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Restructuring South Korea's chaebol.

The chaebol played a pivotal role in the country's past economic success

But they are also partly responsible for its current plight

Family owners must now focus on value, not growth, and invite foreign investors onto the board

South Korea's family-owned conglomerates have played a pivotal role in the country's development, taking it from war-torn economy to member of the OECD within four decades. But these conglomerates, or chaebol, are also partly responsible for leading South Korea into its current deep recession.

What is to blame is their blind focus on capacity expansion. Over the past ten years, the chaebol have taken on massive amounts of short-term debt. This was manageable so long as the economy was growing, even though returns on investment were often low because of overcapacity and cut-throat competition. But when domestic demand stalled, the truth was revealed: the chaebol had a huge debt problem. Debt-to-equity ratios now commonly range between 500 and 800, sometimes higher.

Those hardest hit have been the banks that extended the loans. Some have gone under. But unless measures are taken, almost all of South Korea's industrial sector will be threatened, so great is the chaebol's dominance of the economy. Listed South Korean companies reported a combined loss for the first half of 1998 of US $13 billion (compared with a market capitalization in June of $44 billion), and analysts expect second-half earnings to be even worse. The ratio of non-performing loans to all bank loans is already 8.6, up from 5.8 at the end of 1997 - an official figure that many suspect is a substantial underestimate.

It is clear that the chaebol need to act, both to survive the present crunch and, in the longer term, to attract the investment funds they need to grow. They must learn to run their companies in an entirely new way, abandoning empire building to focus on creating value for shareholders.

Wayward entrepreneurs

In 1955, after a war that split the country in two and left any remnants of industry in what had been the more industrialized north, South Korea's gross domestic product per capita stood at $65. By 1996, it had soared to $10,000, and South Korea had become a member of the OECD. At that time, the top 30 chaebol owned 50 percent of total assets.

This achievement was grounded in the early endeavors of entrepreneurs such as Juyoung Chung of today's Hyundai Group, Byungchul Lee of Samsung, and Inwhae Koo of LG Group: men who began building businesses in basic industries such as sugar, soap, construction, and trading. They were helped by successive governments that provided generous loans and protected the domestic market from foreign competition - tactics used by most advanced economies at some stage in their development. Their success was no less impressive for that. By the mid-1980s, the typical chaebol could boast between 30 and 50 companies in all key business areas, including construction, petrochemicals, automotive, consumer electronics, heavy industries, trading, and securities.

The model had its downside, however. Intense rivalry between the chaebol led their owners to invest in many areas that had growth potential but did not necessarily provide good returns. Samsung's decision to enter the automobile business in 1995, when the domestic market was already oversupplied by four established manufacturers, is one example. Another can be seen in the chemicals industry, where South Korea added almost as much new capacity between 1990 and 1997 as the whole of Western Europe, even though world markets for many products were already glutted [ILLUSTRATION FOR EXHIBIT 1 OMITTED].

The results of this strategy showed up in returns to shareholders. Although revenue soared, the chaebol were not earning the cost of their debt, let alone the weighted average cost of capital. For most of the past decade, in fact, the chaebol have actually destroyed shareholder value [ILLUSTRATION FOR EXHIBIT 2 OMITTED].

While the economy was growing and stocks were rising, few shareholders (almost all of whom were domestic investors) seemed to mind. Even if they had, they would not have been able to influence events because of the chaebol's ownership structure. Holding companies were illegal in South Korea because of government concerns about the concentration of economic power, so the chaebol used cross-shareholdings instead. Although family owners typically hold about 10 percent of the shares of several core companies within the group, these companies themselves possess holdings in other companies in the group. Add to this the chaebol's high debt-to-equity ratios, and the family owners came in effect to have full control of assets worth 408 trillion won ($255 billion), with investments equal to just over 1 percent of these assets [ILLUSTRATION FOR EXHIBIT 3 OMITTED].

The downturn

It was only in the mid-1990s, when the South Korean market reached saturation and the economy slowed, that the flaws in the chaebol model began to show.

Exports were one problem. The chaebol's efforts here met with mixed success. In some Asian markets, exporters quickly established substantial market share. But they found it more difficult to build a sizeable presence in the West. The conglomerates found that with a few exceptions (such as semiconductors), the goods they produced for the protected domestic market were regarded as sub-standard for their price in this export market.

Hyundai Motor's experience in the United States and Canada in the early 1980s is a case in point. Sales were good at first, and Hyundai quickly became the biggest exporter of cars to Canada. But within a few years, quality and servicing problems began to surface, and Hyundai lost market share. As other South Korean manufacturers experienced similar difficulties, the image of the country's products began to suffer.

The collapse of the domestic market has been another setback. Although the recent devaluation of the won has given South Korean exporters some respite, any gain in market share abroad will do little to compensate for the drop in demand at home, where sales of cars, for example, plummeted by 62 percent between May 1997 and May 1998. Before the recession, the domestic market accounted for half of Hyundai's sales, and 30 percent of Daewoo's. To make matters worse, the financial crisis faced by other Asian countries means that demand in these export markets has also dried up.

The chaebol thus seem to have little choice but to adopt a new approach. Investors are unlikely to provide the funds they need to repair their businesses unless they are convinced that their investments and rights as shareholders will be protected. With this in mind, the government is abolishing many of the regulations that featherbedded the chaebol [ILLUSTRATION FOR EXHIBIT 4 OMITTED]. Cross-shareholdings will be limited to 25 percent of net worth for the 30 leading chaebol, and cross-guarantees - an important instrument that enables the chaebol to use the financing power of established businesses to raise easy funds for new ventures - are due to be phased out by 2000. The aim is to increase transparency and put pressure on affiliates to stand on their own feet.

These developments are difficult for the chaebol to take on board. Proud of the companies they have built, the owners fear they will lose control and see their economic interests suffer. But it is only by facing up to the challenge that they can hope to revive their businesses.

Making the transition

To this end, the chaebol must embark on a fast turnaround program comprising five elements: short-term crisis management to ensure survival; creation of viable businesses as a platform for growth; operational improvement; introduction of a performance ethic; and formation of alliances with Western companies. Parts of the program would apply to any distressed company anywhere in the world. Other parts address the specific problems presented by South Korea and by family-owned businesses (FOBs).

Short-term crisis management

Survival is the priority. An indebted chaebol needs to be clear about the short-term cashflow both of the group and of its businesses. This is a difficult undertaking given the complexity of the group. The aim should be to identify and contain risks that might jeopardize survival, either by making provisions or by separating healthy businesses from ailing ones.

At the same time, the chaebol needs to release cash by, for example, selling nonessential assets, limiting capital spending to the bare minimum, and cutting back hard on inventories and accounts receivable. It must also reassure lenders if loans are to continue, or even increase.

The approach the chaebol adopt to manage the short-term crisis should not be so very different from that taken by any multinational in similar straits, although they face a tougher challenge in that few have any experience of crisis management. Many Korean managers are unprepared. Most have yet to act, leaving many of their companies vulnerable.

Create viable businesses

As we saw, government policy supported the chaebol in their efforts to diversify. But diversification is no longer tenable. The chaebol do not have the capacity to manage all of their businesses well, nor is the domestic market big enough to support them.

The businesses are also too small to compete internationally. Few can reap the economies of scale that overseas competitors enjoy, or achieve the massive sales volumes necessary to maintain world-class research and development. In addition, deregulation at home will inevitably trigger consolidation as weaker, less productive firms give way to larger, more competitive ones.

To respond, the chaebol must first focus on core businesses that have a chance of becoming internationally competitive, then sell, spin off, or close other businesses. This approach is the only way to attract international investors, improve debt-to-equity ratios, and provide a platform for future growth and prosperity.

The most pragmatic solution would be for the chaebol to swap businesses among themselves, enabling each to exit some areas and focus on others. With less fragmentation and less rivalry, the chaebol would have incentives to cut excess capacity.

As yet, however, they do not seem ready to make such a move. Instead, some have announced plans to merge their operations. Hyundai and LG, for example, have said they will merge their memory chip operations, while Samsung and Hyundai want to amalgamate their petrochemical divisions. Both industries suffer from overcapacity. But while mergers may be a step in the right direction, it is unclear that they will automatically lead to the necessary plant closures.

Operational improvement

In its report Productivity-led growth for Korea, the McKinsey Global Institute revealed the extent to which South Korea's capital and labor productivity lag behind those of other industrialized countries [ILLUSTRATION FOR EXHIBIT 5 OMITTED].(*) When the economy was growing fast, the country paid little attention to returns on capital investment. Similarly, as long as labor remained cheap, labor efficiency was not an issue.

Today, improved productivity is a priority in every part of any business, from research and development to sales. The steps South Korean companies need to take are standard practice in most multinationals. For the chaebol, however, the extent of the improvements they must make represents a massive challenge.

At some stage, the conglomerates will have no option but to cut jobs, although South Korea's rigid labor laws make this difficult. Until March 1998, it was actually illegal to lay off staff. Though the law has changed, companies still have little freedom in this respect: they are obliged to apply for government permission and meet stringent regulations. Even then, they may find themselves challenged in court and on the streets. Hyundai's recent plan to shed 1,600 workers set off riots; the company was eventually able to cut fewer than 200 jobs.

There is still plenty the chaebol can do to improve operational performance, however. Promoting early retirement and negotiating salary reductions are two possibilities. Reducing purchasing costs and improving marketing and pricing capabilities are essential. Issues such as quality and pricing were simply not addressed when the economy was booming and volume growth was the priority.

Similarly, there was little incentive to scrutinize the cost of goods sold. Exhibit 6 compares the cost structures of the top 20 chaebol with those of the S&P 500 companies. The key issues the chaebol will have to address to bring down their costs are listed in Exhibit 7.
Exhibit 7

Reducing the cost of goods sold

                Key issues

Supplier        Consolidate fragmented supplier
management      structure

                Create partnerships and involve suppliers
                in product development

Purchasing      Pool demand across group affiliates
                Upgrade and train staff

                Establish or improve modern information
                system

                Ensure negotiation is objective and avoid
                special relationships

                Make purchasing a top management issue

Product         Reduce product complexity
development
                Create platforms and introduce modular
                production

                Improve project management leadership
                and introduce crossfunctional teams

                Design development projects to meet real
                market needs

Manufacturing   Improve product quality
                efficiency Optimize work flow

                Introduce proactive maintenance schemes


Establish a stronger performance ethic

Performance is a management priority in multinational companies. In South Korea, however, performance-based incentives are still largely unknown, and pay and promotion are determined by seniority, not merit. Value is placed not on individual contributions to a company, but on solidarity within peer groups of employees who joined the company at the same time.

Add to this the prevailing attitude among employees that the company should take care of them rather than the other way round, and it is clear how difficult it has been for the chaebol to improve performance. Yet if performance-based incentives were introduced, the scope for improvement would be enormous. On this point, some conglomerates need little convincing and have already begun to set up bonus systems.

It isn't just employees who need to be judged by their performance. If they are to participate in running the business, the chaebol family owners should be subjected to the same scrutiny. How far family members should be involved in managing their companies is a common source of conflict in FOBs throughout the world. The founder of any FOB usually plays an effective management role at the outset, but as the business grows, families can be reluctant to share management control with outsiders who may be better qualified.

For their part, good managers can be wary of joining FOBs, suspecting that family tradition will overrule sound management judgment and that family members are likely to land the best jobs. Companies are often short on management talent as a result. A particular problem for the chaebol will be to attract overseas managers with solid experience.

Management issues extend to board level. As a company grows, family members may not be in the best position to judge whether strategic decisions are in its best interests. The chaebol's longstanding focus on capacity expansion is a case in point. Moreover, FOBs can find it difficult to raise the investment funds they need to grow. Outside shareholders will expect transparency in the way a company is run, while bigger shareholders will demand a degree of control. FOBs may be reluctant to provide either.

Failure to overcome these performance issues at management and board level does not necessarily mean a company will fail. There are plenty of mediocre FOBs. But if the chaebol are to become top performers and maximize value, they need the best management talent, a first-class board, and outside investment.

Build foreign support where needed

South Korea needs three things: investment funds to overcome the debt crisis and restart growth; advanced technology to enable it to compete internationally (since developing its own expertise would take years); and the management skills to compete in international markets. It will almost certainly need foreign support to find them.

Of all the five challenges in the action program, attracting this support may turn out to be the hardest. Investors will want independent company boards that protect shareholders' rights and transparent financial statements prepared and audited to global standards, neither of which is available at the moment. Companies with technological knowhow will want reassurance that their intellectual property rights will be respected. And under current conditions, well-qualified foreign managers will probably be reluctant to join South Korean companies, and may demand sky-high salaries that the chaebol can ill afford.

Joint ventures or alliances might seem to be the key to satisfying all these demands. But many attempts at alliances have failed because of South Korean companies' poor record of complying with contractual agreements, honoring intellectual property rights, and sharing management control. In 1993, GM sold its 50 percent equity stake in Daewoo Motors, unhappy about its lack of management control, while Ford and Mazda were unable to prevent Kia from going bankrupt. Despite a sizeable minority stake, they had little influence over the car manufacturer's managerial decisions.

Not surprisingly, prospective foreign partners are wary, not simply because of the country's uncertain economic future, but because of the way the chaebol conduct business. To address these problems, the chaebol will have to:

* Establish independent boards that include representatives of minority shareholders.

* Introduce and adhere to international accounting standards.

* Build public relations; to date, they have made little attempt to keep investors informed.

A new role for the family

Once the five steps of the turnaround program have been implemented and family interests aligned with those of the business, the chaebol will find themselves transformed. They will fall into line with FOBs worldwide such as Ford, Bechtel, and Campbell in the United States (where 30 percent of Fortune 500 companies are family owned), and Marks & Spencer, Wallenberg, Michelin, Krupp, Fiat, and Toyota elsewhere.

These international companies are structured in various ways, giving family members different degrees of control over management and policy decisions. At one end of the spectrum is Italian clothes manufacturer Benetton, which remains wholly owned by the Benetton family and is largely run by its members.

Somewhere in the middle lies commodity trader and processor Cargill, the largest privately held company in the United States and a fourth-generation family business of which 85 percent is owned by family members. In accordance with its decision to give family members senior roles only if they have the necessary expertise and experience, Cargill has professional managers running its business units, a board made up of both family members and outsiders, and a CEO from outside the family.

At the other end of the spectrum is Wallenberg, which controls 40 percent of the Swedish stock market through its investment company Investor. Although a minority shareholder in most of its holdings, Investor commands a controlling stake by virtue of its preferential voting rights shares. However, the boards of Investor and the holdings are largely made up of directors from outside the family.

While families hold influential stakes in all these companies, they differ in the extent to which they run the businesses. The rule of thumb seems to be that the more complicated the business, the more the family is separated from it, taking a role on the board rather than in management and ensuring that its composition fairly represents other shareholders' interests.

The chaebol seem compelled to follow suit and make the same separation. Even after restructuring, their businesses will be too complex to allow them to rely on the management talent of family members alone, while the need to raise investment funds dictates that their boards be independent.

The government's role

The chaebol must acknowledge that their approach to business has to alter, and start making changes. To succeed, they will need government support, although not the protectionism of the past. Rather, the urgency of raising productivity and attracting Western investment demands that the government accept the need for rationalization and job losses. South Korea has no experience of this type of upheaval, and the government is rightly cautious about the social consequences. But unless it facilitates the restructuring, economic recovery will be delayed.

In the mean time, healthy businesses are being bled to keep weak ones alive. If a company declares itself bankrupt, for instance, the government pores over its books for management wrongdoing, trying to find grounds to prosecute. The idea is that the chaebol owners should shoulder their share of suffering. But well intentioned as this may be, it deters the chaebol owners from closing plants.

Banking practices tell a similar story. Although not yet defaulting on loans, many companies are effectively bankrupt because of their debt load. But banks are reluctant to write off these debts for fear of going under themselves.

Instead, they keep bad businesses afloat wherever possible by rolling over and even extending their debt, while starving potentially viable small and medium-sized companies of funds. Nothing is likely to change until the government makes it easier for large companies to declare bankruptcy. Plenty of smaller ones have already gone under.

There will be much opposition. More banks will fail if they are forced to value their risks properly and write off bad loans. Some chaebol will lose equity, and many South Koreans will lose their jobs, which is why it is also important for the government to improve social provision.

But the outlook is not entirely gloomy. There is value to be created through industry consolidation. Moreover, economic crisis has accelerated deregulation, which will open up new investment opportunities in retailing, consumer goods, banking, and many other industries. As the economy begins to recover, foreigners aware of these opportunities will be looking for reliable local partners.

Like the entrepreneurs who built the economy after the Korean war, today's chaebol have the opportunity to lead a revival if they can redirect their businesses. Rapid expansion had its place while the economy was developing, but things have changed. Today, those willing to forgo expansion in favor of building focused, productive businesses that create value for shareholders will be those that can look forward to the brightest future.

* Seoul and Washington, DC, March 1998. For a summary of the report's findings, see Martin N. Baily, Cuong V. Do, Yong Sung Kim, William W Lewis, Victoria Lee Nam, Vincent Palmade, and Eric Zitzewitz, "The roots of Korea's crisis," The McKinsey Quarterly, 1998 Number 2, pp. 76-83.

Yuji Akaba and Florian Budde are principals and Jungkiu Choi is a consultant in McKinsey's Seoul office. Copyright [C] 1998 McKinsey & Company. All rights reserved.
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Title Annotation:family-owned business enterprises
Author:Akaba, Yuji; Budde, Florian; Choi, Jungkiu
Publication:The McKinsey Quarterly
Date:Sep 22, 1998
Words:3670
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