Joint investments between private equity funds and strategic investors are on the rise. 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, we have seen a sharp decline in liquidity that was overflowing in the market until 2021. In this way, there has been a slowdown of fund formation and M&A activity involving funds, generally. With that said, there has been a modest uptick in these activities over the course of the past twelve months, with liquidity largely coming by way of equity commitments as leverage continues to be hampered by high interest rates.
The FISCMA was amended on 20 April 2021 and such 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 are 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, have become more rigorous.
As investors that can take part in institutional private funds are 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 have become more impenetrable.
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). That said, on June 29 2023 a cabinet meeting of the Presidential office has approved the amendment of the Monopoly Regulation and Fair Trade Act pursuant to which the formation of private equity funds will no longer be subject to the business combination report and it is likely to be passed by the National Assembly. 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 conducting 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. One of such requirements is to furnish proof of funds sufficient to satisfy accepted offers prior to the commencement of the tender offer. This, in practice, is burdensome for private equity funds due to the nature of the timeline of their capital calls (ie, within a certain period leading up to closing). In the recent Osstem Implant transaction, a landmark tender offer deal in South Korea, Lee & Ko furnished such proof of funds to regulators in the form of letters of commitment (which led to the regulators later revising the relevant regulations to expressly allow such form of proof). In this way, investments by way of tender offer has become a considerable option for private equity funds.
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 telecommunication. 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 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 case by case, 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 or fact-books, particularly in the context of an auction sale. 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. However, from 2023 there have been several high profile tender offers involving private equity buyers such as MBK and Unison Capital Korea (UCK) Partners’ tender offer of Osstem Implant, IMM PE’s tender offer of Hanssem, and Hahn & Company’s tender offer of Lutronic.
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, 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 investors of the fund. For funds that apply a leverage strategy, the IPC may additionally secure financing, but under the current FISCMA, the leverage ratio thereof is restricted at 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 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 that are blind funds in possession of considerable assets under management or dry powder are not often required to furnish equity or debt commitment letters. Apart from such instances - particularly if project funds or other debt financing sources are employed - equity or debt commitment letters are more likely to be requested from these blind funds. Furthermore, in the Korean M&A market, a contract deposit representing 5-10% of the purchase price is commonly requested by the sell-side, in which case private equity buyers often satisfy this requirement by furnishing equity or debt commitment letters.
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, direct and/or indirect co-investment by strategic/corporate investors who seek to acquire control over the target in the future and to make financial gain, alongside private equity funds is commonplace. Under the FISCMA, investment by such strategic investors in the IPC is also 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.
Fixed prices with or without a locked-box structure and completion accounts are all used as mechanisms for consideration in M&A transactions but the predominant form is fixed price without a locked-box mechanism. 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.
Rollover structures are common in transactions involving individual founders of the target who hold considerable equity stakes (eg, the largest shareholder) where their shares in the target, along with management and control rights, are transferred to private equity funds. Following this, the founders acquire a minority stake in the fund’s capital (eg, 20-30% of sale proceeds).
While there are deals involving earn-outs, it is not a common feature of private equity transactions. For example, 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. Reverse interest on leakage is not common.
Dispute resolution mechanisms featuring a dedicated expert are commonly found in locked-box or completion accounts consideration structure and typically the parties to private equity transactions are obliged to adhere to the decision of these dedicated experts. It is common for a designated independent accounting firm to act as the dedicated expert on disputes for locked-box and completion accounts consideration structures. Consideration structures which take into account the outcome of certain contingent events or investigations (eg, environmental studies of real property) may involve a dedicated expert of the relevant field (eg, environmental consultants).
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 is 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. There is often a distinction between merger-control and foreign investment conditions where, unless the underlying target's assets comprise of national core technology resulting in greater foreign investment scrutiny, the “hell or high water” undertaking typically relates to matters of merger-control.
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.
The triggers and volume of break fees varies greatly from one deal to another, but a common trigger in deals involving private equity funds is when a party fails to consummate closing despite all closing conditions having been satisfied.
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 where a private equity fund is the seller, and, in particular, where the 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 above 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.
When prescribing to W&I insurance, the coverage often extends to both fundamental and general business warranties including tax warranties (for unknown risks), albeit the claims period for fundamental warranties would typically be for a longer duration. From time to time the buyer may be inclined to acquire a standalone tax cover to insure any potential liability (which is a known risk) resulting from the seller’s capital gains tax obligations (as discussed above), particularly if the seller is a foreign entity.
In the case of escrow or holdback amounts, there is typically no distinction between recourse for fundamental or general business warranties.
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).
Up until the first half of 2023, public-to-privates in private equity transactions have been highly uncommon. In the case of the Osstem Implant take-private transaction, which is currently in the process of delisting, the buy-side consortium comprised of MBK Partners and UCK Partners had undergone two tranches of tender offers in order to meet the minimum shareholding threshold for delisting. Market observers believe that a key component for success in this landmark transaction was that the tender offer price was equal across the board and all participants benefited from the management premium.
In a public-to-privates transaction, the involvement of the target and its board of directors is limited until the tender offer is completed. That said, the company plays a key role in holding meetings with shareholders and the board of directors during the delisting phase of the transaction. Relationship agreements between the buyer and the target are highly uncommon in Korea.
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 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 shares must report on the change to the number of shares held where the change is in relation to 1,000 shares or more.
In order to make a tender offer including private equity-backed bidders, one must first publicly disclose the tender offer and file a tender offer statement and a prospectus thereof, which includes the following:
The FISCMA 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 this case, even if the transactions were not made at a stock exchange, they are deemed over-the-counter unless they were made via blind auction.
The Financial Services Commission recently announced new revisions to the FISCMA during 2023, including a mandatory threshold for tender offers to secure more than 50% plus one share when proposing to acquire 25% or more of the shares of the target issuer. Private equity funds in Korea are closely monitoring this development.
In most cases, the consideration is cash. There are no minimum price rules applying to tender offers.
Until 2022, listed company transactions were 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. Until recently, 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).
From the first half of 2023, there have been several takeovers by private equity backed buyers of listed companies by tender offer. A financing condition is not legally permitted since the tender offer statement must be accompanied by a document substantiating the balance of deposits in financial institutions or any funds pooled, equivalent to or more than the amount required for the tender offer.
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 shares via a tender offer, the buyer can apply for voluntary delisting. In this 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 shares may cash out the 5% shareholders by undergoing a certain procedure, which is not highly utilised in practice, but this process can be used in obtaining 5% or less shares following the voluntary delisting.
There are no particular mechanisms for a private equity-backed bidder to achieve a debt push-down into the target following a successful offer. That said, it should be noted that Korean courts have ruled that putting up the target’s assets for collateral relative to the debt of the parent (eg, acquisition financing) is considered a breach of fiduciary duty of the target's board of directors. On a similar note, Korean courts have also found that merging the target following a successful offer with a highly leveraged parent may be considered a violation of such fiduciary obligations.
As discussed in previous responses, obtaining the shares of a listed company via a tender offer is rare in Korea.
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, caused to continue to manage the company or (ii) cause the founder/seller of an unlisted company to reinvest in the fund with a lower priority in dividend 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. 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 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. Such undertakings are often stipulated in employment contracts.
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, including anti-dilution protections.
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 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, like 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.
Common Forms of Private Equity Exit
Until several years ago, (while there were no explicit regulations), the Korea Exchange (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.
Although infrequent in practice, there are instances where a partial exit is accommodated through recapitalisation prior to the final sale and/or IPO of the target. Subject to individual circumstances of the target and the relevant private equity funds involved, it is often the case that the most preferred exit strategy will be employed, whether that be in the form of a private sale, IPO or recapitalisation, and it is uncommon to concurrently pursue a dual or triple track exit.
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. Although thresholds are not typically prescribed for tag rights (ie, prorated tag-along), change of control is a common threshold (eg, where 50% or more of the shares of the target are disposed by the controlling shareholder).
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.
As discussed under 10.1 Types of Exit, until several years ago the KRX did not allow the listing of companies in which the largest shareholder was a private equity fund, but today, the KRX allows IPOs of these companies, and private equity-led IPOs are no different.
Current Overview of Private Equity Funds in Korea
Private equity funds account for a significant share of the M&A market in Korea. In 2022, transactions involving funds constituted close to 31.7% of the overall M&A market, which was an increase from 2021 levels (29.6% of the overall M&A market) and levelled with 2019 levels (31% of the market). Of the 1,123 deals reported in 2022, 356 involved funds. In 2021, the aggregate transaction value of these deals (USD60.126 billion) represented 46.5% of the total combined value of all reported deals, including those not involving funds (USD129.25 billion). Although the proportion of reported deals involving funds significantly increased in 2022 (representing 34% of the total combined value of all reported deals), the aggregate transaction value of such deals (USD39.17 billion) dipped.
Earlier regulatory changes
The easing of regulations on private equity funds through the amendment of the Financial Investment Services and Capital Markets Act (FISCMA) following 2015 greatly contributed to the growth of private equity funds. At the time of the amendment of the FISCMA in 2015, the financial authorities significantly eased regulations by converting the prior registration scheme for private equity funds to an ex post reporting scheme and allowing strategic investors to invest in special-purpose companies established for investments and the utilisation of multi-level special-purpose companies. These regulatory changes provided the impetus for private equity funds to become one of the major players in the Korean M&A market.
Recent Trends in the Korean Private Equity Fund (PEF) Market
Joint investments between private equity funds and strategic investors are on the rise
This trend stems from the amendment to the 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.
Strategic investors’ growing familiarity with private equity funds
As joint transactions by private equity funds and strategic investors are growing, strategic investors are becoming better accustomed to transacting with private equity funds. Accordingly, there has been a growing number of cases where strategic investors do not demand deposits or monetary penalties from the private equity counterparties and such compromises are reflected in the relevant documentation.
Contraction in fund formation
Due to the sharp rise in interest rates, returns investors could have expected by investing in funds through leveraged finance have declined. In this way, there has been a global slowdown of fund formation and M&A activity involving funds, with deal volumes dropping by 4% as to the second half of 2022. As the M&A landscape within South Korea is not an exception to this global trend, the proportion of funds involved in M&A deals decreased from 41% to 32% in terms of deal volume, and from 47% to 34% in terms of deal value during the course of 2022.
Blurring of boundaries
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.
Overseas private equity
In particular, overseas private equity funds making inbound investments in Korea are displaying the following trends.
Recent Updates to the Regulations on Tender Offers
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. One of these requirements is to furnish proof of funds sufficient to satisfy accepted offers prior to the commencement of the tender offer, which in practice is burdensome for private equity funds due to the nature of the timeline of their capital calls (ie, within a certain period leading up to closing). In the recent Osstem Implant transaction, a landmark tender offer deal in South Korea, Lee & Ko furnished such proof of funds to regulators in the form of letters of commitment (which led to the regulators later revising the relevant regulations to expressly allow such form of proof). In this manner, investments by way of tender offer have become a considerable option for private equity funds.
Amendments to the Regulations on Private Equity Funds
Previously, the FISCMA distinguished private equity funds from hedge funds in the "private fund" category and allowed hedge funds to freely invest (except in the case of investments acquiring control over the target), while maintaining a complex regulatory matrix on permitted investment securities, methods and return periods for private equity funds. By way of example, private equity funds were only allowed to invest by participating in business management through the appointment of directors or investing in 10% or more of the shares of the investment target and were prohibited from investment by way of lending funds. Thus, the previous regulatory regime under the FISCMA had focused on the investment target and distinguished private funds thereby.
However, the FISCMA was amended on 20 April 2021 and the amended law 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 have transitioned into institutional private funds. Both types of private funds are allowed to invest freely, but the scope of investors for institutional private funds are 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, have become more rigorous. The most significant changes in the FISCMA amendment are therefore the change in regulatory framework from one categorising private funds based on the investment target to that of categorisation by type of investor, and the removal of restrictions on property management for private funds.
Consequently, from the above changes, the general partners operating private equity funds are able to structure the management of such funds in various ways and so-called acquisition financing funds and mezzanine funds are likely to appear in the market. In the past, as investment by way of loans was not viable, private equity funds were restricted from being granted put options from the counterparties selling shares in M&A transactions. The restrictions were put in place because put options, exercisable in the amount of the purchase price multiplied by a certain interest rate, were regulated by supervisory authorities as they were deemed to be loans in substance. However, under the amended FISCMA, all such restrictions on property management have disappeared.
Additionally, for institutional private funds, as investors that may take part in such funds are limited to financial companies, listed companies meeting certain requirements and other institutional investors, market entry by newly formed general partners that do not have ready access to such investors has become more difficult.
Under the current FISCMA, borrowing at the fund level is largely restricted and, as such, a private equity fund had to establish a special-purpose company to borrow funds and could not realistically borrow funds itself. However, the amended FISCMA has repealed the above restriction to allow for borrowing at the fund level.
Under the amended FISCMA, the number of investors that may invest in private equity funds has expanded from 50 to 100 and this expansion is interpreted as a regulatory easement.
Amendments to the Regulations on General Partners
The amended FISCMA additionally prescribes regulations on fund-managing personnel affiliated with the general partners to allow only those who are essentially in charge of the fund management duties at financial institutions or general partners to become fund-managing personnel. As the FISCMA to date had not specifically provided any restrictions on fund-managing personnel, the fund-managing personnel could consist of not only those essentially in charge of fund management, but also those related to the private equity fund’s investment target. For example, an unseasoned general partner seeking to form a project private equity fund to invest in a certain company may have those with industry experience in the target’s industry as fund-managing personnel as well. Pursuant to the amended FISCMA, such personnel can no longer become fund-managing personnel and only those directly responsible for the fund management may register as fund-managing personnel.
Additionally, regulations on general partners have been strengthened such that unlike in the past, where general partners were indirectly regulated by regulations on private equity funds, there are now various regulatory mechanisms that take direct measures for inspection on general partners under the amended FISCMA. This change likely reflects the intent of the Korean supervisory authorities to further tighten the supervision of general partners henceforth.
Finally, as mentioned above, as new restrictions are imposed on the types of investors that can participate in institutional private funds, newly established general partners who cannot receive investments from such investors face heightened barriers to market entry.