Korean chaebol forced to reduce cross-affiliate deals

2013-05-05 10:48

Chaebol forced to reduce cross-affiliate deals

Regulations feared to drive large firms out of country
By Lee Hyo-sik
President Park Geun-hye’s pledge to penalize inter-subsidiary dealings has been troubling Korea’s family-controlled conglomerates. She has vowed to curb business transactions among chaebol affiliates in the name of “economic democratization,” which her advisors say seeks to correct unfair business practices by large family-run groups, as well as protect small businesses.

The government expects the National Assembly will approve the revised Fair Trade Act in July, designed to discourage intra-group transactions by imposing fines on and prosecuting those orchestrating them.

Policymakers and civic groups argue that generating the bulk of revenues from exclusive dealings with affiliated companies is tantamount to unfair business practices. Such transactions, they say, deprive unrelated firms, most of which are small- and medium-sized enterprises, of potential business opportunities.

They also say the exclusive intra-group dealing is misused, serving to boost the wealth of offspring and other family members of group chairmen. These family members often hold substantial stakes in the benefiting entities.However, conglomerates claim inter-subsidiary transactions are necessary to lower operational expenses, boost competitiveness and protect corporate secrets. In response to the tightening restriction, an increasing number of chaebol subsidiaries are seeking to expand their operations overseas, while maintaining the status quo in Korea.

Many economists warn that penalizing inter-subsidiary dealings may create unintended side effects as companies could choose to invest and create jobs abroad rather than in Korea. This could negatively affect President Park’s desperate efforts to promote corporate investment and hiring.

Looming effects of banning inter-subsidiary dealings

“The extent of restrictions on inter-subsidiary transactions has weakened due to fear of their potential negative fallout on corporate activities. In any case, it will definitely affect the way companies transact with their affiliates,” said Yu Byoung-gyu, executive director at the Hyundai Research Institute (HRI). “The National Assembly will likely pass the revision in the coming months. The Fair Trade Commission (FTC) will then look into intra-group dealings.”

Yu said inter-subsidiary dealings have helped conglomerates hone their corporate competitiveness. “Korean business groups have been able to boost their global edge through efficient, low-cost internal transactions. Even if inter-subsidiary dealings are banned and work is given to small firms, I don’t think there are many capable of meeting the task.”
The executive director urged the government to place top priority on helping to strengthen the competitiveness of small enterprises, rather than on restricting activities of large companies.

“Small firms need to upgrade their competitiveness so that they can handle what is required of them by larger counterparts. In this way, conglomerates can do business with smaller partners and do not have to nurture own units,” Yu said. “Business decisions are made in accordance with market economy principles. If companies are forced by the government to act otherwise, they could go bankrupt.”

Despite the looming restrictions, entities affiliated with conglomerates will have to find ways to remain competitive and profitable, he said. “Some are thinking about heading overseas and downsizing local operations. This will pour cold water on the nationwide effort to create jobs. Others will likely try to merge with other affiliates to reduce a portion of the intra-group transactions,” Yu said.

Samsung Group units in exodus

Samsung S1, a security solution provider affiliated with Samsung Group, has recently decided to accelerate its overseas expansion drive.

“In 2011, we established a subsidiary in China, which has been providing security-related services to Korean companies doing business in the world’s fastest growing economy,” a spokesman for Samsung S1 said. “We plan to expand our reach to Southeast Asia, the Middle East and North America. We will try to serve not only Korean firms overseas, but also home-grown companies in host nations.”

He said the company has sought to establish a larger foothold outside Korea to achieve a 5 trillion won increase in revenue by 2020. The government’s recent move to regulate inter-subsidiary transactions has further spurred its overseas drive.

“Corporate security is a sensitive matter so it is not easy for group units to hire outsiders. That is why they work with us,” the spokesman stressed. “Also, no security firm in the country can offer what we do.”

He said S1’s inter-subsidiary transactions account for less than 30 percent of its entire revenue, as it increasingly deals with non-Samsung entities.

“We do not benefit from intra-group transactions as much as other chaebol affiliates. Thus, we will continue to increase our overseas business in anticipation of the approval of the revised Fair Trade Act,” the spokesman said.

Samsung S1 has begun recruiting personnel willing to work in foreign countries. It said new recruits will be assigned to nuclear power plants, airports, hospitals and other commercial facilities in China, Southeast Asia and the Middle East.

Samsung SDS, the system integration (SI) unit of Korea’s largest conglomerate, has also stepped up efforts to enlarge its overseas business in recent months. The firm is a popular target of those criticizing chaebol’s intra-group transactions.

According to the FTC, Samsung SDS earned revenue of 3.95 trillion won in 2011. Of this, 2.92 trillion won, or 73 percent, was generated through business transactions with Samsung Electronics and other Samsung group units, up from 63 percent in 2010. “It is really hard to expand our business here because most major groups that need extensive network systems have their own SI units,” a spokesman for Samsung SDS said. “We will find new sources of revenues abroad by doing business with multinational companies.”

He said SDS has been successfully undertaking smart infrastructure engineering projects, building automatic fare collection (AFC) systems for subways and e-government systems in Vietnam and Mongolia.

“We have secured contracts to build the subway AFC system in Deli and other Indian cities,” the spokesman said. “We also won a contract to create an information technology system for a cultural center to be built in Saudi Arabia.”

Samsung Everland, the group’s entertainment and food service unit, has also accelerated its overseas expansion following the growing criticism of inter-subsidiary transactions. About 34 percent of its revenues were generated through dealing with affiliates in 2011, the company said.

“We entered China in early 2012 to capitalize on the growing demand for high-quality, sanitary food catering services. China’s food service sector, currently valued at $7 billion, will increase at an explosive pace,” a Samsung Everland spokesman said. “To further reduce our dependence on group affiliates, we are entering other developing countries.”

Samsung Group’s media unit Cheil Worldwide has also been beefing up its presence abroad in a bid to cut its dependence on affiliates and find new sources of income. The firm operates 54 offices in 32 countries.

“We don’t rely entirely on the group because we do business with many non-Samsung firms,” a Cheil spokesman said. “In 2012 alone, we secured 60 new clients, including Jaguar and Estee Lauder.”

Hyundai Motor desperate to cut intra-group dealing

Hyundai Motor Group, which has been dogged by allegations that inter-subsidiary dealings are widely carried out to boost the wealth of Chairman Chung Mong-koo’s children, has encouraged its units to do business with non-affiliated firms and advance into overseas markets.

Among others, Innocean Worldwide, the group’s advertising unit, which was founded in 2005, has been aggressive in enlarging its overseas presence.

The company currently operates 20 offices in 16 countries. Chairman Chung’s eldest daughter Sung-yi holds a 40-percent stake in the company. According to the FTC, it earned 47.7 percent of its revenue from inter-subsidiary transactions in 2011.

“The company was established to undertake global advertising and marketing activities for Hyundai Motor, Kia Motors and other affiliates. We will nurture our capability as the world’s top marketing and communication firm to secure orders from foreign carmakers and other businesses,” a company spokesman said.

Hyundai’s logistics unit Glovis has also been eager to diversify its revenue source. Group Chairman Chung’s only son, Eui-sun, holds a 32 percent stake in the logistics unit that handles the two carmakers’ transportation of vehicles and auto parts. Intra-group dealings accounted for 45.2 percent of its revenue in 2011.

“We cannot comment on the government move to penalize inter-subsidiary transactions. What we can say is that using our global network of 33 offices, we will emerge as an internationally competitive logistics provider,” a Glovis spokesman said. “In particular, we would like to find clients among foreign automakers.”

Subsidiaries to merge or pay higher dividends

Besides overseas expansion, some conglomerates seek to merge affiliates to reduce the size of intra-group dealing. Others are prepared to pay larger dividends so that major stakeholders are better able to cover possible financial penalties.

For instance, SK C&C, SK Group’s SI unit, recently acquired its used-car affiliate SK Encar, which operates 40 branches nationwide. The company said publicly that the acquisition was intended to diversify its business portfolios. But critics say that it did so to lower the portion of its inter-subsidiary transactions. The takeover is said to cut SK C&C’s intra-group dealings to 45 percent from the previous 64.1 percent.

“More chaebol affiliates will merge in a bid to dodge the strengthened regulations,” said Yu of HRI. “This is in contrast to what happened following the 1997-98 Asian financial crisis. At that time, policymakers urged conglomerates to split large units into smaller ones to boost management efficiency.”

Yu also said chaebol units could make larger dividend payments to help majority stakeholders, most of whom are members of the founding family, in dealing with potential penalties as a result of greater restrictions against intra-group transactions.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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