You're reading: Funds' problems highlight flaws in privatization

June 24, 1998

In 1994, when Ukraine was launching its first privatization property certificates (PPCs), the State Property Fund ran an advertisement promising Ukrainian citizens they would be able to buy for their kids a toy and a piece of chocolate ‘every day’ if they invested their PPCs wisely into one of the various voucher investment funds that were starting up at the time.

Four years later, the many citizens who put faith in such claims stand to be sorely disappointed. Forget the chocolate and the toys. Most citizens stand to earn back not a single kopek on their initial PPC investment. The reason for this is that, by most accounts, the vast majority of the nation’s approximately 300 voucher funds stand to drown in bankruptcy within the next year and a half.

‘We are about to witness the mass death of funds,’ says Yaroslav Alexandrov, Assistant President of the Kievskaya Rus Financial Investment Group, which runs three voucher funds. He predicts that out of the approximately 300 voucher funds currently running in Ukraine, only about 15 of the better-managed ones will survive until the presidential elections next fall, among them Kievskaya Rus.

A voucher fund can exist either as closed joint-stock company, engaged solely in collective investment, or as a mutual fund within an investment company. All voucher funds are closed-end funds that operate for a fixed amount of years, established at the time of creation. A fund accumulates PPCs from individuals or intermediaries, who receive in return an investment certificate entitling them to a proportional share in the assets of that fund.

When a voucher fund expires, it is required by law to compensate each holder of an investment certificate with either a proportional share of the fund’s net assets, or the market value of a PPC, which currently stands at $10.50.

Therein lies the problem. With most of these funds having invested in illiquid companies, their net assets are essentially worthless. Many investors will thus be demanding $10.50 when these funds mature in the next few years. And few companies will be able to afford this. What’s more, many of the funds with longer expiration terms will go bankrupt before they reach their maturity date.

Viktor Fedorov from the sales department of the Tekt investment company, which operates a voucher fund maturing in January of 1999, says his company is prepared for a full one-third of its approximately 450,000 shareholders to demand cash compensation. How much will Tekt repay its investors? Federov would only say the sum would be ‘no less than $10.50;’ hardly a rich return, but better than nothing.

The contributing factors to the voucher funds’ woes include insufficient legislation and the poor state of the nation’s economy. But most of all, it is plain bad management that has brought most of these funds to the brink of death.

According to Alexandrov, even the poorly performing funds tend to live lavishly, a lifestyle that is not justified given the dreadful state of Ukrainian capital markets. ‘By our estimates, it costs $15,000 per month for the average fund just to run its day-to-day affairs. I’m surprised by how luxuriously the lesser well-off funds are running. Just the calculator of the assets in these funds has a cell phone and access to a nice car.’

Such luxury might have been justified a year ago, when Ukraine’s stock market was experiencing astronomical growth and cash was rarely a problem for Ukrainian investment companies. But with Ukraine’s stock market down over 50 percent since the beginning of the year, now funds are left to rely on the personal cash savings of its managers to survive. Not even the wealthiest of Ukrainian fund managers can afford $15,000 per month and still survive.

A Western fund manager who asked that his name not be used, put it more succinctly: ‘Most of what these funds invested in was garbage.’

To be sure, the poor quality of investment objects has something to do with the lack of structural reforms in the country. But the presence of several funds that have thrived in this environment highlights poor management within the failed funds.

‘The successful funds have good portfolio managers that bought only highly liquid assets,’ says Tekt’s Fedorov. ‘Each shareholder will actually possess significant assets when these [successful] funds are liquidated.’

Management fraud is another problem. According to Stanislov Coufal, director of trading at Atlantik East in Kyiv, the loose regulatory system currently governing voucher funds allows fund managers to legally bilk their investors through a process called ‘tunneling,’ and several other techniques.

What will be the effects of the impending crisis surrounding voucher funds? Coufal, who lived in his native Czech Republic three years ago when that nation went through a similar crisis, says Ukrainian citizens long ago gave up hope that they would get any sort of windfall from their PPC investment. But many of the fraudulent practices he describes have resulted in companies acquiring managers that care nothing about the well-being of the company. This leaves companies operating inefficiently, and contributes to the general problem of illiquidity in the nation.

One Western fund manager who requested anonymity was a little more dramatic. He said the impending collapse of these funds symbolizes that Ukraine’s privatization process has been nothing less than a failure.

‘The government spent a lot of energy convincing the public of the merits of the populist program,’ the fund manager says. He continues, ‘The people were basically forced to participate in the process. This [problem with the funds] will just prove to them that it was all a pipe dream, that it was never going to work.’

When privatization was launched, both the government and Western advisors did indeed trumpet the idea as the ultimate populist vehicle. PPCs, unlike their kindred compensation certificates (CCs), cannot be traded legally; thus, by design at least, they ensure that ordinary citizens will achieve real interest in public companies. The populism of the PPC concept enabled the government to convince left-leaning forces as well as democrats of the merits of privatization.

As the Western fund manager says, however, ‘Not only did the populist approach slow down privatization, it also didn’t end up being very populist.’