Private equity in South Korea: market and regulatory overview
A Q&A guide to private equity law in South Korea.
The Q&A gives a high level overview of the key practical issues including the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.
To compare answers across multiple jurisdictions visit the Private Equity Country Q&A Tool.
This Q&A is part of the global guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.
Private equity funds (PEFs) were introduced to Korea in 2004 under the former Indirect Investment Asset Management Business Act, which was integrated into the Financial Investment Services and Capital Markets Act (FSCMA) in 2009. During the early years since inception, most limited partners (LPs) were financial institutions and pension funds (80% in 2005). However, the composition of LPs has gradually evolved, and now more capital commitment is provided by general corporations (up from 11% in 2004 to 30% in 2010). PEFs in Korea are supervised by the Financial Services Commission (FSC).
Investments by PEFs in Korea have historically been concentrated on local corporations. However, this trend is changing as more and more PEFs in Korea are also investing in foreign corporations. In the early stages of the development of the PEF market, foreign investments by PEFs were concentrated in the US and other developed countries. However, since 2008, investments to China, Taiwan and Hong Kong have started to increase, leading to more geographical diversity in PEFs' investment portfolios. As PEFs have grown and expanded significantly, global private equity houses overall have become less active in Korea while regional private equity houses remain relatively stable.
Hedge funds were only introduced in 2011 and domestic hedge funds' activities have generally been limited, although these activities are expected to grow in the future.
Between 2007 and 2013, the:
Number of PEFs in Korea grew by 439% to 237.
Total commitment amount grew by 389% to KRW44 trillion.
This upward trend is expected to continue as managers (or general partners (GPs)) build up track record, and more companies and wealthy individuals in Korea are increasingly exposed and attracted to the private equity market.
As of November 2014, there were 32 hedge funds registered with the FSC, accounting for about KRW2.7 trillion of funds raised. Their investment activities remain limited.
Traditionally, private equity investment activity has been bifurcated in Korea, with venture capital funds investing in early stage and start-up businesses, and PEFs investing in established businesses. Venture capital funds are available for early stage businesses. However, recently, more funds are re-characterising themselves as PEFs and are investing in more established businesses. This is especially true since 2009, when the investments in more established businesses doubled compared to those in early stage businesses.
Management buyouts and buy-ins have been rare. While leveraged buyouts are relatively popular, the global financial crisis has placed constraints on financial sourcing options for PEFs. As a result, leveraged buyouts have decreased significantly over the last few years. In 2011, a PEF engaged in a public-to-private transaction for the first time and a number of such transactions followed suit since then. One notable trend since 2011 is that traditional buyout firms have become increasingly more interested in investments in significant minority stakes. In 2013, private equity funds deployed in excess of KRW9.3 trillion in capital in South Korea, the largest total amount of PEF investments in South Korean history. The growth in investments is credited to blind PEFs participating in a number of large scale M&A transactions.
Traditionally, PEFs have preferred trade sales to strategic buyouts when seeking market consolidation or expansion. While this is still the case, it is likely that the number of secondary buyouts will increase along with the increase of the number of PEFs. There are only a very limited number of cases where PEFs have exited through flotation and it is unclear whether this is an attractive method of exit for PEFs, given the relatively unstable capital market.
As many PEFs now in operation were established after 2007, it will take some years before investors realise profits (or losses). Total return on investments in 2013 was KRW3.7 trillion, an increase of KRW1.6 trillion from 2012. The following shows the number of PEFs dissolved, and the return on investments, from 2004 to 2013:
2004 to 2010: 14 PEFs were dissolved, with a return on investments of KRW2.7 trillion.
2011: 10 PEFs were dissolved, with a return on investments of KRW3.8 trillion.
2012: 15 PEFs were dissolved, with a return on investments of KRW2.1 trillion.
2013: 34 PEFs were dissolved, with a return on investments of KRW3.7 trillion.
From 2004 to 2013, a total of 73 PEFs were dissolved, with a total return on investments of KRW12.3 trillion.
No substantial changes have been made to the PEF legal framework following its introduction in 2004.
However, the FSC has proposed to amend the FSCMA to relax the current PEF regime. As of January 2015, this Bill is currently being considered by the National Assembly, pending legislative approval, and includes the following amendments:
Classification of private funds to be consolidated from four categories to two:
Specialised Investment-Type Private Collective Investment Vehicles (Hedge Fund);
Management Participation-Type Private Collective Investment Vehicles (PEF).
PEF incorporation procedures to be eased by instituting a post-incorporation reporting requirement in lieu of the current post-incorporation registration requirement, which requires review by the financial regulators.
PEFs to be permitted to allocate up to 30% (increase from 5% currently) of its net assets in securities and invest in currency exchange-related derivative products with respect to their general assets.
PEF will be restricted from engaging in related party transactions and acquiring securities issued by a general partner (GP) affiliate or an affiliate of a limited partner (LP) that has de facto control over the PEF.
PEFs to be permitted to establish daughter and granddaughter special purpose companies (SPCs) in the implementation of investment structures.
Tax incentive schemes
There is only one defined legal form for a domestic PEF, a hapja-hoesa (similar to a limited partnership). A hapja-hoesa is a corporate entity similar to a limited liability partnership (Korean Commercial Code). The hapja-hoesa is composed of members with limited liability and is managed by a GP. The detailed terms of fund and capital allocation are governed by the PEF's articles of incorporation (AOI).
Domestic PEFs can elect to be treated as a tax pass-through entity, and if so there is no income tax at the PEF level (Article 100-15 (1) of the Restriction of Special Taxation Act). If the PEF does not make the election, the fund itself, not the investors, will be liable for taxes as it is treated as a standalone legal entity.
Income allocated by domestic PEFs to foreign investors is treated as dividend income and normally subject to Korean withholding tax at the rate of 22% (unless it is reduced under an applicable tax treaty between Korea and the country where the investment vehicle of the foreign investors is established). However, the Korean tax authorities may consider various factors in determining beneficial ownership, including:
Physical substance: the existence and maintenance of physical presence (for example, an actual office), employees, payroll expenses and operating expenses.
Corporate governance: the legal registration of income recipient, designation of venue for board and shareholder meetings, maintenance of corporate documents, conduct of shareholder stewardship activities, tax return filings in other jurisdictions.
Economic substance: records of assuming business/investment risks and flow of investment/income, possession of disposal right to income, commercial reasons justifying its existence in the treaty country, engagement in business activities in other countries.
Depending on the applicable circumstances, the beneficial ownership of the offshore investment vehicle (that is, holding company) may be denied.
The common investment objectives of PEFs investing in Korea are to achieve superior risk-adjusted returns. This is done primarily through investing in equity, equity-related and similar securities of small- to mid- cap companies that are often acquired in privately negotiated transactions, where the PEF will have a controlling or significant equity position. Generally, PEFs are offered with a shorter fund term of five to seven years, compared to the international standard of ten to 12 years. However, more extended fund terms were given for more recently closed domestic PEFs.
Fund regulation and licensing
Domestic PEFs and investment companies must register with the FSC. Other than that, a domestic PEF is treated differently from an investment company from a regulatory perspective (Article 277(1), FSCMA).
For example, the offering circular or other investment marketing documents do not need to be registered, approved or delivered to the potential investors. In general, there are no particular limitations in terms of marketing and advertising as long as the offering is made privately.
There are no exemptions from the PEF registration requirements.
The minimum investment amount of an LP is KRW1 billion for an individual and KRW2 billion for a corporation or any other organisation. There is no maximum investment amount. Except in very special cases, there are no restrictions on the nationality of the LPs. Domestic PEFs must have 49 or fewer LPs (excluding certain LPs, which are financial institutions) to be treated as a domestic PEF under the relevant Korean regulations (Article 269, FSCMA).
Financial regulators have proposed to amend the FSCMA to reduce the minimum investment amount of an LP to KRW500 million, but restrict LPs to those qualified investors who have the capacity to bear the loss of their investment.
There is no limit on the investment period. However, the life of a domestic PEF cannot exceed 15 years (Article 268, FSCMA). There are no statutory limitations on the transfer of interests in domestic PEFs. However, LPs are required by law under the domestic PEF's governing document (that is, the AOI) to obtain consent from the GP to transfer its interests to another eligible investor (Article 273, FSCMA).
The relationship between the investor and the fund is governed by the terms of the AOI of the domestic PEF, which must be written in Korean and registered with the court having jurisdiction over the PEF. As with any other PEFs' investors, investors in domestic PEFs seek protection through contractual provisions under the AOI such as:
No fault divorce.
In addition, a typical AOI also includes fund advisory committee provisions under which LPs may have the right to appoint advisory committee members.
Interests in portfolio companies
Most common form
The most common form of equity interest is common shares. Commercial loans are the most common form of debt interest. However, convertible preferred shares and redeemable convertible preferred shares have also been popular. With the amendment of the Korean Commercial Code (Articles 344 and 469) (effective April 2012), the forms of debt and equity interest are expected to become more varied and creative with time, giving more flexibility to structuring options. The type of equity interest has become more varied and the restrictions on mezzanine financing more relaxed.
With the introduction of the International Financial Reporting Standards (IFRS) in Korea, redeemable shares, in most cases, are treated as a company liability, which has made redeemable shares unattractive. Commercial loans are more commonly used than bonds, as debt providers are mostly commercial banks.
Unless a corporation elects to subject transfer of its shares to the approval of the board of directors under its AOI, transfer of shares is not restricted (Article 335, Korean Commercial Code). Issuance of new shares through private placements requires either:
Authorisation under the AOI and board approval.
In the case of listed companies, the issue price of new shares with regard to non-existing shareholders is strictly regulated unless such issuance is through a rights offering. A domestic PEF is prohibited from transferring the acquired shares within six months of the acquisition, with limited exceptions (for example, where it is clearly foreseeable that the prohibition will result in undermining the existing shareholders' interests, the application of all exceptions being subject to the prior approval of the FSC).
For Korean companies that are lenders, interest income is to be included in ordinary income and is therefore subject to corporate tax at a rate of 11% to 24.2%, depending on the level of income. Interest income of offshore companies is to be withheld at 22%, while a reduced rate under a relevant tax treaty may be applied.
Capital gains from a Korean company's transfer of equity must be included in ordinary income and is therefore subject to corporate tax at a rate of 11% to 24.2%, depending on (the Korean company's) level of income. Barring any exemption under a relevant tax treaty, an offshore entity's capital gains on Korean shares is subject to capital gains tax at the lower of:
22% of capital gains.
11% of the sales proceeds.
Transfers within the Korean market of Korean shares owned by an offshore entity are exempt from capital gains tax if all of the following are satisfied:
The shares are listed.
The shares are traded through the stock markets or the KOSDAQ market of the Korean Exchange.
The offshore entity's ownership (that is, participation in the Korean company's capital) has not exceeded 25% during the five year period preceding the transfer.
In addition, a securities transaction tax at a rate of 0.3% to 0.5% of the sales proceeds is imposed.
The number of buyouts of listed companies (public-to-private) is increasing in Korea. General securities provisions in the FSCMA and listing regulations may apply to the buyout transactions the application of which will vary depending on the particular type and terms of each transaction. There are no special regulatory provisions governing buyouts in Korea.
Once the definitive agreement is executed, it is generally enforceable. The seller (including the issuer) is generally not permitted contractually to seek other buyers willing to pay a higher price.
Typically, PEFs request a no-shop provision in the definitive agreement. It is rare for PEFs to request a termination fee in exchange for go-shop provisions.
There have been cases where a PEF buyer would have the option to put the acquired shares back to the seller under certain economic metrics to be contractually agreed (such as internal rate of return (IRR)). However, on 15 April 2013, the amendment to the Model Guidelines on Option Investments was promulgated. This implemented broad restrictions on option investments, restrictions which only had limited applicability before the promulgation. Under the Model Guidelines, options are exercisable only in limited circumstances, to:
Prevent unilateral decision making by the largest shareholder.
Counter breaches of contractual obligations tied to business performance.
The exercise price must be based on the business performance of the invested company.
Managers of a portfolio company owe a general duty of care (including confidentiality obligation) and a duty of loyalty to the portfolio company but not to shareholders of the portfolio company (Articles 382-3 and 382-4, Korean Commercial Code). A shareholder holding at least 1% of the total issued and outstanding shares of a company can bring derivative suits against a director who commits an illegal act on behalf of the company (Article 402, Korean Commercial Code).
As MBOs are rare in Korea, the matters that relate to fiduciary duty or duty of care have rarely become an issue.
It is common practice for PEFs investing in Korea to send a representative to the portfolio company, who is elected as a non-standing director to oversee the board's actions and company operations. In a transaction involving the acquisition of a significant minority stake, management control is defined and agreed under the shareholders' agreement between the investors and the company. In addition to board representation, the following are also typically sought by the investors:
Veto rights (in the case of significant minority investment).
The leverage ratio has decreased over time in the last few years and in a typical private equity transaction in Korea, the amount of debt financing is usually equal to or less than the equity portion. The form of debt financing used for acquisitions is predominantly commercial loans that include term loan and revolving credit facilities (often put in place to pay the interest under the term loan when cash flow from the portfolio companies is expected to fall short to meet the interest coverage). Along with acquisition financing, the need for refinancing of debt facilities at the portfolio company level is common, which is typically composed of term loan and working capital facilities.
The most common and typical form of security is a pledge over the shares of the target. Offering the target's assets as security in a leveraged buyout has been limited as it may trigger a breach of fiduciary duty, which is a criminal offence in Korea (Articles 356 and 355(2) , Korean Criminal Code).
Contractual and structural mechanisms
As a result, certain deals have been structured at the request of the lenders either to have the acquiring company merge into the target after the acquisition such that the target's assets can be provided as security to reduce such risks or to cause the target company to periodically declare dividends or conduct a capital reduction. Financial covenants are also heavily negotiated, although the basic types of financial covenants are typically sought.
Financial assistance in the form of either the guarantee or provision of security by the target for the acquirer (see Question 24) could lead to the target's directors breaching their fiduciary duty owed to the company, whether public or private, which is a criminal offence (Articles 356 and 355(2), Korean Criminal Code).
Under current case law in Korea, it is not entirely clear how the directors of the target company can avoid this potential criminal liability when they approve the financial assistance, as the courts' decisions were based on specific facts and circumstances applicable to the respective cases.
There are no exemptions.
The statutory priorities for repayment are first secured claims, unsecured claims and then equity. Certain claims, including liquidation fees/charges and outstanding wages, statutorily have priority over unsecured claims. Aside from these claims, the relevant parties can agree to subordinate a claim contractually.
Naked warrants or options (that is, warrants or options issued without an accompanying bond) are not available to debt holders (an amendment to the law permitting naked warrants in the case of listed companies had been under discussion before the National Assembly, but was not introduced). To achieve equity appreciation, debt holders must hold equity-linked securities, such as bonds with warrants or exchangeable/convertible bonds.
Portfolio company management
The most common management incentives are:
Share appreciation rights (phantom shares) based on exit price.
Performance-based bonuses (based on earnings before interest, taxes, depreciation and amortisation (EBITDA)).
Offshore PEFs usually opt to give performance-linked cash bonuses to the managers of portfolio companies.
It is not common to have anti-corruption/anti-bribery provisions applicable to the management of portfolio companies included in the investment documents. Generally, fund executives are not held liable solely by virtue of their position. Rather, a certain level of culpability must be established for fund executives to be subject to criminal sanctions.
Forms of exit
The prevailing form of exit is the trade sale. IPOs are relatively rare.
Secondary buyouts are not common in Korea, although secondary buyouts are gaining more interest in the Korean private equity market. Recently, some Korean investors have shown stronger interest in secondary buyout deals with regard to offshore PEFs although their interest in onshore secondary buyout deals for Korea PEFs has remained low.
Advantages and disadvantages
A trade sale to a strategic investor has historically generated the most attractive investment return. Trade sales by offshore PEFs have scrutiny by the Korean tax authority, especially with regards to the beneficial ownership of the offshore PEFs. Taxes will be generally assessed based on the tax treaty of the jurisdiction in which the beneficial ownership lies.
Exit after IPO may be most tax efficient if the PEF owns less than 25% of total issued shares (at anytime during the last five years) and exits through the market, in which case tax is exempt on capital gains under the domestic tax law.
Private equity/venture capital associations
Korean Venture Capital Association (KVCA)
Status. KVCA is a non-governmental organisation.
Membership. KVCA has over 90 domestic venture capital companies as members.
Principal activities. KVCA was established in 1989 and acts as a hub to promote the advancement and growth of venture capital industry in Korea. It also, among other things:
- Promotes a more favourable system and vibrant investment environment for the development of the venture capital industry.
- Enhances awareness and understanding of the importance of venture capital to the Korean economy.
- Facilitates interaction among its members as well as communication between the members and key industry participants, which include:
- Promotes international networking for the mutual co-operation of the international venture capital community.
- Organises a range of activities from professional development to raising professional standards across the industry.
- Develops policy relating to venture capital and tax legislation.
Published guidelines. There are no published guidelines
Legal Information Center of Korea Ministry of Government Legislation
Description. This website is maintained by the Korea Ministry of Government Legislation and it is the official website of Korean law. It contains current laws, enforcement decrees and detailed regulations, historical information about those laws and regulations, and those laws coming into force in the near future. This website does not provide any translation.
Jong Hyun Park, Senior Attorney
Kim & Chang
Professional qualifications. Korea, 1998
Areas of practice. Mergers and acquisitions; corporate governance; private equity; securities regulations; securities.
- Extensive experience advising publicly and privately held multi-national and Korean companies and financial institutions in a wide range of cross-border and domestic transactions, including share and asset purchases, joint venture, corporate governance and securities area.
- Representative work in recent years includes assisting major domestic and multi-national private equity funds in their acquisitions of shares in Korean companies and advising major domestic companies regarding corporate governance matters.
Languages. Korean and English
Professional associations/memberships. Korean Bar Association.
European Lawyer Reference Series - Mergers & Acquisitions (First edition): "South Korea" chapter (Co-author, Thomson Reuters, 2012).
"Recent developments in the short sale rule and bank/bank holding company ownership in Korea", International Investment & Securities Review 2009 (Co-author, Euromoney Yearbooks, 2009).
Joon B Kim, Senior Foreign Attorney
Kim & Chang
Professional qualifications. New York, 2003
Areas of practice. Mergers and acquisitions; foreign direct investment; anti-trust and competition; corporate governance; outbound practice; real estate and construction.
- Extensively advises foreign corporations and large domestic conglomerates on a range of issues in connection with mergers and acquisitions, real estate transactions, fair trade law and cross-border corporate transactions.
- Primary areas of expertise include both inbound and outbound mergers and acquisitions of public and private companies, as well as disputes and investigations relating to foreign direct investment and anti-trust issues involving multi-national corporations.
Languages. English and Korean
Professional associations/memberships. Korean Bar Association.
Euromoney Yearbooks International Investment & ETFs Review 2010: "Korea" section, "Adopting Poison Pill in Korea as a Defensive Mechanism to Hostile Takeovers" (2010).
Practical Law Corporate Real Estate Multi-jurisdictional Guide 2007/08: "South Korea" section (2008).
The Capital Guide To REITS in Asia: Market Overview-Republic of Korea (2007).
IFLR, the 2007 Guide to Real Estate: Real Estate Funds (2007).
Getting the Deal Through Real Estate 2008: "Korea" section (2008).
Byoung Kwon Park, Attorney
Kim & Chang
Professional qualifications. Korea, 2007
Areas of practice. Corporate governance; mergers and acquisitions; securities regulations; securities; capital markets; private equity.
Languages. Korean and English
Professional associations/memberships. Korean Bar Association.