Korea's real winners: local banks not foreign private equity

With the Lone Star probe nearing an end, we reprint the November cover story from FinanceAsia magazine. It analyses how Korean banks have made more profit from their investments than foreign private equity firms.
ItÆs hardly a dirty secret, but nor has it been well publicised. Indeed, in a climate in which South Koreans rail against the profits made by foreign private equity firms, it will surprise many in Korea that the biggest æprivate equityÆ profits have probably been made by the Korean banks themselves.

How so? Well, ironically, itÆs largely thanks to the 1997 financial crisis. This was a period when many major Korean corporate groups û better known as chaebol û faced financial distress. The Korean banks were left holding the problem loans and after a debt restructuring ended up holding equity in many of these firms. Perhaps the best known example is semiconductor company, Hynix but other major holdings included Hyundai Engineering & Construction, Hyundai Corp, Daewoo Engineering & Construction, Daewoo Shipbuilding and Daewoo International. Then, in subsequent problem periods û the credit card debacle and a crisis at the SK chaebol û they also picked up equity in LG Card and SK Networks.

In a curious piece of alchemy, these assets have turned to gold. Partly, this was thanks to the swift recovery of KoreaÆs economy. But restructurings at the distressed companies themselves, led to a turnaround in these firmsÆ fortunes. By last year it became evident to the Korean creditor banks that these equity stakes were becoming increasingly valuable. Towards the end of 2005 and throughout this year they have sold stakes for enormous profits û and this process is likely to continue for a couple more years.

This is something that bank analysts have begun to pick up on. CLSAÆs Korean banks analyst, Shaun Cochran calculates that the value of these stakes amounts to W8 trillion ($8.6 billion). In a mid-October research report by Philippa Rogers of Goldman Sachs, she calculates the value of the seven major stakes too (see table below). Rogers writes: ôWe estimate that the sale of these seven securities, at current market value [minus their original book value of W2.3 trillion], would add W8.5 trillion in non-operating gains to the P&L [profit and loss]. To put this in context, the potential gain to be booked through the P&L amounts to 24% of operating profits in 2007 and 30% in 2008. The gain would also add an estimated 5% to the current book value of the banks.ö

Goldman banker David Chung û whose expertise in the Korean financial sector dates back to the late nineties when the US investment bank bought an equity stake in Kookmin Bank û is quick to praise the local banks. ôTheir ability to manage these bad credits has been quite skillful and competent,ö he says.


Of course, the mother of all æbad debtÆ investments has turned out to be Hynix. Back in 2001 this magazine ran a cover story on Hynix which featured a hand grappling to emerge from a grave. It pretty much summed up the feeling. The majority of informed and uninformed opinion believed that Hynix was a dud company simply being kept alive by the Korean state for want of any better ideas.

What has transpired has had many experts eating their microchips. In a miraculous turnaround, Hynix has returned to financial and technological strength, and seen its stock price recover from a low of W2,835 to a recent high of W40,100.

The story of this turnaround deserves to be told at length û especially since it epitomises the ælead to goldÆ trend that this article is describing. And who better to describe it than KEBÆs chairman, Robert Fallon, who played an important role in HynixÆs recovery.

KEB was HynixÆs biggest creditor, and that gave Fallon an extremely important role as chairman of the creditor committee. It turned out he was the right man at the right time. The American had previously ran the Asian operations of Chase Manhattan and could be justly labelled an old Asia hand û given he had resided in the region for 31 years. This was a man who had climbed the highest mountain in Antartica, Mount Vinson. But the scaling of HynixÆs debt mountain may well stick in his mind as his crowning mountaineering achievement.

ôAt the end of 2003 I was aghast at the amount of NPLs at KEB that were still troublesome,ö says Fallon, who was hired from Columbia Business School to become KEBÆs president and chairman. ôThe bank had $3 billion of NPLs, and KEB Card was going bankrupt.ö

Chief among those NPLs was Hynix, which was part of the Hyundai chaebol. ôIn 1997 KEB was the largest private sector bank and lead bank to the Hyundai chaebol. Hyundai Group had liquidity problems and had no means to repay their obligations. Hynix was particularly badly hit û as too was Hyundai Engineering & Construction. They had to be recapped and the creditors took over.ö

Fortunately, Fallon knew Hynix and its business pretty well. ôI was head of Chase in Asia when we financed their first US fab in 1996,ö he says. He recognised that many of HynixÆs problems were not of its own making. In 1999, Hynix was created when the government forced Hyundai Semiconductor to take over LG Semiconductor. Hyundai Semiconductor was doing reasonably well but taking on all the LG Semi debt was tantamount to paying an extraordinary price to book value. ôThere was almost $13.5 billion of debt and it was done at 5 times book value,ö says Fallon.

In 2000 this led to a loss of W2.5 trillion, and in the next two years a debt restructuring. About $7 billion was either forgiven or completely written off. KEB was the largest single creditor with a total exposure of W1.3 trillion. It wrote off over $1 billion (W1,014 billion), so that after the restructuring its outstanding Hynix debt was W0.3 trillion. Some of this was swapped into equity and it got a 13.87% stake in Hynix. hat The net result was that Hynix was left with debt of $3.7 billion.

ôIn June 2003, Hynix had 14 straight quarters of losses. So you are taking a bet that the core business can survive,ö says Fallon, who adds, ôKEB worked very closely with Hynix over the past three years on its restructuring.ö KEB installed senior staff at Hynix, and was proactive in managing the 127 creditors. In fact, it was KEB, as chairman of the creditor council, that was instrumental in drawing up the six point turnaround plan.

The first element of this was to forge a strategic alliance with ST Microelectronics - a move that would gain Hynix exposure to NAND flash memory chip technology. (This proved a smart move, since NAND flash memory has since boomed, thanks to devices like the iPod Nano).

The second point in the plan was highly unpopular with HynixÆs management. This was the sale of the non-memory chip business to CVC, a private equity firm. This raised $1.2 billion.

The third point of the plan utilised some of these new funds for expansion. Hynix made a deal with the Chinese government to transfer technology from Korea to build a fab in Wuxi. The mainland authorities were so enthusiastic about this project, that Hynix got access to loans from Chinese banks to finance it. Under the deal Hynix put in $300 million of cash and agreed to transfer $300 million of semiconductor equipment from Korea û however, the upside for Hynix was that these items had already been depreciated. Hynix got a 67% stake in the new fab and ST Microelectronics got 33%.

(The Wuxi fab recently opened on time û in itself a display of HynixÆs proficiency in project execution. And in what Fallon describes as ôsemiconductor nirvanaö, it opened at over 90% capacity. Hynix already had 40% of the DRAM market in China but thanks to the new fabÆs success it now has over 50%.)

The planÆs fourth point required a further round of debt refinancing. The debt in question was held under the CRPA (the corporate restructuring promotion act) and had to be repaid by 2007. In June 2005 Hynix issued $1.8 billion of new financing via a seven year global bond, a syndicated loan and a FRN. Some of these monies were used to repay W1.25 trillion of CRPA debt.

The early repayment of CRPA debt allowed the creditors to progress to point five of their plan. This would begin the monetisation of their Hynix equity stake. In September 2005 they sold a $2 billion stake û which, to put it in perspective, was the fourth largest equity offering ever from Korea.


Hynix has 127 creditors, but the major Korean banks are the principal equity holders. Before the equity sale, KEBÆs original stake was 13.87%, WooriÆs was 9.34%, Shinhan 7.91% and the public held 26%. After the sale, KEB retained 8.06%, Woori 7.87%, Shinhan 5.9%, KDB 6.11%, KDIC 3.5%, and other creditors 7.82%. The public holds 59%.

In fact, another reason for the rise in the public float relates to point six of the plan. This recognised the need for Hynix to raise fresh capital. So six months after the first equity sale, Hynix returned to the markets with a $300 million placement of new capital. In a measure of how far Hynix had turned around, Fidelity, Putnam, and Capital all bought stock.

The creditorsÆ remaining equity is locked up until the end of next year, and at that point they can sell as a block or individually. Until that point they want to control the company, and hence were unwilling to be diluted below the 35% mark. With this in mind û and HynixÆs continued desire for new capital û a $400 million convertible bond was recently completed.

So far so good; but how well has KEB done from the Hynix restructuring plan? KEB lost W1,014 billion on Hynix and has so far recovered W604 billion. However, its remaining stake is worth W1,145.8 billion û based on HynixÆs stock price at the end of September (W37,000). So KEB has made a total return of W1.7 trillion, for a loss of W1 trillion. That is a profit of $760 million.

If you extrapolate this to the entire Korean banking sector, the number is even more extraordinary. The Korean banks initially took a capital loss of W7 trillion on Hynix. However, they have now recovered this and made an additional profit of $4.9 billion. That profit, of course, could prove to be even larger if HynixÆs stock keeps on its upward trajectory. ôI am very bullish on this company,ö says Fallon. ôIt is a fierce competitor in a fierce industry.ö


The second ôhomerunö for the Korean banking sector is LG Card. The banks bailed out this firm û which blew-up during the nationÆs credit card meltdown û in 2003. If the truth be known they were not entirely keen on bailing out LG Card, and were actually prodded to do so by the government. However, once again the result has been a happy one.

Shinhan bought LG Card, in a deal that valued the formerly troubled company at W8.5 trillion. The Korean bank paid W68,500 per share to acquire the 85% of the company which was held by creditor banks (of which it was one). It is estimated that the Korean banks will make a profit of $3.5 billion from their stakes in LG Card. The sale to Shinhan should finalise early next year, with major beneficiaries including Woori, Hana and Kookmin.

The next major asset disposal will be Hyundai Construction & Engineering û which is KoreaÆs biggest construction company û with an M&A advisor soon to be appointed. It is expected this megatransaction will see a highly competitive auction by June next year, with the creditor banks offloading a controlling 51% stake. Both Hyundai and Doosan are expected to bid aggressively, with one M&A specialist putting Hyundai C&EÆs value at over $12 billion û suggesting that creditor banks could pocket up to $6 billion.

To put this in perspective: when the firm was bailed out in March 2001 its market value was only $370 million. ôThis is a superior company to Daewoo Engineering & Construction which was recently sold to Kumho Asiana for $6.9 billion,ö says the banker. ôApart from the fact that its core business is booming, it holds a very valuable land portfolio in western Korea.ö

Hyundai E&CÆs net profit rose 89% to a record W323.8 billion ($330 million) last year, which compared with a loss of W2.98 trillion in 2000.

In the first quarter of 2006 the bottom line improved 47% from a year earlier to W95 billion as sales rose 15% to W1.06 trillion. The company also said it has secured enough construction orders to last for at least five years.

ôIt probably has one of the biggest portfolios of overseas contracts, particularly in the Middle East, and operationally it is doing very well,ö one observer says.

Hyundai E&C, has already seen one bank realise some big gains. In June KEB sold 5.2% for $252 million and followed this in August by offloading a further stake worth $97 million.

Another major sale û slated for 2008 û is the creditor banksÆ stake in SK Networks. ôThis will be the last of the big æcrisisÆ assets to be sold,ö says one banker, ôAnd it will be big.ö Once again, SK Networks financial performance has turned around, with the trading companyÆs market capitalisation recently surging to W7.7 trillion.

There are other major deals that might occur before the SK Networks disposal. Probably first to go will be Daewoo Shipbuilding ûwhich one banker estimates could fetch as much as W4 trillion. KDB is the major creditor in this case. And then there is Daewoo International. The trading company has seen its business recover. But perhaps, the real sweetener for an acquiror are its three Myanmar gas fields (containing 10 trillion cubic feet of gas) and a 24% stake in Kyobo Life.

KEBÆs Fallon reckons that ôwhen all the dust settlesö and all of the asset disposals are complete, the Korean banks will reap at least $10 billion in profit from the sales. He adds that this is one reason why Korean banks are now among the best capitalised in the region.

ôIt was not clear these positions would turn out so well and we would end up with such profitable positions,ö says Yu Sung-hun, the deputy head of IR at Shinhan Financial. ôBut it looks like the workout loans will graduate, and will improve our BIS ratio.ö

ôWe expect it will take 2-3 years to sell all of the shares,ö says Kim Youngsun of Woori Financial. ôBut our capital should increase.ö WHY BAD IS GOOD

ôThey have turned distressed assets into a very solid banking system,ö is the verdict of CitigroupÆs head of corporate and investment banking in Korea, Michael Zink.

ôThe Korean banks are reaping the benefits of their old sins,ö concludes CLSA bank analyst, Cochran. ôThe market had written these assets off. But they have made a damn good return.ö

ôThey made a good bet,ö agrees Yang Ho- Chull, who runs Morgan Stanley in Seoul. ôThey had confidence in the management, technology and the franchises of these companies. They kept assisting these companies financially, and it has paid off.ö

Indeed, it has paid off royally. ôPeople always talk about how much money the foreign private equity firms have made,ö notes Lee Chunkee, Credit SuissesÆs head of Korea investment banking. ôBut in actuality the real winners have been the Korean banks.ö Steve Lim, who heads JPMorgan in Korea agrees: ôThe banks have made at least the same return on investment as the foreign private equity firms.ö

In fact, it is probably more. The foreign private equity firms have probably made about $8 billion of profits from Korea û and that assumes Lone StarÆs sale of KEB goes ahead. It looks likely that the Korean banks will make $10 billion û and very possibly more.

Aside from the sheer monetary gain, it has given the banks a new skillset and new confidence. ôThe expertise this has given the banks is immense and it has given the banks a lot of confidence about how to deal with distress situations,ö says KEBÆs Fallon. For example, he points out that when Daekyung û an SME that makes heat exchangers for petrochemical plants û had a problem last year, KEB was quick to act. ôWe didnÆt blink. We converted the debt for equity and began a restructuring. We recapped it and one year later itÆs already turning around.ö

So amid all the hysteria in Seoul about how much money foreign private equity funds have made, just remember: the Korean banks have done even better.
¬ Haymarket Media Limited. All rights reserved.
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