A deal which has, to date, elicited little but criticism from Asian equity professionals looks like it will be the first to benefit from the country's one notch upgrade yesterday (Tuesday) to BBB+ by Standard & Poor's.
Many had expected roadshows to begin this week. However, the formal start date has been pushed back until after Thanksgiving next Thursday (November 22) because of the additional time needed to acquire all the necessary sign-offs from the Korean Ministry of Finance & Economy, KDIC (Korea Deposit Insurance Corporation), Cho Hung Bank and Woori Financial Holdings, plus the eight banks it represents.
As one banker comments with classic understatement, "The Koreans had been hoping to launch the deal before Thanksgiving, but getting everyone on the same page has logistically been a little painful."
Yet while, convertible specialists believe that the deal has been racked by disagreements between the three lead managers - Goldman Sachs, JPMorgan and UBS Warburg - not to mention legal fees already said to be in excess of $1 million, participants state that the technicalities of the deal have been all but finalised.
In essence, the structure will comprise a straight bond issue with a minimum three-year maturity that will transform into an exchangeable subject to two trigger events. Investors will not pay for any equity optionality upfront, as most agree there is none because of the considerable cynicism which surrounds the government's ability to get Cho Hung and Woori into a position where there is an attractive story for equity investors. What investors will receive is a yield premium over the theoretical trading levels of straight KDIC debt, which will then drop subject to two trigger events.
Bankers say the key to understanding the deal is the Korean government's desire to ensure conversion into the two banks rather than sell straight debt. But unlike previous going public bonds from Asia, investors will not be enticed by the ability to buy a subsequent IPO at a discount to issue price, since this is felt to weigh too heavily on any future equity offering.
Bankers say that there are three possible scenarios. Investors may either acquire full equity optionality after the second trigger event and gain little from the first. Alternatively, they will gain some optionality from the first trigger event, but pay more from the second. Or they will gain most optionality from the first trigger event and little from the second.
The two trigger events comprise an IPO for Woori, which the Korean government has stated will occur before January 2005 and a certain liquidity threshold for Cho Hung, which is currently 80% owned by KDIC.
Selling the deal as straight debt is regarded as the easy part of the equation. For the government, the difficult part will be revitalising Cho Hung and Woori. In its ratings upgrade, Standard & Poor's crystallized the Republic s problem when it concluded that the current rating is constrained by the state's ownership of most of the banking sector.
"The financial sector, which has already required W148 trillion of upfront assistance, is likely to require an additional W32 trillion, taking the upfront cost since the Asian crisis to 38% of 1997 GDP," it concluded.
Year-to-date Cho Hung Bank has considerably outperformed the Kospi, rising 59.28% to W2,660 Tuesday, versus a 14.3% rise for the index. However, while the bank has reported a strong increase in third quarter earnings, all improvements are offset by the need for more aggressive provisioning.
For example, the bank said that third quarter profit almost doubled from the same period last year, rising to W165.16 billion versus W65.53 billion in 2000. It also said that future profitability should be enhanced by the sale of a 49% stake in Cho Hung Investment Management and also the bank's credit card business.
But at the same time, it said it planned to raise its provisioning to Hynix from 19% to 40%, an increase that is still far below stronger banks such as KorAm and Kookmin, which have almost completely written off their exposure to the semiconductor company.
"The problem is that any positive gains on the balance sheet are negated by the fact that the bank is not provisioned aggressively enough," says one Korean expert. "If Cho Hung was to fully provision for Hynix and its other main exposure to Ssangyong, it would completely wipe out its equity. It's a very positive sign that its retained earnings are increasing, but the bank has been constrained by the need to maintain a capital adequacy ratio of 10%. It writes off as many NPL's as it can, but it's going to take time for all the losses to be fed through the balance sheet and this will mute the equity story for some time to come."
Nevertheless, Korean specialists believe that the ratings upgrade will give the prospective transaction a considerable boost among fixed income investors. KDIC was upgraded alongside the sovereign and spreads on the Republic's benchmark 8.75% 2008 bond tightened about 10bp yesterday to a bid/offer level of 106bp/97bp.
One banker concludes, "Structural complexities aside, market conditions are in this deal's favour. Korean demand will be a key driver and there is a strong onshore bid at the moment. This will be further backed up by all the cash washing round the private banking sector in Asia and among global convertible funds."
