Overview of the Korean PEF Market and Major Issues

Funds and Pensions Overview of the Korean PEF Market and Major Issues Yong Rin Park, Research Fellow* The PEF market in Korea has grown to be a market with a total commitment of KRW 28 trillion over the past six years since its inception. Given that PEFs in general have almost finished the investment cycle from fund raising to exit, this article reviews the Korean PEF market over the past six years, discusses characteristics of each stage in the investment cycle, and suggests areas to be improved as follows: Strengthen the role of pension funds and benefit associations, diversify the LP base, pursue balanced exit markets, strengthen the overseas investment capability including foreign exchange risk management, put more focus on value enhancement and the quality of investment returns, and provide performance attribution methodologies. I. Overview of the PEF Market in Korea Private equity funds (PEF) were brought to market via the revision of the Indirect Investment Asset Management Act, which is now called the Financial Investment Services and Capital Markets Act (FSCMA), in December 2004. PEF was introduced in an effort to promote corporate restructuring by encouraging M&As and to develop the asset management industry by providing diverse investment assets. The PEF in Korea is a type of private funds in the form of a limited partnership, and it involves fundraising from 49 or less professional investors, investment into equity or equitylinked securities, value enhancement of investee companies, and exits. Although the PEF in Korea has been introduced to induce buyout among various sub-types of private * All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as the Korea Capital Market Institute s official position. Tel: 02-3771-0830, E-mail: yrpark@kcmi.re.kr 17

Capital Market PERSPECTIVE equity (PE) investments such as buyout, growth capital, distressed asset, and venture capital, it is flexible enough to include other types of PE investments. The PEF in Korea has constantly grown in number since its inception at the end of 2004, and a total of 162 PEFs have been established and 14 of them liquidated by the end of 2010. As of the end of May 2011, a total of 167 PEFs with a total commitment of KRW 28.9 trillion are registered, boasting its rapid growth to a sizable market in a short period of time. Such a rapid growth has been achieved despite significant shrinkage of the global PE market due to the financial crisis in 2007. Whereas the total fundraising in the global private equity market decreased from the peak of USD 624.5 billion in 2007 to USD 250.9 billion in 2010, the total fundraising in the Korean PEF market constantly grew from KRW 2.8 trillion in 2007, reaching KRW 6.6 trillion in 2010. Such a rapid growth of the Korean PEF market despite global contraction can be attributed to the following three factors. First, Korea s real economy has been relatively less affected by the global financial crisis. Second, the Korean economy as one of the leading emerging economies has shown growth potential, partly driven by the rapid growth of the Chinese economy. Third, although the global financial crisis happened in the early stage of the Korean PEF, market participants held high expectation for the Korean PEF market. Therefore, the Korean PEF market could enjoy advantages that were given for the early stage. Table 1. PEF fundraising by year (Unit: USD billion, KRW trillion) 2003 2004 2005 2006 2007 2008 2009 2010 Global (USD billion) 133.8 206.3 361.1 525 624.5 553.8 296.1 250.9 Korea (KRW trillion) 4.7 1.5 2.8 5.6 5.4 6.6 Note: Cumulative funds raised at year-end Source: Financial Supervisory Service, Preqin Then, is the growth of the Korean PEF market likely to last? To get a feel for how mature a PE is and whether it has further growth potential, the PE penetration rate is commonly used. The PE penetration rate is a measure where PE investment over a year is divided by the GDP of that year. The PE penetration rate by country using the average PE investment and average GDP over the past two years from 2009 to 2010 is 18 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues shown in the following table. The PE penetration rates of the US, the largest PE market where PE originated, and the UK, the second largest PE market, are 0.67% and 0.74%, respectively, whereas that of Korea is about 0.14%, a similar level to Brazil and China. Table 2. PE penetration rates by country (Unit: %) Country UK US India Brazil China Korea South Africa Russia Japan Turkey PE Penetration rate 0.74 0.67 0.38 0.15 0.15 0.14 0.14 0.06 0.05 0.05 Note: The PE penetration rate is defined as PE investment/gdp. The figures are based on the average of two years (2009 and 2010). Source: Financial Supervisory Service, EMPEA (2011) Therefore, a cross-country comparison of the rather simple PE penetration rates bodes well for further growth of the Korean PEF market. Of course, a low level of the PE penetration for Korea does not necessarily mean that the PE penetration rate will increase to the US or UK level. This is because PEF investment is a part of M&A activities, and it is well known that M&A activities of a country are determined by various factors such as its own legal system, corporate governance, and shareholding structures, not just by the size of GDP. In this article, the characteristics of the Korean PEF market by each part of the PEF investment cycle, i.e., fundraising, investment, value enhancement, and exit are discussed, and also their implications for further development of the Korean PEF market are covered. II. Overview of Korean PEFs by Each PEF Investment Cycle 1. Fundraising The most outstanding fact about Korea s PEF market related to fundraising is that small-sized PEFs with commitments of less than KRW 100 billion account for over half 19

Capital Market PERSPECTIVE the number of the total PEFs. Among the 148 PEFs registered as of the end of 2010, the number of PEFs with commitments of less than KRW 100 billion is 79, taking up 53.4% of PEFs. Meanwhile, the number of large PEFs with commitments over KRW 300 billion and the number of mid-sized PEFs with commitments between KRW 300 billion and KRW 100 billion are 31 and 38, respectively, taking up 20.9% and 25.7%, respectively. This is more so since 2008, and the number of large and mid-sized PEFs increased by 53.8% and 15.0% in 2008 and 2009, respectively, whereas the number of small PEFs increased 100.0% and 77.8% in 2008 and 2009, respectively, showing much higher growth. The average commitment per PEF stands at KRW 154.2 billion in 2010, and this has been under KRW 200 billion since the inception of PEF, except in 2005 when a few large PEFs were set up in the early history of the Korean PEF. This is in stark contrast with overseas PE, where the average commitment of overseas PE is over KRW 700 billion. In any case, Korean PEFs of all size categories are growing in number regardless of the size of commitment. Table 3. Number of PEFs by average commitment size Commitment 2005 2006 2007 2008 2009 2010 Large Over KRW 300 billion 7 9 13 20 23 31 Mid Between KRW 100 and 300 billion 4 6 13 20 23 38 Small Under KRW 100 billion 4 10 18 36 64 79 Average commitment (KRW billion) 410.5 174.4 157.7 181.5 181.3 154.2 Total number 15 25 44 76 110 148 Note: The number of PEFs is based on PEFs registered at year-end and the average commitment is based on all PEFs registered during the year. Source: Financial Supervisory Service The dominance of small and mid-sized PEFs in the Korean PEF market is due to the fact that project funds (or deal-by-deal funds) take up the majority of PEFs because of the lack of confidence in PEFs and general partners (GP) who manage the PEFs. A blind fund is a type of PEF where funds are committed by limited partners (LP) with investee companies undetermined, whereas a project fund is a type of PEF where LP 20 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues commitment is made after the investee company is known to and confirmed with LP. A PEF is generally a blind fund, and normally blind funds account for the majority of PEFs as the PEF market matures and the GP reputation market forms. This can be seen in the following table. The proportion of blind funds in the large PEF category increased from 78.6% in the 2004~2007 period to 84.2% in the 2008~2010 period, as leading GPs have built track records. On the contrary, the proportion of blind funds in the small to mid-sized categories decreases from 79.2% in the 2004~2007 period to 49.5% in 2008~2010 period. However, this should not be interpreted as evidence that the PEF market has gone backward. Rather, this was caused because the potential that Korea s PEF market shows induced new GPs to enter the market, and without much track record, these GPs had to focus more on small to mid-sized project funds. In other words, there appears to be market segmentation under progress: The number of blind funds increases as leading GPs accumulate track record, while new and specialized GPs are dedicated to project funds. Table 4. Number of PEFs by type Year Small to mid-sized PEF Large PEF Blind Project Total Blind Project Total 2004~2007 19 5 24 11 3 14 2008~2010 52 53 105 16 3 19 Total 71 58 129 27 6 33 Source: Financial Supervisory Service Regarding the LP composition, financial companies and non-financial corporations take up 38.8% and 29.9%, respectively, of the LP commitments in 2010, larger than 17.5%, the proportion of pension funds and other benefit associations. The proportion of pension funds and other benefit associations has not exceeded 20% since 2005. A major difference between Korean PEFs and overseas PE is that financial institutions play a significant role, and that foundations, university endowments, and wealthy families are not actively participating as major LPs. Overseas PE has diverse types of LPs, whereas financial companies and non-financial corporations take up a total of 68.7%, accounting for the majority of LP commitment in the Korean PEF market. This 21

Capital Market PERSPECTIVE seems to arise from the lack of trust between GPs and LPs: The Korean PEF market has a short history, and therefore GPs have not accumulated enough capability to build trust with LPs. Table 5. LP composition (Unit: %) 2005 2006 2007 2008 2009 2010 Financial companies 60.8 52.2 49.3 44.9 41.9 38.8 Non-financial corporations 12.7 16.7 22.0 23.6 28.0 29.9 Pension funds and others 19.6 16.1 17.9 15.8 14.8 17.5 Individuals 6.9 13.3 9.5 13.6 12.3 11.4 Others 0 1.7 1.4 2.2 3.0 2.4 Total 100 100 100 100 100 100 Source: Financial Supervisory Service Table 6. LP Composition between Korean and overseas PEF markets LP in Korean PEF LP composition LP in overseas PEF LP composition Financial companies 38.8% Pension funds and others 20.0% Non-financial corporations 29.9% Foundations and endowments 18.0% Pension funds and others 17.5% Financial companies 16.0% Individuals 11.4% Individuals 15.0% Others 2.4% Others 17.0% Total 100.0% Total 100.0% Note: The Korean LP data are as of 2010, and overseas LP data are as of 2009. Source: Financial Supervisory Service, Preqin (2010) Nevertheless, GPs, particularly leading GPs, have been gradually building a track record in the Korean PEF market. This can be seen in the proportion of blind funds mentioned above and that of repeat PEFs, PEFs that are established by GPs with prior fund raising and management experience. The proportion of repeat PEFs has generally been on an upward trend since 2006, increasing from 50% in 2006 to 78% in 2010. For large PEFs, the proportion of repeat PEFs has shown more drastic growth, increasing from 67% in 2006 to 100% in 2010. 22 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues Table 7. of repeat PEFs Year Total Large PEF Repeat PEF Total Small to mid-sized PEF Repeat PEF 2006 3 2 66.7% 9 4 44.4% 2007 4 3 75.0% 15 6 40.0% 2008 7 6 85.7% 25 17 68.0% 2009 3 1 33.3% 34 14 41.2% 2010 9 9 100.0% 37 27 73.0% Total 26 21 80.8% 129 69 53.5% Source: Financial Supervisory Service The primary reason that financial companies participate as LPs in the Korean PEF market is that affiliates or subsidiaries of financial companies often participate as GPs in the PEF market and financial companies want to support affiliated GPs as anchor investors to ensure that affiliated GPs gain market share at an early stage of market development. This is because first-time GPs with no prior track record can hardly raise funds due to the lack of LP trust. Another reason for the high proportion of financial companies in the LP composition is that unlike GPs in overseas markets where about 1% of nominal GP contribution is the norm, GPs are expected to contribute a significant proportion to the fund. On the other hand, the primary reason for the high proportion of non-financial corporations in the LP composition is that the participation of LP or GP gives them not only investment returns, but also opportunities for technological or strategic alliances with their existing businesses or entry into new businesses. In particular, some of large corporations are known to use PEF to finance their non-listed subsidiaries. These two types of LPs exhibit different trends in the market. As GPs build track record, the proportion of financial companies as LP has been constantly decreasing after the peak of 60.8% in 2005, whereas that of non-financial corporations as LP has been constantly increasing after the trough of 12.7% in 2005. This is because non-financial corporations began to note the potential of PEF for the management of their own businesses as PEF market grows. 23

Capital Market PERSPECTIVE 2. Investment Although PEFs in Korea were introduced to induce buyout among the various types of PE, there have been other types of PE investments in Korea, such as growth capital and distressed investments. Buyout is a subcategory of PE involving the transfer of ownership that involves most active value enhancement. Meanwhile, growth capital is a subcategory that provides a fast growing company with financing, consulting and networking services, and that distributes returns by maximizing growth potential via an acquisition of significant minority stake, which does not involve the transfer of ownership. Most leading GPs in Korea are thought to pursue buyout transactions. An investigation of publically disclosed investment details of PEFs registered between 2005 and 2009 reveals that out of the total 155 investments identified with KRW 14.8 billion worth, buyouts are 57 cases with KRW 9.3 billion, taking up 36.8% and 62.5%, respectively, in number and amount. On the other hand, minority investments and joint investment with strategic investors account for 56.8% and 6.5%, respectively, in number, and 24.5% and 12.9%, respectively, in amount. Minority investments account for more than half of the number of investments because some PEFs with less PEF management experience and more risk aversion, focus on minority investments, especially investments into listed companies, which offer easier exit opportunities. Investments into listed companies account for 36.8% and 38.6%, respectively, in number and amount. Table 8. PEF investments by type Number Amount (KRW billion) Average investment (KRW billion) Buyout 57 36.8% 9,263.7 62.5% 162.5 Minority 88 56.8% 3,632.8 24.5% 41.3 Joint with SI 10 6.5% 1,913.7 12.9% 191.4 Total 155 100.0% 14,810.2 100.0% 95.5 Note: The data are based on the PEF transactions registered between 2005 and 2009 that were disclosed or announced in the press, but exclude all outbound PEF investments. The data compiled for the current purpose may be different from those of the Financial Supervisory Service. Source: Korea Capital Market Institute (KCMI) 24 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues Table 9. PEF investments by listing status Number Amount (KRW billion) Average investment (KRW billion) Listed 57 36.8% 5,712.2 38.6% 100.2 Non-listed 98 63.2% 9,098.0 61.4% 92.8 Total 155 100.0% 14,810.2 100.0% 95.5 Note: The data are based on the PEF transactions registered between 2005 and 2009, that were disclosed or announced in the press, but exclude all outbound PEF investments. The data compiled for the current purpose may be different from those of the Financial Supervisory Service. Source: Korea Capital Market Institute (KCMI) The characteristics of PEF investments related to minority stakes are also seen through the types of instruments that PEFs use. Common shares account for 63.2% and 88.9%, respectively, in number and amount, while mezzanine investments such as convertible bonds (CB), bonds with warrant (BW), redeemable convertible preferred shares (RCPS) take up 26.4% and 7.5%, in number and amount. While mezzanine instruments have lower risk, offer easier exit routes, and therefore are often used for high risk growth firms, they are widely used in the Korean PEF market regardless of investee company types. Table 10. PEF investments by instrument Number Amount (KRW billion) Average investment (KRW billion) Common Shares 98 63.2% 13,161.7 88.9% 134.3 CB 4 2.6% 182.8 1.2% 45.7 BW 5 3.2% 32.0 0.2% 6.4 RCPS 32 20.6% 903.4 6.1% 28.2 Combined 13 8.4% 485.3 3.3% 37.3 Others 3 1.9% 45.0 0.3% 15.0 Total 155 100.0% 14,810.2 100.0% 95.5 Note: The data are based on the transactions of PEFs registered between 2005 and 2009, that were disclosed or announced in the press, but exclude all outbound PEF investments. The data compiled for the current purpose may be different from those of the Financial Supervisory Service. Source: Korea Capital Market Institute (KCMI) 25

Capital Market PERSPECTIVE On the industry front, industries investee companies belong to are widespread. IT and internet related industries take up the largest proportion, driven by small scale minority investments into high growth companies in those industries. On the other hand, construction and media account for the largest proportion in amount due to PEFs active participation in the restructuring of Daewoo Construction, and the buyout transaction of C&M, a multiple CATV operator, both of which were significantly large transactions. Number Table 11. PEF investments by industry Amount (KRW billion) Average investment (KRW billion) IT/Internet 32 20.6% 1,558.8 10.5% 48.7 Financial 22 14.2% 1,533.1 10.4% 69.7 Construction 10 6.5% 4,245.4 28.7% 424.5 Industrial 10 6.5% 304.2 2.1% 30.4 Logistics 8 5.2% 540.5 3.6% 67.6 Media 8 5.2% 2,389.4 16.1% 298.7 Energy 7 4.5% 456.9 3.1% 65.3 Metal 7 4.5% 242.4 1.6% 34.6 Food & Beverage 6 3.9% 565.2 3.8% 94.2 Consumer 6 3.9% 175.7 1.2% 29.3 Healthcare/ Pharmaceutical 6 3.8% 217.7 1.5% 36.3 Education 5 3.2% 229.2 1.5% 45.8 Distribution 4 2.6% 282.0 1.9% 70.5 Chemical 4 2.6% 190.5 1.3% 47.6 Environment 4 2.6% 60.0 0.4% 15.0 Leisure 3 1.9% 361.0 2.4% 120.3 Holding Company 3 1.9% 640.0 4.3% 213.3 Shipbuilding 2 1.3% 38.0 0.3% 19.0 Paper 2 1.3% 297.6 2.0% 148.8 Telecom 1 0.6% 37.4 0.3% 37.4 Optical 1 0.6% 30.0 0.2% 30.0 Others 4 2.6% 415.3 2.8% 103.8 Total 155 100.0% 14,810.2 100.0% 95.5 Note: The data are based on the transactions of PEFs registered between 2005 and 2009, that were disclosed or announced in the press, but exclude all outbound PEF investments. The data compiled for the current purpose may be different from those of the Financial Supervisory Service. Source: Korea Capital Market Institute (KCMI) 26 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues Buyouts are often interchangeably called leveraged buyouts (LBO) since buyers often take out loans as long as the cashflow or assets of the target are large enough to back the leverage in order to maximize investment returns. Back in the 1980s when LBO transactions were at their prime, the leverage ratio of many LBO transactions, often called highly levered transaction (HLT), was as high as 1000%. However, inherent high risks of such transactions, the collapse of the junk bond market, and the scarcity of ideal targets due to the disappearance of inefficiency of those targets all resulted in the disappearance of HLTs, and the average leverage ratio in LBO transactions since then significantly declined, standing on average at about 150% during the 2013~2010 period. Starting from 156% in 2003, the leverage ratio gradually increased to 203% in 2007 on the back of a global liquidity glut and the buyout boom, but plunged to 96% in 2009 owing to the financial crisis, slightly reverting back to 127% in recent years with the easing of credit market. Table 12. Average leverage of PEF investments 2003 2004 2005 2006 2007 2008 2009 2010 Korea N/A N/A N/A N/A 16.3% 27.7% 34.7% 49.1% US 156% 186% 213% 194% 203% 133% 96% 127% Note: The US data are based on buyout only and the Korean data based on the whole PEF transactions. Source: Financial Supervisory Service, Standard & Poors The Financial Investment Services and Capital Markets Act (FSCMA) in Korea requires the leverage ratio of Korean PEFs to be up to 200% only through a special purpose company (SPC). Despite such a limit on the leverage ratio, the average leverage ratio of Korean PEF investments is much lower than the limit. This seems to stem from the fact that in the early stage of PEF market development, PEFs have focused more on growth capital, mezzanine, and minority investments into listed companies than on leverage-based buyouts. However, as GPs gain more experience and confidence in managing PEF transactions and buyouts take up a higher portion of PEF investments, the average leverage is recently on an upward trend. Though the average leverage ratio gradually rose from only 16.3% in 2007 to 49.1% in 2010, it is at a still relatively low level and therefore, there seems to be hardly any systemic risk related to LBOs. 27

Capital Market PERSPECTIVE Meanwhile, some GPs have set up PEFs that focus on overseas investment opportunities or have already invested in overseas companies as a portfolio company. Out of 263 companies that PEFs invested between 2005 and 2010, the number of foreign companies were 25, taking up 9.5%, out of which, 17 companies are from advanced countries such as the US, Japan, and certain European countries. Related to overseas investments, partnership with domestic strategic investors will become more important. Already a few strategic investors have formed strategic partnerships with PEFs in overseas resources development projects. From the standpoint of PEFs, the partnership with strategic investors is helpful to PEF management. First, long standing business experience of strategic investors can be utilized for deal sourcing. Second, joint acquisition of corporate control provides another exit route to PEF, i.e., buyback to the strategic investor. Third, management know-how and insight of strategic investors help the value enhancement process. However, a partnership with strategic investors in overseas investments is likely to be used by PEFs mostly to reduce risks in overseas investments until they build up enough foreign investment experience. Table 13. PEF investments by destination 2005 2006 2007 2008 2009 2010 Total Domestic 8 39 40 51 41 59 283 Overseas 2 7 5 2 9 25 US, Japan, Europe 2 6 2 2 5 17 Others 1 3-4 8 Total 8 41 47 56 43 68 263 Source: Financial Supervisory Service 3. Value Enhancement In general, PEF investment returns have the following four sources: multiple expansion, leverage, sales growth, and improved profitability. Multiple expansion is the case where returns are generated by the change in the valuation due to market conditions or sentiment unrelated to the change in the fundamentals of investee companies, and 28 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues thus are related to market timing, whereas sales growth and improved profitability are from improvements in fundamentals. Considering the relatively low leverage in Korean PEF investments, PEF returns in Korea are likely to be relatively restricted. Due to the lack of investee company level data on the investment performance, a rigorous empirical analysis is impossible. However, given that the average holding period of PEF investments is believed to be between two and three years, a relatively short period compared to global standards, investment returns from value enhancement activities such as sales growth and improved profitability are considered limited. In particular, many of early PEF investments exited by 2010 seem to have returns mostly generated from multiple expansion. As a reference, Blackstone PE, one of the global PE leaders, discloses that 65% of their investment returns is from operational improvement, 24% from multiple expansion, and the rest 11% from leverage. 1) Returns generated from value enhancement are perceived as a typical merit of PE. 4. Exits Finally, KRW 2.7 trillion worth of investments has exited by the end of 2010, mostly by PEFs raised early on, and the proportion of exited investments is 32.1% and 18.9%, respectively, in number and amount of investments. A surge in exits is expected in a few years since the majority of currently registered PEFs were established after 2007, and fund liquidation is coming soon. Returns from exited investments measured as the internal rate of return (IRR) are not available both for the PEF level and individual investment level, but the rate of returns in terms of the exit amount relative to the amount originally invested is 1.46 on average, which appears to be fair considering the short history of Korean PEFs. 1) Blackstone Annual Report (2009) 29

Capital Market PERSPECTIVE Table 14. PEF Exits (Unit: KRW billion) Exit year Exit amount Investment Exit/Investment 2005~2007 565.2 279.9 2.02 2008 344.9 274.9 1.25 2009 861.1 683.7 1.26 2010 917.9 599.6 1.53 Total 2,689.1 1,838.1 1.46 Source: Financial Supervisory Service One of the most prominent characteristics regarding the exits of Korean PEFs is the high proportion of exits through open market sales, buybacks to the largest shareholders or investee companies, and paid capital reduction, relative to the typical PE exit routes such as IPO and M&A (or Trade Sale). Among the 49 exits identified for the investments made by PEFs established between 2005 and 2009, exits through M&A and IPO are only 10 and 4 cases, respectively, taking up 20.4% and 8.2% in number and amount, whereas open market sales, buybacks, and paid capital reductions are 11, 10, and 4, respectively, taking up 22.4%, 20.4%, and 8.2%, respectively in number. In terms of amount, buybacks account for 20.8%, higher than the proportion of M&A or IPO. Though diverse exit routes certainly played a beneficial role in increasing the attractiveness of PEF investments, some PEFs have relied more on passive exit routes in order to minimize exit risks since they needed to build a track record in the early stage of the PEF market. Such reliance on passive exit routes helps expand the PEF market, but it reduces incentives for active value enhancement, undermining the merits of PEFs in the long run. For reference, the majority of exit routes North American LBOs have taken are M&A, IPO, and secondary transactions, taking up 48%, 16%, 22%, respectively. 2) As the Korean PEF market matures and the proportion of buyouts and investments into non-listed companies increases, the composition of exit routes will gradually converge to that of typical exit routes observed in the overseas PE market. 2) World Economic Federation, The Global Economic Impact of Private Equity Report 2008 30 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues Table 15. of Exited Investments Number Amount (KRW billion) Average investment (KRW billion) Exited 49 31.6% 2,788.9 18.8% 56.9 Not exited 106 68.4% 12,021.3 81.2% 113.4 Total 155 100.0% 14,810.2 100.0% 95.5 Note: The data are based on the transactions of PEFs registered between 2005 and 2009, that were disclosed or announced in the press, but exclude all outbound PEF investments. The data compiled for the current purpose may be different from those of the Financial Supervisory Service. Source: Korea Capital Market Institute (KCMI) Open Market Sale Number Table 16. PEF Exits by Exit Route Amount (KRW billion) Average investment (KRW billion) 11 22.4% 196.4 7.0% 17.9 Buyback 10 20.4% 578.8 20.8% 57.9 M&A 10 20.4% 459.4 16.5% 45.9 IPO 4 8.2% 312.4 11.2% 64.7 Secondary 4 8.2% 931.0 33.4% 232.8 Paid Capital Reduction 4 8.2% 163.4 5.9% 40.9 Combined 3 6.1% 109.7 3.9% 36.6 Others 3 6.1% 37.8 1.4% 12.6 Total 49 100.0% 2,788.9 100.0% 56.0 Note: The data are based on the transactions of PEFs registered between 2005 and 2009, that were disclosed or announced in the press, but exclude all outbound PEF investments. The data compiled for the current purpose may be different from those of the Financial Supervisory Service. Source: Korea Capital Market Institute (KCMI) 31

Capital Market PERSPECTIVE III. Conclusion and Implications As examined in this article, for further development of the Korean PEF market, which is still at an early stage of development and does not have a good number of GPs with diverse transactions experience, the following areas need to be improved. First, pension funds and other benefit associations should play a more active role as major LPs. So far, pension funds and other benefit associations except the National Pension Fund have been rather passive. Considering that the currently high proportion of financial companies and non-financial corporations in the LP composition will likely decline ultimately as the PEF market matures, a more active role of pension funds and other benefit associations should be encouraged. Also, foundations and endowments including universities in Korea who have not participated as LPs should be encouraged to participate in the Korean PEF market. In overseas PE markets, those institutions have been important LPs, but obviously such an expansion of the LP base in the Korean market will require trust between LPs and GPs based on proven investment capabilities of GPs. Second, relative weights of exit routes need to be changed. In the Korean PEF market, the proportions of M&A and IPO as typical PE exit routes are rather low. For further growth, the PEF market requires superior investment returns, and in this context, M&A and IPO should emerge as major exit routes. However, as the Korean PEF market matures and investment capability of GPs accumulates, PEFs are expected to invest more in buyouts and non-listed companies and accordingly, the exit market is expected to converge to a more balanced one. Third, GPs need to develop skills required in overseas investments that will become more important in the future, just as some of leading GPs are already doing. In order to overcome the potential lack of good deal flows and to capture attractive overseas investment opportunities, GPs need to build the capabilities that match global standards in deal sourcing in foreign countries, network building, local market focused value enhancement, and exit network building. In addition, GPs need to develop foreign exchange (F/X) hedging know-how related to overseas investments. Due to 32 2011 Vol. 3, No. 3

Overview of the Korean PEF Market and Major Issues the relatively long-term fund maturity, PEFs are exposed to long term F/X risk related to interim translation, and repatriation of interim dividends and exit proceeds, but long-term F/X derivative products to hedge such risks are rare. Also, in a bidding for overseas investments, PEFs are exposed to F/X risks between bidding and deal closing, and F/X risk management capability will affect the winning probability by offering the best price that incorporates such F/X risk. Therefore, F/X risk management skills will get more important in the future when PEFs actively invest in overseas companies. Fourth, GPs need to develop value enhancement skills and to demonstrate the sustainability of their investment returns, both to generate good returns and to build reputation with LPs. Although immediate goals of most GPs so far have been mostly to maximize fund returns, in the foreseeable future, returns generated from value enhancement activities, i.e., the quality of returns, will get more important. Finally, in order for PEFs to contribute to the capital markets and to flourish, common efforts by all market participants to put in place the consensus performance attribution methodology are much desired. Such methodologies include benchmark development, fund interim evaluation, and performance attribution of individual investment. If PEFs are to efficiently play the role of restructuring and value creation, LP funding needs to be directed to capable GPs. The performance attribution tools can provide LPs the foundations for screening capable GPs, determination of reasonable management fees and carries, and optimal asset allocation to PEFs. In conclusion, Korean PEFs, having shown rapid growth in a short period of time, need to achieve qualitative improvements for another leap in the future. And such qualitative improvements will be all the more necessary when Korean PEFs need to expand into overseas PE markets due to the limitations of the domestic PEF market size. Competition in overseas PE markets requires both PE investment capabilities of international standards and local networks, all of which require long term efforts. Competitive compensation schemes for professional managers in line with international standards will be able to attract capable PEF managers with extensive global PEF management experience and local professional PEF managers in the overseas market. 33

Capital Market PERSPECTIVE References Blackstone, 2009 Annual Report. EMPEA, EMPEA Industry Statistics, 1Q 2011. Financial Services Commission Financial Supervisory Services, 2011, Evaluation of the Past 6 Years of PEF Market and Future Tasks. Financial Supervisory Commission, 2011, PEF Registry. Preqin, 2009 Preqin Global Private Equity Review. Standard & Poors, Leveraged Lending Review 2011. World Economic Federation, The Global Economic Impact of Private Equity Report 2008. Websites Blackston Private Equity Data Analysis, Retrieval and Transfer System (DART) Emerging Markets Private Equity Association Financial Services Commission Financial Supervisory Service Private Equity Intelligence Standard & Poors www.blackstone.com dart.fss.or.kr www.empea.net www.fsc.go.kr www.fss.or.kr www.preqin.com www.standardandpoors.com 34 2011 Vol. 3, No. 3