Restructuring South Korea's Chaebol
Akaba, Yuji, Budde, Florian, Choi, Jungkiu, The McKinsey Quarterly
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.
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]. …