What does it cost to do deals in South Korea? For Lone Star Funds, a Dallas-based buyout firm, almost $3 billion.

Lone Star, which won control of Korea Exchange Bank in 2003 when no local lenders were interested, spent more than five years entangled by courts, regulators and lawmakers as the fund incited public backlash over the profits on its investment. After it was convicted of stock manipulation and two attempts to cash out were undone by legal disputes, Lone Star agreed this month to sell its majority stake to Hana Financial Group Inc. for $3.4 billion, an almost 50 percent discount to HSBC Holdings Plc's offer in 2007, according to data compiled by Bloomberg.

While Lone Star still stands to double its money from the eight-year investment in Korea Exchange Bank, its experience will undermine the government's ability to dispose of a $3.8 billion stake in Woori Finance Holdings Co., CLSA Asia-Pacific Markets said. It also furthers the perception that South Korea, where companies sell at a discount to the rest of Asia on concern over corporate governance and North Korean aggression, is hostile to foreigners, Market Force Co.'s James Rooney said.

“Investors would look at this case as a kind of horror show, where every kind of risk that is hated by professional investors seemed to show up and create a massive distortion of intelligent markets,” said Rooney, the consulting firm's Seoul- based chief executive officer and a member of the investment committee at Macquarie Korea Opportunities Management. “This case has made the prospects much, much worse for Woori.”

Korea Exchange Bank and Hana Financial fell more than 2 percent today as South Korean shares slid after North Korea said its leader Kim Jong Il died. Woori Finance lost 1.7 percent.

Jed Repko, a spokesman for Lone Star, said the buyout firm declined to comment on whether it was treated fairly by the South Korean government during its legal disputes.

Ernst Lee, a spokesman for South Korea's Financial Services Commission, said “the regulator is treating foreign investors equally with local investors. We don't discriminate or give favors because of where they are based.”

A representative at Korea Exchange Bank declined to comment on when its sale to Hana Financial will close. Lee Jung Dae, a spokesman at Hana Financial, said it wishes to complete the deal for Korea Exchange Bank as soon as possible so it can focus making both Seoul-based banks more competitive.

Lone Star, founded by John Grayken to buy distressed assets, purchased Korea Exchange Bank in October 2003 as South Korea's banking industry was reeling from losses caused by issuing too many credit cards. That year, Korea Exchange Bank reported its biggest net loss since the Asian financial crisis in the late 1990s, data compiled by Bloomberg show.

Windfall Gain

After investing a total of 2.15 trillion won ($1.9 billion), the buyout fund this month agreed to sell its interest to Hana Financial for 3.9 trillion won.

The bank had originally agreed to pay 4.7 trillion won in November 2010, before negotiating two price cuts from Lone Star in the midst of the fund's legal disputes.

In November, Lone Star was ordered by South Korean regulators to sell most of its stake in Korea Exchange Bank after the firm and Paul Yoo, the former head of one of its local units, were found guilty of manipulating the share price of the lender's credit card division to drive down its value.

Lone Star was fined about $22 million, while Yoo was sentenced to three years in prison. The decision reversed an earlier ruling three years ago that cleared Lone Star and Yoo of any wrongdoing, which prosecutors first alleged in 2006.

The firm decided against appealing the conviction, removing the main obstacle to its sale of KEB, as Korea Exchange Bank is commonly known, according to Choi Jung Wook, an analyst at Daishin Securities Co. in Seoul. Lone Star has been trying to sell its holding in the lender since 2005.

One reason that Lone Star became a target of public ire is because as a buyout fund, it purchased Korea Exchange Bank to make money and had little interest in building up a bank franchise, said Hank Morris, Seoul-based North Asia adviser at Triple A Partners Ltd., which helps hedge funds raise capital.

“The Lone Star deal was controversial from the very beginning because Lone Star was not a bank,” he said. “Since no other bank, Korean or foreign, was willing to invest into KEB when Lone Star was willing to do so, it does seem fair that Lone Star should earn its reward.”

Once the largest foreign investor in South Korean financial assets, Lone Star is now exiting the country entirely with its disposal of Korea Exchange Bank.

Opportunity Cost

Today, Lone Star's Bi-Lo LLC agreed to acquire Winn-Dixie Stores Inc. for about $560 million to expand the supermarket operator's presence in the U.S. South.

While the $3.4 billion price tag for Korea Exchange Bank will inflate Lone Star's profit, including dividends and prior share sales, to more than $4 billion over the life of its investment, its five-year legal dispute with the government has cost the firm opportunities for an even bigger payoff.

In November 2006, as regulators investigated whether Korea Exchange Bank's financial strength was deliberately understated to let Lone Star buy the stake, a sale to Kookmin Bank, South Korea's largest bank, collapsed. London-based HSBC, Europe's biggest bank by market value, dropped its $6.3 billion proposal after regulators held the deal in limbo for more than a year.

With politicians using Lone Star's windfall to criticize the buyout fund's investment strategy in South Korea and sway public opinion, foreign investors may stay out of the bidding for Woori Finance and undermine the government's effort to sell the nation's largest financial company by assets, according to Shaun Cochran, head of Korea research at CLSA in Seoul.

“It is unlikely that a foreigner would bid aggressively, if at all” for Woori Finance after Lone Star's experience, he said. “Obviously, long protracted legal battles to exit a position will give foreign investors reasons to be cautious.”

The ruling Grand National Party, which faces a national election next year, characterized Lone Star's approach as “eat and flee,” in a Dec. 5 posting on its website.

The government has already failed twice to sell its 57 percent stake in Woori Finance, which was created in 2001 as a holding company for lenders rescued after the Asian financial crisis. Since South Korea first announced its plan to dispose of Woori Finance in July 2010, the bank has lost about a third of its market value, or about $2 billion, through last week.

The Public Fund Oversight Committee, in charge of state asset sales, gave up its most recent attempt to offload the lender in August, saying the sole bid it received from a private equity-led group didn't constitute “valid competition.”

Buyer Beware

Lee Jae Sool, appointed as a member of the Public Fund Oversight Committee in September, also said this month the government should discourage buyout firms from bidding for Woori Finance to avoid repeating the mistake it made with Lone Star.

“It's time to let Lone Star leave and keep our national image, and learn the lesson that private equity funds won't benefit the long-term development of banks,” he said.

For overseas investors, Lone Star's experience may instead serve to reinforce the view that South Korean companies aren't receptive to the demands of foreign ownership, said Pruksa Iamthongthong, a Singapore-based investment manager at Aberdeen Asset Management, which has about $75 billion of assets in Asia.

Many of South Korea's largest companies, including Samsung Electronics Co. and Hyundai Motor Co., are or were part of family owned conglomerates known as “chaebol.”

“It's a land of home-grown giants,” Iamthongthong said. “The level of corporate governance in Korea is lower relative to the rest of the region.”

In the past five years, foreign institutional investors have unloaded $30 billion worth of shares in South Korean companies on a net basis, more than in any other country in Asia, according to data compiled by Bloomberg.

That's reflected in the “Korea discount,” where investor concerns over corporate governance, a lack of accountability and an armed conflict with North Korea have left South Korean companies undervalued relative to the rest of Asia.

The Kospi index, the benchmark gauge for South Korean common equity, sells for 8.5 times next year's earnings, according to data compiled by Bloomberg. That's the lowest of Asia's 10 biggest equity markets.

While the discount also makes South Korean companies some of the region's biggest bargains, few foreign buyers will want to follow in Lone Star's footsteps, Market Force's Rooney said.

“Why would any new investor want to get involved in another similar social, political, governmental, financial, taxation, economic and emotional conflict?” he said. “Most investors brave enough to attempt acquisitions in Korea have already been here and I do not expect many more to come.”

What happened with Lone Star is “one part of the reason for that,” he said.

Bloomberg News

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South Korean M&A Can Be Costly

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