END OF THE AFFAIR
The Asian conglomerate model has to move on by sifting the bad assets from the good. Here's how.
By Abe De Ramos

If Alex Chow had it his way, then New World Development wouldn't have had to restructure in the first place. "I'm a simple, straightforward guy," says the CFO of the Hong Kong conglomerate. "I hate complicated matrices." In his 27 years at New World, Chow has seen the family-controlled group grab scores of hit-and-miss opportunities - from ports, transportation and technology in the administrative region, to toll roads, power plants and water-treatment systems in the mainland - and gather them within a mere four listed entities. The result has been a disappointment to New World's majority owners, the Cheng family, and devastating to minority shareholders. Debts and losses from non-performing ventures weighed down on the better performers, and investors, who couldn't tell where their money was going, watched helpless as the parent company's stock plunged from HK$28 to HK$4 during the past five years.

Back in the days of the expansion binge, Chow had a solution in mind. "When some of the businesses had grown big, when they had become bulky, then you would think about getting an IPO," he says. But then the Asian crisis knocked Hong Kong down, and Chow said goodbye to the IPOs. His eyes reveal regret when he says: "Who would have thought that NWD would have so many subsidiaries? Nobody has a crystal ball on day one; it just evolved that way." So in late 2002, New World restructured, launching a thorough attempt to align the group entities by isolating their risks. Now, Chow says he has a clearer view of managing the group's finances.

Could New World have caught the reorganization wind blowing across Asia from South Korea? The US$92 billion-a-year LG Group, which has interests ranging from financial services to chemicals to electronics, is just completing its five-year restructuring. LG's odyssey has been closely watched by its peer group of large Asian conglomerates. These companies, often controlled by a single family, famously built their empires in the no-holds-barred mode of the Asian boom years, using cosy relationships with banks and cheap money to diversify into many businesses, placing scale above all else.

By the beginning of March, LG will be the first chaebol to completely toss the model and adopt a Western-style holding company structure, which places greater emphasis on profitability and dividends of individual investments. LG's and New World's aims are virtually the same - to separate good assets from the bad, and clear up an ownership structure that destroys value both for majority and minority owners. Says S.K. Chung, executive vice president of LG Group in charge of restructuring: "Investors had been turned off by our companies' investments in unrelated businesses, and found our corporate structures to be lacking in visibility and hard to comprehend."

Grin and Bare It

The result is a tale of two company restructurings in entirely different Asian markets that have remarkable similarities. The Asian conglomerate model, or "relationship capitalism", where pointless diversification is abetted by weak regulators and imprudent financiers, has been under attack since the crisis. Since then, watchdogs have been strengthened and financial sector reforms have taken place, but only a few conglomerates - namely those that teetered into bankruptcy or foreclosure - have made their structures leaner. Many hold on to loss-making ventures, keeping them alive through cross shareholdings. Fuelling them are related party transactions, where healthy affiliates share their resources with those that are hemorrhaging money. Think of it as internal liquidity management, but of the investing capital kind, where minority shareholders can be easily disregarded.

Five years on from the worst of the financial crisis, it's easy to understand why the pace of corporate reforms in Asia has been slow. Aside from the likelihood that family relations are involved in the less-than-desirable units, there is the issue of pride: some families just don't want to take haircuts. Michael Pomerleano, lead financial specialist in the financial sector development department of the World Bank, summed up the situation in a paper last year about corporate restructuring in Asia: "Many assets were grossly overvalued when the crisis hit, and few are willing to take responsibility for huge losses if the assets are disposed of at 'true market value'."

Given this phenomenon, the least family conglomerates could do is to introduce a game of survival of the fittest within their group. The ground rules are straightforward: identify the non-value- adding enterprises, disclose them to shareholders, reorganize the group so that they are isolated and introduce improved management, accountability and corporate governance to give the distressed units either a second chance, or a better shot at being sold at a better price. Of course, they must do all these without trampling on the rights of minority shareholders. And finally, the reorganization must unlock the value of all units, and must be done in a cost-effective way.

In Korea, where the chaebols have dominated the corporate landscape since the end of the Korean War, the LG Group is the single shining example of voluntary restructuring. The group, which is the second largest after Samsung, has blazed the trail towards the formation of holding companies. This is no mean feat, as the chaebols have elevated related party transactions into a fine art.

To understand what LG has done, it's important to know what continues to be at the core of the chaebol structure - what Lee Nam Kee, chairman of the Korean Fair Trade Commission (KFTC), calls "circular investments." This is when the chaebol has one or more subsidiaries, which form or take controlling stakes in other subsidiaries, which, in turn, do the same. This goes down to various levels, but in the end, the top of the pyramid still controls the ones at the bottom. "If you cascade this down from Company A to Company Z, if you calculate it, the chaebol's equity stake in Company Z is less than four percent, and yet, it still ends up controlling it," Lee says.

On top of this are cross-shareholdings in which two or more subsidiaries will invest almost the same amount of equity shares into each other, resulting in a bloated paper capital. Lee says this always results in better credit ratings for the subsidiaries, thereby allowing them to borrow funds easily. Meanwhile, subsidiaries also provide guarantees for each other's debts. All told, the chaebol and its affiliates share risks in untold proportions. "The chaebols like using this scheme to expand their business areas." It doesn't help that non-consolidated information in financial reports is scant.

Anatomy of a Break-Up

Effectively, the vertical chaebol structure concentrates control at the top - the family owners - to whom managers of the subsidiaries are answerable. As such, Lee says minority shareholders of the subsidiaries often have little say in investment decisions. "If the investment doesn't succeed, the risk is distributed to all minority shareholders; it's not just borne by the chaebol owner," says Lee. "That's why shareholders should use their powers, but that rarely happens."

The LG Group, controlled by the Koo and Huh families, is no exception. At one point, it was said that LG family members controlled some 200 companies. The group started the restructuring in 1998 with the merger of 12 major subsidiaries, the sale of five, the spin-off of six, and the liquidation of two. By 1999, LG's cross guarantees had also been unwound. All this was done from 1998 to 2000, and left LG with two major business units - LG Chemical and LG Electronics. But both were still laden with diversified assets.

LG Chemical, for example, had interests in petrochemicals and industrial materials, cosmetics and household goods, and life sciences. In April 2001, it was split into three spin-offs: LG Chem, which handles the high-growth and stable petrochemicals and industrial materials business; LG Household & Healthcare, the very first business of the LG empire; and LGC Investment, which handles life sciences and the investment portfolio management business - the risky businesses that have yet to generate profits.

The warm reception of investors in this transaction - shares in LG Chem, the largest and most important of the three spin-offs, grew from 12,700 won (US$9.8) in April 2001 to 41,360 won last month - paved the way for an identical move in LG Electronics. At that time, LG Electronics was involved not only in computers and consumer electronics, but also in telecommunications, broadband services, and financial services as well. Not all were successful - investors were vocally interested only in the high-growth business of making LCD/CRT computer monitors.

So in April 2002, LGE split into two new entities. The larger, also called LG Electronics, handles the profitable electronics business, as well as LG Micron, LG Innotek, and LG Philips LCD. This unit also carries the financial services portfolio, namely LG Securities and LG Card, both listed on the stock exchange. Meanwhile, LGE Investment took the money-losing LG Telecom, Dacom, and LG Information Systems, among others. This time, investors were able to better place their bets on LG businesses.

Two Become One

The final leg of the restructuring should have formally closed on March 1, when the owners of the non-performing businesses, LGC Investment and LGE Investment, merged to form the one holding company - LG Corporation. In the end, says Chung, the EVP for restructuring, the entire LG empire is now left with 50 affiliated companies, of which 20 are listed. "We now have the most number of listed affiliates among the Korean chaebols," says Chung, adding that group businesses, overall, have also raised about US$6 billion from foreign investors.

To assure investors that management and investment decisions of the subsidiaries are independent, managers of most listed LG entities are non-family members. The board of directors of the two most important businesses, LG Electronics and LG Chem, also each has six members, half of whom are independent. Theoretically, this disperses the control of both companies, which then distributes the accountability should either company stray back to non-core diversification.

The series of asset reshuffling in LG involved millions of dollars worth of share buybacks, swaps, and sales. In many of these transactions, minority shareholders have raised questions on valuations. For example, the group is now facing a lawsuit by a shareholder rights lawyer who claims that in 1999, the Koo family bought a 70 percent stake in then-unlisted LG Petrochemical from its listed parent firm LG Chemical, at about a third of the price cheaper than what should have been its fair value. Nevertheless, most of the shareholders approved the restructuring plan.

Chung says the reorganization is not yet over. LG Corp, he says, is planning to let go of marginal businesses, attract more foreign partners, and opportunistically buy or sell equity stakes in new ventures. "We're also working on listing more of our affiliates to increase transparency," Chung adds. Ultimately, the goal is to have direct stakes in as many affiliates as it can, so that "the units will be able to concentrate their efforts on their own businesses without worrying about equity investment."

Translation: LG Corp will demand, and likely re-invest, dividends from and to existing and new subsidiaries. "The creation of a single holding company does provide further evidence that the high dividend policies mentioned by [some of LG's listed affiliates] will likely be implemented and will continue for the foreseeable future," said Young Chung Mok, an analyst at ING in Seoul, in a report published before the completion of the restructuring.

From a reporting standpoint, the new structure makes Lee of the KFTC happy. "The holding company structure is much simpler than the chaebol system...because the company is only investing to get high returns, without running any business directly," he says. "It will be very simple and easy for us to supervise."

Brave New World

The re-organization of Hong Kong's New World Development is not even a ripple compared to LG's wave of complex transactions. The chaebol system, after all, is perhaps on a par with Japan's keiretsu as the most researched corporate phenomenon in Asia. But the US$3 billion-a-year New World Development is one of the largest conglomerates in the territory, and one of the "great pyramids of Hong Kong", as shareholder activist David Webb puts it. That means large corporate groups with unclear ownership structures.

The pyramid starts at New World Development (NWD), the listed parent that has its own property development projects in Hong Kong and the region. In its original state, NWD had two main subsidiaries - a listed company called New World Infrastructure (NWI) of which it owned 54 percent, and an unlisted company called New World Services (NWS) of which it owned 52 percent. NWI started out in the late 1980s as the arm that invested in traditional infrastructure such as roads and bridges, energy and ports. By 1997, Pacific Ports (PPC) had grown enough to merit its own listing, while remaining a subsidiary of NWI.

In the late 1990s NWI thought it could transform itself from old to "new economy infrastructure," investing as much as HK$1 billion (US$128 million) in telecommunications, media and technology (TMT) ventures. As the internet bubble burst, this proved to be a disaster. Adrian Ngan, analyst at BNP Paribas in Hong Kong, says NWI funded its TMT investments through loans from NWD. NWD, in turn, got the money to lend through bank loans and bonds. Alex Chow, CFO of the group, says the loans were granted on commercial terms. As such, the interest burden of TMT-related debt was stopping NWI from productively using its cashflow from traditional infrastructure - which wasn't much to begin with, says Ngan.

On the other side of the old pyramid is the unlisted entity, New World Services, and the incestuous relationship it had with its parent, New World Development. NWS was created in 1997 to be the provider of services - engineering and construction, for example - for NWD projects. NWS - which also has stable transportation and financial services businesses - was then 52 percent owned by NWD, and the rest by other shareholders, including Chow Tai Fook of the Cheng family - the same family that owns a controlling 38 percent stake in New World Development.

Because NWS was unlisted, it was a black box - information on related party transactions between it and NWD was available only on the information provided by NWD. Independent verification was difficult, and minority shareholders could only rely on independent directors to review the transactions, making sure that they were conducted at arms' length. In its 2001/2002 annual report, NWD disclosed at least 26 related party transactions - beating Hutchison, the largest conglomerate in the former colony, by six. Naturally, transactions such as these would arouse suspicions. And it didn't help that NWS - the unlisted entity - generated far more cash than any of the other listed subsidiaries.

"Skepticism arises because you would wonder who's got the stronger negotiating hands within the group to get better terms," says Amar Gill, a director at investment bank CLSA, which publishes an annual survey of corporate governance in Asia. Where there are listed and unlisted related parties and the unlisted company gets the best terms, then Gill says the majority shareholders are mostly likely to benefit from the transaction - minority shareholders of the related party are left in the cold. Adds Webb: "When a company has that many connected transactions, it's difficult to figure out what's going on. You can say it's not all beneficial to shareholders."

Crashing the Party

Alex Chow turns steely when he says that many of these related party transactions - mostly in the form of debt guarantees - are old. Since NWD invested in infrastructure projects that typically take up to 10 years to generate returns, he says, sources of funding were limited, and NWD helped the subsidiaries with guarantees. "We invested in different projects long ago...the banks are reluctant to relinquish the NWD guarantee, so we just spelled them out" in the annual report, he says. "All these guarantees date back to historical reasons."

Besides, he says, the Chengs - who are also one of the largest jewelers in Hong Kong - are far too cash-rich to expropriate from NWD. "There's only been one or two instances when the family shared the risk (with the listed entity), and they're the ones bringing the business," Chow says. "Even right now, for very short-term funding, we sometimes borrow from Chow Tai Fook - always on commercial terms - and never the other way around."

Nevertheless, the restructuring of the conglomerate was meant to help alleviate concerns related to its non-performing investments and the ownership structure. Pacific Ports, the listed NWI subsidiary, bought the traditional infrastructure assets of NWI through cash, new shares, and assumption of debt. It then acquired 100 percent of the unlisted New World Services through new shares and share swaps. NWI then distributed its remaining PPC shares to its own shareholders. Finally, PPC changed its name to NWS Holdings.

The resulting matrix leaves NWI with nothing but the TMT assets and little debt - most of it has been assumed by what is now NWS Holdings, which means that NWD now has a greater assurance of getting paid on time. The transaction also had the feature of balancing the capital structure of the group. NWI shareholders now have a company with a 15 percent gearing, down from 72 percent, while NWS increases its gearing to 34 percent, from a meager 1.6 percent.

"NWD was not able to fully utilize the cash flow of its subsidiary, NWS, to enhance the group's capital structure," says Jason Au, an executive director at Morgan Stanley in Hong Kong, which advised NWD on the restructuring. The restructuring also means that NWS - with all its assets - is now a listed entity, subject to Hong Kong listing rules. "All transactions will now be between listed entities which will bring additional transparency on connected transactions under the stock exchange's isting rules," Au adds.

That doesn't mean Chow Tai Fook will no longer work with NWS Holdings - transparency at NWS Holdings eventually depends on what it chooses to disclose. "At the New World Development level, it benefits from having fewer pieces to look at," says an analyst with an American investment bank in Hong Kong. "But at the NWS Holdings level, you don't see transparency that way unless the company chooses to disclose more. Having said that, the group is already one of the better companies in Hong Kong in terms of annual reports, with better analysis and disclosure," he adds.

As LG discovered, so too did LG find that analysts and investors were skeptical of the valuations involved in the restructuring. Although shareholder approvals were easily obtained, the current lackluster performance of the share prices of the listed companies, the analyst says, probably means that some valuations were bloated.

Alex Chow chooses not to look behind. Now that the traditional infrastructure investments have been folded with NWS, they can benefit from the latter's stable cashflow. Of course, this means that the previously comfortable NWS has itself diversified and is now exposed to capital-intensive projects - ports, roads, water and power - that could take years to pay back. But Chow says that "under this current deflationary environment, investing in an asset for a 10 percent potential return is very good, especially since it's within the same group."

Or perhaps, simple, straightforward guy that he is, Chow is again preparing his businesses for that elusive IPO.

Abe De Ramos is Executive Editor, Hong Kong, for CFO Asia.