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[CONTRIBUTION] Learning from PE model: power of incentives

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Editor’s note

This article is the first in a three-part contribution on the “Korea discount” and McKinsey Korea’s take on how to resolve it. — ED

By Richard Lee

Richard Lee, senior partner at McKinsey Korea Office / Courtesy of McKinsey Korea Office

Richard Lee, senior partner at McKinsey Korea Office / Courtesy of McKinsey Korea Office

A persistent focal point in the Korean capital market revolves around addressing the ongoing dilemma of closing the so-called “Korea discount” or “K-discount,” a term signifying the widespread undervaluation of listed Korean stocks.

Despite its overall economic volume and leading industries, Korea turns out to be one or two steps behind its economic peers in terms of capital size and maturity.

McKinsey’s report “Korea’s next S-curve: a new economic growth model for 2040” shows that the country’s financial depth – the percentage of public and private equity, bonds, and securitization issuance compared to gross domestic product – fell to 8.2 percent in 2022 from 10.9 percent in 2018.

A significant deterrent in this regard stemmed from challenges within the listed equity market, notably the persistent issue of the K-discount.

In response to this challenge, the government recently bolstered its Corporate Value-up Program. Concurrently, companies are advocating for incentives that enable management to prioritize valuation concerns. Market observers stress the importance of implementing shareholder-friendly policies, including initiatives such as increased dividends and buybacks.

Such increasing calls to action should not come as a surprise, considering the sluggish returns in Korea’s public equity market.

It was in October 2007 that the benchmark KOSPI hit 2,000 for the first time. Since then, the index has stalled and currently stands at around 2,700 as of early April – marking an increase of only 35 percent over the past 17 years. Meanwhile, the S&P 500 in the United States grew from about 1,500 to some 5,200, up over 335 percent during the same period.

In contrast to the slow-growing public equity market, a notable exception arises with a class of investment offering high returns at relatively low risk: the portfolio companies of private equity operators.

According to a McKinsey report in 2018, Korean private equities (PEs) were yielding returns of over 1.4 times their investment within a holding period of less than 3.5 years. The total volume of returns has since experienced significant expansion in recent years. For instance, major homegrown PE firm MBK Partners asserted in its recent annual letter to investors that the total value of its portfolio companies surged 28.6 percent compared to the previous year.

What is it about Korean private equities that enable them to outrun public equities when it comes to overcoming the K-discount phenomenon?

Three reasons stand out – a highly focused portfolio, sufficient long-term mindset, and aligned management incentives.

First, buyout funds tend to include a limited number of companies in their portfolio – 10 or less in most cases.

This marks a clear contrast with the nation’s top 10 conglomerates which have about 82 affiliated companies on average as of 2023, with the number continuing to increase every year. Within such dispersed portfolios, even large-cap subsidiaries may find themselves lacking the necessary level of attention or volume of investment.

Another challenge for proper valuation is the limited tenure of business leaders here.

According to corporate information tracker CEO Score, the average tenure of non-owner CEOs stood at 3.6 years as of 2020, remarkably shorter than that in the U.S. which came to between 7 and 8 years.

However, at PE portfolio firms, CEOs typically maintain their tenure throughout the fund’s ownership period and may even extend their term afterward. This continuity is often facilitated by the fact that the new owner likely considered the management team’s capabilities as a significant factor in the purchase decision.

Also, these portfolio companies often provide incentive programs that reward long-term value creation, eventually motivating management to create added value to business.

For instance, the management would receive regular incentives based on stock options of up to 10 percent of the company’s shares outstanding, as well as bonus once the portfolio company successfully goes public or finds a new owner.

This reward system marks a clear contrast with the typical compensation in Korean companies, where executives usually are given a cash-based payment based on yearly performance. As the assessment excludes significant long-term incentive, or LTI plans, executives are easily led to prioritize short-term gains.

While some may argue that PEs also prioritize short-term gains, aiming for speedy and profitable exits, it is crucial to recognize that they are often diligent in showcasing mid- and long-term growth opportunities for their portfolio firms. This strategic approach is undertaken to attract the attention of potential buyers, which frequently includes other PEs.

The PE operating model may not be the one and only solution to Korea’s long-standing, complex undervaluation dilemma. But if the nation sincerely seeks to boost its industry’s competitiveness and activate the capital market, its top priority should be to turn an impartial eye to diverse models and policy incentives.

The writer is a senior partner at the McKinsey Korea office. His area of expertise includes high technology, media and telecoms and private equity practices in Seoul.

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