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Approaches to privatization: established models and a U.S. innovation.

The pros and cons of four privatization models are charted, comparing approaches that have been used in Great Britain and New Zealand with the old standby - contracting out - and a United States innovation.

Governmental units today are often confronted with a major dilemma: there are growing demands from their constituents for more and better services along with an increasing inclination for tax limitation, if not tax reduction. Limitations on the property taxing authority of state and local governments, compounded with the simultaneous dwindling of federal shared revenues and other subsidies, puts these governments in a constant search for alternative financing sources. Among those alternatives, privatization is an option receiving growing attention. Indeed, President Bush signed an Executive Order on April 30, 1992, to remove regulatory impediments and encourage state and local governments to sell or lease their infrastructure assets obtained with federal assistance to private investors.

Privatization enables private enterprises to perform what has been an exclusively public task or a government dominant function. While gaining popularity, privatization is still a somewhat sporadic event rather than a growing trend in the United States. There has been, however, a systematic effort in the United Kingdom and a national compaign in New Zealand to privatize government operations. Governments have found privatization, when properly implemented, useful in reducing public expenditures, increasing efficiency, raising capital, and/or providing improved services.

Because of the diverse goals and endemic needs of governments, the privatization process varies greatly. Two outwardly similar situations may call for different procedures implemented in different stages, over different time spans. Government finance officers and accountants in both the public and private sectors have been heavily involved in the privatization process. Their potential responsibilities span all of the stages of the transition, and the manner in which they discharge these responsibilities impacts everything from early planning to completion. In addition to various levels of planning, they are involved in such activities as asset valuation, service, pricing and contract negotiation.

Government officials involved in privatization must thoroughly understand the various approaches and processes if they are to ensure a smooth transition that achieves the goals of all concerned. Because the privatization of a governmental function is not commonly part of a finance officer's/accountant's career training or experience, the necessary level of understanding is seldom present when the need first arises. Lessons can be gleaned from the experience of others, however. While the individual process may need to be tailor-made, commonality of methodologies can generally be observed.

This paper summarizes three general privatization models used in the United Kingdom, New Zealand and the United States. The authors have recently experienced a fourth alternative, which incorporates some of the elements of the other three but remains unique in many respects. This new privatization approach is contrasted with the other models. The authors do not suggest that any one method is superior to another, for clearly, the goals of the government and other relevant constraints should dictate which privatization methodology,may be most appropriate in any given situation.

Based on their roots and history, the four approaches introduced in this paper are referred to as 1) the British Model, 2) the New Zealand Experience, 3) the Old Standby and 4) a United States Innovation. Each of these approaches is separately described, with a discussion of some relevant advantages, disadvantages and examples. Exhibit 1 summarizes the major features of the four methods.

The British Model

The outright sale of government assets is probably the most common form of privatization in the United Kingdom.(1) Two primary pricing conventions have been used. Fixed-price stock offerings make single-priced shares available to the public. Tender stock offers, however, do not fix stock prices in advance; thus the price is determined by market forces.

In a sale of assets, the entity to be sold follows typical private-sector procedures. These include, among others, developing a prospectus, identifying underwriters and issuing houses, and selecting the stockbrokers. Since the market values of assets to be sold often are unknown in a governmental environment, determining the fair market value to use in a fixed-price offer or establishing the minimum bid in a tender offer can be difficult and expensive.

In England, it has been found that fixed-price offers tend to undervalue the assets, despite governmental efforts to establish a fair price.(2) A major reason for this phenomenon is that the underwriters also are often the prime bidders, and any shares not sold can be purchased by the underwriters at bargain prices. Thus, there is a built-in incentive for the underwriters to refrain from bidding, which leads to underpricing of assets.

Advantages. The advantage of this public offering method is that there are many accountants, bankers, underwriters and issuing houses who are familiar with the process. It should thus be relatively easy for a governmental entity to find the necessary specialists to assist with a privatization. The proceeds of the sale may provide additional revenues if depreciated assets have higher market values. Therefore, this often is the method of choice when capital generation is one of the goals of government. Further, should the government desire that a wide ownership of assets be a major result of the privatization process, this method can achieve that goal.

Disadvantages. This approach can be very expensive. There may be no market for the assets to be sold. There may be no guarantee that the assets will be fairly valued in order to avoid a loss of net worth to the community. It has been suggested that the British model for wide ownership of assets prevails only in the short term for many sales and that revenue gains may only be an accounting illusion.(3)

Examples. Mexico, aggressively privatizing its governmental enterprises, sold its national telephone agency, Telemex, using this approach. Southwestern Bell of the U.S was part of a bidding group that acquired 20.4 percent of the stock for $1.76 billion.(4) Also, Bancomer, the second largest Mexican bank, was put on the auction block for bids in the $5 billion range.(5)

In the U.S., stocks have not been a common vehicle for government assets sales - most transactions have been consummated in dollars. In 1986, the Navy auctioned off its Truman Annex, located on Key West, to a private developer for $17.5 million. Other recent examples include the $2 million cash sale of a former school to a nonprofit corporation by Stamford, Connecticut, and the sale of the Conrail system.

The New Zealand Experience

Corporatization is a term coined in New Zealand, where privatization of most governmental services is an all-out effort.(6) Using the corporatization approach, the government creates a for-profit corporation having a governing board typically composed of members from the government as well as from the local business community. The government owns all the stock in the new corporation. The net assets of the spin-off entity are transferred to the new corporation at book value in exchange for the stock.

This process enables the newly created corporation to operate free of most of the constraints of government while allowing the government to maintain control and ownership. Entities that have previously obtained their funding from the public budget are required to earn their own revenues after incorporation. Once the corporation has established itself and generated a credit history, then the stock is sold on the open market.

There are some who argue that the final sale of the stock - the actual privatization - is an unnecessary step. Proponents of this method, however, insist that privatization is essential to keep the corporation free of unnecessary government constraints in the long term.(7)

Advantages. Corporatization, in and of itself, provides no additional revenues, but it presumably enables the government to correct inefficiencies and bypass bureaucratic red tape. The sale of stock could generate revenues if the assets have appreciated.

There is generally no shortage of expert assistance in establishing the corporation and effecting the asset transfer. The corporatization process need not be expensive, although the privatization itself would entail expenses similar to those involved in any other sale of assets. This method also allows the government to retain control for as long as it deems necessary while enabling the spin-off entity, time to adjust to the corporate environment. From an accounting perspective, this may be relatively unimportant for functions already accounted for in proprietary or enterprise funds, but crucial for activities in governmental funds,. Buyers may be reluctant to invest in a governmental entity that has never shown the capacity to be self-supporting, much less the ability to generate profits. Corporatization enables the entity to prove itself to potential investors before an offer of sale is made.

Disadvantages. The disadvantages of a sale of assets also apply to the privatization phase of corporatization. The two-step process of first incorporating and then privatizing is usually much more time consuming and expensive than a direct asset sale. Also, there may still be no willing buyers when the stock is offered for sale. The legislative and political barriers may be greater for this method, as well. The process may even require two trips to the appropriating legislature which can be time consuming and politically risky.

Examples. Using this approach, New Zealand has incorporated its post office, energy services, forest services, airways system, and land and survey trading activities. Recently, it also privatized its government computing services. This South Pacific approach has no known counterparts in the U.S. yet - probably due to the fact that most of such privatized functions always have been privately owned in the U.S. Similar privatization formats, however, have been used in developing countries such as Taiwan.

The Old Standby

Contracting out, an old standby approach in most western societies, is perhaps the simplest method available to accomplish privatization. Contracting for services has historical roots in governmental circles and has been used in the U.S. by federal, state and local governmental agencies. The governments establish contractual relationships with outside businesses to provide necessary services. The private businesses supply the personnel and perform the needed service for an agreed upon fee. Assets required to perform the contracted task may be provided by the government or by the private business.

Advantages. The advantages of contracting services are numerous. Governments would normally have the procedures in place for contracting routine services, and legislative involvement may then not be necessary. Because contracts can be rescinded or revised, there is less risk to the government. Suppliers can be changed or the government can resume providing the service if contracting proves ineffective or more costly. Contracting can be accomplished in a relatively shorter time period than an asset sale, thus allowing the government to quickly expand services, if necessary.

In the U.S., the use of tax-exempt financing for the physical facilities may be an important factor in some contracting-out arrangements. Using what were in the past referred to as Industrial Development Bonds (IDBs), state or local governmental units could issue bonds whose interest was exempt from federal income tax and use the proceeds to acquire, construct or rehabilitate industrial facilities, which they then might contractually lease to a private company. The lessee would pay the rent sufficient to cover interest and amortization of the bonds, an attractive arrangement for the private sector since the interest on the bond would be lower than on a comparable taxable bond. However, various federal laws passed in recent decades, and the Tax Reform Act of 1986 (TRA) in particular, have significantly restricted the uses of tax-exempt financing for private activities. To qualify for tax-exempt status under the TRA, a private-activity bond must meet several strict tests concerning the extent of private-sector use of the bond proceeds. IDBs have been limited to $10 million per individual issue and restricted primarily to manufacturing purposes. The tax-exempt financing issue also is raised in the case of the sale to a for-profit entity of a public asset that has been financed with tax-exempt bonds.

Disadvantages. There may not be any willing suppliers of the service, or the available suppliers may not be acceptable to the government. Moreover, contracting some governmental services may not be cost effective. The liability for providing contracted services may remain with the government, thereby requiring the government to monitor contractors, which can be costly and difficult. Also, contracting will not raise capital and may not reduce public expenditures. When the contract-awarding decision becomes political, as in the case of clean-up activities in the wake of Hurricane Alicia in Houston, service performance may be subpar or never completed.(8)

Examples. In recent years, governments have broadened their scope in selecting possible functions to contract out. In 1988, municipalities were reported to have contracted out, on the average, about 27 percent of their services to private companies.(9) Almost all major cities have their public park maintenance done, in part or in whole, by private contrators, who also do garbage collections in Houston, Indianapolis, Los Angeles, Miami and New York, to name a few.(10) Mass transit, motor pool maintenance, entertainment facility (e.g., sports arena, golf course) management and property tax collection are other popular functions that are outsourced. In a 1992 report on state privatization, all states reported contract-out services. Areas where such activities were found most frequently were corrections, health, higher education and mental health. More than 67 percent of the reporting agencies have more than $80 million of external contracts.(11) At the national level, weaponry always has been a big outsourcing item, and the Department of Defense has gone so far as to let a civilian firm operate a small Army airfield on its behalf.(12)

A United States Innovation

A somewhat different approach to privatization has been observed recently in the U.S. Much like corporatization in the initial stages, this technique has a key difference: A nonprofit organization, instead of a for-profit entity, is formed and the government does not retain full control of the new institution. Through this mechanism, a previously governmental function is transferred to a new entity.

The government is actively involved in all phases of the transfer; however, the new nonprofit entity is overseen by its targeted citizen/customer group rather than by the government. The oversight group provides initial start-up capital and shares representation with the government on the governing board of the new entity. Once established, the government and the newly formed entity enter into a contract to provide the required services.

Unlike the British and New Zealand models, in this approach governmental assets are not sold to the entity. Rather, a transfer of asset ownership and performance obligation from the government to a responsible citizen/customer group is the goal.

Transfer Rationale. If the governmental function has been accounted for as a proprietary or enterprise fund and supported primarily by user fees - rather than tax revenues - that specific operation might have been viewed as self-sufficient. However, regular subsidies and hidden overhead for supposedly self-sustaining programs can become burdensome to the government.

During times of shrinking budgets and dwindling resources, concern over hidden costs can often prompt the spin-off of these functions to a separate entity. This allows a more accountable cost allocation and recovery - so that actual users of specific services pay the full costs of those services. More resources can then be made available for functions benefiting the general citizenry. On the other hand, a spin-off may allow the new organization to avoid the absorption of unnecessary overhead allocation and be more responsive to personnel and facility upgrade needs without bureaucratic constraints.

There can be a perception that no real change has occurred if the current staff is maintained and the same task performed by the new entity. It also may be difficult for the various parties to distinguish the legal differences between the previous governmental entity and the new nonprofit operator. This may lead to the view, held by some, that to require the new entity to purchase the governmental assets will cause possible double charging of the customers. The government's perspective, however, will probably be that the transferred assets were originally acquired with governmental resources and, therefore, are governmental assets.

Federal, state or county laws generally may not allow governmental assets to be given away. As a consequence, a transition mechanism may be needed to facilitate the transition of a governmental function to the user group.

A Transition Mechanism. One transfer mechanism that can be used is cost-plus billing. Government personnel who are to become employees of the new entity, perhaps because of their expertise, are hired by the new entity at the beginning of the contract period. This enables the new entity to competently perform the necessary services. The government's assets are utilized by the nonprofit entity to perform those services. The nonprofit entity bills the government for the contracted services on a cost-plus basis.

The cost-plus or the "mark-up" on the services is designed to exhaust the possibility of actual cash settlements on the government's side thus eventually requiring that the government pay for the contracted services by signing over title to the net fixed assets. The agreed-upon fair market value of the net fixed assets is used as the exchange basis.

The process of transferring assets to the new entity can be timed rather closely with this procedure. If the privatization is to take three months, the new entity bills the government in sufficient amounts to completely exhaust the privatizing entity's net assets after three months. Some adjustments in the cost-plus ratio in the final period may be needed to completely transfer the assets.

The "plus" in the cost-plus ratio may need to be quite large to accomplish the asset transfer within a relatively short time period. This may endanger the nonprofit status of the new entity and be a cause of concern for uninformed parties. Therefore, tax experts and involved groups should be regularly consulted when this approach is utilized.

Advantages. This method can be less costly than the British approach, but more expensive than contracting out - at least in the short run. Because there is no need to deal with underwriters or stockholders, the actual cash-related costs under this approach usually are considerably smaller.

This may be the approach of choice when the government is discontinuing a service that a group of citizen/customers desires to continue. This method also may be appropriate when a sale of assets is desired and there are no willing or acceptable buyers available. When a governmental service has evolved to have its primary customers from other governmental entities, perhaps even crossing state lines, this also may be the appropriate choice. If the government wants the service to be performed by a nonprofit entity, this may be the best method to use.

Disadvantages. This type of privatization most likely will not be consummated as an arm's-length transaction and therefore may require special legislative efforts. Further, since the government usually will not realize a profit with such a transfer of assets, this would not be an appropriate approach if capital generation is the goal.

Example. A western state governmental agency providing statewide network database services to other public entities was recently privatized with this approach. The database, which utilized specially designed software, was established with government seed money. Its customers are billed monthly for the use, maintenance and update of the services.

Under the operation of the state agency, the subscriber base grew, and total revenues peaked and stayed at around $5 million for several years. Then the agency started to decline, mainly because the software and technology - which were state-of-the-art at the agency's inception - were becoming outdated.

Out-of-state subscribers attributed the lack of development to the bureaucratic budgeting and management processes of the founding state. Fearing technolgical decline, these customers were willing to incur the costs of switching to a private enterprise competitor if control remained with the single government. Losing the out-of-state subscribers - who had increased to the point that they contributed the majority of the revenue - would mean the death of the agency and the end of services.

Because of the high quality of the database, it was in everyone's interest to keep the agency alive. The founding state had an additional incentive: switching its in-state departments to a competitor would mean excessive hook-up and communication costs, as all alternative providers were outside the state. Consequently, the privatization decision was reached and the transition took place.

The first-year operation of this newly formed nonprofit organization, which has just ended, includes a savings of $600,000 in staff costs and state service cost allocations - a 12 percent savings compared to the previous year. The reduced budget level, approximately $4.4 million, is expected to be maintained for several years until a stable, self-sufficient operation of the new entity is assured.


Privatization is a viable option when the government is seeking methods to reduce public expenditures, increase efficiency or enhance services. As privatization activity increases among state and local government entities in the U.S., more and more finance officers and accountants will become involved in, the planning and implementation stages of the process. To aid in approaching these tasks, this paper summarizes the pros and cons of three proven approaches to privatization and an emerging hybrid type now seen in the U.S.

Privatization is not a panacea for governmental woes: some governmental services are usually excluded - those of the "public goods" nature, such as police protection. Proprietary activities, on the other hand, where a clear customer/vendor relationship can be identified, tend to be more feasible condidates for privatization.

When considering privatizing a governmental function, the government needs clearly specified objectives in order to ascertain whether such a transformation will produce the desired results. The cost-effectiveness of the chosen method of privatization is an important consideration. To ensure ultimate success, a privatization approach must be carefully weighed and carefully implemented, with attention given to applicable laws, the financial condition of the government, and the needs of the citizens.


(1) Mayer, C.P. and Meadowcroft, S.A., "Selling Public Assets: Techniques and Financial Implication," Fiscal Studies, Vol. 6, No. 4, 1985, pp. 42-56. (2) Ibid. (3) Ibid. (4) Pension & Investments, January 7, 1991, p. 19. (5) Houston Chronicle, October 24, 1991, p. 3E. (6) Clark, Margaret and Sinclair, Elizabeth (eds.), Purpose Performance and Profit: Redefining the Public Sector, Studies in Public Administration No. 32, Wellington: Government Printing Office, 1986. (7) Bowman, R.J. and Buchanan, J., "Corporatization and Asset Valuation for a Government Corporation," Financial Accountability & Management, Vol. 6, No. 2, 1990, pp. 79-81. (8) Goodrich, Jonathan, "Privatization in America," Business Horizons, January-February 1988, pp. 11-17. (9) Lietbag, Bill, "Privatizing America," Journal of Accountancy, April 1988, pp. 48-51. (10) Goodrich, Jonathan, "Privatization of America." (11) Apogee Research, Inc., State Government Privatization 1992, (Maryland: Apogee Research, Inc.), 1992, p. 13. (12) Wall Street Journal, "Privatization Lets Small Firms Manage Everything from Libraries to Golf Courses," April 2, 1991, pp. B1-2.

Stanley Y. Chang, Ph.D., CPA, CMA, CIA, is an assistant professor of accountancy at Arizona State University, West. A frequent contributor to publications in governmental accounting and auditing, he is the recipient of the Association of Government Accountants' 1991 Research Achievement Award.

Roberta Ann Jones, CPA, is a doctoral student at the University of Illinois - Champaign/Urbana who has extensive consulting experience working with governmental and nonprofit entities. She served as consultant on the U. S. innovation privatization plan discussed in this paper.
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Author:Chang, Stanley Y.; Jones, Roberta Ann
Publication:Government Finance Review
Date:Aug 1, 1992
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