Private Equity Fund Shall not be Allowed to Invest under the Self-Favored Option

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It has been a quite controversial issue whether Private Equity Funds (PEFs) should be allowed to invest with a certain option clause for their own sake. Because this self-inflicted investment practice is not only considered as a ‘secured loan’ with option, but also against the genuine purpose of PEF: making investment in various equity securities (lesser debt instrument). To set this straight, Korean financial authorities expect to revise the rule of PEFs investment with option; imposing a stricter rule that no more investment with a certain option between investor and investee under at any circumstances.

Korean financial watchdog, FinancialSupervisory Service (FSS) along with Financial Services Commission (FSC) will announce the revised rule of PEFs investment practice; which does not allow any option agreement upon investment between PEFs and target companies. Until now, PEFs have been enjoying their ‘secured’ way of investment; execute the investment upon self-favored option clause (i.e. the option investees promise to buy back equities or bonds with equities they are selling to investor after the certain period of time).

 

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Under the current practices, PEF was able to retrieve its investment with a prearranged profit secured by the option agreement. According to FSS, since its beginning in 2005, most of the PEFs took a full advantage of either or both put/call option agreement with target company and major shareholders and retained their predetermined proceedings – also called as ‘the hurdle rate’. Systematically once the fund reached the hurdle rate and the remaining proceedings shall be paid to GPs at the prearranged portion – also called as ‘success fee’. To achieve this success fee as an incentive, GPs are supposed to do whatever it takes as long as it is allowed to do so.

Expected stricter rule of PEF investment are as follows;

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Upon the revised guideline, fundamentally PEFs should take their own risk on investment decision and should not demand any optional condition to secure their investment. In case that there is a definite term of wrongdoing by investees or major shareholders of investees, put option can be exceptionally allowed. Additionally if there is a clear interference of IPO proceeding and management by investees, PEFs should be able to exercise their option as a penalty. Otherwise, current investment practice of PEFs with indiscriminate option exercise expects to be banned and investment report will be a DOA (Dead on Arrival). Furthermore, any GP (General Partner) who violated the guideline will be fined and put restriction on raising new fund opportunity according to the officials.

Current changes expect to give a heavy blow to small and medium size PEFs while giving little effect on large PEFs, mostly buyout funds. Small and medium PEFs prefer either small cap or meaningful portion of minority investment. In order to raise the fund or attract LP (Limited Partners), they should be able to secure the way of ‘guaranteed’ proceedings in investment process – note that GP shall not guarantee any proceedings and rate of return on investment to LPs whatsoever. Without ‘securing’ their proceedings from investment, the investment can be riskier and will raise the possibility to lessen the rate of return. Obviously poor fund performance and track record will lose the opportunity to invite LPs. Meanwhile, large PEFs, who maintain their dominant market shares and secure funding sources, do not mind the current changes because large PEFs usually focus on the large and buyout deals rather than small deals and they should take the responsibility for their investment and management of the target as whole.

 

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