A handful of South Korean companies were already in talks to replicate Doosan Infracore’s corporate hybrid deal even before the ink on the final prospectus had dried.
Korean Air, Hanjin Shipping and Hyundai Merchant Marine were all hoping to do what the excavator and dump truck maker did to its financial statements. Not only did Doosan walk away with US$500 million for its 30 non-call five deal bond on September 25, but it was also able to slash debt ratios to 310% from 377% as of June of this year, according to Financial Supervisory Service (FSS) figures. That would help bring down interest costs, which are expected to rise to 52% of its operating profit in 2013.
The deal also raised hopes that the country was finally catching up to a market that witnessed vibrant issuance in Asia this year, most notably in Singapore. It’s also been a favoured means of raising capital by Hong Kong’s major property developers such as Hutchison Whampoa.
But the buzz came to an abrupt standstill after the Financial Services Commission (FSC) fired an unexpected shot at Doosan after the deal was completed, saying it did not think that the hybrid would get equity treatment even after the FSS approved the deal. But the FSC skirted responsibility by saying it was up to the Korean Accounting Standards Board (KASB) to announce a final verdict.
The KASB has delayed the announcement indefinitely.
Not only did this come to the distress of bankers who worked on the deal, but it also shocked the international investor community, sending out a signal that Korea can back-pedal decisions even after a deal was completed. Investors may now have to count regulatory issues as a risk to buying Korean credits.
Matters were made worse when a week later, the government added more pressure on the KASB after a state-run researcher released a statement favouring the FSC’s claims that Doosan’s hybrid should not be counted as equity because it did not have a subordinate clause. That would entitle the hybrid bond holders to priority treatment on par with bond holders in a default event, a right that is not given to equity investors.
The fact that the step up after five years was 500 basis points (bp), and an additional 200bp after two years, made it highly likely that Doosan would call the bond, the researcher report added.
This tit-for-tat is a surprising and embarrassing occurrence for a country that boasts one of the most developed bond markets in Asia. Even the head of the Korea Development Bank, which is one of the banks that provided Doosan with a credit backing, said in a November 5 statement that he “could not hide his puzzlement.”
One of the main reasons behind the unwillingness by the FSC to let hybrids flourish in Korea may lie in the authority’s possible discomfort with the deal structure. Doosan’s hybrid was rated ‘A-‘ by Fitch due to a credit enhancement that was provided by highly-rated banks such as Korea Development Bank, Woori Bank and Hana Bank. Fitch did not consider Doosan’s standalone credit rating, effectively making this hybrid a bank credit.
This may not sit well with the FSC, which is in the process of examining the loan books of 10 local banks to map out new measures to control the country’s household debt crisis. The number of companies that were unable to repay debt rose 30% to 18 companies so far this year, and the FSC may also be concerned that Doosan’s weak financials may put creditor banks at risk.
The FSC’s concern over the risk that banks may take for credit-enhancing Doosan’s debt is understandable especially at a time when these lenders are also beefing up their balance sheets to become more Basel-III compliant. But regardless of its best intentions, unwinding a decision that has already been completed is unprofessional to say the least.
It is also not in the FSC’s jurisdiction to directly get involved in these market transactions. If there is a problem, the FSC should discuss solutions with the FSS first and allow the FSS to publically announce guidelines on the examination process for hybrids if it is to compensate for the damage done. The back-and-forth with the KASB has only created more confusion.
What is even more unfortunate is that the uncertain regulatory sentiment now set for Korean hybrids will make it impossible for other companies to subsequently explore the hybrid market. Slowing economic growth has weakened profit for industrial companies in South Korea, and investors are raising concerns over their ability to pay back and refinance debt. Equity markets are also volatile towards year-end, which makes the development of the hybrid market crucial for these companies.
For example, Korean Air’s debt ratios have hovered around 500% in the past three years, and the country’s largest airliner booked KRW20.3 trillion (US$187 billion) in debt in the first half of 2012. An official at the airline told the Hankook Ilbo that it was mulling a US$500 million hybrid deal that could have cut their debt ratios by 200 basis points.
Hyundai Merchant Marine, which is a subsidiary of the Hyundai conglomerate, was also cited by local media as considering a US$300-500 million hybrid to refinance mounting debt. It may look into raising additional shares instead, it said, but that may be a risky bet as the Korea Stock Exchange, which is up a mere 1.2% in the past year.
These companies were desperate to take advantage of the momentum generated from Doosan’s deal, which was the country’s first corporate hybrid. As bank funding becomes increasingly stringent for companies that are highly indebted, it is important that Korea allows a breakthrough in this market to cut the bottlenecks in funding.
The repercussions of not resolving the bickering over hybrids can even lead to a wave of defaults, which will create a bigger headache for the FSC and FSS, and further challenge the credit markets and the country’s economy.