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Private Equity’s Second Act: Challenges and Opportunities
Private Equity
Private Equity’s Second Act: Challenges and Opportunities
  • By matthew
  • November 17, 2014, 09:21
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The heart of the Gangnam district of Seoul. (Photo by Leeyan Kym N. Fontano via Wikimedia Commons)
The heart of the Gangnam district of Seoul. (Photo by Leeyan Kym N. Fontano via Wikimedia Commons)

 

The author F. Scott Fitzgerald once famously remarked that “there are no second acts in (American) life.” Korean investors are hoping that a second act is available for private equity (PE), the much-maligned and often misunderstood alternative investment class that has generated scorn, controversy and revulsion from the Korean public since its public introduction in 2004. Despite PE’s generally impressive track record, Korean public discontent with the alleged missteps and misconduct associated with Lone Star Funds’ acquisition of a controlling interest in Korea Exchange Bank has continued to linger. In order to dispel myths and gain a more impartial perspective on PE’s proper role in Korea, a review of PE’s structure, purpose, and public benefits is vital.

PE has many sub-classes, including leveraged buyouts, growth capital and venture capital, though the last of these is generally thought of as a distinct asset class of its own. By pooling capital provided by a variety of limited partners -- generally, pension funds, sovereign wealth funds, high net worth individuals and other accredited investors -- in the form of a limited partnership, the general partner of a PE fund is then empowered to do many things. The partner can invest the fund capital in private and sometimes public companies at various stages of growth or maturity, restructure the target company’s balance sheets, or make operational improvements and sell the target company to another PE fund (called a secondary buyout), a strategic competitor in the industry, or the general public in the form of an initial public offering (IPO). In addition to potentially realizing returns on its investment from the sale or listing of their portfolio companies, the general partner of a PE fund typically collects management fees (often 1.5 to 2 percent of total assets under management) and performance fees (typically 20 percent of the total returns on investment). Given this fee structure and the multiple sources of positive returns, it is unsurprising that general partners of these funds have often done extraordinarily well.

While the fabulous wealth attained by general partners in managing PE funds has generated popular outcry worldwide, the accompanying benefits to companies, employees, and smaller investors have often escaped notice. Many of the world’s largest and most successful companies have, at one point or another, tapped into the flow of financial, advisory, and relationship capital provided by PE, enabling them to access funds for product development, marketing, manpower, and R&D that would have been otherwise unattainable from banks or public equity investors. Without this infusion of private capital, many of these promising companies may have faced insolvency or closure. Experienced PE managers can also connect companies with valuable customers or business partners, leveraging networks from prior investments or their existing investments in other portfolio companies. If the Park administration is sincere in its commitment to the development of a Korean “creative economy” spearheaded by promising small to medium-sized enterprises, the consideration of PE and other forms of alternative investment to fund the growth required of Korean SMEs and the emerging entrepreneurial class may make a great deal of strategic sense. Family-owned businesses facing succession issues may also find the experience, skills, and resources of top PE firms attractive when they are seeking to exit their businesses.

But PE is not always sunshine and lollipops. While empirical data suggests that the returns provided to investors in top-performing PE funds more than justify the hefty management and performance fees, grave danger abounds for those who choose poorly managed funds. According to a recent study by BlackRock, the asset management firm, the best PE managers produced significantly higher investment returns than their peers in traditional investment classes (like fixed income, equity, and real estate) did, but the bottom PE managers consistently underperformed comparable managers in these other investment classes. During the decade from 2002-2012, the top 10 percent of global PE managers generated a whopping 31.0 percent median return, about 23 percent higher than the 8 percent returns generated by a top 10 percent equity fund manager, and more than 27 percent higher than a comparably-ranked bond fund manager. Conversely, the bottom 25 percent of managers suffered median losses of 11.8 percent, significantly higher than the losses produced by low-performing managers in other investment classes. This broad dispersion of returns underscores PE’s challenges and opportunities.

Despite the risks, PE can offer an opportunity for those with an appetite for risk. Contrary to public belief, many of the LPs invested in PE funds are not the fabulously wealthy, but rather ordinary retirees and government workers who participate indirectly via public and private pension funds. For a country facing the economic growth and demographic challenges of Korea, the impressive returns generated by top PE funds present a compelling opportunity for qualified investors, particularly as the outlook for Korean real estate -- the preferred investment vehicle for Koreans in the postwar period -- and bond funds continues to darken amidst a deflationary environment. However, because of the risk of large losses, PE should only be undertaken by skilled and experienced managers who can properly evaluate, manage, and exit selected investments. Korean regulators can support the investment process and instill public confidence by tightly regulating PE funds and requiring regular outside audits and full disclosure. It is both likely and appropriate that Korean regulators will closely scrutinize the formation and investment structure of PE funds to a degree not often seen in the West.

Recent activity of the PEs in Korea indicates that the industry will continue to grow. A number of large, globally-prominent funds continue to make Korean investment a high priority. There are also many strong and reputable domestic PE funds that are very active in Korea, both in raising funds from LPs and in sourcing and executing successful deals. Provided that eligible Korean investors and companies demonstrate a mature understanding of the industry and undertake a thoughtful appraisal of the risks, all participants can benefit from PE as an important source of growth capital.

Patrick Monaghan is a senior foreign legal consultant at one of Korea's largest law firms. His practice includes cross-border private equity. You can reach him at patrickjmonaghan3@gmail.com.