Cleaning Up at Korea First

Private equity specialist Newbridge has tidied up the bank’s balance sheet. Now the momentum’s building for it to sell its historic investment.

When the International Monetary Fund demanded that South Korea sell bankrupt Korea First Bank to a foreign firm as a part of its $58 billion rescue package for the country in the midst of the 1997-'98 Asian financial crisis, U.S.-based private equity firm Newbridge Capital emerged as the only serious bidder. Not that Newbridge’s early interest made a sale any easier or quicker. To meet an IMF requirement, the Korea Deposit Insurance Corp.,

the government agency that owned the bank, tried -- to no avail -- to drum up offers from other international investors for 18 months. “Nobody was interested during the financial crisis. Nobody was willing to take the risk to buy a bankrupt bank,” recalls Weijian Shan, a Newbridge managing partner who commuted from his Hong Kong base and whiled away his days at the Seoul Hilton waiting for phone calls from government officials that never came.

The KDIC thought that Shan was offering too little money for control of what had been the country’s biggest bank before the crisis and that he wanted too many guarantees if additional bad loans were discovered after the purchase. “He was a tough negotiator,” says a South Korean government official.

In the end, Shan’s persistence paid off. On the last day of 1999, a year after the IMF deadline had expired, the two sides reached a historic agreement. Newbridge paid roughly $500 million for 51 percent of Korea First (KDIC retained the rest), and Seoul agreed to absorb any nonperforming loans discovered in the next two years. For the first time, a foreign firm --

Newbridge is a joint creation of U.S. private equity specialists Texas Pacific Group and Blum Capital Partners -- was allowed to control and run a South Korean financial institution, competing freely in a market where personal relationships counted for more than collateral, and the government and the massive local conglomerates known as chaebol traditionally dictated terms to banks. The deal was a “big event” that opened the local market to meaningful foreign participation, says Sohn Sang Ho, senior research fellow at the Korea Institute of Finance, a think tank supported by banks and the government.

The Newbridge executive team, initially led by American Wilfred Horie, who had set up the Japanese unit of consumer lender Associates First Capital Corp., now part of Citigroup, wasted little time revamping the institution, known locally as Jeil Bank (in Korean, jeil means best or first). They cut the bank’s reliance on huge corporate loans to the chaebol, pushed into such personal finance areas as mortgages, credit cards and household loans, installed first-rate risk management systems, implemented international accounting standards in advance of local rivals and centralized much of the bank’s decision-making processes. Newbridge’s discipline and controls worked. When SK Global, the trading arm of the country’s third-biggest chaebol, SK Group, collapsed under 10 trillion won ($8.3 billion) in debt and other liabilities last year, Korea First, once a major lender to SK Global, was the only big bank with no exposure. “We got out of it before the crisis hit,” says Shan, who has helped shape the bank’s strategy and monitors its progress closely.

Today Korea First is a very different, far more diversified bank than the one that nearly went bust in 1997. Corporate loans, which in the mid-1990s made up more than 90 percent of Korea First’s portfolio, now account for about 40 percent, with consumer finance making up the remainder. The surging mortgage business accounts for more than half of the consumer finance business, with smaller portions in other types of household loans and in credit cards.

Newbridge’s changes have gradually restored Korea First to health. Assets have grown nearly 25 percent, to just under 40 trillion won, since the beginning of 2000, and nonperforming loans, more than 20 percent in 1998, have dropped to just 1.54 percent, the lowest level of any commercial bank in the country. Korea First’s efficiency rating -- operating expenses divided by total revenue -- of just under 60 percent is among the best of South Korean banks. Although flat at 95 billion won, Korea First’s pretax profits held up better than those of most of its rivals in 2003 when an economic slump early in the year and huge credit card write-offs forced many to report losses. “Jeil is the foremost clean bank in Korea,” says researcher Sohn.

All of this leaves Shan, who also serves as a board member, and Newbridge in a delightful position. After more than four long years of painstaking work, they’re getting ready to sell their holding, exiting their investment with a substantial profit for their limited partners. And this time Shan won’t have to worry about getting his phone calls returned. Global financial companies and other investors are jostling for a place in South Korea’s consolidating banking market. Even the government now welcomes the foreigners. “Competition should be a good market force,” says Oh Kap Soo, deputy governor of the Financial Supervisory Service, the country’s financial regulator. “There is no resistance to foreign investment.”

In the most striking development, Citigroup, whose Citibank subsidiary has a dozen local branches, agreed in late February to pay $2.73 billion for Korea First’s slightly bigger rival, KorAm Bank, with 43 trillion won in assets. If approved by shareholders next month, the Citigroup purchase will give a consortium led by two U.S.-based private equity firms, the Carlyle Group and J.P. Morgan Chase & Co.'s J.P. Morgan Corsair II Capital Partners, a sparkling 125 percent return on its 37 percent KorAm stake, bought about three years ago for roughly $450 million. Now Citigroup competitors HSBC Holdings and Standard Chartered are expected to intensify their search for local partners.

Korea First is an obvious target, and Newbridge is likely to be very receptive to overtures. Robert Cohen, who succeeded Horie as CEO in 2001, told Institutional Investor even before Citigroup’s KorAm acquisition that Korea First wanted to sell or go public in 2005. South Korea’s economy is pulling out of last year’s doldrums, and local banks seem to have put the worst of their massive credit card lending troubles behind them. If the improvement continues, Korea First’s highly efficient operating style should allow it to post substantial profit gains over 2003’s results, boosting its value still further, says Cohen. A seasoned French banker, Cohen spent 25 years in Paris and New York with Crédit Lyonnais, serving as CEO for the Americas from 1989 to 1997. He then became vice chairman of Republic Bank of New York, responsible for private and corporate banking, but left in 1999, just a month before HSBC bought it out.

The China-born Shan and his Korea First team have good reason not to wait too long. The competitive landscape has changed substantially since Newbridge’s arrival. New management has put Korea First right, but it now finds itself much further behind its rivals than before in terms of scale. Kookmin Bank, South Korea’s dominant institution, engineered a merger with Housing & Commercial Bank in 2001 and now has a market-leading 219 trillion won in assets; Woori Bank, which absorbed several institutions from the government and remains mostly state owned, is No. 2, with 109 trillion won in assets. Onetime market leader Korea First now ranks as the smallest of the country’s eight nationwide commercial lenders.

Some analysts think that without a deal Korea First risks getting lost among South Korea’s banking giants. As Moody’s Investors Service financial institutions senior analyst Beatrice Woo noted in a report in January, the country’s four biggest banks now have 75 percent of the market. Smaller institutions, she wrote, already “have difficulty competing and will likely have to adopt niche roles or face marginalization.” Before the Citi-KorAm deal was announced, Woo counted both KorAm and Korea First as acquisition candidates. The Korea Institute of Finance’s Sohn reasons that Newbridge should move soon. Given all the improvements its team has already made, he says, “nobody is sure if we can expect higher efficiency.” Translation: There’s no reason to wait.

Even so, the patient Shan insists Newbridge is not in a huge rush to make a deal. “Everybody would say the franchise is worth more than when we started,” says Shan, once a management professor at the Wharton School of the University of Pennsylvania and a former managing director at J.P. Morgan in Hong Kong who was primarily responsible for the bank’s investments in China. “We’ve invested more than $500 million in the bank. The bank started with 1 trillion won in capital. Now it’s got 1.6 trillion won in capital. We’ve made a substantial amount of capital.”

WHEN NEWBRIDGE BOUGHT KOREA FIRST, THE bank was reeling from big loans to some of the worst casualties of the financial crisis, including Daewoo Group, which collapsed in mid-1999 with more than $80 billion in liabilities, and Kia Group, which failed in 1998 and whose automaking unit was later auctioned off to Hyundai Motor Co. Compounding the bank’s problems, the foreign exchange crisis from the end of 1997 to early 1998 sent the won plummeting from 700 to the dollar to nearly 2,000 to the dollar. Thanks to huge loan write-downs, tighter borrowing standards and the won’s decline, Korea First’s assets plunged from 29.4 trillion won in December 1997 (about $40 billion at 1997 exchange rates) to 24.1 trillion won at year-end 2001 ($21 billion at 2001’s lower rate).

Horie began the turnaround by applying international lending standards to local companies and cutting off borrowers that couldn’t achieve performance benchmarks, such as a 3 percent return on assets. To limit its risk, Korea First declined to extend any corporate loans above 200 billion won, or more than about 20 percent of its total equity, even to big creditworthy borrowers like Hyundai Motor and Samsung Electronics. The bank’s exposure to Daewoo alone had been more than 2 trillion won in 1998.

Horie’s defining moment came in 2000, when the government’s Korea Development Bank approached the biggest South Korean banks for help in underwriting a bond offering to aid troubled local companies. Horie alone refused to participate -- the first time anyone could remember a South Korean bank turning down a government request to lend money.

Horie fashioned a cultural makeover as well. Unlike the starchy, remote senior executives who once dominated South Korean banking, he adopted a more informal approach, making such symbolic gestures as opening the CEO’s private elevator to all employees. Near the end of his tenure, Horie began work on a performance-based compensation system that rewarded the most productive executives at the vice president level and above. “It was a revolution,” says Cohen, who hopes to extend the program to all of the bank’s 5,000 employees. For South Korea’s unionized bank workers, accustomed to evenly distributed automatic wage increases, the prospect of merit raises has been unsettling. Their union has agreed in principle to the change but is negotiating for standardized salary increases as well.

These changes were all part of an effort by Horie to shift the bank from its dependence on corporate business to the consumer markets. This revamping wasn’t always easy for Horie, who bore the brunt of the government and corporate criticism of the bank’s occasionally hardball tactics with clients. But he offers no apologies.

“I turned it around into a retail bank,” says Horie, 58, whose abrupt retirement ended quickly when he was named head of Japanese mortgage specialist First Credit Corp. in Tokyo. “I put in most of the platforms, the procedures that would make it into a retail bank. It was primarily a question of reducing exposure in large corporations. Everything we did was designed to turn this bank from a corporate lender aligned with the government into a retail bank.”

Among his changes, Horie extended Korea First’s newfound credit scrutiny to the retail market as well, by pulling the loan approval process out of the branches and centralizing it in Seoul. The bank created a group of 50 analysts responsible for reviewing every consumer loan application. “We’ve got our own data warehouses monitoring the background and history and ability [of customers] to repay,” says Hyun Jae Myung, executive vice president for communications and information technology.

Of course, consumer finance isn’t a panacea, as credit card issuers have learned in South Korea. “This is a crazy market, characterized by crazy products,” says Keith Shachat, Korea First’s chief consumer risk officer. “The favorite product for Koreans is something called a minus loan. As long as you’re within your credit limit, you don’t have to pay your interest, so 90 percent of regular bank loans at other banks are minus loans. It’s impossible to do business if you don’t offer that product, but we charge extra interest for it.”

It has fallen to Cohen, 55, who has broad experience overseeing private banking, capital markets and corporate and retail lending, to accelerate Horie’s push into consumer markets and to get the bank’s corporate loan program back on track. “Initially, they only focused on asset quality,” says Yun Seok, research director at Credit Suisse First Boston’s Seoul branch. “Two years ago they tried to grow.”

Korea First’s overall lending increased by 45 percent last year, aided by a more than doubling of its mortgage portfolio. Korea First’s 400 branches have been churning out 15,000 mortgages a month recently, more than any other bank in the country. That has given it a 10.5 percent share, behind only massive Kookmin, which controls nearly 80 percent of the market.

As part of a reorganization in 2002, a few months after Horie’s departure, the bank installed call centers and more sophisticated back-office information technology systems that freed roughly 1,000 branch staff members to focus on selling mortgage and other consumer products while leaving credit decisions and paperwork to others. Each prospective borrower’s credit risk is assessed, and mortgage pricing is adjusted accordingly by the analysts in Seoul. “We are like a factory,” says Cohen of Korea First’s highly profitable mortgage business.

The bank’s late start in credit cards has worked in its favor. Nationwide, delinquency rates for bank credit cards soared in 2002, peaking above 13 percent in 2003 before dropping back to roughly 12 percent more recently. Although Korea First’s nonperforming credit card loans hit 9.94 percent in 2003, that’s far better than the Woori credit card unit’s astounding 32.97 percent rate or Kookmin’s 15.21 percent. Korea First put aside 221 billion won to cover additional credit card losses in 2003 and believes the worst is over.

Meantime, Cohen and his lending officers have managed to soothe some of the bad feelings among corporate borrowers, and the corporate loan portfolio has grown from 5.7 trillion won at the end of 2001 to about 10 trillion at the close of 2003. Korea First has tried to balance risk with reward. A growing proportion of its corporate loans are structured-finance transactions secured by cash flows. Branches are no longer able to lend to local businesses without permission from headquarters, and concentration risk is strictly monitored to ensure that Korea First doesn’t repeat the mistakes of the mid-1990s.

“It’s the way we conduct business. By centralizing credit, you have consistent underwriting and criteria for the entire bank,” says Shan.

Cohen hasn’t sacrificed the discipline Horie imposed on lending. A report by the Financial Supervisory Service shows that Korea First is relatively free of nonperforming loans. Nonperforming corporate loans amounted to just 1.1 percent in 2003. In contrast, Kookmin’s NPL ratio for corporate loans was 3.59 percent. With the exception of credit cards, Korea First’s consumer finance balance sheet was equally clean. The nonperforming ratio for household loans was 1.36 percent, roughly in line with the local average, and its mortgage delinquencies were just 0.5 percent.

“We cannot avoid an industry downturn, but probably we’re the best in terms of managing consumer loans,” says information specialist Hyun.

Conversely, with such taut controls, Korea First is poised to post big gains if the economy continues to grow, say analysts.

FOR ALL THE SPECULATION ABOUT KOREA FIRST’S fate, the bank has attempted to play the consolidation game itself. In 2002 Cohen tried to make a deal for Chohung Bank, then South Korea’s fifth-largest bank, with assets of 57.9 trillion won. The deal would have vaulted Korea First from eighth to third place, close to second-ranked Woori in assets. Chohung’s bigger credit card business and solid customer base would have supplemented Korea First’s consumer finance push. But the government, which owned the bank, said a local buyer made a better offer. Shinhan Financial Group, whose chief holding is Shinhan Bank, South Korea’s fourth largest, got Chohung for 900 billion won in cash and Shinhan Financial shares worth 1.6 trillion won.

Cohen says he wasn’t about to pay such an exorbitant price and wishes Seoul had given Korea First’s offer more serious consideration. “The government had a choice between a real market deal or an internal deal for Korea,” he says. “We would never have paid what Shinhan paid. Shinhan paid a high price even though it did not have the synergy immediately.”

Shinhan’s willingness to pay a premium was driven in part by the whirlwind mating game under way in South Korea’s banking market. Shinhan had just seen rival Hana Bank purchase SeoulBank from the government to form the country’s third-biggest bank. Not long after Shinhan’s deal, U.S. private equity firm Lone Star bought 51 percent of Korea Exchange Bank, with 61 trillion won in assets, for $1.2 billion.

The Shinhan acquisition also demonstrated the risks a buyer must assume in South Korea’s unpredictable marketplace. Almost immediately, Shinhan had to make concessions: Chohung workers, who threatened to strike, won an agreement that their bank would remain a separate entity for at least three years, effectively scuttling many of the planned cost savings.

The recent deals, plus the hard times many local banks experienced in 2003, are fueling rumors that Hana might consider buying Korea First as a way to catch up with Kookmin and Woori. But many observers dismiss this possibility because Hana must first integrate SeoulBank.

If the Citi-KorAm deal goes through, Cohen may find himself again talking to HSBC, which bought his previous employer Republic and is regarded as the top candidate to buy out Newbridge, or to Standard Chartered. Both operate in South Korea and would benefit from acquiring a bank that adheres to Western standards. “My feeling is that Newbridge will sell to another foreign investor, like HSBC,” says Jason Yu, a banking analyst at Samsung Securities in Seoul. “The best alternative they have will be to sell to another bank” that shares many of the same systems and strategies.

Local media have suggested that HSBC, which tried unsuccessfully four years ago to buy SeoulBank from the government, already has talked to Newbridge about buying its Korea First stake. A Korea First spokesman denies these reports, though a senior HSBC manager in Seoul says with a laugh, “These are exciting times. I’ve heard the rumors,” declining to elaborate.

Standard Chartered, meanwhile, persists in holding on to its 9.76 percent stake in KorAm, waiting to see if Citigroup is able to win shareholder approval for its deal. Some KorAm stockholders have indicated they want a higher price, and Standard Chartered wants to be able to step into the breach if Citigroup can’t close the deal. If, as anticipated, Citigroup’s offer is accepted, Standard Chartered is expected to start hunting for a new partner, with Korea First a likely target.

Even with KorAm in tow, Citigroup isn’t entirely out of the picture for Korea First. Postmerger, Citi-KorAm would still rank as South Korea’s seventh biggest, and a combination with Korea First would vault it into the top echelon. Stephen Long, CEO of Citigroup Corporate and Investment Banking Group Asia Pacific, says, however, that his group will focus on building what it has bought. “We have no plans beyond what is done to maximize the value that is already there,” he says.

Cohen insists that Korea First’s small size doesn’t make it less attractive to buyers. More important, he says, is that “this is an American-style bank” that’s growing and operating profitably in South Korea. Foreign buyers, he adds, would prefer buying a smaller institution rather than, say, Kookmin, whose huge size would give most institutions much more exposure in South Korea than they would want.

Korea First’s other alternative, an IPO, is less appealing: It wouldn’t allow Newbridge to realize a premium for selling control to a single buyer, and South Korea’s banking sector usually trades at a discount to global markets because of investor concerns about corporate governance and government influence. Cohen acknowledges that under the right circumstances Newbridge might offer a 10 percent stake to the public while co-owner KDIC sold a similar amount. A piecemeal sale, however, would drag out the process, and success would depend on the state of South Korea’s volatile local markets.

And if, for whatever reason, Shan can’t make a deal -- a sale or an IPO -- the worst that would happen, says CEO Cohen, is that Newbridge’s portfolio will continue to hold a South Korean bank that’s growing at a 30 percent annual clip. “Everybody knows Newbridge will leave one day. It could be one year or three years or ten years,” he says. “We are highly pragmatic. We will take the opportunity.”

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