The VC ecosystem frozen by the ‘double whammy’ of investment contraction and poor management, will ‘impairment losses’ be a self-rescue measure?

The government's 'operational status' of the mother-of-fund fund that was used as a priming product for the VC industry
Industry shaken by high interest rates, deepening economic uncertainty, and weakening investment sentiment
The market is frozen in the harsh cold, 'helpless' due to investment budget cuts

The Ministry of SMEs and Startups is significantly revising the impairment loss (hereinafter referred to as impairment loss) regulations for fund-of-fund sub-funds. With the recent cold weather in venture investment, an increasing number of invested companies have been recorded as impairment losses in venture funds, and the plan is to reduce the burden on venture capital (VC), which is the management company (GP), and encourage follow-up investments.

Poor operation of mother-of-fund funds becomes visible, government responsibility ‘emerges’

The mother-of-funds system is one of Korea’s major startup support policies. A fund of funds is a financial resource for revitalizing private venture investment. If you invest in a VC, the VC can use this as seed money to create a venture fund and invest in startups. Funds of funds are evaluated as having played a significant role as a priming agent by driving demand for investment in domestic startups. However, opinions differ as to whether the government has properly operated the fund of funds. Some criticize that the government’s poor management of mother-of-funds funds has been a factor in the decline in domestic venture investment.

In fact, in 2022, it was found that the proportion of sub-funds that failed to comply with the deadline for forming sub-funds of mother-of-fund funds increased significantly. Here, a subsidiary fund refers to a fund invested by a mother fund. Typically, the government invests a mother fund to help the private sector create a fund (sub fund) to invest in ventures. In accordance with the government’s ‘Venture Investment Fund Association Management Guidelines’, the time limit for the formation of a sub-fund is within 3 months from the date of selection of the manager. However, Korea Venture Investment, a public institution in charge of the mother fund business, needs to extend the time limit due to unavoidable reasons of the manager. If it is recognized that it exists, it can be extended for up to 3 months. If an additional unavoidable reason arises for the manager, an additional grace period may be granted through consultation with the Minister of SMEs and Startups and the relevant account authority. However, looking at the time taken from the selection of a management company to the formation of a sub-fund over the three years from 2020 to 2022, the proportion of sub-funds that failed to meet the second formation deadline sharply increased from 9.5% in 2020 to 21.2% in 2022. 

In relation to this, Korea Venture Investment explained, “It was difficult to recruit private investors due to the preference for safe assets due to the high interest rate trend in 2022 and the recession in the recovery market.” The problem is that if the formation of a sub-fund is delayed, the supply of private funds is delayed, reducing the effectiveness of the fund of funds project. Another major point of criticism is the decline in the investment execution rate of some sub-funds. In order to achieve the purpose of providing liquidity to start-ups and venture companies, which is the purpose of the fund of funds business, investment by sub-funds must be active. However, looking at the investment execution performance of sub-funds created over the past three years, the investment exhaustion rate of sub-funds is 73.0% of the amount formed in 2020, It was only 47.6% of the size of the formation in 2021 and 8.0% of the size of the formation in 2022. The uninvested amount (based on the amount formed) amounts to KRW 1.1844 trillion in 2020, KRW 2.2917 trillion in 2021, and KRW 2.872 trillion in 2022. Korea Venture Investment explained to the National Assembly, “In 2022, investment sentiment in the venture industry has declined sharply due to high interest rates and economic uncertainty, so overall investment execution is conservative.”

Ministry of SMEs and Startups implements revised impairment loss guidelines

In order to solve the problem of poor management, the Ministry of SMEs and Startups proposed a revision to the ‘Guidelines for Impairment Loss of Funds of Mutual Funds.’ The core of this guideline is the reversal of impairment losses. Here, impairment loss means that if the decline in the value of the asset is difficult to recover, the value of the asset is reduced and recognized as a loss for the current period. Reversal of impairment loss refers to recalculation of the value of the invested company that has been treated as an impairment loss in the accounting books due to complete capital erosion, etc. It means reflecting. The reason why reversal of impairment losses is important is because of the management fee calculation standards for venture fund GPs. Korea Venture Investment, a fund-of-funds management company, calculates the management fees that GPs receive while operating the fund based on the investment balance. For example, assuming a fund formation amount of 20 billion won, investment balance of 10 billion won, and management fee rate of 2%, the GP receives 200 million won per year as management fee. Investment balance refers to the amount invested through the fund.

The problem is when an investee company experiences damage, such as business suspension, complete capital erosion, or non-payment of wages for more than three months. At this time, the GP must write an impairment loss on the investment in the investee company from the investment balance. As a result, the investment balance decreases and the management fee that the GP can collect also decreases. After the damage event is resolved, the GP can return the investment in the investee company back to the investment balance. In the case of complete capital erosion, it can be recovered if the capital erosion is eliminated through follow-up investment. However, using the existing standards for calculating the refund amount, it is virtually impossible to recover the same investment balance as before. The existing standard for calculating the refund amount is the net asset value multiplied by the share ratio. On the other hand, this amendment reflects the unit price of follow-up investment. The redemption amount can be calculated as the unit price of the follow-up investment multiplied by the number of shares.

Government expecting follow-up investment, Hyun Seon says, “Okay”

Ministry of SMEs and Startups officials expect that this guideline revision will lead to follow-up investment from companies that have technological capabilities but are in complete capital erosion due to difficulties in commercializing them. However, field officials predict that it will be difficult for the venture ecosystem to recover just by improving the reduction regulations. In the first place, the key factor in the cold weather for domestic VCs was the triple problem of ‘decrease in investment, lack of financial resources, and market recession.’ Due to this situation, ‘Anavada (use sparingly, share, change and rewrite)’ has recently become widespread in the VC industry. With little money being released into the market and the fruits to be harvested not being properly harvested, the old slogan that appeared during the 1998 foreign exchange crisis was reborn as a word that penetrates today’s society.

According to the Korea Venture Capital Association, the amount of new investment by domestic VCs last year amounted to only KRW 3.6952 trillion, a 32% decrease compared to the same period last year. Just 2-3 years ago, the rush to exhaust investment resources as if competing has seemingly disappeared. As such, the problem of lack of investment funds within the VC ecosystem seems to be becoming more visible recently. In fact, the number of newly formed VC funds last year was 184, a 33.8% decrease compared to the same period last year (278), and the amount plunged 43.1% from KRW 7.2275 trillion to KRW 4.1129 trillion. The reason is that the government significantly reduced the size of its investment in mother-of-funds funds, which serve as a priming agent. The government cut last year’s investment budget by 40% compared to the previous year and by 70% compared to 2021. Korea Venture Investment, however, belatedly presented investment promotion measures such as introducing management fee incentives, but this alone was not enough to thaw frozen investment sentiment. In addition to simply revising the guidelines, it seems necessary to pursue various market revitalization policies.