Optimal Financial Design of Privatization Under Incomplete Information and Bankruptcy Risk

Abstract

This paper studies privatization under moral hazard and adverse selection. We show that under the presence of moral hazard, the optimal financial package of privatization consists of selling 100 per cent equity together with a subsidy on the observed cash flow. Price of the equity reflects the costs of the subsidy. However, in the presence of both moral hazard and adverse selection, the optimal policy consists of a dual method of privatization in which the government offers simultaneously a sale of 100 per cent equity with a subsidy and a higher price with another option where the investor pays a smaller price and buys less than 100 per cent equity without subsidy. The more efficient investors opt for the first method while the less efficient investors prefer the second. The dual privatization method screens investors and provides them with maximum incentives to invest while minimizing the risk of bankruptcy in the post-privatization era. Hence, this paper suggests that while concentrated ownership is optimal for an efficient firm, the less efficient firm should be entitled to less than 100 per cent ownership in the presence of asymmetric information.