This article discusses the experience of distressed investments in Asia, whose approximate origins coincide with the 1997-98 East Asian currency crisis. It touches on the recent history of China and South Korea, but the main focus is on Japan, a country hit by the crisis only indirectly, but which was facing its own economic problems during the period.
THE 1997-98 FINANCIAL CRISIS
Reflecting back on the Asian economic miracle that lasted up to the mid-1990s, the East Asian currency crisis started in mid-1997 as Western investors lost confidence in securities in East Asia, causing a domino effect in the region. Indonesia, South Korea and Thailand were most heavily hit by the crisis, while China and Japan were relatively unaffected.
The International Monetary Fund's (IMF) support for the most-severely hit countries asked for structural adjustment packages and called for banks and financial institutions to go bankrupt. This was a change in style for these countries, because banks typically had endorsed the survival of large troubled companies. Factors enabling such behavior included (1) the protectionist financial sector policies taken by governments and (2) high economic growth.
The IMF's doctrine paved the way for distressed investing in the region to play its market-driven role. It had a spillover effect outside the hardest-hit nations, since many private equity funds of US origin entered the region for the first time with not only prospects of buying troubled assets in countries directly under the IMF's influence, but also expectations that opportunities existed in surrounding nations such as Japan, which had already been quietly wrestling with the banks' mounting non-performing loans (NPL). US private equity firms such as Newbridge Capital, The Carlyle Group, Lone Star, Warburg Pincus and JP Morgan Partners were among the players that entered the region eyeing the longer-term opportunities emerging from the currency crisis. Given the subsequent successes of these funds in post-crisis years, distressed investment proved to be both the solution to the crisis and the trigger of a new market.
Distressed investing in Asia is not natural-born and the region had not exactly been a market where investors could hunt for distressed investments for future harvest. Local governments had to invite risk-taking investors into their economies. They were forced to change their policies to lead these investors to invest in troubled assets.
To put it bluntly, the governments' paradigm shift has been from control to non-control. Mostly before 1997 they could maneuver the economic systems to prevent corporations from free-falling. Harmonious coexistence was made possible because the economies were enjoying linear growth.
However, governments were forced to change their policies due to the economic turmoil after 1997. Particularly, their bank policies were regarded as problematic, since they were responsible for the accumulation of NPL. This recognition resulted in three governments ? South Korea, Japan and China – adopting a similar strategy: injecting capital into banks and buying NPL.
South Korea was a direct victim of the currency crisis. The financial assistance package from the IMF in early December 1997 amounted to $57 billion. Since the assistance from the IMF required structural reforms, it enabled private equity funds to buy banks and their NPL. Whereas private equity funds buying NPL in Japan were a mix of domestic and international players, almost all Korean funds consisted of foreign investors. This has caused a nationalistic drawback in recent years in the Korean market.
Although Japan was not directly hit by the East Asian currency crisis, the troubled regional economy brought a severe blow to the domestic economy which had been weak since the beginning of the 1990s. The year 1997 became a watershed year, when a chain of bankruptcies of major financial institutions, such as Yamaichi Securities and Hokkaido Takushoku Bank, without substantial remedies provided by the government or the banks, happened for the first time. Japan's distressed investing, which started around that period, was already facing mounting NPL. From 1997 thereafter, companies and banks increasingly relied upon the injection of a mix of public and private risk capital.
In China, the currency crisis in 1997 did not affect the economy at all. Although it might have convinced the Chinese government to resolve the NPL issue, which had already existed in the bank sector. Government efforts were initiated quietly in 1998 when it injected $33 billion of public money to banks. Foreign investors have played significant roles in the disposal of NPL, although the private equity industry has played a relatively minor role in this, leaving it an open question as to what extent it could become active in the future.
LACK OF HIGH YIELD MARKET AND STRONG DEBT CULTURE
Conventional wisdom has it that Asia's equity culture is relatively weak. The post- World War II economic growth in the region was based upon indirect financing provided by the banking sector, often times under governmental protection. This was a typical arrangement for a catch-up type of economy where nations lacking in institutional investment relied on indirect financing under which governments were in a better position to allocate capital.
Under such circumstances, distressed investing was relatively unseen in Asia for a long time. Governments, or more directly banks, controlled the processes and the outcomes of distressed companies. Stronger emphasis was put on maintaining the harmony of corporate groups (e.g.
With less mobility of risk-taking equity investors, the high yield market has been non-existent in the region. This is an important factor in discussing the future prospects of distressed investing, because it shows market forces have less of a casting vote in the process of companies going bankrupt. In other words, distressed investing in the region, provoked by banks and weakened by the existence of NPL and change in government policies, could be a temporary phenomenon unless risk capital grows to have more influence, either in a form of distressed funds or high yield bonds.
THE RISE OF PRIVATE EQUITY
The emergence of distressed investing has enabled a private equity market to emerge and expand in the region. Apart from modest level of venture capital investment, buyout and growth capital markets had been basically non-existent until the period of the currency crisis. This was due to the availability of debt and the absence of risk-taking investors in the region. It should be noted that it was the international investment banks that first saw the distressed investing opportunity in the region. US private equity funds came in afterwards. The US PE funds' primary reason for landing in Asia was to meet this market opportunity provided by the currency crisis. The reason why they were able to stay and expand was because they were able to pioneer further market opportunities. Among several underlying factors, the growth of the equity culture and corporate governance reforms, especially in Japan and South Korea, are arguably the most important.
One result of the changing equity culture is the increase of shares held by foreigners. Once dominated by cross-sharing ownerships of
Also worth mentioning are the public vehicles that were created by the government to invite private equity funds to buy distressed debts or assets. They were also responsible for not only meeting shortterm demands of dealing with NPL or countering the crisis, but also paving the way for sustainable growth of private equity deal flow.
In Japan, the Reconstruction and Collection Corporation (RCC) was created in 1999 by the government as a collection agency to acquire NPL from banks. The Industrial Revitalisation Corporation of Japan (IRCJ) was created in 2002 by the government to coordinate the restructuring processes of large corporations and provide capital to enable these procedures. Also in 2002, the state-owned Development Bank of Japan (DBJ) initiated its own mission to commit 100 billion yen to ?corporate rehabilitation funds.?
In South Korea, the Korea Deposit Insurance Corporation (KDIC) and Korea Asset Management Corporation (KAMCO) were created shortly after the currency crisis. KDIC was the managing agency of the deposit insurance fund, while KAMCO, originally founded in 1962, was reformed as a centralised troubled asset resolution vehicle. Such corporate restructuring vehicles as Corporate Restructuring Company (CRC), Corporate Restructuring Fund (CRF) and Corporate Restructuring Vehicles (CRV) were founded, depending on the degree of distress and the lengths of the holding periods.
China's efforts to clear NPL have, naturally, been authority-led as well. The government created four Asset Management Companies (AMCs) in 1999 to receive, manage and dispose of the NPL of four state-owned commercial banks. China Banking Regulatory Commission (CBRC) was founded in 2003 to administer the more aggressive process of restructuring the four state-owned commercial banks and enhancing securitisation of the NPL.
There is another dimension to this story. In Japan, long before 1997, NPL had been a lingering issue ever since the bubble burst in the stock and real estate markets in 1990 and 1991. With a stern belief that the price of real estate, upon which heavy emphasis was put as collateral, would rise again, eventually raising the grading of NPL, the government and the banks were reluctant to introduce any dynamic measures. But as the situation became worse than originally imagined, the government began to react by closing down three major financial institutions in 1995 and injecting Y685 billion of public capital to Jusen, the Housing Loan Firm, in 1996. In 1995, major banks quietly began to securitise their NPL.
In South Korea, most of the changes were directly caused by the currency crisis in 1997. However, it should be noted that then-president-elect Kim Dae-Jung came to power on a platform that included a weakening of the founding families of the Chaebol, meaning that public frustration had been existent even before the crisis.
In China, the government reacted more slowly to the NPL than South Korea, mostly because it was not hit directly by the crisis. Despite the difference in timing, the order of occurrence of public support for distressed investing and the Western investors' reaction was reminiscent of South Korea's case.
Table 1: Selected landmark events of distressed investing in Japan, South Korea and China
|Public activities||investments||Public activities||investments||Public activities||nvestments|
|Bankruptcies of||Advantage||KDIC founded||H&Q buys||Public capital|
|major financial||Partners||(97)||Good Morning||(Remninbi|
|institutions||launches first||KAMCO||(98)||270bn) used for|
|(Yamaichi,||PE fund (97)||reformed (98)||the first time to|
|1997-98||Hokkaido||First NPL bulk||buy NPLs (98)|
|(Crisis years)||Takushoku||sales to Cargill|
|etc.) (97-98)||Warburg Pincus|
|RCC founded||Ripplewood||Asset||Newbridge buys||4AMCs|
|(99)||buys LTCB (00)||Management||Korea First||founded (99)|
|IRCJ founded||Carlyle||Business Act||Bank (99)||CBRC founded|
|(02)||launches||allows domestic||Goldman Sachs||(03)|
|DBJ commits||Japan-focused||PE funds to be||buys Kookmin|
|to “corporate||fund (01)||created(04)||Bank (99)|
|1999-04||rehabilitation||Numbers of||JP Morgan|
|(Post-crisis||funds? (02)||distressed||Partners Asia|
|years)||funds launched||buys Mando|
|Introduction of||Ripplewood's||Tax authorities||MBK, Vogo,||Carlyle's||CDH launches|
|?ShinseiTax?||Shinsei Bank||raid US PE||other domestic||buyout of||China-focused|
|(0.5)||goes public (05)||funds (05)||firms launch||Xugong||fund (05)|
|Permira, KKR||National||funds (05)||Construction||Carlyle agrees|
|2005-||and Bain||Pension Corp||Machinery||to buy Xugong|
|(Repurcussions||Capital open||commits||rejected by the||Construction|
|vs. PE market||offices (05)||$200mn to||governmnet||Machinery (05)|
|maturation)||H&Q (05)||(06)||Carlyle agrees|
|Prosecutors||to invest in|
|raid Lone Star||China Pacific|
Table 2: Number of buyout deals of bankrupt companies in Japan (up to 2003)
|Up to 1999||2000||2001||2002||2003|
|Civil rehabilitation law||–||0||3||4||13|
BUYING NPL PRE-GOVERNMENT INTERVENTION
Among the three countries discussed here, Japan is the only one where investment NPL trading was ongoing prior to the 1997-98 crisis. After the crisis, the Japanese government actively intervened in the disposal of NPL.
The government let three financial institutions, Kizu Credit Cooperative, Cosmo Credit Cooperative and Hyogo Bank, go bankrupt in 1995. These institutions were much smaller than those that would go bankrupt post-1997, and the government did not produce a packaged policy on troubled financial institutions. Securitisations undertaken by some mega banks during this period were small in scale and regarded as temporary.
However, some savvy distressed investors and real estate fund managers such as Secured Capital, Kennedy Wilson, Cargill and international investment banks foresaw opportunities and began establishing Tokyo offices. They knew how to buy and sell distressed assets through their experience with Resolution Trust Corporation (RTC) in the 1990s.
Although distressed investing in Japan would have to wait to blossom until after the crisis year, when the government had strengthened its intervention, it is important to note that in the years of pre-government intervention these distressed investors established the concept of NPL bulk sales.
BUYING NPL POST-GOVERNMENT INTERVENTION
Following the chain of major bankruptcies of financial institutions in 1997, the Japanese government's first substantial intervention in enhancing the NPL disposal was the establishment of The Financial Reconstruction Law of 1998.
The law required banks to classify distressed borrowers into one sub-standard category (under watch) and four non-performing categories. It was also the first legislative effort to resolve the NPL issue, which previously had relied upon the injection of public capital. Echoing the IMF doctrine for South Korea, the law promoted a smooth procedure for banks which were in de facto bankruptcy. Under the law, these troubled banks would temporarily be under the control of the government. LTCB was the first bank to go through this process before being sold by the government to Ripplewood and change its name to Shinsei Bank in 1999.
This legal scheme further paved a way for US distressed funds and private equity funds to either enter or expand their operations in Japan. Kofuku Bank was bought from the government by WL Ross and changed its name to Kansai Sawayaka Bank in 2001. Tokyo Sowa Bank was bought from the government by Lone Star, changing its name to Tokyo Star Bank in 2001. And Nippon Credit Bank, renamed Aozora Bank, was bought from the government by Softbank in 2000 and sold on to Cerberus in 2003.
Meanwhile, the bulk sales of NPL increased rapidly during 1997-98. The buyers included not only the foreign players but also domestic firms. Some foreign distressed investors were discouraged about continuing their businesses and exited from the NPL bulk sales market around the time when the Reconstruction and Collection Corporation (RCC) was created in 1999. RCC, much larger in terms of purchasing power and manpower, bought NPL worth $77 billion by the end of fiscal year 2004.
The turnaround year for NPL disposal was 2002. Given the slower pace of the disposal than previously expected, Prime Minister Junichiro Koizumi launched the Financial Revitalisation Programme, under which NPL of major banks were to be reduced by half by 2004. Under the programme, The Industrial Revitalisation Corporation of Japan (IRCJ) was created, and Development Bank of Japan announced its commitments to turnaround/distressed funds as much as $842 million. In light of these more drastic measures, banks also came to take more proactive steps in disposing NPL. These included (1) selling NPL to independent PE funds and corporate revitalization funds managed by their subsidiaries; and (2) creating special purpose vehicles established between foreign investment banks, as in the case of Bank of Mitsubishi-Tokyo UFJ and Merrill Lynch.
IRCJ tackled a broader mission than RCC, providing at times equity to distressed companies. Some highprofiled deals such as Daiei and Kanebo involved commitments from domestic private equity funds, i.e. Unison Capital, Advantage Partners and MKS Partners.
DISTRESSED INVESTING IN THE FUTURE
Now that Japan's banks and the government are leaving behind the NPL disposal issue, distressed investing in Japan is currently at a crossroads.
There are at least four categories of distressed investors. First are those that entered early before the RCC came into the market to buy NPL in bulk. Many of the foreign firms among them have exited the market since, although some, including Cerberus and Lone Star, stayed and shifted their interest from distressed collateral trading to a corporate restructuring, aiming to increase the equity value of companies.
The second group emerged during Koizumi's push to dispose of NPL during 2002. They were mostly banks' subsidiaries, but included some domestic independent players such as Phoenix Capital and J-Will Partners. While most of the captive funds have ceased to operate, independent firms are attempting to become more equity-oriented in their investment strategies.
The third group comprises domestic and international private equity firms, which started out as plain-vanilla type buyout firms but made opportunistic distressed investments during the crisis years. Since their distressed investments were limited to acquiring the equity of troubled companies, their investment style has not changed during the hot years of distressed investment.
The future of these firms will depend on the extent to which they can influence the management and the operations of portfolio companies to enhance equity value. Until recently, this approach was rare in Japan, but now it is slowly blossoming. Large international buyout firms such as KKR and Permira have spotted an opportunity and entered the market in recent months, despite socio-political repercussions against private equity and the introduction of the ?Shinsei Tax?.
On the debt side, finally, the market for distressed loans is still underdeveloped. In bankruptcy situations, unlike in the US for instance, there is no notion of bondholders taking control to influence the process. It remains to be seen whether distressed debt investing in Japan will become a permanent feature of the market, or whether it will be remembered as a temporary phenomenon of the years between 1997 and 2004.