Group 6(Afternoon)

The change of Korean corporate restructuring market and the Future of PEF


I Introduction of PEF in Korea

Korean Private Equity Fund (hereinafter referred to as “PEF”) was introduced by its government, who was caught by surprise from aggressive business practices of foreign private equity firms such as Lone Star Funds during the sale of Korea Exchange Bank after the IMF crisis, as countermeasures for sudden inrush of foreign capitals.

Unlike foreign private equity firms who operated in a grey area where existing rules and regulations for ordinary investment companies did not apply, Korean investment firms were essentially prohibited, unless it was clearly permitted by other means, from engaging in indirect investment business at the time. In order to promote business takeovers, buyouts and restructurings by active participation of domestic PEF, Korean government introduced Private Equity Fund system through amending relevant laws in October, 2004.

PEF was introduced as a part of Indirect Investment Asset Management Business Act. According to the Investment Asset Management Business Act, PEF is essentially a business buyout fund which is intended to facilitate workouts of distressed companies, as well as to improve corporate efficiencies by strengthening the regulations of management rights market through M&A of companies that are not performing to its capabilities because of such reasons as inefficient management structures. It was established based on two primary principles; 1) investment for management rights, and 2) prohibition of investment of money lending natures.

Ⅱ. The Structure and regulation of PEF in Korea

Stucture of PEF

Domestic PEF is established in a form of Limited Partnership, which is also the structure generally taken by overseas PEF. Domestic PEF must be formed as a general partnership in accordance with the classification of Commercial Code. In United States, PEF generally takes a form of limited partnership where general partnership of Korean Commercial Code provides the most similar structure as the limited partnership of United States. Therefore, general partnership has been selected as the organizational structure for PEF.

As required by law, PEF must register with the Financial Services Commission as a part of establishment processes. At the time of registration, it must furnish information such as objective of establishment, name of firm, business address and personal information of general partners, which are considered matters required to be registered, along with other information such as the management information and summary of PEF’s functions to the commission.

Primary investment objectives of PEF are, whether the investment is made independently or jointly with other PEF, limited to an investment that allows owning 10% or more of a company (need to retain the ownership for 6 months or longer) or an investment that gains the majority control of a company (need to retain the ownership for 6 months or longer). In other words, the primary business of PEF is to buy shares of other company for the purpose of control of such company. PEF can also purchase investment securities issued by SOC (Social Overhead Costs) Investment and Loans Companies or purchase exchange-traded derivatives and OTC derivatives as risk aversion practices, and allowed to purchase investment securities, facilitate short term loans or deposit in financial institutions within the range prescribes by the law. Lastly, PEF can own shares of special purpose companies (SPC) as long as it meets certain requirements. The SPC must be a stock company or an incorporated company according to the Commercial Code, only PEF is allowed to invest in such company, and the total number of investors from both PEF and SPC cannot be over 30 persons. The main items of investment for SPC also are investments to acquire more than 10% or the majority control of the company being invested.

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The total number of partners must include 1 LP and 1 GP, and be smaller than 30 persons. The minimum investment required from LP is 1 billion won for individuals and 2 billion won for companies such as funds and indirect investment firms.
Upon establishment of PEF, it is required by law to register with the Financial Services Commission by furnishing general information such as the name of firm, business address, and personal information of general partners.
Additional information such as information regarding the managements and summary of PEF’s fund management must be provided to the Financial Services Commission as well.

Asset Management

The investment objectives of PEF’s asset management are strictly restricted to business takeover and buyout funds. (Indirect Investment Asset Management Business Act - Article 144.7) The investments are essentially limited to investments that are aimed at gaining management rights, such as acquiring 10% or more shares of the company being invested or the majority control of other companies.

Any acquired shares must be retained for a period of 6 months or longer and more than 50% of initial investment must be reinvested for purpose of acquiring management rights.

However, following investments are exceptionally allowed to ensure flexibility of investment.

- Investment on convertible bonds and bonds with warrants
- Purchase of investment securities issued by SOC investment and loans companies
- Purchase of exchange traded derivatives and OTC derivatives as risk aversion measures
- Deposits in financial institutions, purchase of real estate properties, and portfolio investments within the amount equal to 5% of asset.

Additionally, PEF can establish or invest in a SPC, independently or jointly with other PEF. In such case, the SPC is subject to the same restrictions placed on the PEF regarding its investments. SPC must be established in a form of a stock company or an incorporated company, and restrictions* for loans and guarantees are placed to prevent excessive debts.The aggregate sum of loans and guarantees of PEF is limited to 10% of total assets and the same of SPC cannot go over 200% of its equity capital. All of shareholders and partners of SPC are considered as the partners of PEF and the number of such partners, including the initial investors, cannot go over 30.

Relationships to other laws

Before the introduction of PEF in Korea, indirect investments had been subject to strict regulations that were focused around public subscriptions and other relevant laws such as the Fair Trade Act. However, the Securities and Exchange Act is not applicable to PEF. Also, application of the Fair Trade Act and the regulations applicable to financial holding companies in the Financial Holding Companies Act are postponed for 10 years if the PEF abides by the restrictions to make investment that allows participation in management of the company being invested. This measure is necessary to address the possibility of conflicts with other financial regulations placed by other laws, because requirements for establishing PEF or restrictions on its investment objectives are less strict compare to the restrictions placed on other types of indirect investment firms.

On the other hand, regulations related to non-banking entities* from the Banking Act and the Financial Holding Companies Act still applies to PEF, in order to restrict the ownership of financial institutions by industrial capitals.

* Non-Banking Entities are; ① a non-banking business which owns 25% or more of the aggregate sum of equities of all subsidiaries or with the amount of total assets over 2 trillion won, and ② a securities investment firm of which 4% or more shares are owned by industrial capitals. Such non-banking entity cannot possess more than 4% of total number of shares with voting rights of a financial institution (15% in case of a local financial institution).

In any case where a non-banking entity, who substantially exercises controlling powers, participates as a GP* in a PEF, such PEF is considered as a non-banking entity as well.

Less strict regulation applies when a non-banking entity participates as a LP. Such PEF is considered as a non-banking entity when the investment ratio is over 10% (including the largest investor of 4% or more) or 30% if the investments made by other subsidiary companies are included.

The same regulations apply to overseas private equity funds, provided that shares in excessive percentage may be acquired if certain special circumstances* are approved by the Financial Services Commission.

In case of SC First Bank, Newbridge Capital was able to take over the bank by acquiring extra shares because the special circumstances to restructure an insolvent financial institution was acknowledged by the Financial Services Commission.

Ⅲ. The Market Condition

Key Performances

The first PEF introduced in Korean market was the ‘Mirae Asset #1’ of Mirae Asset Maps Global Investment, established in December 27, 2004. In the early days, PEFs that were funded by financial institutions, such as Woori Bank, Korea Development Bank and Industrial Bank of Korea, led the market, but other independent PEFs such as BOGO Fund and MBK Partners entered the market shortly after. Nearly 50 PEFs had registered with the Financial Services Commissions until the end of February 2008 since December 2004, when the PEF system was first introduced.

Approximately 30 institutions have actively participated in these PEFs as GPs and such institutions can be largely categorized into financial institutions, subsidiaries of financial institutions, and independent firms. As for the financial institutions, banks, securities firms and asset management firms formed the mainstream of GPs in the early days. The participations, however, were expanded to venture capitals, new technology finance firms and mutual savings banks, along with eased regulations. Good examples of such firms are the banks such as Korea Development Bank, Industrial Bank of Korea and Nonghyup, the securities firms such as Daewoo Securities, Woori Investment & Securities and SK Securities, and Mirae Asset Maps Global Investment, Seoul Asset Management, KTB Networks, and Solomon Mutual Savings Bank. These financial institutions have established departments which exclusively deal with PEF related matters to carry out GP roles. Currently, there are 17~18 financial institutions who participate as GPs of 23~24 PEFs in Korea. This means that approximately 2/3 of PEFs in Korea are classified as PEFs with financial institution GPs.

Next are the GPs who are the subsidiaries of financial institutions. These subsidiary companies are spin-off companies of financial institutions that are established as independent firms and its sole purposes are to operate PEFs. Such firms include Shinhan PE, Woori PE and Macquarie Korea Opportunities Fund. Currently there are 4~5 such firms in the market.
Lastly, there are 13~14 independent firms who participate as GPs of domestic PEFs. These firms are fully committed to managing PEFs without being associated with certain financial firms or financial groups. About 10 independent firms including H&Q AP, MBK Partners, BOGO Investment and Woongjin Capital are currently in business.

Until now, over 9 trillion won has been raised by domestic PEFs, but there are substantial numbers of PEFs who have not found the investment objects yet to this date. According to the data collected by the Financial Services Commissions as of the end of February of this year, only 4 trillion 886.1 billion won out of 9 trillion 450.3 billion won have been actually invested so far. That is just over the half of total funds raised. In fact, the sizes of funds are shrinking as well. Funds with minimum of 300 billion won assets took nearly 40% of entire funds until the middle of 2006. However, the vast majority of funds in Korea, except for 4 ~ 5, are small funds with assets that are just around or below 100 billion won. The numbers of funds which are large enough to be selective with their investment decisions and close buyout deals are gradually decreasing.

The relationships between GPs and LPs are not worth comparing to those of global PEFs. New funds are popping up everywhere, but there aren’t enough institutions to provide capitals. Consequently, the market is being manhandled by LPs. Major GP with recognizable name values is yet to emerge and Korean version of Black Stone or KKR is still a far distance away. There aren’t too many institutions or companies who actively participate as investors (LP) of PEFs in Korea. There are about 6~7 public funds and associations like the National Pension Funds, about 15 commercial and savings banks, about 20 insurance and capital companies, and the rest are some companies and individual investors. According to the analysis conducted by Financial Services Commission in last October, financial institutions were took the largest portion of LPs with 54.2%, followed by general corporations (19.4%), public funds (17.0%), individual investors (7.9%), and others (1.6%).
However, there are only few domestic PEFs who can present past profit records because of their relatively short histories. The investment cycle based on typical buyout deals; ‘Fund Raising’  ‘Deal Sourcing & Investment’  ‘Monitoring’  ‘Exit’, can take anywhere from 3 years to 5 years, where it has only been just over 3 years since the PEF system was first introduced in Korean capital market.

Because of such short history, it is also difficult to evaluate the investment performance of PEF. Only the few of the investment objects or the funds have reached its ‘Exit’ stages. Just about 4 domestic PEFs have completed their ‘Exit’ phases to be evaluated for investment performances. In June 2006, MBK Partners acquired Hanmi Capital from Citi Bank at a price of 62.6 billion won. It was later sold to Woori Financial Group at a price of 270 billion won, generation nearly 400% return on investment. Also, KTB Networks purchased SKM with about 50 billion won of investment in 2006. KTB later took out the duty free division of SKM and sold it to Aekyung at a price of 80 billion won.

At this time, information such as track records, fund sizes, portfolio distributions, matters regarding overseas investments, and relationships between limited partners and general partners, are still insufficient to discuss about the ‘performances’ of domestic PEFs.

Trends of Investment made by Key PEF Firms

Firm Name of Fund Capital Companies Invested
Mirae Asset Maps Mirae Asset #1 140 billion won Shinwoo, Sungjin Geo Tech, Jinro and 3 others
Mirae Asset Maps Mirae Asset #3 611 billion won Daewoo Constructions
Woori Investment & Securities MARS #1 34 billion won Sempio Food
Woori Investment & Securities MARS #3 450 billion won Lakeside
Korea Development Bank KDB #1 300 billion won Jinro, Choonwae Pharmaceutical, Seobu Truck Terminal
KTB Networks KTB 2005 150 billion won SKM, S&T Daewoo, Green Cross Life Insurance
KTB Networks KTB 2006 250.1 billion won Daewoo Constructions
BOGO Investment BOGO 511 billion won Tong Yang Life Insurance, Raincom, Novita, Siltron
MBK Partners MBK Partners 1 trillion won HK Mutual Savings Bank, C&M, Ssangyong Capital
Macquarie Korea Opportunities Fund Macquarie Korea Opportunities Fund 1 trillion 214.2 billion won SK E&S, Hanjin Shiipping’s overseas subsidiary, C&M
Korea H&Q AP H&Q-National Pension 300 billion won Korea Petrochemical, Hyunjin Materials, Mando

Characteristics

Firstly, establishment and participation of PEFs by banks with relatively high liquidities are noticeably high and such trend is anticipated to be continued for some time. The majority of banks recognize the asset management industry is the core growth sector of future financial industry and are quickly formulating strategies to seize competitive edges through consolidations.
Starting with Woori Bank, Korea Development Bank, Industrial Bank of Korea, Hana Bank and Shinhan Financial Group, have formed PEFs by now. Especially, Korea Development Bank formed a PEF with initially raised funds of 300 billion won in May 2005 and invested 100 billion won in Hite Beer Consortium, receiving much attention as a PEF formed by a government owned bank. Industrial Bank of Korea has formed a PEF, jointly with KTB Networks, and actively invested in small and medium enterprises with promising growth potentials but currently experiencing financial difficulties.

Secondly, large sized institutional investors, including public funds, are still showing less aggressive attitude in investing in PEFs. In addition, the market system restricts insurance companies from entering to PEF market. There aren’t too many big domestic investors who can invest in PEFs, other than banks and financial institutions, public funds, and some of general corporations. Most of domestic PEFs are yet to be evaluated for their performances and there is no success case produced yet. Therefore, it seems like potential investors such as public funds are holding back their decisions to invest in PEF at least until some tangible investment achievements are produced. On the other hand, insurance companies are prohibited from making investment in PEFs because PEF is excluded from the type of companies allowed as subsidiaries of insurance companies (15% or more shares of such companies can be possessed upon the approval of Financial Services Commission) until the Revision of Enforcement Decree of Insurance Business Act is enacted.

Thirdly, the analysis on PEF’s investment examples as of the end of 2005 shows that the number of investment cases in which PEFs has participated as financial investors is far greater than the number of cases in which PEFs has participated as strategic investors. The reasons for PEFs to make their investment in relatively safe manner like this are; 1) limited partner’s tendency to heavily prefer safety, and 2) lack of general partners with rich experience in business M&A. The majority of current PEF investments are focused on financial investments which depend on the controlling shareholder and the buyback option. Such trend is caused by the domestic M&A market condition which makes it difficult for the investors to sell the companies when they make strategic investments. In other words, domestic PEFs seems to attach more importance to the return on investment, instead of making the best out of the original intents to raise the corporate values and promote M&A market.

Fourthly, there are hardly any PEF who is interested in taking over large sized financial institutions such as insurance companies. This seems to be the case because there are difficulties in raising funds that are big enough to take over financial institutions and also there are restrictions at the systems level that are related to takeovers and buyouts of financial companies. For instance, there is a regulation that requires the PEF to maintain equity capitals that are 4 times of the money invested and regulations that limits the amount of financing by debt, when it tries to buyout a financial institution. Such regulations practically make it impossible for any PEF to takeover a financial institution, unless it possesses equity capitals in addition to the invested money.

Ⅳ. The roles and problems of PEF as a method to bolster company workouts

Recently, PEF has emerged as a key player in the company workout scene. Such trend is caused by increased number of companies with insufficient liquidities while the capital sources are gradually shrinking since the global financial crisis. As a matter of course, much attention is placed on the cash of PEF which were previously secured by public funds and banking circles.
Yusung Min, the president of Korea Development Bank, recently announced that the bank would utilize its PEFs to purchase distressed companies that are offered for sale as a part of company restructuring efforts and make profits by reselling such companies in a several years. In addition to such announcement, the bank says that its policy is to purchase such companies at prices higher than current market values by adding premiums for management rights and give preemptive rights to the original owners when PEF resells the companies. The bank is basically saying that it would bail out the groups who try to sell their subsidiary companies, which experiences liquidity crisis because of their own management failures, by taking over such companies without holding them responsible at all, and simply give them back when things have gotten better. This is just a perfect way to promote moral hazards. Especially, Korea Development Bank says it plans to increase the size of its PEF to some multi trillion won in order to take over subsidiaries or assets of other large business groups in addition to Dongbu Group. The bank says that this is workout through the market system, but in reality, it is nothing more than a form of public funding through a government owned bank called Korea Development Bank.

Structure of Corporate Workout PEF

According to media reports, the corporate workout PEF that is to be formed under the initiative of Korea Development Bank will be utilized to purchase subsidiaries of distressed companies and such distressed companies will be able to repay its debts by securing added liquidity with the sales proceeds. Media also reports that other financial investors, in addition to Korea Development Bank, will participate in such PEF and recruiting the investors would become relatively easy by guaranteeing certain profits to the investors. On other side, PEF says that it will purchase the companies at prices which are 20~30% higher than the market values by adding premiums for management rights and give preemptive rights to selling parties so that they can repurchase their subsidiaries when the market conditions get better in the future. It also plans to sell the purchased companies to third parties if the original owners of the companies decide not to exercise their preemptive rights. In addition, the sales proceeds from such transactions would be shared with the original owners according to the bank.
If, in fact, a corporate workout PEF with this kind of structure is established, all interested parties except for Korea Development Bank would never experience a loss in such business transactions. The financial investors of the PEF will be guaranteed with certain profits and the seller (the original shareholder) will receive premiums for management rights and have rights to exercise call options in the future. In the end, Korea Development Bank is the only one who can experience either a profit or a loss according to the selling price determined by exercise of right of first refusal or the sharing of the proceeds to a third party.

Problems of Corporate Workout PEF of Korea Development Bank

Recently, PEF has been raised as an efficient tool for workout. The big concern, however, is that the discussions for the most important aspect called profitability are being hardly made. Whether it takes a form of buyout or NPL, the demand for PEF to play a role of driving force for workouts are becoming greater, whereas discussions on how much of profit can be generated from such investment are not taking places. If this continues, PEF will eventually be restricted from seeking profits, where it is the ultimate objective of PEF.

In fact, an overwhelming opinion that PEF shall take a leading role in workout trades is being actively suggested. But, the actual blueprint which details the investment structure, the purchase price and the expected profits for individual companies for sale is not being drawn up clearly.

Yusung Min, the president of Korea Development Bank, recently announced that the bank would utilize its PEFs to purchase distressed companies that are offered for sale as a part of company restructuring efforts and make profits by reselling such companies in a several years. In addition to such announcement, the bank says that its policy is to purchase such companies at prices higher than current market values by adding premiums for management rights and give preemptive rights to the original owners when PEF resells the companies. The bank is basically saying that it would bail out the groups who try to sell their subsidiary companies, which experiences liquidity crisis because of their own management failures, by taking over such companies without holding them responsible at all, and simply give them back when things have gotten better. This is just a perfect way to promote moral hazards. Especially, Korea Development Bank says it plans to increase the size of its PEF to some multi trillion won in order to take over subsidiaries or assets of other large business groups in addition to Dongbu Group. The bank says that this is workout through the market system, but in reality, it is nothing more than a form of public funding through a government owned bank called Korea Development Bank. In the end, the workout PEF will only become a form of public funding through Korea Development Bank, in which the tax money paid by ordinary citizens are used to revamp distressed companies. This has a serious problem of typical moral hazards in which the managements and shareholders who actually caused such management failures and the creditors who failed to execute their supervisory duties are indemnified from their liabilities.

In addition, this kind of structure has critical flaws that the profit distributions and the burdens for losses are highly imbalanced and it is worried that such circumstances can seriously impede potentials to develop a self supporting workout schemes in which a reasonable sales and purchase price can be found under the principle of self responsibility. It is practically impossible for a workout market led by private sectors to be established under the circumstance in which a government owned bank takes up all burdens for losses.

There is no significant difference between this workout PEF of Korea Development Bank and the PPIP (Public Private Investment Program) of United States, which is a way of relieving distressed assets through public funding. Therefore, the same criticisms which were raised by Professor Stiglitz and Krugman towards PPIP apply here as well. On March 23, the US Department of Treasury, FDIC, and FRB jointly made an announcement for PPIP. The PPIP is largely divided into two sectors, the Legacy Loans Program and the Legacy Securities Program, according to the natures of distressed assets in trouble. Between the two programs, LLP (Legacy Loans Program) is to be jointly operated by the Department of Treasury and FDIC. The two organizations will form a pool of assets with private investors to purchase outstanding loans owned by financial institutions. If a private investor were to purchase a loan with face value of 100 dollar at a price of 84 dollars through an auction, each of the Treasury and the private investor would provide equity capital of 6 dollars to make 12 dollars and the remaining 72 dollars would be funded by debt financing under the guarantee of FDIC. Here, the PPIF leverage will not exceed 6 to 1 debt to equity ratio. Under this structure, the private investors would always make profits since FDIC guarantees the debt of PPIP, where any losses would be primarily covered with the tax money. The distortion effect of profit and loss structure of PPIP participants and its subsequent incentive structure are practically identical to that of the workout PEF of Korea Development Bank. PPIP of United States is a structure which transfers the wealth from the citizens to the shareholders of banks and private investors, and the structure of workout PEF of Korea Development Bank also causes the shift of wealth from the citizens to the controlling shareholder of selling corporation and the financial investors.

Ⅴ. System Improvement Efforts

According to the Financial Services Commission, it has decided to amend the Capital Market and Financial Investment Business Act and lift much of the restrictions placed on PEF in order to bolster market friendly workouts. Private Equity Funds that are designed to stabilize corporate finances are expected to be launched as early as the end of this year. Currently, PEFs are restricted by law to only make investments with specific objectives of acquiring management controls. In addition, PEFs will be allowed to invest more than 50% of its assets in stocks and real estate properties, as well as business rights and non-performing loans (NPL) owned by companies. This is to make PEFs to take responsibility of one sector of corporate restructurings.

Difference between Current PEF and PEF for Stabilization of Corporate Finances

Classification Current PEF PEF for Stabilization of Corporate Finances
Company to be invested No restrictions Companies which need corporate finance restructuring
Management objective Investment with objective of acquiring management control, Investment must be made to purchase 10% or more of stocks issued by subject company, More than 50% of total assets must be invested in stocks Investment can be made in stocks, BW, NPL and others, regardless of acquisition of management control
Debt Financing Limited to 10% of total assets, *SPC debt financing: within 200% Limited to 200% of total assets, *SPC+PEF debt financing: within 200%
Disposal of Stocks Prohibited for 6 months No restrictions
Loans and Pledging Guarantees Prohibited No restrictions

According to the amendment proposal, the restriction on investment objectives of PEF will be eliminated to attract the companies who have been reluctant to seek investments from PEFs because of the requirement to forfeit their management controls. Distressed companies are provided with opportunities to overcome temporary liquidity crisis without having to hand over management powers. It is also expected to allow PEFs more room to maneuver by being able to make financial investments in smaller scales without taking over the burden of management. PEFs can also invest more than 50% of their assets in real estate properties, NPLs and other matters associated with companies subject to restructurings. Current system requires PEFs to invest 50% or more of their assets in acquiring stocks, but in the future they can just make investments in other areas such as NPLs without being required to purchase stocks, with an exclusion of financial institutions, such as banks, insurance companies, mutual savings banks, and financial holding companies, from the subject of investments. The restriction for disposal within a period 6 months will also be omitted to allow short term investments. The limit for debt financing which currently is 10% will be increased to 200%. The government and the ruling party also agreed to allow ‘private equity funds for stabilization of corporate finances’ in a form of public subscription fund which are allowed to invest in stocks of companies with total assets below 5 trillion won or bond with warrants. This fund must be listed and traded in the stock market, and repurchase is prohibited for a period of 3 years.

The most recent amendment proposal receives positive remarks for removing much of restrictions and broadening the range of investments. However, the positive system which regulates the areas of investments is still kept in place and this is something that needs to be improved further in the future. In cases of foreign countries, the investment areas of PEFs are rarely restricted since most places employee the negative system.

Group Member

Oh, Jae-kyung (research)
Son, Joo-kyung (research)
Kim, Jang-Hyung(translation)
Lee, Hye-jin(editing)
Ha,Se-young(editing)
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