One Fund Two Masters

When Kook Kyung oh, the head of alternative investments at Korea Investment Corp., heard in December that Merrill Lynch & Co. was looking to raise capital, he didn’t hesitate.

KIC hadn’t made any big overseas investments since its founding in 2005. Fund executives, constrained in part by conflicting mandates from South Korea’s Finance Ministry and its central bank, had watched from the sidelines over the preceding month as sovereign wealth funds from China, Singapore and the Gulf region took significant stakes in Citigroup and Morgan Stanley. Kook saw Merrill’s distress as an opening, so he placed a call to Nelson Chai, who had just been appointed as the firm’s executive vice president and chief financial officer.

“We were considering several opportunities, including Merrill,” Kook tells Institutional Investor in a telephone interview. The decision to take a large stake in a big financial company “was a strategic approach,” he adds.

Chai was more than happy to take the call. Merrill was preparing its 2007 results, which would show a record $8.6 billion loss from continuing operations after $22 billion in write-downs on mortgages, asset-backed securities and financial hedges, and it desperately needed fresh capital. After a few weeks of hurried negotiations, KIC agreed in January to inject $2 billion into Merrill by buying convertible preferred shares, part of a $6.6 billion deal that would include major investments by the Kuwait Investment Authority and Japan’s Mizuho Corporate Bank.

The timing would prove to be inauspicious, to say the least. Merrill’s stock price tumbled in the ensuing months as the deepening credit crisis forced the firm to take billions in additional write-downs and post a $6.6 billion loss for the first half of 2008. In July, KIC joined the KIA and Mizuho in converting its preferred shares into common stock some two years ahead of schedule and at a price that was less than half the originally intended level. But even after that maneuver, Merrill’s shares continued to slide, trading late last month at roughly 10 percent below KIC’s purchase price.

For executives at the South Korean sovereign wealth fund, the exercise has provided a tough lesson in the risks of high-stakes global investing and the need for patience. “Since converting, we are observing,” says Khil Jae Uk, an economist on KIC’s steering committee. “That’s all we can do. The Merrill Lynch investment is special from the viewpoint of overall strategy.” Another senior KIC official, speaking on condition of anonymity, emphasizes the fund’s lengthy time horizon. “It’s not proper to gauge unrealized gain/loss every day, as KIC is a long-term investor.” But, he adds, “KIC will [use] a more shrewd process when it makes its next big investment like Merrill.”

The fund had better do so. The Merrill investment, far from cementing KIC’s place on the global stage, has merely aggravated tensions between the Finance Ministry and the Bank of Korea that threaten to restrain the fund’s ambitions. As the traditional guardian of the country’s $248 billion in foreign exchange reserves, the central bank strongly opposed KIC’s creation and has been stingy in funding it, contributing just $17 billion of its $30 billion in assets, compared with initial market expectations of as much as $50 billion. The Finance Ministry has supplied the balance of the funds. From the start, the central bank insisted on a different, more conservative investing mandate for its money. In fact, KIC’s investment in Merrill was made entirely with Finance Ministry funds.

The central bank “is very conservative about its reserves,” says Ji Dong Hyun, executive director of the Kookmin Bank Research Center, an arm of South Korea’s biggest commercial bank. “From the very beginning they are opposed to the KIC. They are not willing to part with more money.” By contrast, Finance Ministry officials supported the Merrill investment because they believed it would assist the government’s broader aim of developing Seoul as an international financial center, a policy goal that KIC is intended to support, Ji says.

“The BoK is not necessarily cooperative,” adds an official at the Financial Services Commission, who spoke on condition of anonymity. “They thought their power to run reserves would be reduced, so they weren’t happy with the idea of the KIC.”

Disagreements between central banks and finance ministries over the role of sovereign wealth funds are hardly new. China’s State Administration of Foreign Exchange, a central bank arm that manages the country’s currency reserves, opposed the creation of China Investment Corp. a year ago and has appeared to be competing with CIC by making some recent equity investments. Saudi Arabia is only beginning to create a sovereign fund — decades after many of its Gulf neighbors — because the Saudi Arabian Monetary Agency has for years zealously guarded its monopoly over the kingdom’s reserves.

South Korea is unique, however, in incorporating those tensions in its sovereign fund, a fact that threatens to impede KIC’s effectiveness. The government founded the fund in July 2005 with the twin aims of boosting earnings on the country’s foreign exchange reserves and fostering South Korea’s development as an Asian financial center. “Ninety percent of our mandate is commercial investment and looking for capital gains,” says Kim Young, who heads KIC’s corporate planning team, adding that the fund also seeks to “foster investment professionalism and improve the quality of the asset management industry” in South Korea.

KIC was seeded with $20 billion in assets — $17 billion from the central bank’s currency reserves and $3 billion from the Finance Ministry’s foreign exchange stabilization fund. Choi Choong Kyung, a Finance vice minister who was instrumental in lobbying for the fund’s creation, persuaded the ministry to chip in an additional $10 billion late last year, before he resigned his post because of controversy over the won’s decline against the dollar.

Having one national fund serve two different masters reflects the rivalries that are prevalent within the country’s government bureaucracy, observers say. “The BoK regards its mandate as protection of national reserves,” says Hank Morris, a longtime fund manager in South Korea and director of IRC, a Seoul-based consulting firm. “The Finance Ministry sees its mandate as promotion of Korea as a financial center. If that’s your mandate, you have a different horizon.”

The man who has the tough task of reconciling those two masters and plotting a coherent investing strategy for KIC is chief investment officer Guan Ong. A Malaysian native who earned a Ph.D. in engineering from Imperial College London, Ong began his financial career as a credit analyst at Credit Suisse First Boston in London, then moved on to a similar job at Lehman Brothers in Hong Kong before joining Prudential Financial in the same city; he rose to become the U.S. insurer’s global CIO, based in Seoul, in 2005.

Ong plays down the differences between the ministry and the central bank but acknowledges that he faced an uphill climb in developing an investing capability after he joined KIC in February 2006.

“We started from scratch,” he tells II in an interview at KIC’s offices in central Seoul. “We didn’t have any staff or systems. We spent over a year developing our system.”

The fund didn’t make its first investment until November 2006, when it plowed about $1 billion into international bonds. Ong declines to disclose the exact holdings but insists that KIC is making “a decent profit” on the bonds.

A lack of South Korean managers with experience in international investing has hampered KIC’s ability to put its money to work, acknowledges corporate planning chief Kim. The fund initially allocated most of its assets to indexed strategies but has been steadily moving toward more-active mandates, he says. KIC doesn’t disclose its portfolio’s allocation or performance targets, but Kim says, “We’re trying to get higher excess return, higher than the benchmark” indexes of Morgan Stanley Capital International.

Ong says he hopes that KIC will have invested more than 90 percent of its funds by the end of this year, with 60 percent devoted to fixed income and 40 percent to equities. Some 70 percent of allocated funds are run by about 20 external managers; Ong’s staff manages the remaining 30 percent from KIC’s offices on the 16th floor of the Seoul Finance Center, an imposing office tower in central Seoul that is on the same avenue where in recent months tens of thousands of South Koreans have protested against U.S. beef imports.

Under the law that created KIC, the fund must invest all of its assets overseas. It cannot buy more than 5 percent of any company or hold board or management positions in portfolio companies.

Ong is sensitive to complaints that KIC has been overly cautious in deploying assets. “We have a certain risk budget,” he says, but given that the fund has been investing for less than two years, “we don’t expect to shoot all the lights out.” Still, Ong and his team are negotiating with the Finance Ministry for new freedom to invest in alternative assets, including real estate, hedge funds and private equity.

A desire to boost returns — and take more risk — led KIC’s Kook to approach Merrill last December. Ong then entered detailed negotiations with the U.S. company, assisted by Yun Young Won, a member of KIC’s steering committee who also advises Samsung Investment Trust Management Co. Officials say Chai’s background — he’s the son of Korean immigrants to the U.S. — was not a factor in the deal, but it certainly didn’t hurt.

Executives at Merrill say Chai, a former NYSE Euronext CFO who was John Thain’s first major outside recruit after he took over as Merrill’s CEO late last year, credits Ong and Yun for appreciating the investment bank’s dilemma and its prospects for recovery.

When the deal was struck in January, the Merrill preferred shares were supposed to be converted into common stock in 2010 at a 17 percent premium over the prevailing market price at the time of $52.40 a share. The subsequent sharp decline in Merrill shares, part of a broad-based sell-off in U.S. financial stocks, prompted Ong to renegotiate the investment. In late July, KIC agreed with Merrill to convert its $2 billion worth of preferred shares into 72.24 million shares of common stock plus $30 million. The terms worked out to a conversion price of $27.27 a share, a 12.1 percent premium to the then-prevailing stock price of $24.33. The stock was hovering around $25 a share late last month.

KIC executives characterize the investment as a learning experience and insist the fund remains committed to holding its Merrill stake for the long term. “We are not making or losing money,” says Yun, who contends that the early conversion of the preferred shares “will strengthen Merrill.” Another senior KIC official is equally upbeat: “It’s not a setback.”

Outsiders are not so kind, though. “The performance of the KIC is not good compared to other SWFs,” says Kookmin Bank’s Ji. He attributes the fund’s difficulties to “the inexperience of the managers” as well as the fact that they had “small assets compared with others,” such as the Government of Singapore Investment Corp. and CIC.

William Ryback, who spent more than 30 years working for the U.S. Federal Reserve Board and the Office of Comptroller of the Currency and who worked as a special adviser to Korea’s Financial Supervisory Service last year, faults the government for failing to provide clear direction for KIC. “The main problem is not that the Koreans lack a vision,” he says. “It is rather that they lack a cohesive governmentwide implementation plan to achieve their goal. They announce their goal, appoint an entity to move ahead on the initiative, and then it falls apart.”

The fund has been getting some closer political attention lately. President Lee Myung Bak, a former CEO of Hyundai Engineering and Construction Co., has been a strong advocate of using KIC to build South Korea into a financial hub. In July he named Chin Young Wook, previously vice chairman of Hanwha Non-Life Insurance Co., as president and CEO of KIC. Chin is a veteran Finance Ministry official who rose to become head of the international policy division, only to be forced out of the ministry in the wake of Asia’s 1997–’98 financial crisis.

KIC executives hope Chin will help them win new assets to manage. “We don’t have any plan to get more money from the BoK but hope to get more from the Finance Ministry,” says planning chief Kim. KIC would also like to get its hands on some of the $220 billion sitting in the National Pension Fund, says Kookmin’s Ji, but the pension fund, like the central bank, wants to keep those assets under its own management.

These are testing times for KIC’s Chin and Ong. If South Korea’s sovereign wealth fund is to keep growing, they will have to deliver stronger performance.