Episode #62 Weijian Shan – A Private Equity Deep Dive and Money Games

Weijian Shan is chairman and CEO of PAG, a leading Asia-focused private equity firm. Prior to PAG, he was a partner of TPG, and co-managing partner of TPG Asia (formerly known as Newbridge Capital).
Over two decades, Weijian Shan has led a number of landmark transactions. Previously, Shan was a managing director of JP Morgan, and an assistant professor at the Wharton School of the University of Pennsylvania. He holds an M.A. and a Ph.D. from the University of California, Berkeley, and an M.B.A. from the University of San Francisco. 
Shan is the author of Out of the Gobi: My Story of China and America (2019) and Money Games: The Inside Story of How American Dealmakers Saved Korea’s Most Iconic Bank (2020). His articles and commentary have been published in the Financial TimesThe New York TimesThe Wall Street JournalForeign Affairs and many other publications.

In this episode we speak about Private Equity. Shan walks us through the entire process of a Private Equity deal, from sourcing deals, the ins and outs buying a company, restructuring or turning around said company, and then exiting the deal successfully. We deep into some of the deals Shan lead during his more than 20 year career, most prominently into the acquisition of Korea First bank. We talk about his book Money Games and Shan leaves us with some fantastic career advice.

Links

https://www.pag.com/en/

https://www.pag.com/en/https://weijian-shan.com/https://www.goodreads.com/book/show/781182.Barbarians_at_the_Gate

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TRANSCRIPT EPISODE 62

[INTRODUCTION]

[00:00:06] ANNOUNCER: Welcome to the Wall Street Lab podcast where we interview top financial professionals and deconstruct their practices to give you an insider look into the world of finance.

[00:00:24] AVH: Hello and welcome to another episode of the Wall Street Lab podcast. I have a fantastic guest for you today whose name I’m definitely going to mispronounce. So I apologize for that in advance. My guest is Weijian Shan. Shan is the chairman and CEO of PAG, a Hong Kong-based private equity firm. Prior to PAG, he was a partner at TPG, a San Francisco-based private equity firm. And he was co-managing partner of TPG Asia, formerly known as New Bridge Capital. He led a number of landmark transactions including the acquisitions of Korea First Bank and China’s Shenzhen Development Bank, which both were made into case studies at Harvard Business School.

Before TPG, he was a managing director at J.P. Morgan, a professor at the Wharton School of the University of Pennsylvania and a farm laborer in China’s Gobi Desert in Inner Mongolia. What a CS. What a life, huh? He additionally holds a master’s degree and a Ph.D. from the University of California Berkeley and an MBA from the University of San Francisco. Shan is also the author of two books, Out of the Gobi and Money Games.

And in today’s episode we speak about his newest book, Money Games, which describes the aforementioned deal of the acquisition of Korea First Bank, which at the time was Korea’s most iconic bank. We talked about this deal in specific, but also about private equity in general. So we talk about the investment criteria that Shan has. We talk about how to turn around a company or a bank in this specific case and how to exit the deal, different strategies, different criterias. If you want to go into more detail, see all the intrigues that happen in this particular deal with the Korean First Bank, I highly recommend you check out the book.

As per usual, if you liked the episode, please leave us a five-star review on Apple Podcast or wherever you get your podcast from. Share with your friends, with your family and everybody interested in finance and private equity.

And now without further ado, my interview with Weijian Shan.

[INTERVIEW]

[00:03:08] AVH: Hello, Shan. Welcome to the Wall Street Lab podcast. It’s such a pleasure to have you here.

[00:03:14] WS: Thank you very much.

[00:03:14] AVH: Making it all the way from Hong Kong. Shan, I know that you’ve been a professor and now you are the CEO and chairman of a large private equity company in Hong Kong. Can you tell us how did you decide to make that switch from teaching into practice? Because I know at least in my world many people do it the other way around. they are first practitioners and then they jump into teaching.

[00:03:43] WS: Yes. I was a professor at the Wharton School for about six years before I decided to get into business, but it was not really a conscious plan. My first job after academic was to be a banker at J.P. Morgan, and the reason that I got into banking was because J.P. Morgan made me an offer that I couldn’t refuse. It was too good in comparison with the salary I was getting as a professor. So that’s why I moved to Hong Kong to join J.P. Morgan as an investment banker.

And then a few years later I received another offer from New Bridge Capital, which was really a franchise of TPG in Asia. And later we changed the name to TPG Asia. That is from New Bridge Capital to TPG Asia. And of course that’s how I got into private equity business.

David Bonderman, my mentor in private equity, he was the founding chairman of TPG, likes to say that those of us in private equity very often just stumbled into it. And in my particular case, I feel that that’s exactly how it happened to me. I just stumbled into it. I received an offer and initially I didn’t know what private equity was all about. And Bonderman sourced through that immediately as I described in my book, Money Games, but it wasn’t the opportune time, because it was right in the middle of the Asian financial crisis in 1997-98 when the stock market crashed.

I still remember on October 23rd, 1997, on that day, Hang Seng index, that is the index for Hong Kong Stock Exchange, dropped 16% in one day. And I knew that the capital market would be shot for a long period of time. And investment banking is of course on the sales side. When the capital market is shut, there’s very little that you can do. Private equity is on the buy side. So when the market craters, it is perfect time to get into buy side or get on to the buy side. And that’s why I made the decision to join New Bridge Capital, that is TPG Asia. That’s how I got into it, quite by chance.

[00:06:24] AVH: As you said, many people said in private equity, it’s by chance. Now you mentioned your book and you also mentioned the Asian financial crisis. And I want to talk about your book a bit. I’ve of course read it, but I don’t want to take much of the things that you talk about in the book away from here. What I would like to do is the book is about how you acquired a Korean bank, right? Can you give us a broad idea of what the book is about?

[00:06:56] WS: Well, the subtitle of the book is the inside story of how American deal makers saved Korea’s most iconic bank. So it was a bank that used to be the largest in Korea. It failed and became nationalized by the government during the Asian financial crisis. And it was in that particular year when I joined private equity that the entire Asia got into the economic and financial crisis to such extent. In fact, by the end of the year, 1997 in December, South Korea’s stock market dropped for that year 49%. Half of the market value disappeared, wiped out.

The currency, Korean won, dropped 65.9 against the US dollar. Two-thirds of its value disappeared. Korea’s foreign exchange reserves with which of course the government pays is foreign obligations, like bonds and foreign debts dropped to $8.9 billion. Now you have to remember that South Korea is the 10th largest economy in the world. It is still the 10th. It was the 10th at that time. It had only less than $9 billion in its foreign exchange reserves.

Now I’m chairman and CEO of PAG, a private equity firm. Today we manage about $40 billion for Xero. Korea, as the 10th largest country in the world, had only $8.9 billion left to pay its foreign debt. So it was running out of money probably within a few days. And it was at that particular point that the IMF, International Monetary Fund, and the World Bank came in and provided a rescue package to Korea. It was $58 billion residual package. It was the largest in history by that time. The package came with a condition, very typical of these multilateral agencies. And the condition was that Korea had to sell off at least one of the two nationalized failed banks, including the bank eventually we bought. So this was the background we got into the negotiation with the Korean government to buy what used to be the largest bank in Korea.

And the story told in the book is the whole process of not only cutting the deal, negotiating, investing in that particular bank, but also about how to turn around that bank and eventually how we exited from that particular investment. You see, in private equity, there’s a lot of interest about it, but very little is known about it. It remains somewhat a mystery. And there are some books written about it, but there’s no book that covers the entire process of the investment from beginning to the end, from investing to exit. And I think in that regard my book is quite unique. It feels a void that covers the entire story of a private equity deal.

I’m sure you have read Barbarians at the Gate, which was a bestseller and turned into a very popular movie. But that book covers only the deal-making part of that transaction, KKRs acquisition of RJR Nabisco. But few people know eventually what happened to that particular transaction after investment was made.

[00:11:12] AVH: Yeah, I can’t agree more. That’s what I wanted to have you on the show and to talk about this, because there’s so little understanding of private equity. And I would love for you to walk us through the big stages of a private equity deal .You can do this describing your banking deal in Korea or any other deals that you make. If you just give us an overview of how did you maybe come across the deal, so the sourcing, to what you then did afterwards step-by-step?

[00:11:48] WS: Every deal is different. So there’s no boilerplate model of how a deal happens. And sometimes it happens by chance. Sometimes it is auction process. But Henry Kravis of KKR, talking about KKR, likes to say that any idiot can buy business. It is what happens afterwards that really matters. When you think about it, that’s absolutely right. If you spend enough money, you’ll be able to buy any business. If you are willing to pay the price, you will be able to buy any business. And that is not too difficult. The difficult part is how you actually make money from your investment.

For example, we were talking about KKRs acquisition of RJR Nabisco. If I recall correctly, that transaction was valued at about $25 billion, largest ever in history by that time. It was about 1988. Of the $25 billion, KKR borrowed I think about $22 billion. It was a leveraged buyout. So it was heavily leveraged. And the equity was about $3 billion. And I’ve read various reports afterwards to my knowledge, which may not be accurate, because of course I’m not the insider of that deal. To my knowledge, KKR held that investment for about 15 years. And eventually when it fully exited, they lost about $750 million out of the $3 billion dollar they invested.

So from the LP, or limited partner, or investors point of view, it was not so successful in investment. In fact, people would have been better off if you had kept your money in the savings account. But if you read the book, Barbarians at the Gate, it’s a fascinating story of how the deal was cut, right? So if you think about what Henry Kravis said, what matters really is about what happens to the business afterwards. And then the entire investment cycle will have to include not only making the deal, making the investment, but also what you did with the business under your ownership and eventually how did you get out. And then what the result is, I think that’s a full story. So with every deal, of course, when you negotiate the transaction in private equity, unlike public market investing where you just buy/sell stocks, in private equity you typically will negotiate a deal with the sell side. Then you make the investment and then you may or may not do something about the business. And in our particular case, it required substantial turnaround, because it was a failed business and it required many years of efforts to improve the business, to grow the business, to add value. And then eventually you will have to exit.

Now, how do you exit through the public market? By listing it, IPO, or by a trade sale sending it to a strategic investor. Those are hard decisions, but the exit process very often is as complex as the entry process and sometimes even more. And then at the end of it, you can count your chickens, whether you have made money or lost money. If you’re not making any money out of the investment, then it can’t be considered to be a successful investment. So I would say a private equity deal typically would involve sourcing the deal, negotiating the deal, then improving or growing the business and then exiting from it.

[00:16:26] AVH: In the negotiation of the deal, I get there’s several things that you need to take into consideration. For example, the price, of course, this is one thing. But then how you decide what is a good price levels. I know there’s like a myriad of things that go into it, and you describe this very well in your book on how you negotiate smaller details that in the end can really turn deal from a, “This is a good deal,” to, “This this might be a bad deal.” But can you give like just a couple of decision criteria that you’re looking out where you in the beginning already try to set yourself up to negotiate a successful a deal. As you said, any idiot can buy a business, but how can you make sure you, at the very beginning, already set yourself up to turning it around. Or what are the criteria where you look between a, “This business has failed and I’m not going to be able to rescue it,” versus, “This is a failed business, but I will be able to rescue it.”

[00:17:32] WS: It is very important to understand that particular business. And therefore the more experience that you have, the better off you become. That is you’re better positioned against your competition, because in every deal situation, there may be others who like to buy a deal. You think it’s a good deal. Others would think it’s a good deal. So very often there’s competition.

How do you decide the price that you can take? Not necessarily what the sell side will name, or not necessarily what the competition. will pay. Well, we will have to make certain assumptions. And typically what we do is to build a model. We say, “If this is what we assume about the growth rate of this business based on its history,” without history, it would be very difficult for you to tell. Based on the economic growth rate of that particular market, a particular country based on the market multiples of EBITDA, price to EBITDA multiples, price to earnings multiples based on what kind of multiple you will be able to achieve in the end when you exit from the business?

So let’s say your target, IR, from this investment is 25%. And you think you will have to hold this business for five years in order to improve the business and build up this business. Then you just come backwards to say, “How do I achieve 25% IR?” If I pay five times EBITDA, I may be able to achieve 25% IRR based on the assumptions that I made about the growth, about the improvement, about the cost cutting and all that, about new products that we can develop. And then you say that’s the right price. And maybe it is six times, maybe eight times EBITDA that will get you where you want it. It is not art. It’s not really a science, because you can’t really predict the market. You can’t really forecast what would happen in the future. But I would say it’s educated estimate or forecast based on experiences, based on history, and different people make different assumptions.

For example, we have a rule within PAG. We would never underwrite exit multiple to be higher than entry multiple. Let’s say we paid 8 times EBITDA to buy this business. We would not assume to be able to sell this business at 10 times EBITDA. That would make it too easy for you to make money, to buy cheap and sell dear. Many people have this misperception that private equity makes money by buying cheap and sell dear. If it were so simple, then anybody could do it.

So we have a rule that if you buy this at eight times, which is more or less where the market is, you can’t assume you will get out nine times. You will have to assume that you will get out at eight times or lower. Sometimes you have some information that other people don’t have. For example, you know how to bring a product to the market through the channels of another business that you own. So there’s a synergy that you know that other people don’t know. So other people are waiting to pay for the market, more or less, is eight times EBITDA as the permitting price. But you’re willing to pay nine times, okay? Because you think you can create more value.

And then in that particular case you can’t assume that you will be able to get out at nine times. So you will have to do what we call multiple compression. You have to assume that you get out at eight times. If you can still make your target return of 25$ IRR or 30$ IRR, then you will be willing to pay that price. Otherwise you may think that’s too expensive. So that’s how we typically would get to a price point.

Now sometimes we win the deal. The sales side would like to work with us. Sometimes we lose a deal because we don’t pay as much as our competition. And typically you don’t just win in private equity on price. That would have been too easy as well. If you read the book you would find it is much, much, much more complicated than the price itself.

What is more important is whether or not the sales side thinks that you can really bring value to this business. Even if the sales side wants to get out 100%, very often they don’t. They may become a minority shareholder. They want to make sure that they hand the business into a pair of safe hands, which would help the business to grow, to add value and to develop, because the seller is also concerned about the employees of the business, other stakeholders and the business in general.

So if you have built a track record for yourself to be able to help a particular business, that very often matters much more to the sell side than the price itself, which is always very important. It’s not the only factor.

[00:23:36] AVH: So, basically, it also has a lot to do with your perception of yourself on how well you are able to turn around the business. And the sell side’s perception of you, how well you are able to turn around the business in question, right? Because as you said, if you want to have buy low, sell high and make a profit out of this, it’s not about the multiple, which absolutely makes sense. Because otherwise, as you said, you’re making it easy for yourself. So you really try to then increase EBITDA. If you have to multiply it yourself, you try to increase EBIDTA.

But, for example, in the case that you described in your book, the market is actually not growing. It’s actually declining. The currency is declining. The market is down. What kind of assumptions can you do? You’re like, “Okay, if the market turns around, this is what we will be able to do.” Or how do you look at such a case, for example, if all the indicators at the moment are going down instead of up?

[00:24:41] WS: That’s a very good question. In fact, when we build a model, it’s never just one case. We would have a base case. We will have a downside case and then we’ll have upside case. Aside from that, it all is a matter of making assumptions. In the downside case, of course, you would assume that the market doesn’t grow. The market actually would decline. Or somehow your effort to turn around or grow the business is not successful. In the upside case, of course, you assume that the crisis will be over and the market will resume growth. It’s very much like what we are experiencing today.

In so many major economies in the world today, we’re in the recession. So some business may come out of it doing much better, like e-commerce. Some other business, let’s say related to hospitality, maybe permanently impaired, right? Like in hotel business or in some entertainment business. So you have to make judgment whether or not the market will move in a particular direction.

I think in private equity we talk about doing analysis at the business level, or what I call the micro level. Looking at the product, looking at market share, looking at the customer base and all that. That’s all at the business level. But in my view, it’s more important to do what I call macro underwriting of the entire market conditions. If you invest in a market where there’s no growth, where the economy has been in chronic difficulties, then you know no matter how good this business is it’s unlikely for you to make money or it’s just too difficult for you to make money. Or if you think that there may be a crisis on the horizon, you want to get out of the way as well.

See, in public market investing, there are different ways of hedging against macro risks. If you think that the market is going to go down, you’re short on the market, you’re short on the index. So you protect yourself by hedging. In private equity, we don’t have liquidity at any given moment in time, because you can’t get out. You can’t just sell the business at a moment’s notice. And there’s also no way to hedge it, because it’s a private business.

So in private equity, the only way to hatch the market is to stay away from it if you think the risk is too great. And therefore we do macro underwriting in every market in which we invest. If we think that the risk is too high, the currency is too weak, the inflation rate is too high and the recession is too deep, we stay away from it if we don’t think that there’s any prospect of recovery in the foreseeable future or on the horizon.

In the particular case, which I described in the book, it was the worst crisis since after the war for South Korea. But the country had experienced many decades of rapid economic growth. And we knew that what really created the crisis for the Korean economy was its banking system. And if the banking system was restructured and fixed and sufficiently recapitalized, then there was very good chance for economic recovery. And therefore investing in the bank is a bet on the macro economy. We were waiting to make that bet because we thought that recovery was just a matter of time.

Somewhat similar to what’s happening in the United States. We know this year is a down year because of the pandemic, because of the lockdowns, because of the economic slowdown. But with the vaccine, with the pandemic behind us, we can expect a fairly strong recovery in the United States. So if you think that there’s a business, which has potential, which is not permanently impaired, maybe this is as good time to buy as any other.

[00:29:41] AVH: So do you then employ a lot of macro researchers, or do you try to get outside research on the macro base? Or is it just a sense of having a good understanding of what are the causes for the problems on the macro basis? And what are the potential inclinations that come out of that? Or how do you approach this macro view?

[00:30:09] WS: Both. We do our own research. Of course, we’d look at the market research, which is very much available. And very often for a major transaction we hire a consulting company to do an industry analysis, to do a macro analysis, because we ourselves, our team would typically just focus at the business level as supposed to interviewing all the players, major players in the marketplace. We just don’t have the resources or the expertise to do so. And then you hire somebody like McKinsey or Bain or somebody else to do that kind of research for you. So we have to understand the macro conditions, and then we’ll have to take a view.

[00:31:01] AVH: Then do you try to first look at the macro? So for example, let’s take Malaysia. You have like, “Okay, Malaysia has a very good macro forecast,” and you’re actively looking for deals in Malaysia. Or is the other way around? You happen to come across a deal, potentially in Malaysia, and then you’re doing the macro research. Which way does it usually go?

[00:31:27] WS: Typically we do macro underwriting first. See, if you look at Asia, PAG has offices in Seoul of South Korea, in Tokyo of Japan, in Shanghai of China, in Hong Kong, in Singapore for Southeast Asia, in Mumbai for India, in Melbourne for Australia. Those are major markets. And there are some countries we don’t have an office and we’re not very active, because we are not so convinced that the macro economic conditions are conducive to private equity. I wouldn’t name countries, but I would name the countries for which were somewhat bullish about. And then we have a team on the ground. And then we do deals in those countries. For those countries where we don’t have a presence, it doesn’t necessarily mean that we would stay away from the market. It means that for some, it’s just too risky for us. For others, it may have not gone to a stage where we think there are larger deals.

For example, Vietnam, is probably one of the only two countries in the world this year to register a positive economic growth. The other country is China. But Vietnam has handled the pandemic exceptionally well this year. And therefore they probably will achieve GPD positive growth this year. This country with 19 million people and has produced 6 to 7% GDP growth rate in the past few years. So it reminds me of China about 20 years ago, and it’s certainly a very interesting market. But it’s up and coming. So we have not really devoted enough resources to that country. But that doesn’t mean we’re not interested. We’re still watching and monitoring the economy and the market very closely and we possibly will be able to do a deal before we set our office over there.

[00:33:41] AVH: So you’re trying to get the macro perspective first and then you try to find the deals within the country. And then if you have a long-term bullish outlook, you establish an office there.

[00:33:53] WS: That’s correct. For example, in my book, I talk about this major transaction in Korea. At that time, New Bridge Capital, that is my old firm, TPG Asia, didn’t even have an office in Seoul. And it was afterwards, after we did the deal, that we started the office over there.

[00:34:15] AVH: How much capital do you usually try to deploy in a deal? I could hear a bit that some countries you don’t see that there’s the deal size potential that you’re looking at. And I just had an interview where the guests said, “Well, they talked to a lot of companies, but they would at least at minimum want to deploy 20 million.” And that’s in a VC context. What is a deal that like below that it’s just not worth, or you can’t find several deals of that size, it’s not really worth to look too deeply into this country?

[00:34:50] WS: PAG is no alternative as a management company. And it’s a private equity company, but with three major businesses. Real estate have to return, which includes credit fund, special situation, distressed debt and so forth and then private equity. In private equity, we have buyout fund, we have a growth fund. I’m chairman/CEO of the entire group, but I focus only on private equity. I don’t pay much attention to real estate. We have very good partnership managing real estate business. And I know very little about absolute return business. I focus almost all my time on private equity.

In our buy out business, we will not invest less than 100 million dollars per deal. And typically several hundred million dollars, sometimes, of course, over a billion dollars equity capital. Including that, it could be much larger. We don’t necessarily have a limit or cap how much capital we can invest, because our investors from the United States, from Canada, from Europe from Middle East and from Asia are institutional investors. They’re very large. So if we do a multi-billion dollar deal, we can always find capital from among our LPs, or limited partners.

So for the buyout business typically it’s several hundred million dollars. We will not definitely bother with a deal that’s like $20 million or even less than $100 million. But we have a growth fund which focuses on technology. For the growth fund, the ticket size per deal typically is much smaller. They’re often $30 million, $50 million or $60 million. Typically not exceeding, let’s say, $60 million. If the ticket size is too large, we do it together with the buyout fund.

For example, and this is public information, we bought a large pharmaceutical company in China last year called Hisun BioRay from a listed company. It’s a division of a listed company. We bought control of it. Now we own 58% of it. We spent about $540 million to buy that business. Again, this is public information, because the seller is a listed company.

Now the deal was sourced by our growth fund, which would deploy no more than $50 million per deal. And when they look at the deal, initially, it was a minority transaction and they thought it would make sense to buy control over this company, and they can’t do it. So the two funds, the buyout funds and growth funds work together to buy control of that company. So both growth fund and buyout fund put money into that particular transaction, but the growth fun, no more than $50 million. The rest is from the buyout fund. That’s how we work.

[00:38:18] AVH: That’s a very good segue, because I wanted to ask, when you do a transaction in the private equity fund, do you always take control of the company and then with the aim to turn it around. Or is it sometimes that you say, “A minority state is okay because I believe in the business. And as a seller, wanting to get rid of it.” For example, needs liquidity. And you think it’s a good price that you can get in on. Or is it always a business that might be run better if you’re taking control?

[00:38:53] WS: For the buyout fund, we strongly prefer control. Occasionally, we will do a minority transaction, but always with a structure that gives us a downside protection. Why? Because private equity is a risky business. No matter how well you underwrite an investment, sometimes things just go wrong. And if you have control, you can fix it or at least you will make an effort to fix it. If you’re a minority shareholder, you basically take a right. There’s not much that you can do if something goes wrong. And that’s why if we are a minority shareholder, we need downside protection, because the controlling shareholder will have to be able to fix it, otherwise we get out at least with our money back and with some meaningful return as well. So we prefer control for buyout fund.

And there’s another advantage to have control. That is you can better time your exit. If you have control, it’s like you’re the driver of the bus. You can stop at any particular moment. You can take any exit that you like. If you’re a minority shareholder, you’re just a passenger. You can’t get out until the bus stops, right? And that’s why control is so important. But for our growth fund, we don’t have control. If you invest in a startup company – We typically don’t invest in a startup company. We have to wait until there’s revenue there’s cash flow in order for us to make an investment, because we’re risk averse. We’re not like a venture capital firm. And in that kind of business, let’s say it’s a biotechnology company, or if it is, say, a new technology company. The funder is the key to the success of the business. If you take over control, you don’t actually know what to do with it. So you really have to invest in the funder and in the technical people who started the business. And that’s why in the growth fun we will not ask for control, but we typically would ask for downside protection. If the controlling shareholder, if the funder doesn’t have the confidence to give us the downside protection, where do we get the confidence to invest in the business?

[00:41:23] AVH: What is downside protection for you?

[00:41:27] WS: For example, you invest for a convertible bond. So basically if things go well according to your plan, you convert a bond into equity to get your upside. But if things don’t go well, then your investment is like a debt, and then the company is obligated to pay you back, because it’s a bond. So that’s just one of the structures. But of course you have to make sure that the credit behind or under your bond is good enough.

For example, if they own the building. They say the building is charged to you as collateral. And you invest, say, $50 million. The building is worth $100 million. I’m just giving a hypothetical example. Then you think that the downside is well-protected. If it’s a startup company with no assets, they say, “Oh, we gave you a convertible bond.” Then there’s no credit behind it. If things go wrong, if the company goes bankrupt, there’s nothing that you can recover, right?

So for us, it’s very important that you have sufficient credit behind whatever structure you put together. It may be a convertible bond. It may be just a put right. You have the right to sell your stake back to the company or to a controlling shareholder at a specified price. For example, three years ago we invested in a particular business. It was a minority investment. And there was a put right held by us. So we had the right to put or to sell our stake back to the controlling shareholder at a specified price, which would give us 13$ IRR. Don’t ask me why 13%. That’s how we negotiated, just 13% IRR.

So to our surprise, that the regulatory environment changed to make it very difficult for this business to be as profitable as it used to be. Very often regulations would change to the detriment of the company. So we just exercise our put right and sold our stake back to the controlling shareholder and we only made 13$ IRR, but under the circumstances we were protected against if the company went into either bankruptcy or very low profit.

[00:44:17] AVH: That absolutely makes sense. I want to turn back a bit and ask your other “protection” in quotation marks. You’re taking control of a company that is probably about to fail, not run very well. What are typical measures that you would deploy of a company? I know every deal is different, but are there some commonalities, some – This is like the three things you always do or that are particularly successful.

[00:44:48] WS: Again, every deal is very different. But going back to my book, Money Games, which of course is a story about buying control of a major bank in Korea, the key to that particular transaction was what you do or what you would do with the legacy loans. The bank failed because of the bad loans during the financial crisis. And we would inherit some of the bad loans. Some really bad loans were carved out and taken away by the government, but we would keep some loans, which either are not completely normal that is performing, paying interest, paying amortized principles. It’s not completely normal nor are we sure that you will continue to pay in the future.

So what do you do with what we call legacy loans, future loans? We would have to take responsibility because we’re the owner. We make the lending decisions and we have to know the credit and we take full responsibility. For legacy loans, if the loan goes bad, then we take the loss. If too many loans go bad and then the company can go bankrupt again as it happened before. So the negotiation was focused on government protection of the legacy loans. It’s a very complicated story, but it’s a very interesting story. It’s a very fascinating story and I would encourage the listener to read the book to get it.

But every case is quite different. It’s quite different. Sometimes it has to do with the business itself. We just made an announcement two days ago, I think, in Australia. We would invest in a business by the stock ticker name of Rexit’s, it’s Regional Airline Business. It’s called the Regional Express. So it’s a regional airline business.

Australia is a very big country in terms of geographical size. Australia is as big as 95% of continental United States. That’s how big it is. And therefore there’s a great need for internal flight services within Australia. You get from one city to another, from Sydney to Melbourne and all that. And this is not a very good time for airlines as we know worldwide, right? We are investing in this particular airline, which like all airlines in the world are experiencing some difficulties. And we’re willing to make the investment, because we think sooner or later this business will recover, because there’s a need for it in Australia’s market. But we’re also concerned that there may be a downside that the business may not recover for a long period of time, longer than we can hold this particular investment.

So as announced, and the announcement is released by the stock exchange. Therefore I can talk about it. We will invest for a convertible bond secured by some very good assets including aircraft. And then the company will draw down capital from us as needed under certain conditions. So we know that the money is put to very good use to grow the business and to make sure that the business that they get into, let’s say, purchasing a new aircraft, starting a new route, will be profitable before they can draw down another trench of capital. So there are many different ways to protect both the investors and the company.

[00:49:02] AVH: Now we’ve talked about sourcing deals. We’ve talked about turning around. What are some important decisions or some important points when exiting a deal? You can talk about the example from your book or from any other example just to round up the conversation.

[00:49:23] WS: Well, private equity typically has finite period of time to hold a particular business. And you don’t want to sell the business if there’s still strong growth potential. On the other hand, if there’s no growth potential for the business, nobody is going to pay top dollars for it. So you will have to time the exit very well. And then it depends on the market. Sometimes if somebody approaches you to buy the business, sometimes you will have to look for buyers. So there’s no fixed formula. But typically when we underwrite an investment including the deal that I described in Money Games, in our model, we have to answer the question, “How do we get out?” If we can’t answer that question, then we would typically not invest in that business.

If you invest in the bank, you have to know how difficult it is to get into banking sector in Korea, for example. In any country, banking is strictly licensed. You can’t just start up a bank. The banking regulators will have to approve for you to set up a bank, and typically it’s extremely difficult to set up a bank. So it’s a highly restrictive market. And very often, especially in Asia and especially at that time, foreign banks would find it very difficult to get into that market. And the only way to do it is to buy an existing bank. So we knew that. We knew we were competing with one of the largest banks in the world for the bank that we eventually were working to make an investment as I described in the book. So we knew that there was strong interest among large banks, global banks, to acquire this business. But typically, established banks are reluctant to buy a broken bank, because they will have to turn it around. They will have to make provisions. It’s very costly proposition. But they like to buy a clean bank. The bank that has already been turned around, well-capitalized, with very clean balance sheet. So we know that if we create a healthy and clean bank, we will be able to sell it at a very good price. And we already calculated it.

And then whether or not we were able to achieve our objective as we underwrote, you will have to read the book. I think that’s a story in and of itself. But in every business, we try to figure out how we eventually will get out. And then after a certain period of time, we would actively look for different ways of exiting from the business. Sometimes it’s IPO, which I personally don’t prefer, because it’s hard for you to sell 100% of a business through IPO. If you want to get out, typically, public market investors don’t want to invest. Say, “Why you won’t get out?” So you have to get out through a long period of time. And that’s why it’s not an excellent route that I prefer personally. A trade sale is the cleanest, and typically you can command a control premium through a trade sale because you have control.

[00:53:12] AVH: Thank you. Now we have made the whole way from sourcing to exit. And just I want to ask about one detail in the book just because I found it very funny how small things matter in the turnaround. So can you quickly, before we wrap up, tell us the story of – I hope I pronounced the name right, Shachat’s dog. It had to be brought from New York.

[00:53:38] WS: His first name is Keith Shachat, yes. He is what we call a rocket scientist. To do retail banking you need a lot of data. Today we talk about artificial intelligence. We talk about big data. Well, that has been around for very long time. And you have to have a lot of data in order to discover patterns how consumers, borrowers behave. If you’re talking about small loans to, let’s say, credit card holders, or consumer finance customers. You can’t really look into the personal finances of an individual one by one in order to decide whether or not to make a $50,000 loan. The cost of doing so would be too high.

So what banks do is to analyze a lot of data to try to discover a pattern. And then they use a scoring card system to say, let’s say, if you are a salaried man making $10,000 a month, that would be part of your score. If you own your home as opposed to renting your home, that’s a score. If you have a family or if you’re single, and that’s a score. So we use a scorecard to decide whether or not to make the loan. So that’s the science, and what we call rocket science, because hundreds of variables are used in the decision-making process all through computers.

And Keith was such a scientist. He works with data. So we wanted to bring him to Korea, but there was one constraint. He had a very big dog, and no commercial airline could take his dog to Seoul. And eventually we got David Bonderman to fly the dog in his private jet together I suppose with Keith. And it was really a quite troublesome thing to bring a big dog from America all the way to Seoul in order to bring Keith to his job.

But as I described in my book, we also had the comfort that once there, it would be very difficult for him to leave, because it would be difficult for him to ship his dog out.

[00:56:21] AVH: Yeah. Thank you. This story has just made me laugh, and I thought this might be a really nice way to tell people. It’s not always about a spreadsheet. It’s not always about the numbers. There’re real people involved with real problems.

The last question I want to ask you before I let you get along with your evening is you described that you had a 25-year-old, a very young associate, who you gave a lot of responsibilities to. And because most of our listeners –

[00:56:55] WS: Daniel Poon is his name. Yes.

[00:56:57] AVH: And a lot of our listeners are around that age, young professionals. Why did you choose him? What could you give our listeners on a way to how they can take on a lot of responsibility to get them further in their career, to be so early well-recognized?

[00:57:17] WS: Of course, a good education is very important. Daniel, I think, studied in America from University of Pennsylvania and then eventually he got an MBA from the Wharton School, where I taught, but he didn’t overlap with me. He was very smart, very intelligent and very well-trained and quite experienced even by the age of 25. But I think the most important attribute to make somebody successful either in private equity or in any business is a strong sense for ownership. If you think that you own this business, you think you’re investing your own money, then you don’t need so much training. You don’t need to know so much about the business. You will be able to do it well, because it’s your own money and you want to learn everything. You want to be very careful. You want to look at every detail.

So in our firm, we have a KPI. We review every professional at the end of every year about this time of the year. The first attribute we evaluate people on is a sense of ownership. We assume, if you have a sense of ownership, you will do your job very well. Now, sense of ownership is not quantifiable. So how do we measure somebody’s sense of ownership? You don’t have to quantify it. People around you know whether or not you have sense of ownership. So if we do peer reviews, if we do 360 degree peer reviews, you will get a score, and it’s very accurate.

And Daniel Poon had a very strong sense of ownership. When he worked, you felt that it was his business, it was his money, and he was so meticulous, he was so careful, he was so dedicated, he was so hard working that leaving anything to him, you really didn’t have to worry about anything at all. And he was really a key part of the team as we did in that particular transaction even though he was only 25-years-old.

[00:59:39] AVH: Perfect. Thank you so much. It really certainly inspired me to take ownership. I hope it did inspire our listeners. Shan, thank you so much for coming on the show, for telling us so much about private equity and giving us this great career advice. And I would encourage every listener that wants to get deeper into the weeds of private equity, especially of that particular deal, to get the book, to read the book. It’s been really fascinating for me. And, Shan, thank you so much for taking the time.

[01:00:13] WS: Thank you very, very much for having me.

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