A Fat Tail World – Regulation worries

By Preston Keat

One of the most important upshots of the global economic crisis is that governments are now a lot more involved in driving economic policy. And this is not going to change anytime soon. Whether they like it or not, governments in both developed and emerging markets are now the central drivers of economic rescue policies ranging from fiscal stimulus, to industrial bailouts and support, to financial re-regulation.

Regulation of firms is a particularly complex issue, which has just become even more politicized. Even governments that are inclined not to intervene in markets with heavy regulations are recognizing the need to change some of the rules. On the surface this may sound like the worst of all worlds for businesses, but some governments and industries are bound to fare better than others — and there is often an underlying political story behind these outcomes.

One trouble with regulatory risks is that they involve governments that have both the sophistication and the need to actively regulate their economies and societies. This is partly because more sophisticated economies need to be integrated into the global economy if growth levels are to be maintained for the longer term. At the same time, these governments have the legal and regulatory capacity to selectively interfere with foreign investments and trade in a way that favors domestic interests without attracting too much negative publicity. In countries with relatively strong and stable state institutions, traditional political risks like expropriations, civil strife, and breaches of contract remain of some concern, but the more significant risks usually come from more subtle forms of official discrimination.

Below we highlight a case from The Fat Tail, where politically-driven regulatory shifts in South Korea’s finance sector undermined what looked like a successful investment strategy by a foreign firm.

As any good investor knows, the commonly used adage "buy when there is blood in the streets" applies not only to literal times of bloodletting but also to metaphorical ones. It is best to buy cheap assets in the wake of some crisis. With this in mind, in August 2003 the Dallas-based private equity firm Lone Star Funds believed it had found an unusually promising investment deal in South Korea. The country’s macroeconomic conditions were sound, but twin economic shocks-the 1997 Asian financial crisis and a 2002 credit card crisis-had inflicted heavy damage on local businesses in the financial and industrial sectors, Overwhelmed by bad debt, thousands of Korean firms faced insolvency. Lone Star determined that the Korea Exchange Bank (KEB), the country’s only foreign exchange bank, provided a good opportunity to enter the Korean financial market.

Many other Korean firms were sold, merged, or simply left to collapse, but Lone Star bought KEB for $1.3 billion, injecting new capital into the troubled financial institution and assuming management control. Under Lone Star’s guidance, the bank was restructured and put on a path to profitability.

At the same time, the Korean financial sector and the economy in general began to recover, generating substantial profits for private equity investors that had entered the market a few years earlier. For private equity firms, this story looks (so far) like a textbook example of intelligent investment. Invest in distressed assets like KEB, manage them back to health, and then (hopefully) sell them at a significantly higher price during a period of promising economic growth.

Yet, with the economy recovering, South Korean attitudes toward foreign investors began to sour. Local media began to run stories alleging that foreign investors were reaping enormous and unfair profits. Local attitudes toward foreign private equity investors shifted from gratitude toward economic saviors to anger at greedy profiteers.

In 2005 Lone Star decided to sell its KEB stake, offering its majority share holdings to a Korean bank, Kookmin Bank, for $6 billion. Lone Star decided to use its Belgian subsidiary to transact the bank sales to take advantage of a bilateral tax treaty to recoup $4.5 billion in profit from the sale tax-free. There was nothing illegal or even unethical about the move.  After all, without going into arcane details of tax law, tax treaties are meant to be used, and Lone Star did have a Belgian subsidiary.

Yet given the state of public opinion, the decision triggered a storm of public outrage-and multiple government and regulatory investigations into Lone Star. These investigations were extensive; they did not limit themselves to the proposed sale of KEB to Kookmin, but examined the legality of Lone Star’s original deal to buy KEB. Even the Korean government officials who had approved the sale were questioned.

Thus began a sweeping government effort to find fault with Lone Star and to prevent the company from recouping this profit. Government prosecutors ultimately charged the executives of Lone Star and the Korea Exchange Bank with illegal acquisition of the bank, collusion, stock manipulation, and tax evasion, locking the financial firms into multiple drawn-out legal battles.

Korean financial regulators blocked any approval for Lone Star to sell its management control of KEB as long as court proceedings continued. The court battles have already derailed two deals to sell KEB, first to South Korea’s Kookmin Bank and then to Singapore’s DBS, and is currently threatening to disrupt a third with HSBC.

The Lone Star case illustrates the kind of treatment that foreign firms can encounter in overseas markets. The problem may be getting worse. Ironically, some of the countries that have benefited most from globalization (including the United States) have exhibited a growing tendency toward government action against foreign firms. A closer look suggests a number of concerns driving the developed world’s reaction against globalization: Fear that national identity will fade, anxiety over immigration, growing unemployment in formerly dominant sectors, and the rise of new economic powers (e.g., China and India). In the developing world, corruption, weak governing institutions, and concern for protecting noncompetitive indigenous industrial sectors still drive much of the discriminatory actions against multinational corporations.

Most countries have begun resorting to more subtle forms of discrimination against multinational corporations, in order to avoid the economic, legal, and diplomatic retaliation that accompanies blatant interference. The most pervasive and subtle forms of government interference with trade and foreign investment can be broadly labeled "regulatory discrimination." Especially for corporations that invest in multiple countries, monitoring and complying with the varying regulatory environments across the globe can be both complicated and costly. Because they are so prevalent, and also difficult to observe and mitigate, regulatory risks pose as least as great a threat to multinational corporations’ operations abroad as terrorism, natural disasters, country risks, and other economic risks.

Excerpt reprinted with permission from The Fat Tail: The Power of Political Knowledge for Strategic Investing published by Oxford University Press.  Copyright © 2009 by Oxford University Press, Inc.