Special Report On South Korea: New Valuation Rules For .

became hard to obtain liquidity by converting the bondsinto the stocks as we planned”.commercial banks who are now being investigated byregulators on allegations of mis-selling risky financialproducts. Investors claim the banks failed to explain therisks associated with the fund and promoted it as a ‘safe’investment.The experience with LAM has stoked investor fears aboutthe industry and has now resulted in regulatory interventionto ensure market stability, enhance transparency, andimprove measures to protect investors.Figure 7: Commercial Bank Sales of LAM funds, July 2019 (KRW bn)2. The role of total return swaps7596 4%5%Total return swaps (TRS) help hedge funds enjoy leverageby allowing them to control underlying assets with minimalcash outlay upfront. Under a TRS, the hedge fund enterseffectively into a loan with a financial firm (broker, insurer orbank) whereby the financial firm purchases the assets andholds legal ownership over them. The hedge fund thenpays the financial firm a fee in exchange for receiving thetotal return (distributions plus capital gains/losses) on thereference assets. Importantly, TRS agreements endowinstitutional lenders with priority ranking over individualinvestors in the event of liquidation.KEB Hana Bank42121%(KRW bn)(%)(KRW 5667042KB Kookmin BankOtherAn unexpected beneficiary of the scandal has been theforeign banks, which are free from involvement in the DLFand LAM cases. In January 2020 it was reported that agrowing number of retail investors had pulled their moneyout of local banks and put into foreign banks that theybelieve are more reliable and will manage their assets in asafer and more systematic manner.4. The Ponzi schemeIn December 2019 the FSS launched an investigation intoLAM for concealing losses from its investors related to itsPluto TF-1 fund which had invested KRW 240 billion (viaTRS with Shinhan) in Structured Trade Finance Fund(STFF) – a fund operated by International InvestmentGroup (IIG) based in New York5.In November 2019 the U.S. SEC had revoked IIGs licenseand frozen its assets on charges of securities fraud,including concealing losses from its investors and sellingUSD 60 million in fake loan assets to clients. According tothe SEC, IIG had engaged in a Ponzi scheme byovervaluing troubled loans to hide losses and replacingdefaulted loans with fake “performing” loan assets. Tomeet redemption requests, IIG would then sell theovervalued or fictitious loans to new investors and use theproceeds to pay off earlier investors.Recovery Scenario II(KRW bn)Busan BankSource: FSS, KOFIAFigure 6: Recovery ScenariosInstitutionalShinhan Bank1,07054%As of April 2020, LAMs confirmed losses were estimated atKRW 700 billion, implying a recovery rate of 56 percent toinvestors (see Recovery Scenario I below). However, thisignores the impact of TRS on retail investors who make uproughly 60 percent of the KRW 1.6 trillion frozen assets4.As the financial institutions that provided TRS-basedleverage to the fund have senior rights in liquidation, retailinvestors will be left with only KRW 230 billion (25 percentrecovery). Financial institutions will start to incur losseswhen the fund loss rate exceeds 58% (Recovery ScenarioII). After this point, retail investors will lose all their money.Fund Value Recovery Scenario IWoori Bank19410%LAM entered into TRS contracts worth KRW 670 billion forthe troubled master funds with local prime brokerage firms:Shinhan Investment & Securities (KRW 500 billion), KBSecurities (KRW 100 billion) and Korea Investment &Securities (KRW 70 billion).InvestorType1276%Source: pulsenews.co.krThe role of TRS has also created conflict betweenbrokerages over their roles in the LAM fiasco. Forexample, Shinhan, KB Securities and Korea Investment &Securities jointly refused Daishin Securities request thatthey redeem their investments before Daishins’ customers.This decision means Daishins’ customers will likely incursignificantly bigger losses and put huge pressure onDaishin to pay compensation to victims that were largelyunaware they had become subordinated.The FSS suspects LAM knew in advance that IIG was introuble and failed to notify clients of the related risks. InJune 2019, LAM sold its stake in STFF to a Singaporeancommodity trader in return for promissory notes, which wasmeant to secure a lump-sum to repay investors in the PlutoTF-1 fund. However, LAMs failure to notify investors aboutthe transaction, which effectively altered the method of itsinvestment in STFF, could constitute fraud.3. The commercial bank controversyMore recently, the FSS has also accused Shinhan offinancial fraud, saying they colluded with LAM todeliberately cover losses and continue selling the fund byIn July 2019 LAM fund sales had reached a high of KRW5.7 trillion. However, KRW 2 trillion was sold via local4

adjusting the price of Pluto TF-1, raising it 0.45 percenteach month from June to November 2019 when IIG hadsuspended fund reporting.firm, however prosecutors were unable to find him. Afugitive warrant was subsequently issued for his arrest.On 24 April 2020 the Vice Chairman of Leed was foundguilty of embezzlement and received a prison sentenceof eight years. Other executives were sentenced tobetween three to four years for collusion. Trading inLeeds shares was suspended and the company ispending a court decision to delist from the Kosdaq.European Perspective:Given the protections that Europe has enjoyed inthe post-Madoff era could this factor in the crisishave been avoided as the feeder vehicle used isn’tinherently different from many that fall underAIFMD? Under AIFMD, investment funds areobliged to appoint an independent depositary thatsupervises the investment fund’s transactions andacts as a custodian over the investment fund’sassets. The depositary is the ‘legal conscience’ ofthe investment fund and acts as a safekeeper in theinterest of investors. The fact that Madoff was ableto deceive investors for so long was in part becausethe appointed depositary had delegated its custodytasks to an entity run by Madoff itself, i.e. was notindependentIn late April 2020, Kim Bong Hyun and Lee Jong-pil werearrested along with an ex-Shinhan Investment wealthmanager named Shim Moon-sup. They had been on therun for several months. At time of writing, the financialauthorities are investigating LAMs other portfoliocompanies for further evidence of foul play.Implications for asset managersThe DLF and LAM scandals have exposed investorprotection vulnerabilities in the system following problemsof mis-selling, liquidity management and other unfairpractices. To prevent similar instances from arising andrestore confidence in the system, asset managers will needto bolster their risk management procedures. As shown,this becomes particularly important when a fund faceshigher than usual redemptions, increasing the liquidity riskwith potentially catastrophic results for remaining investors.This practice raised questions on the role andliabilities of depositaries of investment funds. Inresponse, UCITS V and AIFMD have introducedrules on (the liability of) the depositary and on thedelegation of its tasks to sub-custodians.NAV and PEF valuationUnder Article 24(1) UCITS V and Article 21(12)AIFMD, Member States need to ensure that adepositary is liable to investment funds andinvestors for the loss of assets held in custody andfor all other losses that result from a depositary’snegligent or intentional failure to fulfil its obligationsunder UCITS V or AIFMD.The sale or purchase price for a PEF is determined by theNet Asset Value per share or NAV. NAV is equal to the netassets of the fund divided by the number of shares or unitsheld by investors so pricing and valuation of the assets areclearly important.For investors to have confidence in a PEF, they must beable to trust the valuations it uses for individual assets andfor the NAV. Investors buy shares or units in a PEFwithout knowing the exact price, which is only establishedafter the deal has been placed. As a rule, the latest officialmarket closing prices must be used to value publicly-tradedsecurities, otherwise a 'fair market value' must be provided.This is designed to offer protection against late trading,market timing and other practices that can affect the valueof a fund.5. Portfolio company embezzlementThe ex-chief investment officer of LAM along with seniorexecutives in two LAM portfolio companies have beencharged with embezzlement: Kim Bong Hyun, former chairman of Star Mobility (acircuit board manufacturer) is accused of embezzlingLAMs KRW 20 billion investment in the company, inwhich he is said to have colluded with LAMs ex-CIO,Lee Jong-pil. Kim is also accused of bribing a formerpresidential official in return for information related tothe FSS probe into LAM to dodge criminal charges 6. InDecember 2019 prosecutors filed an arrest warrant forKim for separate counts of embezzlement including afuneral company and local bus operator worth KRW 16billion, however he had gone missing.When a fund contains illiquid assets, it makes the valuationprocess more complicated and introduces greatersubjectivity into the NAV calculation. The fund managermay appoint an outside firm to carry out such valuations. Ifthe manager carries out valuations in-house, the processmust be independent of the portfolio management to avoidconflicts of interest.Improving guidelines for valuing unlistedequitiesIn October 2019, six executives of Leed Corporation (aKosdaq-listed display equipment manufacturer) wereindicted for allegedly siphoning company funds. Thefollowing month, Lee Jong-pil was due to appear incourt for allegedly mediating a KRW 85 billionembezzlement of Leed funds with executives at theCapturing the risks and appropriately valuing unlistedassets may be a challenge for the manager. This matterwas recognised by the FSS on March 2019 when theyreleased guidance outlining when Cost may be used as a5

proxy for Fair Value to “ease the corporate burden”.However, in the aftermath of the LAM scandal the FSSreleased new guidance in January 2020 which allowsmanagers to use the Cost Method only in very limitedcircumstances. This change brings FSS guidance moreclosely aligned with global best practices such as thoserecommended by the International Private Equity andVenture Capital Valuation Guidelines Board (IPEV), whichin December 2018 issued a revised guidance note that“Removed ‘Price of a Recent Investment’ as a ValuationTechnique to reinforce the premise that Fair Value must beestimated at each Measurement Date.” This removes thepossibility that funds or valuation advisors rely on historicalfunding data for too long, and accordingly, valuation andrisk policies become extremely important for illiquid assets.5. The probability of default, loss given default andexpected volatility in the listed share price of thecompany (or its closest comparables).The IPEV guideline update also follows IFRS9 which wentlive in January of 2018 (replaced IAS 39 as of January 1,2018). Management teams and specifically CFOs havemade important choices over the measurement andreporting of private debt investments. The new standardeffectively sets out three major classifications; namelyAmortised Cost (AC), Fair Value Through Profit or Loss(FVTPL) and Fair Value Through Other ComprehensiveIncome (FVOCI). The standard encourages the movementto Fair Value from Cost which in turn aids investors / LPs inthe following ways:3. Milestone-Based Model (or adjusted price of recentinvestment). Fair Value is the norm for real money investors for theirown financial reporting purposes. In Europe, Solvency IIreporting / prudential valuation requirements have madethis even more important for insurance groups. Liability driven investors use Fair Value as a commonbasis to make asset allocation and specific investmentmanager selection decisions, track-record appraisalsover different time horizons are vital. Fair Value assessment forms part of allocatorperformance evaluation and can be an importantconsideration in compensation decisions.Due to the difficulty of gauging the probability and financialimpact of the success or failure of development activities ofearly stage companies, one should consider that thetraditional valuation techniques cannot be used in allcases. In their latest valuation guidelines, the IPEV andthe AICPA recommend the use of more complex valuationmethodologies, when necessary. These may include:1. Scenario-Based Model (or PWERM).2. Option Pricing Models.4. Monte Carlo Simulation.For Level 3 assets such as private debt, one shouldincorporate different techniques in order to build a robustvaluation process due to the transactionless nature of theassets (in secondary terms). Hence observed transactionsare mostly in additional rounds of funding (new debtissuance), recaps or proxies to the portfolio companyasset.Various techniques and sources of market data could beused to create proxies for a particular mix of risk attributeswhich form a Bespoke Beta very comparable in terms ofaggregate risk to the portfolio company debt. Even thenit’s possible the valuer still needs to employ specificadjustments to best reflect the risks embedded in the dealstructure. This could include sub-sector adjustments, creditratings adjustments, duration adjustments, region of riskadjustments, etc. Bespoke Beta is normally achieved via atailored baskets of referenceable assets. Alternatively, itcan be done using curves generated by multi-variant factorcurves or term structures of comparable entities and thenadjusting for the points of difference. All these techniquesreally act as mechanisms to incorporate a variety of viewsto create a robust valuation which draws on best availabledata and techniques in capital markets.Valuation Considerations for Early-StageInnovative CompaniesWhen valuing convertible bonds issued by early stageinnovative companies such as those on the Kosdaq, anumber of factors should be considered including:For senior mid-market loans, often the best place to findsuitable discount factors is among syndicated or morevisible mid-market loans. Alternatively, for mezzanine loansand distressed debt, methodologies may include EnterpriseValuation based on a market approach (multiples) or anincome approach (DCF) to establish if the value breaks intothe debt capital structure and if so how deep is the valuebreak. If there is sufficient value in the equity classes andno break into the debt, the valuation agent (and fundpolicy) may choose to use a market approach again on thedebt to account for dynamic credit risk reflected via thespreads of comparable assets. Within a given approach,the best practice is to corroborate multiple techniques andassumptions to gain a point of centrality to the valuation orjustify the chosen methodology through a range of values.Having the ability to view asset valuation from multiplevantage points is clearly a benefit of Fair Value.1. The change in market and sector pricing conditions.2. Funding risk, cash burn and liquidity profile of thecompany.3. The seniority of the bond in the capital structure of thecompany.4. Recent developments in the underlying technology andinnovation of the business and the industry.6

will put downward pressure on fair valuation of debtinstruments.IPEV Special Valuation Guidance, March2020It's important to note that the key difference when dealingwith Level 3 assets (and particularly early-stage unlistedequity assets or convertibles) is the heavily analyst-drivenapproach to valuation. Valuations analysts in suchinvestments must have the aptitude to understand legaldocumentation of the deal, corporate finance theory,financial performance and the relevance of milestones anddisclosures, as well as the modelling skills to ensure theseare appropriately captured at inception and throughout thelife of the deal. Due to the heterogeneous nature ofinvestments, this requires significant access to the correctmarket data, research, model infrastructure, people andcontrol oversights.As the impact of COVID-19 continues to ripple across theglobe and affect the fundamental outlook of a wide array ofsectors, the need to apply additional valuation techniquesto estimate the fair value of investments is becomingincreasingly necessary. This point was recognized by theInternational Private Equity and Venture Capital ValuationGuidelines Board (IPEV) who recently issued a SpecialValuation Guidance note to assist with 31 Marchvaluations.Key aspects of the Special Guidance: Fair value must capture current market conditions. Fairvalue does not equal a “fire sale” price. Valuation inputs such as performance metrics and/orfuture cash flows need to be adjusted for the impact ofthe crisis. Greater uncertainty may translate into greater risk whichmay translate into greater required returns which maytranslate into lower asset values. Closing remarksAt time of writing, the fallout from both the DLF andLAM scandals continues to play out:It may no longer be appropriate for recent transactionprices, especially those from before the expansion ofthe pandemic to receive significant, if any, weight indetermining fair value. This will increase the need formark-to-model valuation techniques.The board further highlights the following key aspects withrespect to valuing certain types of equity and debtinvestments which should be considered on an investmentby investment basis: The impact of the crisis on the portfolio company’srevenue/customers, supply chain, and operations mustbe rigorously considered. Adjustments to performance projections and/or metricsare likely to be necessary to reflect current conditionsand uncertainty in projections. Scenario analysis is likely to be necessary to assessand incorporate the probability of the crisis extendingfor 3-, 6-, 12-, 18-months or longer. Liquidity needs must be evaluated more than ever.What is the likelihood of a loan covenant breach? Whatis the impact of customers delaying payments ornonpayment and the impact on reduced cash flow?What is the source of working capital required to“restart” the business if impacted by the crisis? Ascenario analysis that weighs various potentialoutcomes (including the risk of default or potentialgovernment support) may be appropriate to assist inestimating fair value. Par value or face value or cost value is notautomatically fair value. Credit spreads have widenedfor various industries, credit ratings, and terms, which Woori and Hana Bank have filed objectionsagainst the fines imposed by the financialauthorities for mis-selling derivative products,meaning the final decision must now be madeby a court ruling. A “bad bank” that was supposed to beestablished in May 2020 to take over thetroubled funds of LAM has been delayed. Thenew entity will be co-managed by 19 distributorsof LAMs funds, however no agreement has yetbeen reached on who will become the largestshareholder7. Legal action against LAM isexpected to commence in June 2020.The recent scandals are concerning for the hedgeand private equity fund management industry,which may suffer reputation damage, but also forSMEs that rely on convertible bonds and othermezzanine instruments for funding. The latestsupervisory measures (see Appendix for moredetails) are therefore seen as a necessary andwelcome step towards restoring public trust in thefund management industry. The rules will bringPEF-related regulations including risk management(in particular the valuation of non-marketableassets), investor protection, and regulatoryoversight into closer alignment with global bestpractice standards, whilst ensuring that the criticalfunction of PEFs, such as the supply of capital, isnot compromised.7

Footnotes1A situation described by the FSS as “maturitymismatch”.2Unlike the U.S., South Korea has no equivalent of the144A rule which only permits QIIs to trade inconvertibles.3The Kosdaq lost roughly 15% of its value in 2018 and afurther 8% between 1 January – 10 October 2019.4Roughly 4,000 retail accounts were invested to thefunds, equivalent to KRW 230 million per account.5IIG specializes in lending to SMEs in emerging marketsvia a diversified portfolio of fund products andinvestment vehicles such as CLOs.6The official in question (also named Kim) was arrestedon 18 April 2020 on charges of bribery and leaking ofstate secrets.7The entities seem to be trying to avoid becoming thelargest shareholder as this would stigmatize them asthe financial firm with the greatest involvement in theLime scandal (source: koreatimes.co.kr)Author contact detailsPeter AllestonAsia-Pacific Head of Business DevelopmentPrivate Equity & Debt Services, IHS Markitpeter.alleston@ihsmarkit.comLeon SinclairGlobal HeadPrivate Equity & Debt Services, IHS MarkitLeon.sinclair@ihsmarkit.com8

provide a supervisory role and provide ‘checks andbalances’ against one another.Appendix: FSC Measures to Improvethe Regulatory Framework on PEFsII. Improving investor protection. Regulation to addressfund structures that are vulnerable to liquidity risk.III. Strengthen supervision and inspection by FSS/FSC.New Valuation MeasuresAs part of I., Fund Management Companies (FMCs) willneed to comply with measures aimed at bolsteringvaluation best practice:1. Submit standardised internal control and riskmanagement ‘check-list’ reports to the FSS. As part ofthis requirement FMCs will need to establish fund:BackgroundThe Korean private equity market has grown significantly,backed by the government’s policy to promote itsdevelopment:2004201120152018 Valuation policy. The policy should containguidelines for valuing non-marketable assetsincluding unlisted equity, hybrid securities, privatedebt and suspended stocks. In preparing theguidelines FMCs should refer to global bestpractices, such as the U.S. AICPA Accounting andValuation Guide (June 2019)PEF introducedHedge fund introducedPEF rules eased to promote new entrantsPEF rules eased to harmonize with hedge fund regulations: PEFs no longer need to hold more than a 10 percent stake ina company to participate in its

bonds and the constant maturity swap (CMS) rates of the U.S. and UK. The products guaranteed returns of 3-4 percent if interest rates stayed within a predetermined range until maturity. However, when major economies around the world began lowering interest rates in 2019 to stave off eco