Korea buyouts: Young pretender?

MBK Partners was not the first choice investor for water purifier manufacturer Coway. KTB Private Equity appeared to have won the race last July, agreeing to put up 60% of the equity required for the KRW1.2 trillion ($1.1 billion) deal with Woongjin, Coway's parent, contributing the rest. The question was, in the absence of a fund large enough to accommodate a transaction of this size, could KTB find the capital?

"They couldn't get the money, MBK knew they couldn't get the money, and so it waited for Woongjin to come back with more favorable terms," a source familiar with the transaction told AVCJ last year. "And that's what happened - they came back and it resulted in a much larger deal, which entailed a full transfer of control."

But the story didn't end there. Just over a month after an agreement was reached for the 31% stake, Woongjin filed for bankruptcy. The company had been relying on the proceeds of the deal to pay down debt incurred in parts of its empire, but MBK's capital didn't come quick enough. The PE firm faced the prospect of, at best, a delay, and at worst, a cancellation.

Fortunately, the court tasked with overseeing the bankruptcy proceedings decided the agreement should be honored, bringing a near one-year process to an end in January.

Buoyed by the Coway transaction, private equity investment in South Korea reached $6.9 billion in 2012, more than the previous two years combined. Only two other countries in Asia - the relatively small Mongolia and New Zealand.

But for all that Korea punches above its weight as a PE destination, the market remains patchy and immature in some respects: domestic buyers, though many in number, don't necessarily have the capital to come through on deals; and the deal flow itself, particularly that driven by conglomerates making divestments, doesn't quite live up to the hype.

Who's selling?

Of last year's total, nearly 40% came through three deals - Coway, plus two long-expected divestments of stakes in Kyobo Life Insurance. Scott Hahn, managing partner at Hahn & Co, which spun-out from Morgan Stanley Private Equity Asia, doesn't expect a similarly heady 2013.

"We are not seeing anything in the pipeline to indicate that," he tells AVCJ. "There are a couple of large transactions that are distressed sales by distressed business groups or creditors. There are a couple of chaebols currently in trouble but it remains to be seen whether that leads to actual sales or whether they get assistance from other government-backed financial institutions to keep their businesses afloat."

There is no shortage of conglomerates, or chaebols, mooted as potential sellers, most of them drawn from the second and third tiers of corporate Korea. STX Group, a shipping, trading and shipbuilding titan struggling to meet its debt obligations in the face of weak dry-bulk freight rates and sluggish demand for new vessels, is the most obvious. Industry participants point to Kumho Asiana Group, Tongyang Group, Woongjin and even government-linked steelmaker Posco as other potential deal sources.

Conglomerates divest assets for a number of reasons: Kumho, Tongyang and Woongjin have offloaded subsidiaries in recent years after running into distress; Posco was one of the Kyobo Life sellers because it picked up the asset through the acquisition of Daewoo International and never planned on keeping it; Doosan Group exited Burger King to Vogo Investment last year to complete its strategic transition from food and beverage to heavy industry.

However, the pressure point currently being felt by all chaebols is political. Keen to restrain the growth of conglomerates, which is thought to come at the expense of small- and medium-sized enterprises (SMEs), the government is taking action. Numerous policies have been suggested, from fines for violating fair trade laws to restricting the cross-shareholding structures that hold chaebols together. The goal is to prevent the octopus-like tendencies that see these companies expand beyond their core businesses.

"There are a lot of bad practices among the chaebols," says Taigon Kim, senior partner and head of South Korea, Headland Capital Partners. "For example, the founder might set up a logistics company, hand control to his children, and then give it all the logistics contracts from the parent group. The company grows very quickly, squeezing out SMEs. Then the children sell some shares and invest the proceeds in the parent group. It's an immoral but legally legitimate way of inheriting wealth."

Overreaching has also sent various chaebols to the brink, prompting divestments that are used to pay down debt in the hope of staving off bankruptcy. What makes the assets attractive is that they are often untainted by underperformance elsewhere in the group.

Woongjin's error was to invest heavily in solar energy at a time when its construction and finance units were struggling, but Coway was still a strong business; Kumho's problems stem from a highly leveraged acquisition of Daewoo Engineering & Construction in 2006, not from any problems at Kumho Rent-A-Car, which was sold to MBK and Korea Telecom two years ago.

Even if assets do come to market, there is unlikely to be a flood of PE deal flow; rather, companies will be squeezed into submission by lenders and regulators. Also, there is no guarantee that the assets will be worth buying. STX has yet to find any takers for its shipping unit and Hahn & Co. recently pulled out of buying bankrupt Korea Line when it emerged that certain liabilities wouldn't be removed from the balance sheet, which made the deal too risky.

As one regional buyout executive observes, Korea's chaebols go through cycles, making big acquisitions and then divesting assets because they have too much debt, before starting over again. For private equity investors, it is a case of getting in at the right time at the right price. "Some of these people are greedy so the assets won't be as cheap as people think they might be," the buyout executive adds.

Seeking value

The valuation proposition is complicated by the fact that, among the mid to large buyout deals, Korea has become a phenomenally efficient market, with carefully intermediated auctions bidding up prices. "Assets are known to be on the market even before it goes to a sell-side advisor," says Peter Whang, founder and CEO of Joshua Tree, which spun-out from AIG's former Korea PE operation last year.

Joshua Tree's response is to focus on minority deals in the small- to mid-cap growth space where it sees more inefficiency and therefore a better chance of delivering strong returns. For Hahn & Co. and Headland, buyouts remain the primary focus and, although both firms consider chaebols divestments, their meat and drink is supporting corporate transition in smaller entities: succession planning, industry consolidation, and expansion into new markets.

Another regional buyout fund manager, who has bought assets from chaebols in the past, says that these deals only account for one third of deals that come under consideration. The remaining two thirds is split between succession planning buyouts and significant minority stakes in expanding businesses, with the latter becoming more prominent.

The emergence of independent, Korea-dedicated GPs in the last couple of years - in addition to Hahn & Co. and Joshua Tree, there is Anchor Capital, set up by members of Goldman Sachs' local PE team - adds credence to the mid-market investment thesis. These GPs have the ability and background to raise capital from overseas investors, stealing a march on many of their domestic counterparts, on the basis that they can deliver proprietary deal flow.

For foreign LPs, it offers a variation on the pan-regional buyout approach, while for the wider market, it suggests that deal flow is sustainable. Indeed, should the government's chaebols curbs actually kick in, both strategies could benefit - the pan-regional funds as buyers of divested assets and the country funds as investors in SMEs no longer living in the shadow of big brother.

But, as Headland's Kim warns, this doesn't necessarily make deal sourcing any easier. Although entrepreneurs who set up businesses in the 1960s are retiring in greater numbers, it still takes time to convince them to sell. "Last year we acquired YoungToys [a Korean toymaker] and the investment was secured within six months," he says. "But there are other deals that haven't closed yet and we have been working on them for three years."

SIDEBAR: Spot funds - Going solo

The single-project or spot funds that feature so prominently in South Korea's private equity market are a product of necessity, not choice. Domestic GPs have been required to register with the Financial Supervisory Commission since 2005 and about 100 licenses have been issued. However, industry participants claim that only 10 or so of these firms have actually raised traditional blind pools of capital.

The rest exist on a middle ground peculiar to Asian markets apart from Korea, pitching sellers for assets and, once they've reached an agreement, pitching LPs for capital. Should they succeed, the money is placed in a vehicle dedicated to managing one asset. For example, last year Shinhan Private Equity and Stonebridge Capital created the Shinhan-Stonebridge Petro Private Equity Fund, with enough registered capital to cover a spin-out of SK Energy's SK Incheon Refinery.

For domestic LPs, it is a trust issue. When they first started allocated capital to private equity seven years ago, commitments were spread widely but thinly because there were no track records to back. Since then, few private equity firms have done much to distinguish themselves.

"Many of these GPs have now ceased to exist because they couldn't perform - some went out of business because they couldn't source any deals, others invested poorly and their track records are horrible," says Jason Shin, managing partner at Vogo Investment. "I would say just 10 or so GPs are now considered reliable enough to get money on a discretionary basis. Everyone else with an interest in PE will have to do it some other way and that happens to be project-specific funds."

The presence of these vehicles adds an interesting competitive twist to the market. On the one hand, these managers are desperate to secure deals and therefore willing to bid up prices; on the other, they often lack credibility in the eyes of sellers because there is no certainty that the promised capital will be forthcoming.

Domestic GPs' ability to raise sustainable discretionary funds is hindered by the terms on which LPs will let them operate. Korea's National Pension Service (NPS), by far the most active private equity investor, decrees that first-time funds must have a life of six years, which means GPs must start exiting assets in year four.

"Oftentimes the IR clock starts ticking when the fund is initiated, not when the deals are done. As soon as you get the money they want you to spread it as quickly as possible," says Peter Whang, founder and CEO of Joshua Tree. "Our view is that private equity is a 10-year asset class. We are sensitive to the economics and investment cycles - it's not the number of deals executed but the quality of deals underwritten."

This emphasis on speed of deployment is not only rooted in the industry's venture capital origins, but also LPs' concerns about paying management fees to GPs who are sitting idle. There are even conditions whereby management fees are cut unless a certain proportion of the corpus is invested in the first two years.

NPS has become more flexible with time and it is suggested that the standard fund life could be extended to eight years. This would encourage continuity in management and operating, both of which may have a knock-on effect in terms of performance. LPs are also allocating capital in a more concentrated fashion, as lengthening track records make manager selection more informed process.

Industry participants expect the market to fall in line with international norms as it matures. But there is still an element of chicken-and-egg, which puts pressure on GPs to resign themselves to spot funds or watch from the sidelines.

"There is logic to what LPs are doing," explains Scott Hahn, CEO of Hahn & Co. "They would say, ‘How many PE managers in Korea have consistently delivered returns through business cycles?' Until GPs in Korea can successfully answer that, longer term discretionary funds will be difficult to raise."

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• Topics
• Buyouts
• Buyout
• North Asia
• South Korea
• buyout
• MBK Partners
• Vogo Investment
• John C. Hahn
• Headland Capital Partners