Privatization as an Age Privatization as an agencyproblem- Auctions versus private...

7/29/2019 Privatization as an Age Privatization as an agencyproblem- Auctions versus private negotiationsncyproblem- Auctions Versus Private Negotiations

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Privatization as an agency problem: Auctionsversus private negotiations

Zsuzsanna Fluck a, Kose John b, S. Abraham Ravid c,*

a Eli Broad College of Business, Michigan State University, 319 Eppley Center, United Statesb Stern School of Business, New York University, 44 W. 4th St., NY 10012, United States

c Rutgers Business School, 180 University Ave., Newark, NJ 07102, United States

Received 18 April 2006; accepted 1 December 2006Available online 31 January 2007

Abstract

This paper investigates the design of privatization mechanisms in emerging market economies

characterized by political constraints that limit the set of viable privatization options. Our objectiveis to explain the striking diversity of mechanisms observed in practice and the frequent use of anapparently sub-optimal privatization mechanism: private negotiations.

We develop a simple model in which privatization is to be carried out by a government agent, whoplays favorites among bidders but is potentially disciplined by losing his private benefits of staying inoffice. If the political environment is such that the privatization agent himself aims at raising the fairvalue for the company, then privatization auctions and private negotiations are equally successful inraising public revenues. If, however, political considerations distort the agents incentives, it may bethat a seemingly transparent auction will raise less revenue, than opaque private negotiations. Wealso show that information disclosure laws may have negative welfare implications: they may helpthe privatization agent to collude with some of the bidders to the disadvantage of non-colluding

bidders. 2007 Elsevier B.V. All rights reserved.

JEL classification: L33; G28; G34; K22; C72

Keywords: Privatization; Agency; Political constraints; Auctions; Private negotiations

0378-4266/$ - see front matter 2007 Elsevier B.V. All rights reserved.

doi:10.1016/j.jbankfin.2006.12.008

*

Corresponding author. Tel.: +1 973 353 5540.E-mail address: [email protected] (S.A. Ravid).

Journal of Banking & Finance 31 (2007) 27302750

www.elsevier.com/locate/jbf
mailto:[email protected]:[email protected]


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The agent we have in mind is either the manager of a state-owned firm who is appointedto privatize the firm,2 or a bureaucrat from the state privatization agency. In either casethe agent is in a position to potentially monopolize information about the company inquestion.3 Business and financial information is typically scarce in emerging market econ-

omies. Financial markets are nonexistent or at infancy. Many of the firms for sale havenever been audited before and follow ancient accounting practices.4 Hence, a crucial pieceof information may not be publicly available, and the official may have strong incentivesto help his friends in this respect. In our model, the agent provides an informational edgeto one of the bidders. This is obviously stylized, however, it is important to realize that ourresults go through even if what happens in reality is a meeting in a cafe where some impor-tant tip is passed on to a favorite bidder.5

The other important question is the objective function of the government or the peo-ple. Clearly, selling companies below value can create scandals, and hence the govern-ment would like to raise adequate revenues. On the other hand, in emerging marketeconomies there is public concern if entrepreneurs end up losing money in the privatiza-tion process.6 These goals translate into an incentive scheme that penalizes the agent fora positive valueprice differential ex-post while not rewarding him for raising more moneythan the company is worth. Such incentives are not consistent with profit-sharing con-tracts that create incentives to overcharge for bad companies. Also, conflict-of-interest reg-ulations naturally exclude explicit profit-sharing contracts between the Treasury and thebureaucrat in charge of privatization.

Similar to Grossman and Hart (1988) or Harris and Raviv (1988) in a different context,we compare the outcomes of commonly used mechanisms. Auctions and private negotia-

tions are the most widely employed privatization mechanisms in emerging market econo-mies. The typical auctions are first-price sealed-bid auctions (The Revenge of the Nerds,1994). Our paper thus investigates how much revenue privatization auctions and privatenegotiations yield in emerging market economies by explicitly modeling the political con-straints discussed above. This paper provides new insights into collusion between a bidderand a sellers agent. While collusion among bidders received a lot of attention in the liter-ature (see McAfee and McMillan (1987, p. 724) or Rothkopf and Harstad (1994) for excel-lent surveys of this literature or Porter and Zona (1993) for a recent study of this type ofcollusion), collusion between a bidder and a sellers representative is largely unexplored.

2 A commonly used privatization mechanism for small and medium-sized companies in Hungary is self-privatization. The government appoints the manager of the state owned firm to privatize the company ( Major,1994).3 For a different view of the advantage of developed markets in diffusing information as compared to emerging

markets see Berkovitch and Israel (1999).4 As J. Mark Mobius, portfolio manager of the Templeton Russia fund explains: We invest in the face of very

iffy data. The amount of information available leaves a lot to be desired. (Best Single Country Fund: TempletonRussia, Mutual Funds, March 1997, p. 48).5 Besides information regarding the value of the company in question, the official may control information

about the sequencing of future privatizations, future changes in the tax code, or other decisions at the planningstage that can materially affect the value of the company for the bidders. This information, though incremental, is

very valuable and likely to be costly to produce for a market research firm.6 To prevent severe losses by entrepreneurs, governments in these economies frequently grant bidders the rightto sell the privatized company back to the government within a period of three to five years at the price it waspurchased for, or, alternatively, offer compensation packages for unexpected losses incurred by entrepreneursduring the first few years of operation (Major, 1994).

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We recognize that collusion among bidders may affect privatization auctions as well, how-ever, to keep our model tractable we assume away this type of collusion here.7

We find that in addition to the negotiating skills of the agent, it is the degree of politicalconstraints that determines which mechanism is more successful in raising funds. If the

agent himself aims at raising fair value for the company, then privatization auctionsand private negotiations are equally successful in raising public revenues. In this casethe official will disclose all information publicly and the winning bid will approach value.If, however, political constraints distort the agents incentives, then one mechanism out-performs the other. In particular, if the distortion is moderate, then, surprisingly, privatenegotiations raise more value for a successful enterprise than privatization auctions. Thisis true even though the auction is fair and transparent, save for this little tip in the cafe .The intuition is that even though a bureaucrat in charge of the privatization processmay compromise both auctions and private negotiations, he or she has much more directcontrol over the outcome of private negotiations than over the outcome of auctions.Whereas in private negotiations the privatization agent can potentially attain his most pre-ferred outcome, the winning bid in an auction may very well exceed or fall short of theagents target. If the agents target is sufficiently high, the expected winning bid in the priv-atization auction is likely to fall short of the agents target. Interestingly, our results holdregardless of whether information disclosure is mandated for the bidders in the economy.

The rest of the paper is organized as follows. In Section 2 we describe the assumptionsof the model. In Section 3 we discuss the benchmark case when the privatization agent vol-untarily reveals information to all bidders. In Sections 4 and 5 we investigate the optimal-ity of auctions versus private negotiations when disclosure rules are in effect and when they

are not in effect. In Section 6 we discuss the regulatory implications of our model. We closethe paper with some concluding remarks and recommendations for the design of privati-zation procedures.

2. The model

2.1. The basic setup

We consider a privatization target that can be either a gem or a lemon with equal prob-

abilities. The gem is valued atv, the lemon is valued at v. Two mechanisms are compared a first-price sealed-bid auction and private negotiations. The comparison is in terms of the

ability to raise a fair price for the company. There are two bidders. The bidders are risk-neutral profit-maximizers. Each bidder is equally capable of operating the company. Thebidders know the agents preferences and the distribution of company values. They maylearn the value of the company they bid for if the agent reveals information to both orone of them. Any bidder may decide to purchase information from a research companyat cost c. The privatization program is to be carried out by a government agent whoderives utility from both pecuniary benefits, l, and private benefits from staying in office,W. The pecuniary benefits are the side-payments he receives if he colludes with a bidder.

The non-pecuniary benefits, Wcapture the value of perks, power, and the agents ability togenerate side-payments in the future. We normalize the agents salary to zero. The agent

7 For a real-life perspective on the subject see Cramtons (1997) on FCC spectrum auctions.

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maximizes the sum of his monetary payoff and expected private benefits. Our specificationof the agents preferences originates in the corporate control literature. Similar objectivefunctions in the context of asset sale include Grossman and Hart (1988), Harris and Raviv(1988), Shleifer and Vishny (1989), Burkart et al. (1997).

The agents monetary payoff, l, depends on the valueprice differential, vp, and on hisbargaining power (negotiating skills), a. The higher the valueprice differential the morethe colluding parties can split as side-payment. Moreover, the agent can extract more fromthe bidder the better is his bargaining position. Note that the extreme case of no rent shar-ing rules out collusion. If the bidder can capture all the rents, the agents objective reducesto maximizing his expected private benefits. In this case the agent has no incentive to col-lude. If all rents accrue to the agent, then the bidders have no incentive to collude with theagent. As long as the official expects favors from the colluding bidder when he is dismissed(e.g. a high level appointment in the bidders firm), he is willing to split the rents with thebidder.8 Similarly, as long as the colluding bidder expects future favors from the privati-zation agent if the agent stays in office (e.g. information about companies to be privatizedlater), he is willing to share his rents with the agent.

The agents expected private benefits depend on the likelihood that he remains in office.In the corporate finance context it is commonly assumed that the agent loses his privatebenefits of control with a certain probability. This would happen when he is dismisseddue to decisions by the corporate board, proxy fights, and takeovers. Such models weredeveloped by, among others, Harris and Raviv (1988), Berkovitch and Israel (1999), Stulz(1988), and Fluck (1999). In our context of privatization, the likelihood that an agent staysin office depends on his performance and on whether or not public attention is focused on

privatization. If the public focuses on privatization issues and a company is sold at a pricefar below value then the agent is dismissed. Hence we model the probability, p, that theagent is dismissed as an increasing function of the valueprice differential, vp. That is,the larger is the discrepancy between the value of the company and the price the winnerpaid for it, the more likely it is that public attention should turn to privatization issuesand the agent will be dismissed. The value of p is positive and increasing for v > p and0 for v 6 p.9 Thus, the agents objective function takes the following form:

max1 pv p W lv p; a; 1

where p characterizes the economy, W the privatization agent and a the bargaining pro-

cess. Notice that the privatization agent faces a trade-off when deciding how to pricethe firm: on one hand, he would like a low price to capture some of the buyers profits.On the other hand, he would like a high price to increase his chances of keeping his privatebenefits.

We compare two mechanisms, a first-price sealed-bid (common-value) auction and pri-vate negotiations, with a minimum bid set at v in either case.10 Since one of our aims is to

8 In real life, bribes do not need to be in cash. Promises of future jobs or benefits when the official retires can besufficient and commonly happen even in more law abiding countries this may be sufficient to motivate theofficial to play favorites among bidders, and our results will qualitatively go through.9

Note that the probability can be 100% as well in that sense our setting is more general and realistic.10 We assume that the number of bidders remains the same regardless of the sale mechanism. Clearly, if eithermechanism will attract more bidders, it can skew the result in favor of that mechanism. Papers such as Bulow andKlemperer (1996) suggest that auctions can have a better outcome if more bidders appear. However, it can be thatprivate negotiations will attract more bidders if they hope for a better outcome.



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derive policy implications for the privatization process, we want to model auctions andprivate negotiations, in a manner that closely approximates the actual bidding process.In privatization auctions bidding is allowed only in currency units or multiples of currencyunits.11 Thus, in our model bidding is conducted in multiples of currency units with the

smallest allowable bidding unit set at e. In other words, one can bid v, v + e, v + 2e, etc.Unlike open auctions that can always attract additional bidders (Hendricks et al., 1993;

Bulow and Klemperer, 1996), potential bidders in privatization auctions of emerging mar-ket economies come from a tight group of insiders, competitor-firms, wealthy individuals,or investor groups. They are screened in advance to assure that they can raise the neces-sary funds to finance the deal. Some of these insiders have close ties with those in charge ofthe privatization process and tend to be frequent participants at other privatization auc-tions. Thus, we model privatization auctions and private negotiations with a fixed numberof bidders, one of whom may have a continuing relationship with the privatization agent.We solve for a trembling hand perfect Nash equilibrium whenever several equilibria arepossible.

The timing of the auction is as follows. The privatization agent decides whether toreveal information to one or both parties or to none at all. We assume that if the agentdecides to collude with one of the bidders, he will not cheat the colluding bidder. The col-luding parties privately agree on the side-payment conditional on the valueprice differen-tial. If the agents bargaining power is a, then, for the good company, the bidder pays theagent a fraction of the expected valueprice differential, where expectation is taken overthe set of possible winning bids in the auction.12 As noted, at a cost of c anyone can findout exactly what the target company is worth. Our assumption that both the official and

the research company know precisely the value of the firm, substantially simplifies theanalysis without altering the nature of our results. With appropriate changes in the param-eter restrictions, our results will carry through even if (1) the officials information is noisy;(2) the information of the research company has lower precision than the privatizationofficials; or (3) the information supplied by the research company is complementary tothat of the privatization official.

In the case of private negotiations the agent decides whether to reveal information toone or both parties or to none at all. If he decides to share information publicly, thenhe can only accept bids that approximate value. If he decides to reveal information pri-vately, then he approaches one of the bidders to sell the company to the bidder in

exchange of sharing the rents. Given a (the agents bargaining power) the parties negotiatea payment v + a(v v) from the bidder to the agent. That is, each partys share of the rentsis proportional to his bargaining power. The payment for the good company is thusv + a(v v), or the closest acceptable bid, and it is v for the bad company. Since the bidderis indifferent as to how much of his payment become public revenue and how much will

11 Much of the auction literature analyzes continuous auctions. However all real-life auctions are, almost bydefinition, discrete. In fact, in the largest auction to date in this country, the FCC spectrum auction, the FCCexplicitly set discrete bid increments (the design also included discrete time intervals between bids). As it turned

out, there were interesting behavioral consequences to the discrete bid intervals, as is the case in our paper (seeCramton, 1997).12 Our result would be qualitatively the same, if the side-payment were an a fraction of the expected valueprice

differential with expectation taken over the set of possible winning bids in the auction conditionalon the colludingbidder winning, or if the side-payments were to be paid ex-post.



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end up as a bribe, he lets the agent decide the price that will be publicly announced, andlets him pocket the rest of the payment. Naturally, the agent chooses the price that max-imizes his objective function (1) subject to the constraints that l + p = v + a(v v), lP 0,

pP 0.

Once the winner starts to operate the company, the value of the company is publiclyrevealed. If public attention is focused on privatization, and if there is a discrepancybetween the value of the company and the price paid for it, then the official is dismissed.If the public attention is focused on issues other than privatization then the agent stays inoffice.

It has been suggested that information disclosure laws generate more revenues by mak-ing the privatization process more transparent. Thus, we consider two scenarios in ourmodel. In the first case, (Section 4) disclosure laws are in effect; whereas in the secondone (Section 5) information disclosure is not mandated. When no disclosure laws are ineffect, then the purchase of information remains private. When disclosure laws are ineffect, parties who purchase information are expected to disclose their information.Naturally, disclosure rules do not bind the colluding bidder. Hence he appears to be unin-formed from the point of view of the legal system. There is one additional assumption werequire regarding the rate of detection for collusion. When bribery is a more seriousoffense than failing to reveal information, then, for collusion to be incentive compatiblefor the bidder, it must be the case that bribery is more difficult to discover. Thisassumption seems reasonable. As we noted, the collusion we have in mind is a casualand hard to detect conversation, that both parties wish to keep secret. This contrasts withbusiness transactions such as sale of information by a research company that leave a paper

trail.

3. The case of voluntary information revelation

We first discuss the benchmark case in which the agent greatly values staying in onerefuses to be bribed and voluntarily reveals information to all bidders. This s a scenarioin which political constraints and sale mechanisms do not matter. Formally,

W pv p peP v p e 2

for every pP v. For every p, the right hand side shows the maximum bribe the official getswhen he raises p and accepts a bribe rather than raising v e and refusing side-payment.The left-hand side shows the difference between the expected private benefits of these strat-egies. Note that the condition is only sufficient agents may inform both bidders even ifthe condition does not hold.

Proposition 1. When the agent informs both bidders then the subsequent auction p v efor the good company, and p = v for the bad company in any perfect equilibrium.

The intuition is straightforward. If both bidders know that the company is a lemon,then neither bids more than v in equilibrium. If, however, they find out that the companyis good, then they will not bid below v e since they may lose the auction otherwise. Ifeither bids v, then she may win or tie with the other bidder. In either case zero profit is



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made. Either bidder can do at least as well by lowering her bid to v e. Bidding v e forthe company yields an expected profit e/2 for both bidders in equilibrium.13 When thereare no political constraints, then for the privatization agent maximizing utility is equiva-lent to minimizing the probability of dismissal.

Proposition 2. Whenever (2) holds, the privatization agent voluntarily reveals information toboth bidders in any perfect equilibrium.

When (2) holds, then publicly revealing information maximizes the utility of the priv-atization agent (Proposition 1). Obviously, no strategy can improve upon this. As we shallsee later, other strategies make the agent strictly worse off. Disclosure rules do not matterwhen (2) holds. Since both parties are receiving information from the agent, nobody pur-chases information, so there is nothing to disclose. Finally, whenever (2) holds, then anauction yields the same revenue as private negotiations. The agent who publicly revealsinformation extracts nearly full value: the bidders will be indifferent between buying atvalue and walking away.

Proposition 3. Whenever (2) holds, the privatization agent raises v e for the good companyand v for the bad company through private negotiations.

The following sections focus on approachable agents. An agent is called approachable iffor a high enough bribe he is willing to compromise public revenues. When the agent isapproachable, disclosure rules make a difference.

4. Privatization when disclosure laws are in effect

We model disclosure rules in the spirit ofGrossman and Hart (1980), that is, disclosurerules require that any information that a party has about the value of the company mustbe revealed to everybody. The disclosure we model is thus very much in the spirit of whatinsiders at publicly held companies are required to do when they take actions that substan-tively affect shareholder value14 (see Fig. 1).

Disclosure rules have two implications in our model. They force the party who pur-

chased information to reveal this information and thereby reveal their identity. Secretinformation transactions on the other hand, by nature, are not known to anyone butthe parties involved. Since disclosure rules have no impact on the colluding parties whodo not comply with them, they enable the colluding parties to fully realize their costadvantage over the non-colluding party. As a consequence, it does not pay for the non-col-luding party to purchase information unless the cost of acquiring information is negligible.The outcome is an auction with asymmetrically informed bidders.15

13 One could ask the following question: if the official discloses the true value, why do we need an auction at all.As is shown in Propositions 1 and 3, in such case both auctions and private negotiations would extract nearly full

value.14 See for example, Bonin et al. (2005) for a discussion of the role of information disclosure in privatizations intransition economies.15 Our paper is related to Wilson (1967), Milgrom and Weber (1982), Engelbrecht-Wiggans et al. (1983),

Hendricks et al. (1993, 1994) on auctions of mineral rights with asymmetrically informed bidders.

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able bid, the highest allowable bid below. In case the colluding bidder does bid this high, itis not a best response for the uninformed to make such a bid. However, if the informedbids less in the good state, then it is a best response for the uninformed to place a higherbid but never higher than unconditional expected value independently of the state. Staying

out is not Nash equilibrium strategy either.There is a unique perfect Nash equilibrium in mixed strategies, however. In this equi-

librium no bid exceeds the unconditional expected value with positive probability. The col-luding party always bids v when the company is of low quality. When the company is ofhigh quality, the informed mixes between his sure winning bid (the one just below theunconditional expected value) that may, however, be unnecessarily high, and lower bidsthat are potentially more profitable winning bids. The uninformed bids either cautiouslyor aggressively, each with high probability so as to minimize his potential realized lossesand his opportunity losses.

Collusion can be alleviated by setting information costs low or bidding increments highso that c 6 e/4. When this is the case, then scenario 1 arises. In this case collusion breaksdown because the party that does not purchase information becomes suspect as a party tocollusion, since a non-colluding party will always purchase information. Therefore, undercondition c 6 e/4 collusion will become unprofitable and unsustainable. Obviously, privatenegotiations are not affected by disclosure rules. We illustrate the outcome of the auctionand of private negotiations with a simple example for the case when c > e/4.

Example 1. Let v = $1 million and v $6 million. The increment between subsequent bidsis $1 million. The unconditional expected value of the company is $3.5 million. The

government agents private benefit from staying in office is $4 million. The cost ofinformation purchase is $750,000. The political constraints specified by the probability ofdismissal are pv p v p e 0:08 if v p6 3 and pv p v p e 0:2)otherwise. We present below the essence of the solution, a more detailed proof anddescription is available from the authors upon request.

Private negotiations: The colluding bidder makes a payment v av v to the agentfor the good company. The agent sets l and p to maximize (1) subject tol p v av v, lP 0, pP 0. The bidders profits are 1 av v. When the valueof the company is revealed, the agent faces a dismissal with probability pv p. For

example, for a = 2/3, the agent will negotiate a price of $4 million, and pocket a bribeof 1/3 of a million. His utility will be 4.01 million that is higher than the 4 million hecan achieve by revealing information publicly. The bidder receives a profit of 5/3 of a mil-lion. The agent faces a dismissal with probability 0.08.

The auction: After iteratively eliminating weakly dominated strategies, we find that thenon-colluding party will never purchase information and will not bid more than expectedvalue, $3.5 million. The colluding party will not bid above $3.5 million with positive prob-ability for the good company and will not bid $1 million with positive probability for thebad company. In equilibrium, the colluding party bids 3 with probability 2/3 and 2 withprobability 1/3 when the company is good. Furthermore, if the non-colluding party bids 1

with probability 3/5, and 3 with probability 2/5, then in the good state the colluding partyis indifferent between bidding 2 and 3, prefers either of these bids to 4, and might as wellbid 2 with probability 1/3 and 3 with probability 2/3. Similarly, if the colluding party bids2 with probability 1/3 and 3 with probability 2/3 for the good company and 1 for the bad



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company, then the non-colluding party is indifferent between bidding 1 and 3 and might aswell bid 1 with probability 3/5 and 3 with probability 2/5. The colluding party wins thegood company with probability 11/15.

The expected price for the good company is only $2.8 million, about 20% below the

unconditional expected value and less than half of what the company is worth.17 Thisunder-pricing happens even when the agent himself would prefer a price of $4 millionand is able to negotiate this price in the absence of the auction. This would happen, forexample, when a = 2/3. However, when the agents only option is an auction he prefersthe expected winning bid of $2.8 million to the $5 million he can raise by foregoing hisbribe and revealing information to both bidders. His utility from the latter is $4 million.When he reveals information to one bidder only, he raises $2 million with probability1/5 and $3 million with probability 4/5 for the good company. He receives a bribe of1/5 a $4 million + 4/5 a $3 million = 16/5 a. Depending on a, he prefers reveal-ing information to one bidder only. This happens for example when a = 2/3. In this case,the agent prefers revealing information to one bidder only, since by doing so, he expectsthe equivalent of 5.14 million in utility terms.

So far we have assumed that when auction mechanism is used to privatize the companythe official always reveals information to at least one party. Next we establish that the offi-cial will indeed, always designate at least one party as informed in equilibrium. As Prop-osition 5 below shows, not revealing information is a dominated strategy. Depending onhis preferences, the agent either informs one bidder (see Example 1) or both (see the case ofvoluntary information revelation).

Proposition 5. When disclosure rules are in effect and when a sealed-bid auction is used tosell the company, then in equilibrium the official will reveal information to at least one bidder.

Proof. The proof is shown in Appendix. h

Our main result: in an ex ante comparison private negotiations dominate auctions for awide range of preferences and bargaining skills.

Proposition 6. Suppose that c > e/4 and the official is somewhat disciplined by the threat ofdismissal (i.e. p*, the price he would negotiate if he colludes exceeds the expected winning bid

in the auction with asymmetrically informed bidders). Then, private negotiations raise morerevenues for good companies, auctions raise more revenues for bad companies if either of the

following holds: (a) Regardless of the mechanism used, the agent informs only one bidder; or

(b) the agent reveals information to one bidder when conducting an auction and makes

information public when conducting private negotiations.


Proposition 6 presents a striking result: even if the official is so corrupt that half of thecompanys value disappears in the pocket of the colluding parties, private negotiations can

17 The expected price the colluding party pays for the good company when he wins is $2.7 million, so thecolluding party pays less than the non-colluding party when winning the good company.



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raise more value than the asymmetric information auction. This is illustrated in Example1. Such logic may explain why one observes private negotiations in countries where cor-ruption and collusion are widespread. If the official will distorts both outcomes, then arequest by external monitors or the public to conduct an open auction may backfire,

whereas private negotiations may increase social welfare and lead to better prices. Anothercomparison relevant for political considerations, is the ex-post comparison of the realizedwinning bid of the auction with the price attained through private negotiations.

Corollary 6a. Suppose c > e/4 and p* > v + e. Then, when the agent reveals information toonly one bidder there is at least one price in the auction that private negotiations can improve

upon.

Since any bid below expected value is sufficient to win the good company with positive

probability in the auction with asymmetrically informed bidders, this corollary demon-strates that there is always a price in the auction private negotiations can improve uponex-post, provided that p*, the price that maximizes the utility of the privatization officialexceeds v. Since low bids are used with high probability (see Example 1) the dominationcan be quite strong. The reverse is not true: for a range of the agents preferences, all pricesin the auction are dominated by private negotiations. The situation is somewhat differentwhen no disclosure rule is in effect.

We presented sufficient conditions for private negotiations to dominate auctions in non-transparent regimes. These conditions seem to be consistent with empirical findings in thebank privatization literature (see Clarke et al., 2005; Haber, 2005) as well as evidence cited

in Megginson (2005), which culminates with his recommendation: governments may needto emphasize asset sales to foreign owners (Megginson, 2005, p. 1962). Our next sectionfocuses on a setting in which the non-colluding party is not a transparent entity, and thusmay have a better shot against a corrupt opponent.

5. Privatization when no disclosure laws are in effect

When information disclosure is not mandated, it is potentially advantageous for thenon-colluding party to purchase information (see Fig. 2).

In this case the information structure is asymmetric: the colluding parties do not knowwhether they face an uninformed bidder in the auction. The lack of disclosure protects the

The official

reveals The bidders may Auction Ownership isinformation to one (privately) or private transferred.

both or none purchase negotiation

of the bidders. information. takes place.

0 1 2 3 4

Fig. 2. The timing of the model when no disclosure rules are in effect.



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non-colluding bidder so that he can benefit from purchasing information with some prob-ability. Having an informational advantage, a non-colluding bidder can compete awaypart of the rent the colluding parties could otherwise realize from their cost advantage.As a result more revenues can be raised from privatization when information disclosure

is not mandated.Let EV* stand for the unconditional expected value of the target, if it is an allowable

bid, and for the closest allowable bid from above if it is not an allowable bid. Then,

Proposition 7. When no disclosure rule is in effect and when the privatization agent informs

one bidder only, then, depending on the cost of information, c, one of the following applies:

(1) If c 6 e/4, then the non-colluding party always purchases information and the subse-

quent auction facilitates the transfer of ownership for the good company at a price

p v e.(2) Ifc > max vEV

4; vEVe

2

holds, then no party purchases information. There is unique

perfect Nash equilibrium in mixed strategies in the auction such that the expected win-

ning bid for the good company is significantly below the unconditional expected value.

(3) If e=4 < c < max vEV

4; vEV

e2

holds, then the non-colluding party will purchase

information with some probability. There is a unique perfect Nash equilibrium in the

subsequent auction in which the non-colluding party plays mixed strategies conditional

on whether or not he has purchased information. The expected price at which a good

company is sold is higher when disclosure rules are not in effect than when they are

in effect.


Note that the expected price at which the good company is sold is the same no matterwhether disclosure rules are in effect. In scenario 1 the party that does not purchase infor-mation becomes suspect as a party to collusion, since a non-colluding party will alwayspurchase information. Therefore, under condition c 6 e/4 collusion becomes unprofitableand unsustainable. In scenario 3 the expected price at which a good company is sold ishigher when disclosure rules are not in effect because the non-colluding party will purchaseinformation with some probability when his purchase cannot be detected by the colluding

parties. When he learns that the company is good, the non-colluding party is willing to bidhigher than when he is ignorant. He is willing to buy information as long as the cost ofpurchasing information can be recovered.

After iteratively eliminating dominated strategies we find: (1) When uninformed, thenon-colluding party (a) will not bid above expected value; (b) will bid v with positive prob-ability for the good company. (2) No informed party will bid v with positive probabilityfor the good company. (3) The colluding party will bid more aggressively than the non-col-luding party. We illustrate the auction and of private negotiations in Example 2 below forthe case when c > e/4.

Example 2. Let v = $1 million and v $6 million and let the minimum increment be $1million. Assume that the cost of information purchase is $750,000. The unconditionalexpected value of the company is $3.5 million. The political constraints and the outcomeof the private negotiations are as in Example 1.



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In equilibrium, the non-colluding party purchases information with probability 4/7 andif he learns the company is good, he bids either $3 million or $4 million with probabilityhalf each. If he learns the company is bad, he bids $1 million. With probability 3/7 heremains ignorant and bids no higher than $1 million. For the good company the colluding

party bids $4 million half of the times, a bid high enough to win against an equallyinformed bidder and $2 million half of the times to take advantage of bidding against anuniformed bidder. For the bad company, the colluding bidder bids $1 million. Note thatbidders bid more aggressively under no disclosure than under full disclosure. They bothbid $4 million with positive probability under no disclosure, a bid neither placed withpositive probability in the case of full information disclosure. Were the cost of informationlower, they would bid even more aggressively. In contrast, if c were to exceed $2 million,the non-colluding party would never purchase information and would bid the same as inExample 1.

The non-colluding party has no incentive to deviate from his equilibrium strategy evenupon learning that the company is good. He is indifferent between bidding $3 million and$4 million for the good company both ex ante and ex-post provided the colluding partyfollows his equilibrium strategy. The non-colluding party would profit less by biddinghigher than $4 or lower than $3 million after getting good information. Notice also thatthe non-colluding bidder does not bid the same as the colluding bidder even when they both

know the value of the company. The reason is that even though the two bidders have thesame information about the value of the company then, the non-colluding party is betterinformed than the colluding party: he knows when he is informed.

The expected price for the good company in the auction is $3.4 million, about 20%

higher than the $2.8 million price the auction raises under mandated disclosure. It still fallsshort of the $4 million the agent would raise through private negotiations and it is stillbelow the unconditional mean. Again, when the agents only option is the auction heprefers the expected winning bid of $3.4 million to the $5 million he could raise by foregoinghis bribe and revealing information publicly. His utility from the latter is $4 million. Whenhe colludes, he raises $2 million with probability 3/14, $3 million with 1/7 and $4 millionwith 9/14 for the good company. His bribe is 3/14 a $4 + 1/7 a 3 million +9/14 a 2 million = 18/7a. When for example a = 2/3, he prefers revealing informationto one bidder only since by doing so, he expects 4.9 million in utility terms.

So far we assumed that the agent reveals information to at least one bidder. The next

proposition establishes that the privatization agent will disclose information to at least oneparty even when there is imperfect monitoring of information purchases. Depending on hispreferences, he either colludes with one of the bidders (see Example 2) or reveals his infor-mation publicly (see the case of the voluntary information revelation).

Proposition 8. When no disclosure rules are in effect then the privatization agent always

reveals information to at least one bidder.

Proof. The proof is shown in Appendix.h

Having established the equilibrium bids in the auction, it is straightforward to see thatCorollary 6a would also hold for the case when information disclosure is not mandated.That is,



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Corollary 8a. When c > e/4 and when p*, the price that maximizes the utility of theprivatization official, given a, exceeds v, then no matter what the preferences of the privatization

agent are, there is at least one price in the auction which private negotiations can improve upon.

It is important to note that the probabilities implied by the two disclosure scenarios arequite different. When information disclosure is not mandated, auctions produce higherrevenues (see Proposition 7). Depending on the agents preferences, private negotiationsmay still raise more than auctions but for a smaller range of parameter values. Paradox-ically, disclosure rules give rise to lower public revenues and higher bribes when marketand political frictions are prevalent.

6. Implications and additional policy considerations

There are several policy implications one can draw from our model. First, we have seenin scenario 1 in Propositions 4 and 7 that auctions designed with high bidding incrementsmay give rise to higher public revenues and lower bribes. These results suggest that discreteintervals may play an important role in auctions. Intuitively, the higher the bidding incre-ment, the more costly a wrong bid, and the more useful is information.

Similarly, low cost information will reduce the unfair advantage of the colluding bidderand will make higher prices more likely in auctions. In our model if the cost of informationis less than a quarter of the bidding increment, then the official cannot manipulate the auc-tion by strategically releasing information to a favorite bidder. Furthermore, in this caseno collusion between the official and a bidder is sustainable. In such an event, uninformed

bidders will always purchase information, therefore, the fact that a bidder does not acquireinformation signals inside information and makes it easy to detect collusion or corruption.Hence, by setting the bidding increment appropriately high or by subsidizing marketresearch, a government can significantly reduce corruption in the privatization process.

The second, perhaps most striking implication of our model, is that the choice of priv-atization mechanisms should depend on the availability and dissemination of informationand the severity of political constraints. Our model suggests that in economies or in indus-tries where information is widely available, valuation is straightforward and political con-straints do not matter, auctions and private negotiations are equally successful in raisingrevenues. In contrast, in economies or industries where information is scarce, valuation is

highly uncertain and political constraints are present, private negotiations may dominateauctions. The crux of the issue is the recognition that a corrupt agent will be corruptwhether he is negotiating in private or organizing an auction. Whereas an official can bothcompromise auctions and private negotiations he or she has much less direct control of theoutcome of an auction than that of private negotiations. This idea is consistent with therecommendations of both Clarke et al. (2005) and Megginson (2005) which amount toa suggestion of selling directly to private investors as opposed to share auctions.

Our model calls attention to several other issues. First we note that the agents bargain-ing power a, affects the public revenues. The higher is a, the less likely is the official to vol-untarily reveal information and the more likely he is to collude with one of the bidders

regardless of the mechanism used. Thus, a higher a may actually translate into lower pub-lic revenues. On the other hand, even though a does not affect the outcome of the auctiondirectly, (only through the officials decision concerning the sharing of information), itdirectly influences the price attained through private negotiations. Given that the agent



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colludes, the more bargaining power he has, or the better negotiating skills he possesses,the more public revenues private negotiations generate.

These ideas lead to some interesting policy implications. For example, it is plausible tothink that an entrenched privatization official who expects to be involved in many deals to

come is more likely to have a substantial bargaining power as opposed to one who isinvolved in a single deal only. In particular, our theory suggests that the governmentcan exert indirect control over the privatization process by nominating different officialsto run each privatization program (as in Hungary for example) or by choosing officialswho will be responsible for many transactions.

Another important variable in our analysis is the non-pecuniary benefits, W. This var-iable represents the prestige of the privatization agents office or the agents ability toreceive bribes in the future. Thus, agents with different potential tenure are likely to behavedifferently. Limiting tenure to a specific period, or limiting the number of deals the officialcan direct, will reduce W, and may increase the officials willingness to accept bribes. Onthe other hand, by guaranteeing a period of employment, the government can push Wupward, thus making the privatization agent less willing to accept bribes, at least in theearly years of his career. Hence, there is a trade-off between Wand a. The same measuresthat increase W, are likely to decrease a and vice versa.

7. Concluding remarks

This paper has analyzed the privatization process within an agency framework. Wehave focused on the role of a privatization agent and demonstrated that a potential agency

conflict may substantially affect the choice of privatization mechanism. An agency prob-lem spanned by political constraints has interesting implications. Paradoxically, privatenegotiations may raise more value than auctions when the agent-in-charge highly valuesstaying in office and uses his bargaining power to negotiate his target price. Disclosurerules that seem to render an auction more transparent may work in favor of corrupt bid-ders. Our research highlights how the effectiveness of the political process, the severity ofthe political constraints and the availability of information affect the choice of mechanismbetween privatization auctions and private negotiations. Moreover, our theory sheds somelight on the widespread use of private negotiations in economies where political con-straints are significant.

There are several important directions for future research. One is the characterization ofoptimal contracts for government agents conducting privatizations of large-scale enter-prises in countries with political constraints and agency problems. Such contracts mightspecify the length of tenure, the number of deals an agent is involved and the compensa-tion/penalty structure. Other interesting problems awaiting future research include (i) thestudy of privatization mechanisms when the sale object has some private value to the buyer(for example, when the bank complements a bidders other business activities); or (ii) whenthe sale contract includes a buyback clause and there are moral hazard, effort provision,over-optimism and adverse selection problems in the post-sale operation of the enterprise.

Acknowledgements

We acknowledge helpful comments from Vicente Madrigal, Enrico Perrotti, AnthonySaunders, Lemma Senbet, Andrei Shleifer, Jayanthi Sunder, Robert Vishny, Ingo Walter,



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Luigi Zingales and participants in conference presentations at the Pacific Basin FinanceConference, The European Finance Association Meetings, The Annual Conference onFinancial Economics, University of Maryland, at the American Economic Associationmeetings and at seminars at UC-Berkeley, Columbia, Haifa, NYU, Rutgers and Tel Aviv

Universities, the City University of London, the University of Cyprus, ESSEC, Dart-mouth, INSEAD UCLA, USC especially John Matsusaka and Jan Zabojnik, the Univer-sity of Amsterdam, and the United Nations Research Council.

Appendix

Proof of Proposition 4

Step 1: Information purchase (c 6 e/4). Whenever the uninformed purchases information,then with probability 1/2 he learns that he is bidding for the good company. Since disclo-sure rules are in effect, his information acquisition is disclosed to the colluding parties.Consequently, both bidders bid v e in perfect equilibrium (Proposition 1) and thenon-colluding party makes a gross profit ofe with probability 1/2. Consequently, it is onlyworthwhile for the uninformed to purchase information if c 6 e/4.Step 2: No information purchase (c > e/4). Nonexistence of pure strategy equilibrium. Sup-pose the uninformed bids bu and the informed bids v or bi conditional on the value ofthe company. If the informed bids more than E(v) for the good company then the unin-formed bidders best response is v (any above v bid would bring an expected loss to theuninformed). However, if the uninformed bids v, then the informeds best response is

v + e for the good company. If the informed bids less than E(v) then the uninformeds bestresponse is to outbid him. However, for any bid by the uninformed, the informeds bestresponse to outbid him for the good company. Finally, if the informed bids E(v) for thegood company, then the uninformed will stay away from this bid. Consequently, thereexists no pure strategy equilibrium.Step 3: Characterization of the perfect equilibrium when c > e/4. The perfect equilibrium canbe computed using iterated elimination of weakly dominated strategies. In a perfect equi-librium the only strategies that are played with positive probabilities are those that surviveiterated elimination of weakly dominated strategies. Bidding v for the good company isstrongly dominated for the colluding bidder. Bidding more than v for the bad company

is weakly dominated for the colluding bidder. Bidding more than E(v) is weakly dominatedfor the non-colluding bidder. Taking the iteration one step further, bidding more thanE(v + e) is also weakly dominated for the colluding bidder. If the colluding party bidsE(v) or above with positive probability for the good company then the non-colluding partywill never bid E(v) since bidding E(v) would yield him an expected loss.Step 4: Uniqueness when c > e/4. It follows from Step 3 that there exists ~bC 2 v;v suchthat for every bC > ~bC BRN (bC) = v where BRN is the best response correspondence forthe non-colluding party. We select the smallest of these ~bCs and denote it by bC: We knowfrom Steps 2 and 3 that whenever the non-colluding party bids between v;v 2 2 thecolluding partys best response is to outbid him. Similarly, whenever the colluding partys

strategy specifies an expected bid bC < bC; it is the non-colluding partys best responseto outbid him. Consequently, for any bC < bC, the hyperplane bC = bN would separate(BRC)1 and BRN where (BRC)1 is the inverse correspondence of the colludingpartys best response correspondence. Hence, there exists no bC < bC; such that



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BRC(bN) = BRN(bC)1. Since from Step 3 we know that there exists no bN such thatBRC(bN) = v, therefore, bC is the unique solution to BRN(bC) = (BRC(bN))1. It followsfrom Step 2 that there exists no Nash equilibrium in which the colluding party would playa pure strategy, therefore, bC must be the outcome of a mixed strategy. Since the colluding

bidder would not be willing to play the same non-degenerate mixed strategies against dif-ferent mixed strategies by the non-colluding bidder there is a unique bN that solvesBRCbN bC. Consequently, there is a unique perfect equilibrium in mixed strategies.Step 5: The expected price of the good firm is less than

vv

2. When E(v) is an acceptable bid, it

trivially follows from Step 3 that no bidder bids higher than E(v) and that no bidder bidsE(v) with probability 1 for the good company. Consequently, the expected price of thegood firm is less than E(v). When E(v) is not an acceptable bid, then let EV* and EV

*

denote the closest allowable bid from above and below, respectively. Now we need to showthat qI the probability the informed bids EV* is less than half. For the colluding bidder tobid EV* it must be the case that the non-colluding bidder bids EV

*

with some probability.For the non-colluding bidder to bid EV

*it must be the case that

EV2

v EV ProbEVN winsP 0;

ProbEVN winsPEV

2v EV:

Since EVvEV

P1/2, Prob(EVN wins)P 1/4. However, for Prob(EVN wins)P 1/4, it must be

the case that the non-colluding bidder bids EV* for the good company with probabilityless than 1/2. But if it is the case, then the expected winning bid for the good companyis less than E(v). Obviously, the colluding party may not bid as high as EV* with positiveprobability in which case the expected winning bid is even lower. h


Step 1: c 6 e/4. The official is better off disclosing information to both bidders than notdisclosing it to anyone. He gets no bribe either way, but in the former scenario he is morelikely to stay in office. This so since an uninformed would never bid v e with probability1 regardless of what his beliefs are about the other bidder. The officials expected gainfrom disclosing information to both bidders as opposed to none is bounded from below

by p

vv

2 pe W

2 : When c 6 e/4, revealing information to one bidder dominatesrevealing information to both or none of the bidders. This is because when the officialreveals information to one bidder then the non-colluding bidder will purchase informa-tion, the bids will tie at v e for the good company and when the colluding bidder wins,the official also gets a side-payment.Step 2: c 6 e/4. Revealing information to one, both or none of the bidders may raise thesame revenue when c > e/4. However, the official strictly prefers revealing information toone bidder only to his other options since this is the only way he can receive an additionalside-payment. Consequently, not revealing information to any bidder is not part of anyperfect equilibrium. h

Proof of Proposition 6. The price the privatization official negotiates will exceed E(v).Since the expected winning bid in the auction is less then E(v) (see Proof of Proposition4), the negotiated price will exceed any equilibrium winning bid in the auction. h



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Proof of Corollary 6a. It follows from the Proof of Proposition 4 that in the auction v ewill be a winning bid for the good company with positive probability in the perfect equi-librium when c > e/4. Whenever the price at which the utility of the agent is maximizedexceeds v then private negotiations will attain at least v + e. It also follows from Proposi-

tion 4 that the highest winning bid for the good company in the auction is EV*. Conse-quently, if the price at which the utility of the privatization agent is maximized exceedsEV*, then the negotiated price will exceed any price attainable through auction. h

Proof of Proposition 7. The proof of Steps 1, 2, 4 and 5 are identical to Steps 1, 2, 4 and 5in Proposition 4 and are omitted. The proof of Step 3 is shown below.

Step 3:

e=4 < c < maxv EV

4;v EV e

2

& ':

If the colluding party plays his equilibrium strategy derived in the Proof of Proposition4, then it is worthwhile for the uninformed to purchase information and to outbid him aslong as conditions ofProposition 7 hold. On the other hand, given that the non-colludingparty purchases information, then the colluding partys best response is to outbid him sothat the resulting winning bid for the good company will be v e (see also Proposition 1).If on the other hand, the non-colluding party bids v e for the good company, then thecolluding party will never purchase information as long as c > e/4. However, if the non-colluding party will never purchase any information then the colluding party will bidthe same as in Proposition 4. Consequently, the non-colluding party will purchase infor-

mation with some probability (less than 1) in any perfect Nash equilibrium and the win-ning bid will exceed those in Proposition 4. h


Step 1: c > e/4. The agent is at least as well or better off by disclosing information to bothbidders than by not disclosing to anyone. When the official discloses information to bothbidders, they always bid v e for the good company (see Proposition 1) and they bid lessotherwise.

Step 2: c > e/4. Revealing information to one, both or none of the bidders may raise thesame revenue when c > e/4. However, the official strictly prefers revealing informationto one bidder only to his other options since this is the only way he can guarantee hisside-payment. Consequently, not revealing information to any bidder is not part of anymixed strategy Nash equilibrium. h

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