David Ellerman


Voucher Privatization
with Investment Funds:

A Sure Way to Decapitalize Industry

by David Ellerman

The World Bank : Transition



There has been rough consensus among postsocialist reformers and their Western advisers that voucher privatization was the quickest and most politically popular technique for achieving mass privatization. However, without intermediaries this method would spread ownership too wide and thus create a problem of "corporate governance." So the thinking goes that voucher privatization needs to be augmented by voucher investment funds to provide the corporate governance necessary for restructuring the privatized enterprises.


Western Models


In a developed market economy such as the United Kingdom or the United States, where economic institutions have had time to evolve, one finds two extremes, the mutual fund ("unit trust" in the UK) and the (venture capital) holding company, which have rather opposite institutional logics.

Mutual funds hold a diversified portfolio of shares with only a small percentage from any given publicly traded company. The funds exercise no direct corporate governance over companies. They are the very model of the passive institutional owner that lives by the "Wall Street Rule" of voting with one’s feet. Exit is preferred to voice.


Holding companies operate in a diametrically opposite way. They hold all or almost all the shares in a portfolio company so that they will reap most of the capital gains from the development and restructuring of the company. They epitomize the active owner that exercises voice rather than exit.

The voucher investment funds have been envisioned by postsocialist reformers as a mixture of mutual funds and holding companies, a chimera with no direct counterpart in an evolved market economy. Western-style legislation restricting any mutual fund’s share in a single company (for example, a 20 percent maximum) has been enacted in most voucher investment fund regulations as if the funds were mutual funds. But in the next moment, the voucher funds are described as the vehicles for restructuring the voucherized enterprises as if the funds were holding companies.


Obstacles to Good Governance


There are substantive reasons why the voucher investment funds will have trouble functioning in the way mutual funds operate in the West. Most of the shares owned by the voucher funds have no real market. In the West only a small percentage of these companies qualify to be publicly traded and an even smaller percentage would qualify in the transition economies. Yet the voucher privatization programs have corporatized medium-size to large socialist enterprises of almost any quality, and have issued their shares in return for vouchers. The voucher funds thus have a portfolio full of shares that are essentially illiquid at any significant price ("junk shares").

But the funds probably will not operate as restructuring holding companies either. Unlike the typical holding company, which owns the majority of shares in its portfolio companies and thus stands to profit significantly from its investment in restructuring the companies, a voucher investment fund may own 20 percent, or at best 30 percent, of shares in a portfolio company. Thus, if the fund spent the time, effort, and financial resources to restructure the company, it would see 70 to 80 percent of the capital gains accrue to other, free-riding shareholders.


In light of the regulations restricting voucher fund stakeholding in companies, then, the funds have little economic motivation to undertake time-consuming and costly restructuring. Yet the incentive is even weaker than this restriction would suggest. A given fund may have thousands of individual shareholders (citizens who exchanged their voucher for a share in the fund), so control is in the hands of the fund management—typically a separate fund management company. The fund management company’s fee is usually set by regulation as a fixed percentage of the portfolio’s net asset value, rather than being linked to profits or increases in the value of the portfolio. If, for example, a fund owns 30 percent of a company, and the fund management company is entitled to a 3 percent fee, then a $100 increase in the value of the portfolio company increases the management company’s fee by a mere 90 cents, or 3 percent of the 30 percent.

As it has turned out in the Czech Republic and in Russia, fund management companies have found other, more lucrative ways to utilize their power without undertaking the difficult job of restructuring. One way is simply by collecting directors’ fees for sitting on the boards of scores of portfolio companies. Another prominent method of siphoning or tunneling value out of portfolio companies has been through special contracts and nontransparent side deals with firms related to the fund management companies. The profits made through these bypass firms are not shared with other owners of the portfolio company, not to mention the citizen-shareholders of the fund.


As these examples illustrate, problems of corporate governance abound. Since the individuals running the investment funds are not stakeholders but are employees of separate companies contracted to manage the funds, and since they will gain little from the increased profitability of funds, they lack the proper incentives to provide effective corporate governance, the very reason they were hired.

Investment funds find the trading of shares, transfer pricing, and nontransparent equity transactions far more lucrative than striving for profits and dividend payments through efficient governance. Indeed, profits and dividends have been an insignificant source of fund income so far. These arrangements not only reduce the incentive to restructure; they may provide a disincentive. Selling a controlling stake to a strategic investor would remove the board sinecures for the fund managers and their friends. And significant restructuring would probably involve exposing and eliminating the special side deals and bypass arrangements for the fund management company.


Investment and Disinvestment


Postsocialist enterprises typically require serious restructuring if they are to produce profitable products that people will want to buy at prices people are willing to pay. The hope that Western firms would become involved on a large scale and would provide funds and the necessary expertise has, in most postsocialist economies, not been realized. Rather, Western investors have preferred "green-field" investment to the restructuring of existing companies. There have been a few exceptions, notably in Hungary. But most postsocialist firms have been unable to find Western strategic investors.

The alternative to direct strategic investment is portfolio investment. There has been some modest Western portfolio investment in Central European and Russian investment funds. The Polish mass privatization has tried to design funds to be managed by "Western experts" who would restructure the companies in their portfolio. But this approach has not met expectations because of the large number of firms in each portfolio, the distance of the fund from the day-to-day challenges of restructuring a company, and the typical lack of industrial expertise on the part of the fund managers. The investment funds tend to be managed by such professionals as financial analysts, lawyers, and accountants, who have little or no managerial or technical experience in industry.


In the Czech Republic and in Russia, the shares in the funds’ portfolios were acquired in return for citizens’ vouchers invested in the funds. The capital necessary to start up the funds and the fund management companies was provided by the founders, or by loans, and was usually spent on equipment, premises, staff salaries, and advertising. The costs of advertising were high as each fund sought to distinguish itself from the others in the frenzy to attract citizen vouchers. These costs were eventually recovered from the firms themselves. The real impact of these "investment" funds was the disinvestment of the firms in their portfolio. Thus, capital for restructuring is probably the last thing that could have been expected from voucher investment funds. The argument that voucher funds were important for "capital market development" turned out to be false.

Almost nothing was left to pay dividends to the funds’ citizen-shareholders, who soon realized that the value of their "national patrimony" was being siphoned off by this layer of financial intermediaries. The political fallout has been serious.


In summary, the long-term consequence of voucher privatization with investment funds is a de facto real sector decapitalization in favor of short-term rent seeking by fund managers. This takes place through board sinecures and lucrative side deals with portfolio companies and through financial market manipulation. In the absence of strong corporate governance from the funds and lacking stable ownership of their own, many enterprise managers exploit the postsocialist version of the "separation of ownership and control" to seize what they can in the form of salaries, bonuses, perquisites, and side deals. This two-sided grabfest by fund managers and enterprise managers—together with the accompanying drift, stagnation, and decapitalization of the privatized industrial sector—may prove the most prevalent result of the strategy to achieve voucher privatization with investment funds.


The author is economic adviser to the Senior Vice President, Chief Economist at the World Bank; Email:







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