Contributed By Lee & Ko
Joint investments between private equity funds and strategic investors are on the rise in South Korea. This trend stems from the amendment to the Financial Investment Services and Capital Markets Act (FISCMA) in 2015 allowing for (i) the incorporation of multi-level special purpose companies for investment purposes and (ii) investment by strategic investors into special purpose companies. As joint investments with strategic investors came to the fore, funds that had previously focused on buyout transactions have also recently begun to invest as minority financial investors.
As private equity funds invest in start-ups like venture capital, and venture capital invests in large scale like private equity, there is a blurring of the boundaries between private equity and venture capital in the M&A market in Korea.
Due to recent struggles with inflation and the resulting rise in interest rates, there has been a sharp decline in the liquidity that had been overflowing in the market until the past year. In this way, there has been a slowdown of fund formation and M&A activity involving funds, generally.
The FISCMA was amended on 20 April 2021 and this amendment took effect on 21 October 2021. Under the amended FISCMA, private funds are categorised as “general private funds” or “institutional private funds” and private equity funds under the previous law transitioned into institutional private funds. Both types of private funds are allowed to invest freely, but the scope of investors for institutional private funds is limited to qualifying institutional investors, including financial companies and listed companies meeting certain requirements, and the offering procedure for general private funds, which are open to individual and general investors, has become more rigorous.
As the investors that can take part in institutional private funds are now limited to financial companies, listed companies meeting certain requirements and other institutional investors, market entry of newly formed general partners that do not have ready access to such investors has become more difficult.
For the purposes of this article, references to private equity funds are generally in reference to private funds that are categorised as “institutional private funds”.
The primary regulators relevant to private equity funds and transactions involving such funds are the Financial Services Commission and the Financial Supervisory Service since funds established under the FISCMA bear a duty to continuously report matters ex post to the Financial Services Commission and/or the Financial Supervisory Service from the time of incorporation/establishment to the time of liquidation, in accordance with the applicable laws. The subject of these reports consists not only of the fund’s total commitment and contribution amounts, but also the identities of the target companies in which the funds made investments.
On the antitrust regulatory front, as the legal entity form of funds established under the FISCMA is typically a company, the establishment of such funds will in most cases require approval of business combination from the Korea Fair Trade Commission (KFTC). On the other hand, when private equity funds established overseas seek to offer equity to Korean investors, they must undergo a registration process with the Financial Services Commission and the Financial Supervisory Service in advance.
As to anti-bribery, sanctions or environmental, social and governance (ESG) issues, there is a growing trend among overseas funds to conduct separate due diligence on the target’s compliance issues prior to consummating the transaction. To the extent any shortcoming is found in the course of such diligence, the common approach is to introduce new policies or demand enhancement of the existing policies of the target.
There are three main regulatory issues that impact transactions involving private equity funds.
First, if the target is a listed company, private equity funds, like other market participants, bear disclosure obligations on various matters to the Financial Services Commission, the Financial Supervisory Service and/or the Korea Exchange (KRX). Furthermore, although this rarely occurs in Korea, if a private equity fund intends to invest by way of a tender offer, it must proceed in compliance with the procedures prescribed by the FISCMA.
Second, when acquiring more than a certain equity stake in a target that is above a certain size, a private equity fund must obtain approval on business combination from the KFTC. While this regulation also applies to other market participants, in the case of private equity funds, the anti-competitiveness is determined based on the entirety of the fund’s portfolio companies.
The last regulatory issue applies only to overseas funds. Such funds bear an obligation to report on the acquisition of target shares to the Korea Trade-Investment Promotion Agency, foreign exchange banks and/or the Bank of Korea under the Foreign Exchange Transaction Act or the Foreign Investment Promotion Act. Furthermore, these overseas funds may be restricted from investing, or limited in their shareholding ratio, in certain industries in which foreign investments are statutorily barred or regulated, such as broadcasting or telecommunications. In addition, if the target possesses “national core technology” as designated under the Act on Prevention of Divulgence and Protection of Industrial Technology, the overseas fund must obtain prior approval from, or file a report in advance with, the Minister of Trade, Industry and Energy in order to acquire over a certain percentage of the target’s shares.
In the course of M&A in Korea, it is standard practice to conduct a full-blown due diligence, unless the target is very small. Information is usually provided through a virtual data room and management presentations/break-out sessions, as well as periodic requests for information (RFIs) and written Q&As, among other platforms. While the depth of review differs on a case-by-case basis, the legal due diligence is generally conducted without a materiality threshold.
For private equity investors, the focus of legal due diligence does not stray significantly from that of a corporate buyer and due diligence is conducted in all areas including corporate/securities, equity ownership/dilution, material contracts, licences/permits, employment/labour and litigation, etc. However, in the case of private equity investors, it is more common to perform separate due diligence on compliance matters (anti-bribery and corruption/AML/sanctions) or ESG issues.
Although vendor due diligence is generally not a common feature, in comparison to transactions involving a typical corporate seller, transactions involving private equity sellers are more likely to feature vendor due diligence. While there may be instances where advisers attach a liability cap to the vendor due diligence reports upon providing credence thereto, the status quo is non-reliance. This also applies to buy-side diligence reports.
Most private equity funds are acquired through private treaty sale and purchase agreements. Although auction sales are often held for larger-scale M&A, privately negotiated transactions are more common across the board. Tender offers, on the other hand, are rarely carried out in Korea.
There are no notable differences between the terms of a privately negotiated transaction and the terms of an auction sale. However, it is often the case in auction sales that seller-friendly terms (eg, material adverse effect (MAE) bring-down or warranty and indemnity (W&I) insurance) are agreed upon from a closing certainty or seller’s clean exit perspective.
In Korea, although private equity funds sometimes become party to the transaction, it is more often the case that a special purpose company that the fund incorporated for such purpose (investment purpose company, or IPC) becomes involved in the acquisition documentation. In order to limit liability exposure, funds are expected to maintain the current deal practice of utilising IPCs for acquisition documentation purposes. Inbound investments by overseas funds are also structured in the same way by utilising IPCs.
Financing of Private Equity Deals
For private equity funds under the FISCMA, the deals are normally financed by contributions from the fund investors. For funds that apply a leverage strategy, the IPC may additionally secure financing, but under the current FISCMA, the leverage ratio thereof is restricted to 400%. As there is judicial precedent holding that providing assets of the target as security for the acquisition financing of the IPC may be deemed to be a breach of the fiduciary duty of the target’s directors, acquisition financing is not secured by the target’s assets under Korean law. Instead, acquisition financing is secured by the assets of the borrower, the IPC, such as the target shares that the IPC is to acquire through the deal.
Equity Commitment Letters
Private equity funds, incorporated pursuant to the FISCMA, can only be established as a limited partnership company under the Korean Commercial Code (KCC). Under the KCC, a general member of a limited partnership company bears unlimited liability for the debts of the limited partnership company, and a limited member thereof bears direct liability up to its amount of commitment to the limited partnership company. Accordingly, if the fund were to directly become a transactional counterparty (eg, as a buyer or investor in the M&A context), equity commitment letters from the members would not be necessary. However, there are instances where management companies obtain commitment letters from potential members of a fund to secure negotiation rights on transactions (eg, to become the preferred bidder in an auction) prior to the incorporation/establishment of the fund.
For overseas funds, equity commitment letters and debt commitment letters are provided in most instances.
Typical Private Equity Deals
In the past, private equity funds favoured control deals (eg, buyouts), but minority-stake investments have become more frequent as of late. In particular, large-scale private equity funds and overseas funds have been very active in conducting pre-IPO investments and other minority investments.
In buyout investments, it is uncommon for a consortium of private equity sponsors to collectively enter into a transaction, while, on the other hand, in the case of minority investments, it is relatively more common to find a consortium of private equity funds to make a joint investment.
In Korea, co-investment by strategic investors, who seek to acquire control over the target in the future, alongside private equity funds is commonplace and under the FISCMA, investment by such strategic investors in the IPC is permitted.
The articles of incorporation of private equity funds under the FISCMA often include provisions on granting priority rights to the limited partners to make joint investments with the fund, when it is difficult for such funds to unilaterally make investments given the size of the investment opportunity, and large institutional investors (eg, the National Pension Service) actively take advantage of these joint investment opportunities.
Locked box, completion accounts and fixed prices are all used as mechanisms for consideration in M&A transactions but the predominant form is fixed price. In cross-border deals, completion accounts are also in wide use but the domestic M&A market is also seeing more deals with completion accounts as well.
While there are deals involving earn-outs, it is not a common feature of private equity transactions. In particular, an earn-out is rarely used where a private equity fund is the seller, since such funds, especially funds incorporated for the purpose of investing in a single target investment company, are focused on completing distribution and liquidation shortly thereafter. Apart from the above, there are no notable differences between private equity funds and corporate investors or sellers in determining the consideration mechanism and level of protection in relation thereto.
As mentioned in 6.1 Types of Consideration Mechanisms, locked-box consideration structures are not commonly used in private equity transactions but when used, there have been both instances of interest charged on leakage and not charged on leakage.
It is not typical to have a dispute resolution mechanism in place for a locked-box or completion accounts consideration structure and typically the parties to private equity transactions are obliged to adhere to the decision of the designated accounting firm.
The typical level of conditionality in private equity transactions is mainly as follows and does not differ from general M&A transactions:
Limited conditions to regulatory conditions are not typical and financing conditions are rarely found in acquisition documentation. Third-party consent conditions are included on a case-by-case basis, but infrequently and in the case of a change of control provision in contracts with key customers, the deal may be conditional upon procuring the relevant consents; otherwise, termination of such contracts may be deemed to be an MAE. Shareholder approval is included as a condition (only) when legally mandated (eg, transfer of all or a material part of a business).
It is not common for a private equity-backed buyer to accept a “hell or high water” undertaking in deals with a regulatory condition. However, it is sometimes accepted in the bidding process by a fund investor that has no specific competing business in its portfolio to gain an advantage over the other bidders.
In private equity deals, break fees or reverse break fees are ordinarily not used. If break fees are prescribed in the acquisition documentation, however, reverse break fees are generally also prescribed therein.
When prescribing break fees, the Korean Civil Code estimates the fees to be the liquidated damages and if the court finds that such amount is excessive in comparison to the actual damages, the fees can be reduced. Therefore, most documentations deem the break fee to be a monetary penalty because although the Korean Supreme Court has held that even in the case of a monetary penalty, the courts can partially invalidate the amount, the monetary penalty must be “in contravention of public order and standards of public decency” to qualify for such reduction.
Apart from termination by mutual agreement, the typical circumstances of termination in private equity transactions are mainly as follows and do not differ from those of general M&A:
In transactions in which a private equity fund is the seller, and, in particular, in which such fund was solely established to invest in the target company, the seller’s interest lies in prompt distribution and liquidation, and, as such, it typically rejects any additional allocation of risk post-closing (ie, clean exit). Previously, funds achieved this purpose by bearing liability and providing an escrow for breach of representations and warranties for a short term. More recently, it has become common practice for private equity sellers to limit their liability by demanding the buyer to subscribe to W&I insurance and only bearing liability in the case of fraud.
In transactions where a private equity fund is the buyer, there are no notable differences with transactions involving general corporate buyers.
As explained in 6.8 Allocation of Risk, private equity sellers normally provide general warranties, in the same manner as corporate sellers, but attempt to limit liability by requiring the buyer to subscribe to W&I insurance.
For the same reasons as provided in 8.1 Equity Incentivisation and Ownership, it is not customary for the management team to hold shares, but where a management team is selling shares it holds, it normally provides the same level of warranties to the buyer as the private equity seller.
To limit liability for warranties, survival periods, de minimis, basket and cap are all utilised in documentation and anti-sandbagging is generally a fiercely negotiated point. Survival periods for mid to large-size deals that proceed via auction bids are typically one and a half to two years, with longer periods usually granted for specific warranties on tax, labour, environment and compliance. Regarding quantum limitations, the amounts can vary from deal to deal but rarely do caps go beyond 10%. Finally, on limitation on liability for known issues, while full disclosure of the data room as an exception to the warranties was not commonly accepted in the past, recently there has been an uptick in sellers who make such demands in conjunction with anti-sandbagging.
As examined in 6.8 Allocation of Risk, private equity sellers previously sought protections by bearing liability for breach of representations and warranties for a short term and having an escrow in place to back such obligations, but recently, private equity sellers have more often taken protection by making the buyer subscribe to W&I insurance and only bearing liability in the case of fraud. W&I insurance has become commonplace in deals with private equity sellers in the past several years.
However, where the seller is an overseas fund, the buyer must withhold capital gains tax but because the calculation of the withholding amount is based on the information provided by the seller, if tax is later collected from the buyer, the seller must indemnify the buyer thereon. Although insurance companies now offer products that cover liabilities stemming from capital gains tax, such risk is most commonly covered by a guarantee or an escrow for credit reinforcement provided by the overseas fund or its parent.
Litigation in connection with private equity transactions is not common, but occurs from time to time. The most commonly litigated provisions are those on indemnification pursuant to breaches of representations and warranties, but disputes also occur in connection with shareholders’ agreements where a private equity fund is the minority investor (eg, disputes over put options following failure to conduct an IPO).
Public-to-privates in private equity transactions do take place, but they are highly uncommon.
In the case of listed companies, the FISCMA stipulates that holders of 5% or more of the shares in listed companies must disclose various matters, including the quantity and class of shares, security provision status, unit prices at the time of acquisition and disposition, and counterparties in the acquisition and disposition transactions. Here, the 5% is calculated by aggregating the shares held by a shareholder and its specially related parties (including affiliates and joint holders). On the other hand, shareholders of an unlisted company do not bear such obligations.
Moreover, shareholders of listed companies holding 10% or more on an individual basis must disclose their shareholding status. Holders of 5% or more of the shares must report on the change to shareholding where there is a change of 1% or greater to the shareholder’s shareholding ratio. Holders of 10% or more of the shares must report on the change to the number of shares held where the change is in relation to 1,000 shares or more.
Unlike certain other jurisdictions, there are no mandatory offer thresholds applicable for transactions acquiring a certain equity ratio or control in Korea. The FISCMA, however, stipulates a mandatory offer to be triggered where a buyer and its affiliate(s) hold 5% or more of the shares issued by the target by purchasing shares from ten or more persons within a six-month period. In such cases, even if the transactions were not made at a stock exchange, they are deemed over-the-counter unless they were made via blind auction.
In most cases, the consideration is cash.
In Korea, listed company transactions are rarely conducted via a tender offer. Most Korean listed companies have a controlling shareholder and M&A transactions on such listed companies are conducted by purchasing shares over the counter from the controlling shareholder. There have been rare exceptions of the buyer making a tender offer on the remaining shares following the above-mentioned transaction and going private. Over-the-counter transactions with a controlling shareholder include the same conditions as a general private M&A and, as such, financing is rarely included as a condition and the offer conditions cannot include those beyond the limited conditions allowed under the law (eg, certain portion of the shares to be tendered).
Even if a bidder does not obtain 100% ownership of a target, if it obtains sufficient shares to affirmatively resolve shareholder resolutions, the bidder can acquire control through director appointments. Upon obtaining controlling shares from the controlling shareholder of a listed company and subsequently obtaining 95% or more of the shares via a tender offer, the buyer can apply for voluntary delisting. In such case, the purchaser must provide another opportunity to the remaining shareholders on settlement trading following the delisting.
On a related note, under Korean law, a controlling shareholder holding 95% or more of the shares in a company may cash out the 5% shareholders by undergoing a certain procedure, not commonly used in practice, but this process can be used in obtaining 5% or less of the shares following the voluntary delisting.
As discussed in previous responses, obtaining the shares of a listed company via a tender offer is rare in Korea.
Hostile takeover offers are not prohibited, but rarely take place in Korea. However, the trend may change, since there has been a recent emergence of private equity funds advocating for shareholder activism.
Incentivisation of the management team is a common feature of private equity transactions and the incentive can take the form of both cash and equity. Equity incentivisation by equity-linked compensation is commonly found in private equity transactions.
In general, equity ownership is not common for the management team and even if there is such ownership, the ratio thereof is very low. However, it is common for a private equity fund to (i) purchase most of the equity from the founder of an unlisted company with the founder, holding some of the remaining equity, required to continue to manage the company or (ii) require the founder/seller of an unlisted company to reinvest in the fund with a lower priority in dividends compared to those of other investors while continuing to manage the company.
For the reasons raised in 8.1 Equity Incentivisation and Ownership, it is rare for managers to hold equity and even if there is equity ownership, it is generally not structured as sweet equity or institutional strip. Equity tends to be granted to management by the grant of stock options or cash incentives that are linked to performance and/or future exit considerations of the private equity buyer.
For the reasons provided in 8.1 Equity Incentivisation and Ownership, there are no typical leaver or vesting provisions. In the case of stock options, there is a statutory requirement of being in service for at least two years and generally the exercise period is determined to begin two to three years from the grant date until the fifth year therefrom. In the case of equity–linked compensation such as restricted stock units (RSUs), it often takes the structure of vesting over the course of around five years depending on the performance of the company or the individual.
It is customary to agree to restrictive covenants on non-compete and non-solicit undertakings during the term of employment and for a certain period following resignation. However, there is no clear standard on the length of such period under Korean law.
As the non-compete undertaking can raise an issue concerning infringement of the constitutional right to a profession, the risk of invalidation of such undertaking can be minimised where the consideration corresponding to the non-compete undertaking can be proved and the undertaking is not in place for an excessive duration. Although this undertaking is determined on a case-by-case basis, it is understood that the validity thereof is likely recognised for six months to one year and the validity of any period exceeding one year may not be so readily recognised.
For the reasons provided in 8.1 Equity Incentivisation and Ownership, manager shareholders generally do not enjoy any protection other than tag rights nor carry any substantive influence over the exit or control of the private equity fund. However, depending on the equity ratio and importance in company business of the manager shareholders, matters of protection or influence can be settled differently. If the manager shareholder holds a high equity ratio and is key to the company business, rights akin to a minority shareholder’s rights in a joint venture could be negotiated for the manager shareholder.
Private equity fund shareholders with majority shares tend to exercise de facto control over the portfolio companies by appointing directors.
On the other hand, where a fund invests as a minority shareholder, it is typical for such fund to enter into a shareholders’ agreement with the controlling shareholder and obtain the right to appoint at least one person to the board of directors, veto rights over major management matters and information rights.
With respect to the veto rights, while they vary case by case, funds tend to demand veto rights over change to capital or governance structure or transactions concerning assets, capital expenditure (CAPEX) or loans, or related-party transactions, over a certain monetary threshold. However, if the largest shareholder seeks to consolidate its accounts with those of the target company, the consultation on veto rights tends to centre on pure minority protection rights, excluding matters on business plans, budgets, the appointment of representative directors and other ordinary business activities (as veto rights on such operational matters granted to the fund could be seen as stripping control of the largest shareholder, thereby undercutting its efforts to consolidate accounts with the target company).
The Korean Supreme Court interprets the circumstances where the corporate veil may be pierced very narrowly and where the portfolio company is operated in compliance with the general procedural requirements of corporate governance, the courts are very hesitant to do so.
In one case, the court held that it is natural for overlaps to exist between the personnel of a parent company and those of its subsidiaries. The mere fact that the executive management team of the parent company holds similar positions in its subsidiaries, or that the parent company exercises control by virtue of owning all of the issued shares of its subsidiaries (or even that the subsidiaries’ businesses and operations have expanded without their capital being increased) are not sufficient reasons to view such relationships as abuse of separate legal personalities (ie, corporate veil) in relation to obligations owed by subsidiaries to creditors. Something more fundamental is required for such abuse to be seen, such as the total absence of a subsidiary’s independent existence or will to operate whereby its operations are essentially run by the parent company one and the same as part of the parent company’s own business.
In particular, it must be objectively apparent that the business and assets of the parent company and those of its subsidiaries, including as to external commercial transactions, cannot be distinguished or clearly separated. In addition, there must be a subjective element present, namely an intention to avoid the application of law to the parent company or the intention to abuse the corporate veil by utilising the subsidiaries as a purely credit-proofing measure in dealing with creditors.
While Korean private equity funds rarely impose their own compliance policies as of yet, there is a growing trend among overseas funds conducting separate due diligence on the target’s compliance or ESG issues prior to consummating the transaction and if any shortcoming is found in the course of such diligence, either introducing its compliance policies thereon or demanding enhancement of the existing policies of the target. If there are red-flag issues or risk uncovered in the course of due diligence, such demands may also be made as closing conditions and/or pre and post-closing open-ended covenants.
The actual holding period for private equity transactions before the fund exits varies widely, but in the case of private equity funds incorporated under Korean law that were specially incorporated for investment in a certain target, the termination period is around five to six years. In the case of a blind pool fund, the investment period is three to four years, with a seven to eight-year termination period. In consideration of the above, the ideal holding period for the management companies or the investors is likely around five years. However, when the fund makes a minority investment in a target that is expected to go public shortly thereafter, the target is closer to two to three years until the exit by way of an IPO.
Common Forms of Private Equity Exit
Until several years ago, (while there were no explicit regulations), the KRX did not allow the listing of companies in which the largest shareholder was a private equity fund and, accordingly, the exit strategy of private equity funds was limited to a private sale. However, today, the KRX allows IPOs of such companies and IPO precedents are building, with a growing number of funds targeting an IPO as their key exit strategy. This is most applicable to investments to obtain control of the target because for minority investments in a target expected to conduct an IPO in the near future, the exit strategy becomes more complex, with (i) partial sales of shares pre-IPO, (ii) sale during the IPO and (iii) sale of the remaining shares in a post-IPO block deal.
Reinvestment upon Exit
Generally, private equity sellers, incorporated under Korean law, do not reinvest upon exit.
It is not typical for a private equity fund holding a controlling stake of 50% or greater to also hold drag rights against the minority shareholders for its exit. However, where the existing largest shareholder or management remains as a minority shareholder, there are instances of the fund seeking drag rights and, in turn, the minority shareholders seeking tag rights. On a separate note, in an M&A transaction involving a consortium between private equity and a strategic investor, the private equity fund often seeks drag rights that can force the strategic investor to sell its shares at the time of the fund’s sale of its shares carrying management rights.
Conversely, where the fund makes a minority investment, it often seeks drag rights against the controlling shareholder in preparation of any potential failures to exit via an IPO or other primary exit mechanisms (eg, failed put option).
In the scenarios presented in 8.1 Equity Incentivisation and Ownership where the founder remains as a controlling shareholder, or where the private equity fund makes a minority investment, it is typical practice for the minority shareholder to hold tag rights in the case of the controlling shareholder’s disposition of shares that carry management rights.
Under the KRX regulations, a mandatory lock-up obligation is imposed for six months where shares were acquired from a company conducting an IPO, or the largest shareholder and its affiliates thereof, within one year from the date of the company’s application for preliminary examination for listing.
However, if the relevant market is the KOSDAQ market, not the KRX market, the mandatory lock-up period is shortened to one month for private equity funds even if the relevant acquisition was made as above.
Finally, “relationship agreements” are rarely executed by and between the private equity seller and the target company.