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Private equity and venture capital

The number of venture capital firms in Korea has grown rapidly over recent years. In 1999 and 2000 a total of 91 were set up. However, the unsatisfactory performance of these firms, allied with high-profile prosecutions for stock price manipulation and other crimes, has led to restructuring in the venture capital industry, say Wonkyu Han, Je Won Lee and Song Il An of Lee & Ko. This overview of the Korean private equity and venture capital industry details the various laws and regulations that apply for investors looking to invest in venture, such as venture investment partnerships, individual investment partnerships and securities investment trusts.

Over the past few years numerous venture businesses (VBs) have been established in Korea. The establishment and subsequent activities of these businesses have spurred the rapid development of the Korean information and technology, and telecommunications industries. In line with this trend, venture capital companies have also been established in great numbers and their activities have flourished. Recently, however, due to the less than stellar performance of many VBs and the sluggish stock market, the activities of the venture capitalists have slowed somewhat. Also, because of increasing concerns about recovering funds invested in VBs, the establishment of venture capital companies and the formation of venture funds is slowing down. Nonetheless, investments in venture capital companies remain the preferred choice for those investors seeking high returns.

The term ‘venture business' is widely used in Korea to specifically refer to a small- and medium-size enterprise (SME) that has satisfied the relevant requirements under the Act on Special Measures for the Promotion of VBs. However, when defining the term more broadly, it appears more appropriate to refer to those companies established by entrepreneurs to commercialize new technologies or ideas.

What will be discussed in this article is the different ways in which investments are made in VBs. In practice, there is not much difference between investments through venture capital companies and investments made through investment trusts or mutual funds. However, pursuant to relevant Korean laws and regulations, most investments in VBs take place through investment partnerships.

Venture Investment Partnership

A ‘venture capitalist' under the Specialised Credit Financial Business Act may make investments in, provide loans to, and provide managerial and technical assistance to VBs.

Venture capitalists may, together with others, contribute funds to form a venture investment partnership (VIP). There is no restriction on the qualification of third parties who may invest in VIPs. A VIP may only invest in VBs. A venture capitalist who forms a VIP controls and manages the funds of such VIP. However, if the partnership agreement provides otherwise, all or a part of the responsibility of managing the VIP's funds may be delegated to another party. The consideration to be paid to the venture capitalist for its role in managing the funds of the VIP is as stipulated in the relevant partnership agreement; provided that such consideration cannot exceed 20% of the profit earned. In the event of losses, the loss allocation ratio may be decided in the partnership agreement in such way that is advantageous to parties other than the venture capitalist.

VIPs and the partners therein are afforded tax benefits in accordance with the Special Tax Treatment Control Act.

Securities Investment Trust

Under the Securities Investment Trust Business Act, the trustor solicits funds from the investors for the purpose of investing in securities, and instructs the trustee to manage such funds by investing in particular securities. Because the formation of venture funds by way of a securities investment trust does not carry much tax benefits, it is not a widely used investment vehicle. Nonetheless, there are cases where securities investment trusts are used due to certain special needs of the investors.

With respect to redemption of principal and allocation of profits, the investors are treated equally according to their respective number of shares of beneficial interests held in the investment trust. Such shares are represented by the beneficial certificates issued by a trust company. The beneficial certificate stipulates the:

           calculation method of the trust fee and other fees receivable by the trustor and the trustee;
           payment date and method; and 
           the redemption terms of the beneficial certificates.

Management of the trust property is a unique function of the company acting as the trustor; so this function cannot be entrusted to others. Management of the trust property takes place by way of securities trading and futures transactions. Investments in VBs can occur by purchasing the shares or bonds they issue. Because funds raised through a securities investment trust may be used to engage in futures transactions, unlike venture funds set up by venture capital companies, the needs of diverse investors may be satisfied. When managing the trust assets no more than ten per cent of the total trust property may be invested in securities issued by a single entity, and no more than ten per cent of the total shares issued by a single entity may be acquired. However, these restrictions do not apply if the issuance of the relevant securities is not a public offering and there are less than 100 subscribers.

Securities Investment Company

A securities investment company is similar to a mutual fund. It is established for the purpose of investing its assets in securities and distributing the profit to its shareholders. A securities investment company must be a joint-stock company and have capital in excess of Wn400 million. Shares issued by an ordinary joint-stock company must have a par value, but the shares of a securities investment company may be issued without any par value and they may not engage in any business other than investing in securities. In carrying out its duties, a securities investment company must enter into relevant business agreements with an asset manager, a custodian, a placing agent and an administrator.

A securities investment company may manage its assets by:

           trading in securities;
           lending securities up to 50 per cent of the securities held by it;
           making deposits in financial institutions that can engage in money brokerage;
           providing short-term loan of less than 30 days; and
           engaging in futures transactions.

A securities investment company may not invest more than 10% of its total assets in the same securities and may not acquire more than 10% of the total shares issued by a single company. In the case of an open-ended securities investment company, its shareholders may request redemption of the shares.

Korean Venture Investment Partnership

The Korean Small and Medium Industry Promotion Corporation, which manages the ‘funds for the establishment and promotion of SMEs' pursuant to the Promotion of Small and Medium Enterprises and Encouragement of Purchases of Their Products Act may form a Korean Venture Investment Partnership, for the purpose of investing in VBs, by entering into contribution agreements with foreign investors or managers of domestic funds. Investment in VBs refers to the purchase of shares, uncollateralised convertible bonds or uncollateralised bonds with warrants, issued by VBs.

The Korean Small and Medium Industry Promotion Corporation must use the funds of the Korean Venture Investment Partnership for making contributions in small and medium enterprise establishment investment partnerships (SMEEIP) or VIP, or investments related to establishment of SMEs or VBs. The Korean Small and Medium Industry Promotion Corporation may delegate all or a part of the duty of managing and controlling the funds of the Korean Venture Investment Partnership to a third party. In this case, up to 20 per cent of the profits from investments may be allocated to the delegated party. If the Korean Venture Investment Partnership suffers a loss, the loss is first offset from the amount the Korean Small and Medium Industry Promotion Corporation contributed to the Korean Venture Investment Partnership and if there are remaining losses, such losses are allocated to the other contributors up to their respective contribution amount. This means that funds for the establishment and promotion of SMEs will first be used to offset any loss.

Individual Investment Partnership

Individuals may form a partnership (an individual investment partnership) for the purpose of investing in VBs with the support prescribed under the Act on Special Measures for the Promotion of VBs. In this case, the individual must register with the Administrator of the Small and Medium Business Administration. An individual investment partnership is comprised of one general partner and other partners. Individual investment partnerships must satisfy the following requirements:

           total contribution amount must exceed Wn500 million;
           a single contribution must exceed Wn1 million;
           have 49 partners or less;
           the amount contributed by the general partner must exceed 5 per cent of the total contribution
           amount;   
           and the term must be longer than five years.

In carrying out the business of the partnership, the general partner must not:

           borrow funds;
           provide guarantees or collateral; and
           resign or assign its position unless otherwise provided in the partnership agreement.

An individual investment partnership may only purchase shares, uncollateralised convertible bonds or uncollateralised bonds with warrants issued by VBs.

Small and Medium Enterprise Establishment Investment Partnership

Pursuant to the Support for Small and Medium Enterprise Establishment Act, a small and medium enterprise establishment investment company (SMEEIC) may invest in entrepreneurs or VBs. A SMEEIC may jointly form a SMEEIP with others. A SMEEIP is comprised of one general partner who has unlimited liability with respect to the liabilities of the partnership and limited partners who are liable up to their respective contribution amounts. The investment company acts as the general partner and other partners are limited partners. The minimum contribution amount and the minimum amount for one share of beneficial interest are Wn1 billion and Wn1 million, respectively. There may be no more than 99 limited partners, the contribution amount of the general partner must be 5 per cent or more of the total contribution amount, and the term of the investment partnership must be five years or more. The SMEEIP is presently the most widely used form of partnership in Korea.

The partners may contribute their respective contribution amounts at once or in installments, in accordance with the partnership agreement. The SMEEIP can allocate up to 20 per cent of the profit from investments to the general partner, the SMEEIC. The general partner can then allocate up to 50 per cent of the amount received to its officers and employees, who have contributed to the profit, as performance incentives.

If the SMEEIP invests a certain percentage of its funds in entrepreneurs and VBs, it can make overseas investments, up to 30 per cent of its contribution amount, to secure, supply and promote foreign technologies.

Parts and Materials-specialised Investment Partnership

Small and medium enterprise establishment investment companies, venture capitalists, the Korea Development Bank, Industrial Bank of Korea, banks, securities companies and insurance companies may, pursuant to the Act on Special Measures for Promotion of Parts and Materials-specialized Enterprises, jointly form parts and materials-specialized investment partnerships (PMIPs) with others while acting as the general partner. A PMIP must make investments in parts and materials-specialized companies. A ‘parts and materials-specialised company' refers to a company whose parts and materials sales amount to over 50 per cent of its total sales. Under the Act on Special Measures for Promotion of Parts and Materials-specialized Enterprises, ‘parts and materials' refers to:

           raw materials used in production;
           work in progress that adds great value to the end product;
           parts that accompany high or core technologies;
           materials that can create technology or add value; and
           materials that can be the foundation of an industry or link industries.

The total contribution amount of a PMIP must be Wn1 billion or more, the contribution amount of the general partner must be 5% or more of the total contribution amount and the term must be five years or more. The assets of a PMIP must not be used for purposes other than investing in a parts and materials-specialized companies. In carrying out its duties, the general partner must not borrow funds nor provide guarantees or collateral.

Conclusion

Regulations regarding the formation of venture funds through venture capital companies overlap in many ways under different laws and regulations. The wave of VBs in 1999 and 2000 led to the establishment of 26 and 65 venture capital companies in 1999 and 2000, respectively. However, this wave brought about adverse effects, resulting in many officers and employees of venture capital companies facing sanctions and punishments for stock price manipulation and other crimes. As a result, the venture capital industry is presently undergoing restructuring - some venture capital companies were forced to give up their business licences and M&A among the venture capital companies is taking place. Moreover, the Korean government, in its attempt to create a more sound venture investment environment, is planning to further tighten existing restrictions.

Considering the above, investors have recently shown interests in venture funds that do not have restrictions on investment targets. A mezzanine fund is one such example. Presently, tax advantageous venture investments take place by way of venture capital companies or VIPs under special laws and regulations. In this case, to reap the tax benefit, restrictions on investment targets and other restrictions under the relevant laws and regulations must be complied with. If the tax benefits are waived, however, such restrictions are not applicable. In light of this, other types of partnerships are being highlighted as alternate means of investment.

There will always be entrepreneurs who long to commercialize new technologies and ideas. So long as such entrepreneurs do not have sufficient funds, the support of venture capital companies will be needed. At the same time, investors who do not have the sophistication to evaluate new technologies and ideas will turn to venture capital companies for investments in VBs. Taking into account the foregoing, Korea is in the process of re-examining the legal infrastructure for VBs, and is preparing to set up a more sound legal infrastructure.

Lee & Ko, 18th Floor, Marine Center Main Building, 118, 2-Ka Namdaemun-ro, Chung-ku, Seoul, Korea
Tel: 82 2 772 4000
Fax: 82 2 772 4001/2
Website: www.lawleeko.com

Copyright © 2002 IFLR

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