Korea macro: Tempered tiger

Whether they’re shrugging off nuclear threats or bailing themselves out of the Asian financial crisis by donating their personal gold en masse, South Koreans have always been known for stoicism under pressure. Investors would do well to heed this example as the local economy settles into a prolonged downcycle amid a maelstrom of unpredictable macro factors.  

Although tension with the North has never translated into a tangible investment issue, it hangs over everything and has recently begun to take a larger portion of government bandwidth that might normally focus on economic workarounds for an aging population. Meanwhile, China’s rise in both political and economic spheres has shaken up trade norms on which Korea depends and eroded the country’s competitiveness in a number of important industries.

Annual GDP growth rates in Korea regularly surpassed 10% between the 1960s and the turn of the century until the economy became so large and sophisticated that it could no longer sustain such a fast rate of expansion. Growth has tracked below 4% for the past decade – apart from a spike in 2010 – and is projected to fluctuate under 3% for the next three years. Tensions with China over missile defense and the impeachment of President Park Guen-hye have only served to dampen sentiment in recent times.

“Many of our clients feel the situation is not good for the Korean economy because competition from Chinese manufacturers is making it hard to find companies that will be sustainable for the next 5-10 years,” says Yidong Kim, a partner at KPMG. “But private equity firms in Korea have a huge amount of liquidity and they’re finding new ways to use their networks. As the economy upgrades and valuations go down to more realistic multiples this year and next, it will be good timing for private equity buyouts.”

Since his election last year, President Moon Jae-in has prioritized relations with the North and a reduction in youth unemployment, which is officially tracking around 10% but suspected to be much higher. According to Natixis, the agenda isn’t working. The investment bank said this month that a recent hike in the minimum wage aimed at curing Korean labor market woes has resulted in smaller corporates slashing headcounts to guard profits and chaebols offshoring labor to cheaper markets.

Alicia Garcia-Herrero, chief economist for Asia Pacific at Natixis, sees chaebol reform and an opening up to foreign competition as the best ways to create more high-paying jobs. “Relations with North Korea are important but not the key to increasing productivity. This can only come from increased competition in the Korean economy,” she says. “That should be the focus of Moon’s administration. Wage polices will not help either unless more labor productivity is achieved. We Europeans have learned that the welfare state can only be maintained by increases in productivity.”

The PE angle

From a private equity perspective, these concerns have been mostly academic so far. Pan-regional firms that don’t already have a meaningful footprint in Korea are expanding – notably Bain Capital and TPG Capital – as they eye large-cap opportunities. Meanwhile, local fundraising has remained robust as leading managers raise ever larger funds and younger players push through. Crescendo Equity Partners recently raised about $400 million for its second fund, with most of the commitments coming from domestic investors. 

“The macroeconomic impact is important but at the end of the day, it’s the performance of the individual companies that you invest in,” says Kevin Lee, founding partner at Crescendo. “If you invest in companies that perform well for the next five years, that will generally overcome the negative macro effects. But for private equity, investing in high-performing export industries is not so straightforward because it has been traditionally driven by the large corporates.”

Crescendo finds entries in technology exports by targeting B2B companies instead of consumer-facing brands. The idea is that Korea can mimic the success of Japan in playing the role of behind-the-scenes industrial supplier even as emerging regional competitors take greater market share in high-profile manufacturing segments. This perspective shines a positive light on Korean fears around following the fate of Japan, which, although economically stagnant for a generation, has continued to thrive in various supply chain niches and snowballed an increasingly significant private equity ecosystem.

Guarded optimism about deal flow in Korea is also being contextualized in government efforts to pressure chaebols into reducing their dominance of the economy by divesting non-core businesses, with impending legislation set to target in-house systems integration or IT units specifically. The policy has been warmly welcomed by the private equity industry, which has perceived the country’s large footprint of conglomerate-denominated companies as antithetical to a traditional founder-owner M&A approach.

Most of the landmark transactions in this vein to date have included multinationals exiting the country, with Tesco’s sale of multi-channel retailer Homeplus to an MBK-led consortium for $6.4 billion being a prime example. Divestments by local players have tended to be smaller and involve lower-tier chaebol groups, but deal sizes are expected to increase. This trend was signposted in February when CJ Corporation agreed to divest its healthcare business to Kolmar Korea for KRW1.3 trillion ($1.2 billion). H&Q Korea, Mirae Asset Private Equity, and STIC Investment participated as minority investors. 

Hopes that private equity will play a meaningful role in this emerging M&A environment are further supported by what appears to be an increasingly widespread social determination to chip away at chaebol hegemony. The impeachment of Park brought the issue to the fore in dramatic fashion with scandals involving a number of conglomerates looming large in her political downfall. PE stands to benefit not only by securing corporate carve-outs, but also through investments in earlier-stage and smaller-size deals, where job creation will be a priority.

“I think most people would agree that the big corporations are probably going to butt heads with the government in the near future, but if you focus on smaller mom-and-pops, the policy and tax environment is going to help you,” says Richard Kim, head of Korea at First Avenue. “That’s why it’s a better time for VCs than the large buyout firms, which will face a lot more headwinds. It’s not a fair game from the point of view of the chaebols, but that’s how Korea is going to try to reduce unemployment.”

Trade tribulations

One of the biggest variables in the opening up of Korea’s corporate landscape is the notion that the majority of the industries involved are reliant on an uncertain global trade environment. Some 75% of Korea’s GDP is said to be in foreign trade, two-thirds of which is exports. As a result, the specter of constricted global supply chains due to US-China trade tensions has loomed ominously in medium-term outlooks for the country’s industrial sector.

Still, many investors are upbeat. Exports proved to be the main driver of Korea’s recovery during both the Asian and global financial crises, in turn leading to rebounds in household incomes and domestic consumption. Although most of the industries caught in the US-China crossfire relate to machinery and electrical equipment, which are lynchpins of the Korean economy, private equity players expect to be able to maneuver creatively as trade flows are redrawn. 

“The sectors that the US has set forth with regards to increasing tariffs represent a very small proportion of Korea’s GDP in terms of Korean exports to the US,” says Michael Chung, head of Korea and managing director at Morgan Stanley Private Equity Asia (MSPEA). “Korea is either number one or two in Asia exporting a lot of those products for which either the US and China have expressed intensions of increasing tariffs, and as such if trade is reduced between China and the US, someone will need to fill that gap and Korea will be quite well positioned to do so.”

MSPEA has demonstrated that as China moves up the value chain in global technology supply, private equity opportunities in Korea may actually be most targetable in low-tech, domestically-facing industries. For example, the GP has recently transitioned a relatively low-end manufacturing company, Jeonju Paper, into a local renewable energy leader through a biomass capacity build-out. In effect, the plan leveraged low competition in an unfashionable segment to offset Korea’s abysmal terms of trade in energy, which is 80% imported.    

Basic manufacturing, along with offline retail and food and beverage, could become a difficult segment going forward, however, as the government’s minimum wage hikes start to be reflected in company budgets. Exceptions could exist in a number of fields aimed at leveraging changing demographics such as lifestyle plays based on smaller family sizes and aged care, although some investors are concerned healthcare is too small and heavily regulated to present much opportunity.

Upgraded technology is therefore typically cited as a potential PE inroad but always in the same breath as warnings about Korea’s trade surplus with China, which has withered from about 5% of GDP five years ago to less than 3% last year. Perhaps most dramatically, this process has included Samsung’s mobile telephony exposure in China falling from 20% to about 2%.

Semiconductors, Korea’s most competitive category, has likewise lost ground to players such as Hong Kong-listed SMIC, but investors do expect to be able to find supporting cross-border connections. “The emergence of China is not going to completely take away everything from Korea in terms of what the country has developed in its technology ecosystem, including semiconductors,” says Crescendo’s Lee. “As China catches up in those industries, suppliers in Korea that used to rely only on Samsung or SK Hynix will have additional customers. It will be complementary as well as competitive.”

More upside regarding China has been proved out in Korea’s popular cosmetics industry, which has generated deal flow for a string of private equity investors. Interestingly, these plays benefit from Korean cultural cachet, which makes foreign competition difficult. Bain Capital and Goldman Sachs logged the most notable success last year with the sale of skin care products maker Carver Korea for $2.7 billion – more than four times the valuation at which they bought the business in 2016.

Dented deal flow

Nevertheless, high valuations and uncertainty around regulations relating to chaebol divestments and the minimum wage have dented deal flow this year. Bain & Company estimates PE investment in the country during the first half of 2018 reached $4.3 billion, versus $13 billion for the whole of 2017. This figure is expected to firm up to a range of $10-15 billion per year until 2023 as new policies are better understood and cultural aspects of the demographics shift come into focus.

Eight of the 20 largest private equity transactions in Korea in 2017 were chaebol-driven with an even mix of distress-related and strategic divestments. The remaining 12 were a roughly even mix of founder succession deals and secondary sales. Succession planning situations are shaped by Korea’s boom days of the 1990s, when many founders were in their 40s. While those entrepreneurs, now in their 60s and 70s, are still retiring, the next generation has already started complicating the market.

“We expected deal flow to be mostly driven by succession, but we are seeing a new trend where young owners want to partner with global and regional funds in order to get access to the right resources to expand their businesses, especially in talent,” says Wonpyo Choi, a partner at Bain & Company. “High caliber people in Korea want to work for big corporates and large professional funds, rather than midcap companies.”

This view highlights the need for private equity investors to flex their value-add credentials as new opportunities and stress points gradually reshape the Korean M&A market. The question is whether or not the country’s locally founded GPs, which have less experience overhauling portfolio company operations than their regional competitors, will be able to adapt.

“It could become increasingly challenging for PE to source good companies and good deals at reasonable prices,” says MSPEA’s Chung. “If you look at the prices paid by private equity firms in the past three to four years, it has on average been in double digits in terms of EBITDA multiples, and at some of those valuations, you need the valuation multiples to sustain or increase by the time you sell, or be able to transform a business into something more interesting.”

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• Topics
• North Asia
• GPs
• Fundraising
• Regulation
• South Korea
• M&A
• Economy
• KPMG
• Crescendo Equity Partners
• Morgan Stanley Private Equity Asia
• manufacturing
• Technology
• Consumer