DeCeMber 2008 47150 About the Author Lessons Learned from Past Financial Crises: JeAn-MArie MAsse is head of business Develop- Korea 1998-2000 - investing equity/Quasi- ment, Global Financial Markets, iFC. Prior to this, equity with Agility in Financial institutions Jean-Marie worked for Crédit Agricole in France and in the us. IFC was very active in the republic of Korea approved investments of about US$670 million immediately after the asian financial crisis in 16 banks and finance companies. erupted in 1997. IFC reestablished operations in Korea and opened a local office in october IFC focused on: 1998, and closed it in late 2002 after Korea recovered from the crisis. · Strengthening existing banks and non- banks(lifeinsurance,leasing,stock/futures at the end of 1997, the Korean economy brokerage) suddenly started to contract, the Korean won · Establishing new institutions to broaden plummeted by over 100 percent against the the capital markets (mutual fund US dollar, and liquidity in the banking sector management, pension fund management, dried up. major commercial banks as well as secondary mortgage finance) smaller specialized financial institutions all · Strengthening the financial infrastructure faced increases in non-performing loans and through the establishment of credit rating were unable to roll over their shorter-term agencies and credit bureaus funding. · Introducingfinancingandriskmanagement instruments and techniques such as In response to this crisis, IFC's first priority was securitization and derivative products to to strengthen financial institutions through the local capital markets. both financing and advisory services, and enable them to lead the restructuring process. the results for IFC were far-reaching. IFC got IFC then injected liquidity into the trading publicity highlighting its ability to quickly close system through trade enhancement facilities. a deal once the deal structure was accepted by IFCsupportedtherestructuringofcorporations a particular client. Frequent press releases, facing liquidity problems and helped its clients deal-signing ceremonies, and even prime-time grow as the recovery began. tV interviews of IFC senior management reinforced IFC's positive image. In addition, between 1997 and 2002, IFC invested almost goodwill was generated with local authorities US$1 billion in Korea for a total project cost of and contacts at all levels of the Korean about US$3 billion. most investments were made in 1998 and 1999. the crisis response strategy focused on thefinancialsector,andalsosupported corporate governance and improvements in transparency and disclosure standards to help modernize financial markets and improve their efficiency. In the corporate sector, IFC helped restructure Korean companies through direct investments complemented by advisory services. IFC helped strengthen Korea's financial sector by giving priority to financial sector reform. the board IFC SmartLeSSonS -- deCember 2008 1 Korea: Macro-Indicators 300 12 10 250 8 6 200 4 GDP (RHS %) 150 2 StkPrice FX Rate 0 100 -2 -4 50 -6 0 -8 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2008 administration, creating an image of IFC as a "get things financial crisis when investing equity in financial done" organization. institutions. IFC's ability to respond quickly, assess risks, and put Lessons Learned mitigating measures in place, as well as its client relationship skills, enabled IFC to provide significant assistance to Korea's 1) Equity/quasi-equity investments make sense in a financial sector and thereby contribute to its recovery. crisis situation and require strong legal support. the graph above clearly illustrates that the "perfect storm" at the outset of the asian crisis, investment staff were was set for the period from January 1998­march 1999 instructed by IFC Senior management to originate and when: process equity deals and avoid loans because experienced · The Korean won was at its lowest level against the US staff time was scarce. It takes longer to negotiate a loan dollar in May 1998 than an equity investment when spreads are very volatile. · The stock market index was at the bottom (it went this is still the case today. during the 1994 economic crisis from 30 in July 1998 to 105 in June 2000, a 3.5 time in mexico, IFC found that by the time it had finalized the increase documentation for senior loans with clients, the equity · Gross domestic product (GDP) was on a trend to bounce markets had recovered and spreads had to be renegotiated back from -7% in 1998 to +9% in 1999. downward,resultinginthelossofcapitalgainopportunities for IFC. thus, IFC found that it would have a stronger impact this is a classic case of "a V-shaped recovery," and it is through equity investments rather than loans, due to the important to take advantage of the equity window in such lengthy process involved in closing the negotiations for cases. the Korean economic and financial recovery was loans in a crisis situation (no pricing benchmark). helped by vigorous structural reforms of the economy influenced by the World bank/ International monetary equity investments offer a better risk/reward trade-off than Fund rescue package, and strong exports from Korean loans. to facilitate an equity/quasi-equity investment companies to the United States. While such a situation program in Korea, IFC hired top-notch Wall Street lawyers mightnothappenunderthecurrentglobalcrisis,thelessons to lead the documentation process alongside IFC's learned from investing in Korea during 1998-2000 can investment team. once IFC closed one deal, we found that provide useful guidance to IFC investment professionals at the legal documentation and deal structure concepts could this time. be used again for other deals. this paper describes seven lessons learned from Korea that Important features were: (a) creating anti-dilution clauses we hope are helpful to IFC staff during the current global on convertible instruments (resetting the price per share 2 IFC SmartLeSSonS -- deCember 2008 during the pre-conversion period, in case the company supervisionistotakeadvantageofnegotiateddealfeatures. raises equity at a price below market); and (b) making hard- In addition, it is important to continue building-up the currency­denominated loans convertible into local relationship with the investee company's senior currency­denominated shares, thereby hedging IFC's management, board, and key shareholders, supervise foreign-exchange exposure during the pre-conversion advisory services output, if relevant, and ensure that IFC period. this illustrates the importance of having a delivers added value to the project and quickly reacts to streamlined legal process in place. possible eventual bad news during the portfolio supervision phase. If the same investment officer does the supervision, 2) Advisory services are crucial during a crisis. he or she can react faster in volatile situations because of familiarity with people, institutions, etc. Specialized consultants can complement IFC staff during the due diligence process. this is particularly the case when 4) IFC is an agile organization, and working on IFC`s there are tight deadlines, which is typical during crisis countercyclical investments is rewarding. situations. (Vince Polizzato, IFC Chief Credit officer, started working for IFC as a consultant in Korea). Working on projects in crisis countries is hard work and extremely formative. during a crisis, IFC offers numerous Posting resident advisors in an investee company helps opportunities for investment professionals to add value-- provide IFC with extremely valuable information that could striking at the core of IFC's mission. the experience in Korea not be obtained otherwise when structuring or supervising showed that the investment approach in a crisis country a deal. resident advisors are consultants hired by IFC or an requires a great deal of effort on the part of staff, as investee company to meet IFC's investment criteria. the investments are often undertaken alongside co-investors resident advisor should bring a considerable level of and as part of turn-around programs/consortium of experience to add value to senior executives and staff of shareholders acquiring a controlling stake. thus, the deal's local companies. He or she must be able to gain the trust of timetable is dictated by the market. deals are often high the investee company management, be an effective profile, and IFC investment staff must understand the big networker in emerging markets, and be able to work for a picture, be able to develop a vast network of contacts, period of up to 2 years in an emerging market country. We handle corporate relations issues (IFC is often portrayed as should also stress that local consultants often have access a blue chip/unique investor with global knowledge of best and can convey to IFC what is happening "on the ground," practices), have the stature to speak to experts in crisis and it is very important to engage and work closely with management and macro-economic restructuring, and tap them. opportunities when they arise. Someexamplesofrecommendedadvisoryservicesprograms the investment negotiation and processing must often be that consultants can work on are: handled in an "urgent" mode leading to deal closing within a compressed time frame (about 2 months). the time · Assigning a strategic advisor to work with the Chief crunch can be eased, for example, by recycling a tested legal Executive Officer structure and having clear investment strategies and good · Establishing a corporate work-out unit at a bank deal targeting. most of all, the investment officer must headquarters and training staff know how to leverage IFC's field presence and work across · Strengthening the internal audit unit time zones. · Preparing International Accounting Standards (IAS) consolidated accounts teams working on initiatives related to IFC's response to the · Posting a Board member with a special mandate to current global crisis have high-profile assignments and establish best practice corporate governance. shouldbeacknowledgedwithintheCorporation.Corporate relations should also highlight the work externally to board representation and corporate governance are showcase IFC's major initiatives and global leadership. this paramount when creating shareholder value, particularly in in turn will ease recruitment and deal sourcing and attract the case of IFC straight equity investments. IFC should be the best and the brightest to IFC. very demanding in this area. It is preferable that board members be external consultants rather than IFC staff 5) Different teams should work on "work-outs" and because they must act in the best interest of shareholders "new investments" and their task can be very time-consuming. the work-out unit usually works from a "zero" cost base, 3) The team booking the deal should also be in charge of because most investments they work on have been fully supervision. provisioned, which can lead to restructuring decisions that may be different from those that are taken the team booking the deal should also be in charge of to make new investments generate future value. the work- supervision in order to maximize return on IFC's due out unit should continue to focus on the IFC jeopardy diligence and investment structure, at least for one-to-two portfolio, while other investment teams should work on years post-investment. Some equity investments and almost new deals with a goal of creating value through new all quasi-equity investments are designed to mitigate investments. downside risk and capture upside potential; however, the more structured the deals are, the more important IFC SmartLeSSonS -- deCember 2008 3 6) Banks require special care during a booking new assets which cannot be funded financial crisis. due to the lack of liquidity in the banking system during a crisis. In addition, the banks' Ceos and senior management of banks must equity portfolio should be parked under a deal with shifting priorities, and they need to separate vehicle (not the bank's balance sheet) concentrate on loan-portfolio restructuring to and managed by appropriate teams of address corporate and retail lending defaults experts. and provisioning, bank recapitalization plans, and liquidity management. In addition, they IFC and banks should develop expertise in needtoaddressmarketrumors,publicrelations accountingareas,becausemanyissuesinvolved and staffing issues, and deal with stock market in restoring market confidence are also linked analysts, credit rating agencies, and external to banks' financial disclosure. auditors. there is often intense interaction with government authorities, ImF, supervisory 7) IFC must work closely with local authori- authorities and mergers with other banks, as ties, the World Bank, and the IMF. we are witnessing today. Liaising with local authorities at a very senior during a crisis, IFC can address some of the level (Governor of the Central bank, minister above issues through frequent interaction of Finance, etc.) and relevant executive with the bank's management team, quickly director offices in Washington to "sell" IFC's reacting to breaking news, sharing macro- investment program requires special care. economicviewsandstaffexperience,providing these meetings should highlight that IFC's corporate governance plans, tailoring advisory products and services are tools to help services to the bank, and mobilizing top-notch strengthen the private sector of a particular expertise to address particular issues. country, thus it is important to outline private sector priorities and determine where IFC can Special care must be paid to valuation and due be most effective. diligence considerations. a crisis typically leads to market distortion in the banking sector, and In the case of Korea, we found that both the this can impair a traditional bank's due Wb and ImF sent highly qualified experts to diligence approach. during a crisis, the quality crisis countries. there is a firewall between IFC of a bank's management team must be on one side and the Wb/ImF on the other, due assessed, as well as its strategy and its to a conflict of interest between IFC's private willingness to accept IFC as a shareholder. sector investments at the company level and agreement must be reached on the policies at the country level. However, Wb and implementation of measures to create ImF experts do speak to many market shareholder value. all of the above, plus good participants, and it is important for IFC timing of IFC equity investments, may rank as investment staff to be among those who are more important factors in bank valuation than consulted at the project/country level in order the traditional asset quality/capitalization to share knowledge and increase IFC's criteria used during non-crisis times. Some contribution to a crisis country. examples of market distortions impacting the assessment of the value of equity in banks include: bank mergers and nationalizations; state guarantees on deposits equalizing risks across banks; state-sponsored agencies buying DisCLAiMer bad loan portfolios based on non-market iFC smartLessons is an awards prices; and exacerbated currency movements program to share lessons learned in foreign exchange markets, making it in development-oriented advisory preferable to invest equity after local currency services and investment operations. the findings, depreciation. interpretations, and conclusions expressed in this paper are those banks should also be appraised on a of the author(s) and do not comparative basis relative to country or necessarily reflect the views of iFC regional peers. or its partner organizations, the executive Directors of the World bank or the governments they after IFC's initial investment, there are a represent. iFC does not assume number of issues that IFC should address. IFC any responsibility for the should be prepared to help banks value the completeness or accuracy of the information contained in this quality of their loan portfolio. banks should document. Please see the terms consider rotating front-office investment staff and conditions at www.ifc.org/ to portfolio/back-office functions so that they smartlessons or contact the work on portfolio restructurings instead of program at smartlessons@ifc.org. IFC SmartLeSSonS -- deCember 2008 4