[Turning Point for Private Equity Funds]②Regulations Only Hurt Domestic Firms... No Room for Small and Mid-Sized PEFs

Banks Pull Back PEF Investments Amid RWA Constraints
Major Investors Like National Pension Service Distance Themselves After Homeplus Incident
Polarization Deepens as Capital Concentrates on Large GPs
Tighter Regulations May Only Strengthen Foreign PEFs

Editor's NoteThis year marks the 20th anniversary since buyout private equity funds (PEFs) first appeared in South Korea. Now that the PEF industry has reached maturity, a sense of crisis is spreading. Criticism of PEFs has intensified following the Homeplus incident, and amendments to the Commercial Act and the Capital Markets Act, which emphasize the principle of equality, are also shrinking the scope of PEF activities. This three-part series examines the current state and future of Korean PEFs at this critical turning point.

The position of domestic PEFs is weakening. Major players in the Korean capital market are either postponing or reducing their commitments to PEFs. In addition, political circles are moving to strengthen regulations on PEFs. Concerns are being raised in the market that such changes may only serve to strengthen foreign PEFs, which are not subject to these regulations, potentially leading to the domination of the domestic market by overseas capital.

Bank Investments in PEFs Plummet

Commercial banks, which are among the major players in the domestic capital market, have strengthened their management of risk-weighted assets (RWA) this year. This is because an increase in RWA affects the Common Equity Tier 1 (CET1) ratio, which could disrupt their value-up plans. The CET1 ratio is an indicator of a financial institution’s soundness, and the ability to pay dividends to shareholders is determined by this ratio.

Since the global implementation of the Basel Committee on Banking Supervision (BCBS) Basel III regulations in 2023, capital adequacy management at the bank holding company level has been reinforced in Korea as well. With the adoption of Basel III, there was a change in how RWA weights are applied: for unlisted stock transactions for trading purposes, a risk weight of 400% is now applied.

This means that if 10 billion won is committed to a PEF, 40 billion won is applied to RWA. Naturally, not only banks but also other financial holding company subsidiaries such as capital firms are now reducing or taking a more conservative approach to PEF commitments in order to lower their RWA burden.

Especially after the Homeplus incident earlier this year, mutual finance cooperatives, pension funds, and public funds have also closed their wallets, further compounding the difficulties for PEFs. As banks have also become more cautious about commitments due to RWA management, small and mid-sized PEF houses are struggling to secure funding.

An industry insider commented, "By uniformly applying a 400% RWA to PEF commitments, limited partners under financial holding companies, especially capital firms, have drastically reduced their commitments. As a result, only foreign PEFs that do not rely on domestic capital are benefiting from the current situation."

"Prevent Reverse Discrimination Against Domestic PEFs"

As banks tighten their purse strings, major domestic limited partners (LPs), including the National Pension Service, have also begun to take a more conservative approach to PEF fund commitments. This is a direct result of the Homeplus incident. With stricter criteria for fund commitments, the position of small and mid-sized PEFs is rapidly shrinking. Industry insiders are concerned that if regulations are further tightened in an already contracting market, small and mid-sized PEFs may no longer have a place to survive.

According to the "2024 Institutional Private Equity Fund Management Status" report released last month by the Financial Supervisory Service, the concentration of funds among large general partners (GPs) has accelerated. The proportion of large GPs (with committed capital of 1 trillion won or more) in the market increased significantly from 60.4% in 2022 to 66.2% last year. In contrast, the market share of small GPs (with committed capital of less than 100 billion won) fell from 5.3% to 4.6% over the same period.

Even among PEF commitments made between January and July this year, the concentration toward large GPs was evident. During this period, major LPs such as the National Pension Service, Korea Development Bank, Korea Growth Investment Corporation, Government Employees Pension Service, Korea Radioactive Waste Agency Fund, and the General Assembly Pension Fund committed a total of 2.42 trillion won. Most of the selected GPs were well-known large firms such as MBK Partners, IMM PE, and JKL Partners.

An official from a public fund commented, "To inject capital into the mid-cap market (M&A of small and medium-sized companies) handled by small and mid-sized GPs, we divide commitments into leagues for large, medium, and small GPs. However, recently, even in small-scale commitment projects, large GPs are entering the scene, and since there is a preference for firms with proven investment track records, capital is being concentrated in large GPs."

Meanwhile, the National Assembly has successively proposed amendments to the Capital Markets Act to regulate PEF activities. The core content is to regulate leveraged buyouts (LBOs), where the shares and real estate of the acquired company are used as collateral to raise loans and issue corporate bonds to pay the acquisition price.

A representative from a small or mid-sized PEF said, "When we win a policy fund, we usually expand the fund by matching it with commitments from banks. However, as large GPs monopolize commitment projects, it has become difficult to raise money from the private sector. If regulations are further strengthened, small and mid-sized firms will face even greater difficulties."

As a result, there is a growing call for caution in regulating PEFs. Lim Hyungjun, Senior Research Fellow at the Korea Institute of Finance, pointed out in his report "A Regulatory Approach to PEFs Considering Market and Regulatory Environments" that regulations should be aligned with global standards to avoid disadvantaging only domestic PEFs.

He stated, "There is a risk that regulatory arbitrage may occur, where only domestic companies and funds are weakened, while foreign PEFs, which account for a significant portion of the domestic large-cap buyout market, remain unaffected. To prevent regulatory arbitrage, revisions to the Capital Markets Act and the restructuring of PEF regulations should be carried out in a manner consistent with the regulatory standards and practices of the United States and the European Union (EU)."