Dilute conglomerate holdings

Dilute conglomerate holdings

By Hidayat Jati

JAKARTA (JP): Four years after the financial crisis broke out
in 1997, more and more skeletons are coming out of the closets of
Indonesia's conglomerates; the last of which concerns the once-
mighty Sinar Mas Group. Creditors (including the Indonesian
government) and minority shareholders learned that they are
increasingly placed at the receiving end of the group's inter-
company transactions and complicated structure.

All the skeletons indicate that many Indonesian conglomerates
are hollow, as their financial strengths and management prowess
had been overrated. Indeed, these weaknesses had been masked by
the flow of easy money (thanks to gullible asset managers,
corrupt state bankers and the violations of the legal lending
limit regulation) in the early 1990s.

The flow of leverage into those conglomerates, in fact, had
been a major source of growth and a key driver for return on
equity, as asset turnover was relatively slow. This was well
demonstrated in a recent study of corporate governance produced
by the Asian Development Bank (ADB).

This, consequently, shows that for the most part the
Indonesian corporate sector had been skating on thin ice -- due
to the high leverage that came amid the country's nonexistent
governance, poor legal infrastructure and growing current account
deficit in the late 1990s. Lenders and investors alike chose to
ignore such fundamental factors for the most part. The ADB study
shows, for example, that listed property/real estate companies --
a sector that almost all Indonesian conglomerates had exposure to
-- between 1994 and 1996 continued to have average annual debt-
equity ratio of 163 percent while average annual sales growth
over the same period was a negative 15.5 percent. This seems to
confirm that, indeed, easy money tends to be dumb money. For more
examples, just ask those folks that used to run the bonds
department of Peregrine Investments in Hong Kong.

The structural causes of the conglomerates' current mess are
threefold:

* Complicated ownership structure of the conglomerate, especially
regarding cross holdings between banking/financial companies and
nonfinancial, a factor which encourages the companies within the
conglomerate to carry out incestuous deals and transactions
(violations of bank industry lending rules);

* Overwhelming domination of the controlling shareholders over
listed companies (usually flagship units of conglomerate groups),
leading to inevitable passive roles of minority investors and
little management accountability. This contributed to high
leverage, as bank lending retained majority ownership while
providing engines for growth;

* Weak regulatory regime due to co-opted, corrupt and inept
bureaucracy.

It is public knowledge that for the most part -- PT Astra
International Tbk is a notable exception -- Indonesian
conglomerates are not structured under one holding company. The
lack of a unified structure is a deliberate way to minimize tax
obligations and public scrutiny.

Tycoons like Sjamsul Nursalim, Eka Tjipta Widjaja and Sudono
Salim tend to use different "holding" companies, usually little
known, to represent their ownership in their flagship
subsidiaries. Some even use proxies to conceal their ownership or
offshore-registered companies, especially to break the legal
lending limit, to make the entire scheme even more opaque. This
has resulted in a complex web of companies whose common link is
the same majority shareholder.

To make things even more complicated, practically all
Indonesian conglomerates are family owned, a factor which
contributes significantly in hindering governance. Family
ownership inevitably encourages these conglomerates to adopt a
management culture based more on filial piety rather than
professional accountability.

After all, how can a manager/nephew say no to the clan
patriarch or to the heir apparent? How can the patriarch say no
to the favorite son? How can the chairman-cum-eldest brother deny
the wishes of the maverick younger brother who wants to expand
into real estate and television broadcasting at the same time?

It is in Indonesia that the concentration of conglomerates'
ownership is most extreme, especially when compared to other
Asian former tigers. A 1999 World Bank study on the subject,
which is also quoted by ADB's governance study, shows that in
1996 about 15 families controlled 61.7 percent of Jakarta's
market capitalization. This is the highest rate of concentration
in all the Asian countries surveyed by the bank. It is surely no
coincidence that Indonesia's corporate sector was also the most
leveraged and now the weakest in the region.

Subsequently, a very dangerous symptom emerged from the
complex structure of family firms. This is the incestuous
transactions between companies within the same conglomerate. Most
typical are the cases involving the listed entities (usually the
crown jewel of the conglomerates) and the privately held
entities.

All these practices breed moral hazards since it is almost
certain that in most cases, there is no competitive bidding. In
cases of inter-company acquisitions (most often involving a
private asset being acquired by a listed unit), a common
phenomenon on the Indonesian capital market, valuations had
always been suspect, while the synergic pretext for the
acquisitions, was often, well, just pretext.

This symptom is dangerous because it reflects a very
fundamental flaw in the thinking of the controlling shareholders.
On the one hand, they aim to create a real institution, a going
concern, while, at the other, they want to exploit their crown
jewel for short-term benefit.

Such contradictory activities by definition cannot be
sustainable, as over time these companies will lose their sense
of strategy -- in the Michael Porter sense of the word, as they
are never forced to make a trade-off in their investing
decisions. More profoundly, inter-company transactions make the
line between personal interests of the owners and what the
company really needs very hazy.

In some extreme cases, the line disappears altogether, as
evidenced in the example of one Indonesian cement company, owned
by a conglomerate, who "lost" US$250 million from its coffers. A
less controversial example was provided in 1995, when an
Indonesian cigarette company, following the personal investment
decision of its chief executive officer-cum-largest shareholder,
began to accumulate shares of PT Astra International, a largely
automotive company (the cigarette company has sold all its Astra
holdings by now).

To put an academic spin to the issue, it strongly appears that
a case of institutional failure overcame most of Indonesia's
conglomerates. The contradiction mentioned previously reflects
that impersonal rule, a cardinal rule in all modern institutions
as formulated by the great sociologist Max Weber, failed to
materialize among Indonesian conglomerates.

In the meantime, the most obvious and immediate costs for such
incestuous practices, of course, falls on minority shareholders
and creditors, especially the unsecured ones. But because of the
conglomerates' exposure to the banking industry, and the
incestuous bad lending that resulted, Indonesian taxpayers too
are paying the price to resurrect the banking and corporate
sectors, even though most of them never directly enjoyed the
fruits of the abuses.

The solutions must go to the heart of the problems. It must
address the matter of corporate structure, the lack of
shareholder activism and the debt overhang. This is a monumental
task, but some steps can be taken.

The solution must involve an element of de-personalization of
listed companies. In other words, the government must provide the
carrots to encourage founding shareholders to release more shares
into the market, so that a healthier ownership structure, at
least for listed companies, is attained. This could be done in
the form of zero capital gain tax charged on founders to reduce
their holdings in listed entities (during an initial public
offering or a right issue). In some restructuring cases, a
dilution of the founders' ownership has already taken place, such
as in the case of PT Bakrie Brothers Tbk.

True, this is a controversial idea given the current fiscal
outlook. But the potential benefits of having extra liquidity in
the stock market (which may result in greater capital inflow,
something which should help the current account situation) as
well as greater control of the investing public should be
considered. The potential long-term benefit is likely to override
the short-term fiscal cost.

The second element of the solution is shareholder activism to
counter the founding shareholders and their management teams.
Rather than waiting for the government to provide the
aforementioned carrot, and to reinvent the wheel, Indonesian
market regulators and investors (pension fund managers, insurance
companies) should consider a recent proposal suggested by David
Webb, a lone but increasingly respected market watchdog in Hong
Kong. His proposal is smart, realistic, market-friendly and
applicable to Indonesia (http://www.webb-
site.com/articles/hams.htm.). This proposal, centered on the
formation of an association of independent shareholders (to be
financed by a small levy on stock transactions) has been endorsed
by the Asian Wall Street Journal.

Third, and most difficult, is debt restructuring/workout. This
exercise, usually quite mundane affairs in developed markets, is
highly political in Indonesia given its persistently weak legal
system and the Soeharto legacy of unholy alliances between
tycoons and political leaders. But without restructuring, which
may or may not involve bankruptcy, the Indonesian corporate
sector cannot move on, as it cannot get new capital. (The ADB
points out that unlike Korea and Thailand, foreign banks directly
lent to Indonesian companies. The two countries' foreign
creditors first enter the domestic banking sector, a factor
contributed in a speedier restructuring process.)

This part of the solution clearly requires careful thought.
But it is clear that the chief condition to force deadbeat
companies to deal with their lenders (read: taxpayers -- who are
financing the new capital in the form of recapitalization bonds
into the banking system) is a reliable stick, i.e. an impartial
commercial court. The current outlook for this to develop remains
mixed at best. Why?

Because we continue to hear, even today, that families of
political leaders travel overseas with owners of deadbeat
companies, who have possibly committed corrupt acts in the past.
We also continue to hear and see how defense attorneys easily
flaunt their "friendship" with judges.

In short, it is clear that Indonesia's public institutions too
are in a major mess. On this issue, it remains to be seen whether
this saying is true in the Indonesian case: "The more things
change, the more they look the same."

The writer is a Jakarta-based business researcher.