Why Inbound Buyers Are Wary Of Deals in Korea Korea responded to its financial crisis by welcoming foreign capital, but outside investors fear that many of the old turnoffs still survive.

Following Thailand, Indonesia, and Malaysia, Korea became domino number four in the Asian economic crisis in November 1997. The Korean government, which had been trying to stave off the foreign currency reserve and short-term foreign debt crisis until after the December presidential election, was forced to seek assistance from the International Monetary Fund (IMF). The response to the crisis by Korea’s leadership has been to make fundamental and sweeping changes in foreign investment policies and domestic regulation that promise to open the economy to market forces and foreign investors. The response by potential foreign investors to the new policy directions has been highly positive; Seoul’s leading hotels have been jammed since January with visiting investors and bankers. But to the disappointment of many Koreans who were expecting a wave of much-needed capital to flow in once they opened the door, most potential investors still are waiting to move. In contrast to other Asian countries, which are still developing economies, Korea, which recently became the second Asian country (after Japan) to join the Organization for Economic Cooperation and Development (OECD), has drawn special attention from potential investors. That is attributable to its strong and varied industrial base, its well-developed domestic market, and an industrial structure dominated by giant “chaebol” conglomerates that is inefficient and overripe for restructuring on a massive scale. Korea has been a “capital-intensive” developing economy, and big-league industrial ownership is highly concentrated, which for investors and investment bankers means that large deals can be done in Korea. And there are many potential large deals. Korean companies tend to have a preference for debt. The average debt ratio of listed companies on the Korea Stock Exchange is more than 500%. With the additional damage done to balance sheets by the economic crisis and devaluation, corporate Korea essentially needed to be recapitalized. Korea also has drawn interest because, relative to its economy and importance in world trade, it has been “underinvested” by foreign companies. Many foreign companies are interested in the market and its strategic position in Asia but heretofore have been effectively barred from participation on a reasonably level playing field or have found the environment not conductive to expansion of existing commitments. So, they have tilted in favor of opportunities in other Asian nations. The underinvestment has resulted from a combination of factors that can be summarized as overregulation, government controls, lack of transparency, and negative attitudes toward foreigners participating in the economy unless they brought technology sought by Koreans. Opaque government practices, frequent disputes among joint venture partners, and labor practices and regulations that tended to increase costs and reduce flexibility were other major barriers. A well-known political risk consulting firm, Political & Economic Risk Consultancy, commenting in December 1997 on the new opportunities for foreign investment in Asia after the economic crisis, rated South Korea next to last in attractiveness for direct investment. Only Vietnam was lower. But if given the opportunity and the incentives, many international competitors that are well-established across the globe would like to expand their participation in the Korean economy. Kim Dae-Jung, elected president last December in the middle of the crisis, has rallied the country behind new policies of deregulation of domestic industries and restructuring of industry to force the closure of insolvent companies and banks. Simultaneously, the government is seeking to attract capital from foreign investors by removing most major restrictions on foreign investment and on certain types of transactions, such as hostile takeovers, that tend to improve management’s focus on creating good economic returns and shareholder value. While foreign investors find these policies attractive, the real beneficiaries are Korean companies, which always have labored under the restrictions and bureaucratic direction of many sectors of the economy. These policies include: * Removing most restrictions on foreign ownership of listed companies; * Permitting hostile takeovers, formerly off-limits for both Korean and foreign entities; * Removing restrictions on foreign investment in companies registered on KOSDAQ, Korea’s over-the-counter market, which for most companies is considered an intermediate stage before going public and being listed on the Korea Stock Exchange; * Removing restrictions on international capital flows and foreign exchange controls; * Removing restrictions on direct borrowing by Korean companies from overseas sources; * Removing prohibitions on foreign acquisition of Korean real estate; * Instituting measures to increase financial transparency of Korean companies and their financial structures by eliminating accounting and credit allocation abuses as well as dangerous financial practices, such as cross-guarantees of financial transactions within a corporate group; and * Closing insolvent financial institutions and encouraging the windup of insolvent companies. The policy announcements constitute a wish list that foreign companies long have coveted in Korea. The question is whether deeds will match words. Foreign companies experienced in Korea know that there is often a huge gap between policy announcements, enabling legislation, and actual implementation and policy. Prior to his February 1998 inauguration, Kim Dae-Jung was able to exact commitments from labor for cooperation in new measures to reduce employment commitments and increase the flexibility of the labor market and simultaneously force commitments from big business groups to restructure and eliminate money-losing subsidiaries. But Kim was elected by only a minority of the electorate in a three-way race and his party was not able to win a majority in the National Assembly. Consequently, the lines of resistance from Korean big business firmed up quickly and were joined by labor, which still is waiting for Kim’s, promised “social safety net” to be put in place. Predictably, the initial surge of transactions involving acquisitions by foreign investors has been a wave of buyouts by Korean joint venture partners. In the first quarter of 1998, 47 JV partner buyouts were recorded by Korean authorities. This category of strategic direct investment always has been the largest category of m&a transactions in Korea involving foreign companies. They first emerged after Korea amended its Foreign Capital Inducement Law (FCIL) in 1987 to permit 100% foreign direct investment in many industrial categories. Although some of these partner buyouts were undertaken to resolve management issues or were forced by capitalization requirements, the typical decision drivers were the forces of globalization of management and competition. These elements have required multinationals to integrate Korean operations into regional and global operations, rather than just focus on the domestic Korean market with Korean partners. From a management perspective, buying out a partner is also the type of transaction that makes sense. The Korean business environment is complex and difficult to maneuver for Korean companies as well as foreign firms. Even though it is no longer required by law, many non-Korean firms still prefer to start out with local joint venture partners to learn about the environment. But eventually interests diverge in even the closest partnerships, and Korea has been known as an environment in which management priorities for Korean companies often differ radically from those of foreign partners. In fact, a number of the buyouts recorded after the Asian crisis began actually were under negotiation well before the crisis broke. These included some of the most prominent transactions in December 1997, such as BASF AG’s buyout of Hanhwa Chemical’s 50% share of Hanhwa-BASF Urethane Ltd. and the German chemical firm’s purchase of Hyosung T&C’s 50% stake in Hyosung BASF Co. Pfizer Inc. of the U.S. bought out its Korean partners to take full control of Pfizer Korea Ltd. and Canadian-based Seagram Co. Ltd. assumed complete ownership of its venture with Doosan. After the crisis hit, many of the deals that had been under intermittent discussions rapidly jelled. Some foreign investors seized the opportunity and initiated discussions with their partners; in some cases, the Korean partners began the talks. Many buyouts announced in the first months after the crisis were defensive or rescue reactions to the failure of a key business partner. Among the most noteworthy of these transactions was the move by Adolph Coors Co., the third-largest U.S. brewer, to take over its Jinro-Coors Brewing Co. joint venture with a cash infusion of $100 million. Coors entered the JV in 1994 with a 33% stake, providing technology and marketing know-how but ceding management to the Jinro Group, an alcoholic beverage and beer producer. Jinro accumulated massive debts in a multi-faceted expansion drive in the early 1990s and went into bankruptcy in April 1997 as one of the early casualties of the credit tightening and re-ratings that followed the collapse of Hanbo Group the previous January. A special twist in the transaction is that Coors is demanding that creditor banks take a loss on a portion of the debt and convert another large portion to equity. This structure is not unusual when Korean creditor banks arrange for bankrupt debtors to be taken over by Korean firms. But if Coors is successful in obtaining the loan write-down, it will set a major precedent as the first overseas firm to obtain that relief and open the way for foreign “turnaround” takeovers of bankrupt Korean companies. Usually, Korean acquirers will agree to assume the “bad” debt, but essentially interest-free. Likewise, the plunge into bankruptcy by Kia Automotive forced its foreign partners in key components and subsystems joint ventures to take them over. An example is German firm Robert Bosch GmbH’s takeover of Korea Motor System & Technology in December 1997. A third deal category might be called “cooperative” transactions in which foreign firms already in majority- control positions in JVs purchase the shares of their Korean partners in essentially friendly deals motivated by good business relationships. In one example, Hewlett-Packard Co. of the U.S. bought the 45% share in Hewlett-Packard Korea that was held by Samsung Group. The sub-segment of foreign partner buyouts that represents a radical departure from the past has involved purchases by Japanese companies. Historically, almost all Japanese participation in joint ventures in Korea has been through capital and technology contributions, not management responsibility. They key factors for these arrangements have been Korean sensitivity to Japanese influence, because of the bitter colonial experience that ended at the close of World War II, and the government’s application of special restrictions on Japanese imports. These barriers have been dropped at least for the duration of the economic crisis but probably won’t be resurrected for the longer term as Korean attitudes mature. One transaction in which a passive Japanese partner took control of a JV was at Korea Xerox. The Japanese company, Fuji Xerox, is controlled by shareholders in Japan, not by Xerox Corp. of the U.S. Control shifted to the Japanese at KTP Corp., an engineering plastics firm established as a 50-50 joint venture between Kolon Industries of Korea and Toray Industries Inc. of Japan in 1996. In June 1998, Toray raised its stake to 70% to infuse capital and reduce the debt-to-equity ratio, but Kolon will continue to manage the JV. The second most prevalent type of transaction is the move by foreign companies that already are well-established in Korea and are seeking to expand through acquisitions. The key enabling factors are the availability of businesses to purchase, which was quite unusual in the past, and the rise of “motivated” sellers, mostly Korean companies seeking to deleverage debt-heavy balance sheets in the era of tighter credit. BASF also executed the most prominent transaction in the strategic acquisition category by purchasing a new lysine manufacturing unit from Daesang Group for about $600 million. It is noteworthy that BASF bought a facility and a business unit, not an entire company. The advantage for BASF was that it could avoid all of the hidden problems and obligations present in a corporate structure and deal directly with such operational questions as white-collar staff overhead and management responsibilities. On the Korean side, selling off the business unit instead of the company avoided critical cultural issues of leadership and control by the owner family. A similar case was the agreement by Hyundai Electronics Industries to sell its photomask operations to Du Pont Co.’s photomask subsidiary in Korea, a deal in which Du Pont obtained both facilities and a customer relationship with Hyundai. In contrast to the surge of JV partner buyouts, the number of transactions that represent new entries into the Korean market by industrial or financial investors buying direct equity was limited during the first six months after IMF intervention in the Asian economic crisis. But those that were announced shared two common features: * They tended to be capital-intensive. For example, in the paper and pulp industry, Shinho Paper Manufacturing agreed to sell a new paper plant to Norway’s Norske Skogindustrier A/S for $175 million, and Bowater PLC of the U.K. purchased Halla Pulp, also for $175 million. In the power field, AES Corp. of the U.S. bought Hanhwa Energy’s generating facility near Inchon, reportedly for $874 million. * They involve industrial production facilities with small, technically proficient work forces. A primary case is the acquisition by Sweden’s AB Volvo of the construction equipment division of Samsung Heavy Industries, reportedly for $760 million, in a deal that coincidentally fell into the capital-intensive category. For Korean companies seeking to raise cash and reduce debt, the most active market has been oversas activity. Divestitures of overseas subsidiaries, often to strategic purchasers, actually are much easier for Korean companies to execute than domestic sell-offs. They also are easier on the foreign buyer that can avoid going abroad to an unfamiliar land and that does not have to engineer a complex disentangling of the target company from a web of cross-holdings and obligations manifested in the Korean group business system. The best known of these sell-offs, Hyundai Electronics’ disposition of its Symbios Inc. adapter card subsidiary, acquired only three years earlier from AT&T Corp., took on a bizarre twist before being sealed. Hyundai first agreed to sell the Colorado-based unit to Adaptec Inc. for $775 million, only to scrub the deal in the face of a looming antitrust challenge against Adaptec’s potential domination of the market for adapter cards, which manage data traffic on computer networks. Within days, however, Hyundai came up with a new buyer, LSI Logic Corp., at $760 million, including the assumption of debt. Financial investors have been active in these overseas dispositions. In May, Kohap Ltd., a polyester and nylon maker, announced the sale of its German magnetic tape unit, Emtec Magnetics GmbH, to a European investor group. Extraordinary foreign exchange gains represent an additional advantage to Korean companies. Most overseas subsidiaries were acquired or built at average exchange rates of about 680 to 850 won per U.S. dollar. Proceeds from assets sold overseas now can be repatriated at rates between 1,350 and 1,550 won to the dollar. As a result, bargaining is easier. If a Korean seller can negotiate a purchase price close to the original dollar price it paid for the overseas business, the seller is guaranteed a 50% or greater foreign exchange gain. Industry sources observed that the price Hyundai received for Symbios was at the low end of the typical price range, when measured as a multiple of sales. On the home company’s books, however, the price probably represents a gain of more than 400% in terms of the won in less than three years. A key barrier to deals in Korea is valuation. Valuation of overseas assets is relatively straightforward; agreement on valuations in Korea is more difficult. Transparency in Korea is lower than in many foreign countries, and a variety of considerations and attitudes affect the intangible values that are assumed. But two other barriers deserve special mention. First, Korean attitudes toward debt tend to be indifferent to high debt ratios and separate debt from the value of the business. Debt is seen as a natural fact of doing business, a view that is buttressed by the ability of operating companies to borrow from friendly banks and to offer a tangible asset base, preferably real estate, as collateral. Companies with insupportable debt loads still will seek to get back at least the paid-in equity capital. Consequently, there have been especially large gaps between the valuations derived by potential financial investors and Korean companies trying to sell subsidiaries. A second barrier has been created by government policies intended to redress regulatory distortions of the past and improve potential valuations. The key policy is the announcement that Korean companies would be permitted to revalue real estate and tangible assets without paying special taxes. What does this policy, in effect a reversal of prior positions, stem from? During Korea’s miracle economic growth from the 1960s to the early 1980s a period of tremendous economic value creation Korean companies were permitted to revalue tangible assets and recognize the increased values in their equity accounts with only minimal tax consequences. Because of extreme price increases in real estate and the government’s desire to repress the influence of real estate inflation on general inflation and the consumer price index, the government shifted course in the early 1980s and embarked on a series of measures to restrain real estate prices. Among them was the refusal to permit real estate and tangible asset revaluation, except for companies that went public between 1987 and 1990. In February 1998, the government shifted again as part of its announcement of bold measures to open Korea for foreign investment. It created a special revaluation period for 1998 during which companies can revalue with minimal tax consequences. The explicit objective was to improve Korean company balance sheets in anticipation of aggressive inbound investments. The immediate effect of the measure was to stop many acquisition negotiations. The Koreans wanted to delay proceedings so they could execute revaluations, which would strengthen their positions, while foreign investors believed the revaluations were rather artificial. Potential foreign investors saw the measure as a warning sign of government economic regulation by fiat. They further believed that it held “surprises” for foreigners and represented a continuing lack of transparency in regulation. To complicate matters technically, real estate prices now are declining rapidly and some predictions call for declines of 50% in the value of major commercial and real estate assets. If that drop materializes, Korean companies may find that the revaluation that they regarded as an opportunity for a windfall actually reduced assets rather than increased them. Korea’s capital market liberalization, removal of restrictions on foreign investors, and deregulation of domestic business has just begun. Although there is keen interest on the part of many potential investors, there is also awareness of the many difficulties and barriers that remain. If Korea is successful in implementing the reforms and staying the course without erecting new thickets of regulation, it will be successful in attracting foreign investment and strengthening the foundation for future economic success. Besides the extraordinary personal vision of Kim Dae-Jung and his commitment to make hard decisions and lead the transition, a watershed change has occurred in man-on-the-street public opinion. Foreign investment and achievement of economic efficiency through the free play of market forces now is seen as beneficial and necessary, and no longer the threat to national and cultural sovereignty that Koreans were long encouraged to believe. It is no longer embarrassing to sell controlling interests to a foreign company or to allow a foreign company to invest and take control. But the process is likely to take years to run its course. Many Korean companies now are in a desperate search for new capital, preferably foreign capital. The initial stage of inbound investment attracted by the opportunities has been dominated by foreign companies already established in Korea and experienced in the ways of the country. The longer the experience, the less the risk. The second stage has involved direct investment by new entrants to the market that have some type of experience doing business with Koreans and are investing for strategic purposes. The stage at which entirely new investors, such as financial buyers, start to commit to Korean deals in large numbers is on the horizon. It will begin in earnest when these investors see proof that the policy initiatives promised by the government are implemented and they become comfortable with the new environment. That may come as soon as the second half of 1998. But until then, they have plenty of off-shore deals involving Korean-owned assets to keep themselves occupied.Tarnished golden opportunityThe flood of inbound acquisitions anticipated inthe wake of Korea’s economic crisis remains a trickle. Despite government pronouncements opening the gate to overseas capital, Korean companies’ need for capital infusions, and theopportunity for non-Koreans to pick up good butfinancially damaged assets on the cheap, outsidebuyers have held back. Their fear is that toomany of the cultural and regulatory trappingsthat favored Korean firms and made businessdifficult for outsiders still are imbedded in the system. There have been several buyouts of strapped Korean partners in joint ventures, and Koreanfirms have actively shopped overseas subsidiaries to raise cash. But still in the wings is the much-awaited wave of direct purchases of Korean companies by overseas-based multinationals and financial buyers.