Portfolio: Hahn & Co and H-Line Shipping

For all practical business-related purposes, South Korea is an island, not a peninsula. With the country's only land border representing a decidedly uncommercial no-trade zone, 100% of importing and exporting must be done by sea.

There are worse places for this predicament, however. Flanked by Asia's two largest economies in China and Japan, Korea has emerged as a global leader in seaborne freight – a place where a four-year-old carve-out investment can claim status as the most profitable shipping company in the world.

H-Line Shipping, an iron ore, coal and liquefied natural gas (LNG) freighter backed by Hahn & Co, emerged from a number of bulk carrier divisions at Hanjin Shipping in 2014 to become that company. Revenue was tracking at about $400 million a year at the time of acquisition and is now clocking in at around $700 million a year with a nearly 40% margin.

Strategy and execution have played significant roles in the success to date, but much of it boils down to the Korea factor. More than 80% of energy is imported and 75% of GDP is in foreign trade, one-third of which is imports. Investors have historically targeted industrial connections to this opportunity set under the "Korea Inc" moniker, a socio-economic concept that perhaps best explains how cyclical industries like commodities shipping can become sturdy medium-term bets.

"We're bringing in 35-40% of the entire country's needs in iron ore, coal and LNG. It doesn't matter what the price is at any given moment – the country needs these products," says Scott Hahn, CEO of Hahn & Co. "That's very different than a bulk shipping company in other markets, where there may be a highly speculative trading component. Some people are good at that and some are not, but we want to do more of a Korea logistics play."

H-Line connects commodity exporters on every continent with Korea via some $1.6 billion worth of industrial assets, including 43 coal and iron carriers and seven LNG vessels. Employees number about 780, 90% of whom work directly with the ships. The company claims to be the largest long-term bulk shipping company in the country across various metrics and is planning a domestic IPO next year.

The build-up since 2014 has been approached on a number of fronts, with prioritization to the idea that contracting should match Korea's requirements, not its moods. Government-backed partners are therefore preferred, including the likes of Korea Gas Corporation. Additional growth has been realized through bolt-on acquisitions, talent sourcing, a more focused long-term vision, and operational efficiencies in areas such as vessel safety, fuel procurement, and administrative alignment.

"Hahn & Co's risk management policy, which is a mixture of systems analysis to minimize the market exposure and getting a lot of information with a long-term focus on the market, has been the key for us enhancing the value of our company," says Myung-Deuk Seo, CEO of H-Line. "Their system is very organized with deep communication between the operations, management and commercial departments and can lead to very timely decision-making."

Comprehensive carve-out

H-Line was founded in 2014 by separating and reorganizing the bulk commodity assets of Hanjin. Hahn & Co ultimately acquired 100% of the targeted divisions in a proprietary deal worth KRW1.6 trillion ($1.4 billion), including equity and debt. This gave Hanjin the opportunity to offload non-core businesses at a time when its relatively higher management costs were exacerbating pressures around a global contraction in the industry. 

Hanjin – which ended up filing for bankruptcy last year – was an approximately $7 billion entity at the time and Korea's largest shipping player with 12 divisions. While the company controlled about 25% of the global bulk commodities market at the time of the deal, its primary focus was container ships that transported manufactured goods. Other divisions operated in areas such as terminals and ports.

"The biggest value-add has been in the creation of the business itself and unlocking it from a large, diversified shipping business into a pure and focused long-term bulk shipping company," says Hahn. "In shipping, there's really nothing similar between bulk and containers.  They're completely different businesses, but we found bulk shipping to be more of a Korea Inc sort of industry that has a lot of strategic importance."

In addition, the bulk business was scooped up because it is an area where a smaller company could excel, whereas in container shipping, massive corporate scope is often considered necessary to remain competitive. Hahn & Co recognized that Hanjin lacked a specific long-term strategy in commodities and set about rectifying the problem by zeroing in on the most predictive niches while reducing day-to-day operating costs.

"To make companies extremely efficient and profitable in shipping, we think you need to take them out of that diversified conglomerate structure because the various divisions of these companies will underperform when they're all grouped together and unfocused," says Hahn. "That's particularly true in Asia, where in particular the Korean and Japanese shipping companies tend to be a little bit too diversified."

Commodities have been volatile during the holding period to date. Some of the hardest hit categories have been H-Line's mainstay energy and steelmaking ingredients, which began tumbling around 2016, triggering record lows for the Baltic Dry Index, a bulk shipping bellwether since 1985. Pricing has been erratic and shipping companies dealing in short-term and spot contracts have consequently been the most vulnerable.

H-Line has circumvented this effect with a strong focus on long-term contracts. The company currently has 13 contracts with Korean steelmaker Posco ranging from 20 to 25 years, which represents about a third of its long-term commitments. Last year, it agreed its first deal with a non-Korean customer, signing up Brazilian iron ore giant Vale to a 25-year contract.

"One of the success factors for H-Line is Hahn & Co's keen insight to take over lucrative long-term contracts, which have been very reliable and with good margin rates regardless of market fluctuations," says Seo. "We are continuing to expand those kinds of contracts as the shipping market has recently been recovering and will be bright in the coming years even though it has been bearish for the past several years."

A countercyclical play

The steel industry offers an interesting glimpse at shipping outlooks considering steelmaking ingredients including coking coal and iron ore account for almost half of bulk trade in a given year. Arguably the biggest new macro driver on this front is China's One Belt One Road infrastructure program which could add 44 million tons of steel demand to the global market every year even if only 10% of forecast spending goes toward the metal. Every ton of steel requires two tons of iron ore and one ton of coke.

According to data from the World Steel Association (Worldsteel) and McKinsey & Company, steel demand has leveled off in recent years at around 1.5 billion metric tons a year but is set to climb as high as 1.6 billion tons in 2025 despite an expected dip in Chinese appetite. In a tighter outlook, Worldsteel expects demand to grow 1.8% this year and another 0.7% in 2019. Although H-Line aims to insulate itself from price movements, the underlying momentum is seen as a boon.

Most of the company's traction, however, has come from more proactive growth drivers, including the development of a currency and interest rate management system that aims to reduce or eliminate any volatility from changes in currency and rare fluctuations on a long-term basis. It was the first time that the former Hanjin divisions had implemented such mechanisms.

Meanwhile, operational improvement efforts included a strong focus on efficiency in procurement and maintenance practices. In some cases, this process has entailed integrating new technologies and advanced instruments, while in others, the fix was simply a matter of setting new guidelines and operational protocols.

"When you bring a ship in for maintenance, that's a couple of months that you have to put it on the docks, and it's costly," says Hahn. "Our view has been to revamp those kinds of processes, automate and systematize them. We have also set up additional operating systems and have reduced operating expense per day by over 50% to date since we've owned the business."

Like many of its Korean competitors, H-Line was obliged to implement systemic changes in the difficult context of having non-Korean crews, in this case largely Filipino and Indonesian. However, the company's relatively tight focus on bulk operations helped streamline the exercise. "Training a foreign crew can be challenging but we have our own training system that improves crew abilities and qualifications in a systematic and continuous manner." Seo adds.

Staffing up with fresh management talent was also a priority and pursued with a view to extend relationships with shipbuilders and other related parties in the Korean ecosystem. As a result, H-Line's CEO, COO, and CFO were all brought in from outside of Hanjin, with Seo joining after a 30-year career at Posco, where he focused on shipping and raw materials procurement.

The plan was to maximize the global informational advantage that comes with being able to network within Korea's densely concentrated shipping industry by in turn leveraging the reputational draw of Hanjin. "One of the reasons we were able to get best-in-class people is because if you're in bulk shipping in Korea, this is a company you want to work for," says Hahn.

Scale proposition

The crux of the value-add story, however, was defined in 2016, when H-Line acquired 100% of the bulk and LNG units at Hyundai Merchant Marine (HMM) in a deal worth about KRW560 billion. HMM, then Korea's second largest shipping company, was seen as a natural fit, with similar vessel sizes and cargo capabilities suggesting potential for immediate operational synergies. 

Much of the higher-level decision making echoed the Hanjin transaction, with H-Line seeking to double down on the bulk segment while HMM, a troubled container-focused conglomerate, tried to stay afloat in an industry downturn. In additional to absorbing a competitor, the deal allowed H-Line to realize economies of scale by growing its fleet from 36 to 50 ships.

"By putting the businesses together, we were able to achieve additional cost savings on sheer scale and market position," Hahn adds. "If you're procuring fuel, for example, which is a very important cost, bidding for one ship is quite different to bidding for 50. Players that are sub-optimal in scale are also going to have trouble putting in IT networks and even getting best management."

Achieving scale is also viewed as an important part of navigating an increasingly difficult compliance landscape under the International Maritime Organization (IMO), a UN agency that regulates the industry globally. This includes new rules in environmentally sensitive areas such as ballast water management systems (BWMS), which will be subject to tougher standards starting in 2019, and sulfur-oxide emissions will be capped at 0.5% rather than the current 3.5% as of 2020.

"We've already finished preparations for the BWMS and now we decided to establish scrubber in some vessels for IMO's sulfur-oxide regulation which is currently a big issue in the ship industry," says Seo. "Other vessels are also being discussed with our customers as to whether to use scrubbers or low-sulfur fuel oil. The freight market is optimistic for the next 3-5 years, but we have to be more focused on regulations because the IMO is considering stricter environmental rules in the future."

Heavy regulatory oversight is nothing new in Korea Inc, however. Indeed, much of the reason that Hahn & Co has flourished in its first shipping sector investment comes back to the firm's historical preference for economically fundamental import-export plays with government ties and trans-jurisdictional angles.

More than half of the Hahn & Co portfolio, including H-Line, counts its revenue in US dollars despite being focused on Korea, and 73% of employees in these companies are non-Korean. While these are fairly unique ratios in private equity, they highlight an indispensable approach to competitiveness in certain markets and certain industries, Korean bulk shipping being a standout example.

"We are a Korea country-focused private equity firm, but the exposure we get is global, which means we need to be absolutely on top of global changes and global as well as regional competitive dynamics," says Hahn. "Shipping is different than other industries too, because if you don't have internationally-minded shareholders and management, you'll be at a disadvantage."

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• Topics
• North Asia
• Industrials
• Buyouts
• South Korea
• Hahn & Co
• shipping
• Logistics
• Commodities