealand government assets.

by on September 16, 2011
Anonymous

ok, lets view this from another angle. You accept that it makes sense in some circumstances for governments to both buy and sell assets. You also accept that governments have certain structural impediments that mean that they are not necessarily in a good position to negotiate commercially optimal deals in the market. The question that then arises given the above, and the comments that you have made regarding the likelihood of the government achieving a sale price equal to exceeding the "NPV" is what is the alternative? What criteria would you use to make rational choices about the optimal portfolio. Let simplify and limit the portfolio to assets that don't have any (potential) wider societal benefits and that only reside on the government balance sheets because of historical circumstance and inertia. Solid Energy and Landcorp stand out in this manner. On what basis does a rational portfolio maximising government decide whether they should retain, or sell the asset or alternatively invest further capital  (or extract dividends)?

by Antoine on September 21, 2011
Antoine

@jm

If you know you are going to get ripped off whenever you sell anything and whenever you buy anything, then surely the rational choice is to try to transact as little as possible...

by on September 21, 2011
Anonymous

Your argument has some validity, although ultimate it is flawed. Time doesn't stand still and the do nothing argument, whilst appealing because it would led to the longer term reduction in the size of the govt v the wider economy isn't practical. Equally governments can't resist the temptation to dabble.

As a point of clarification my arguments above don't just apply to the sale or purchase of an entire enterprise, they also apply to any capital related decision associated with an enterprise. e.g. the level of dividends that the govt will take v reinvest in the company. This decision also need to be made using rational investment criteria, like to discounted value of expected future returns.

To some degree it doesn't matter what investment criteria are used to make capital decisions, as long as they are clear, consistent and open to challenge. Unfortunately governements almost always fail in this regard and consequently are at a disadvantage against orgainsations and individuals that have clearer objectives.

Ultimately governments should stick to what they are best at, providing public goods and services that the wider economy either doesn't provide and / or is inefficient at providing. Even in this area the performance criteria used to make decisions should be clear and consistent (and linked to the democratic process)

 

 

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