KOREA CAPITAL MARKET INSTITUTE

Competitiveness-enhancing measures and regulatory reform

In response to Japan’s trade restrictions, Korea enacted the Act on Special Measures for Strengthening Competitiveness of Materials, Parts, and Equipment Industries (Act on Special Measures, hereinafter), aiming to bolster the competitiveness of the relevant industries. Passing the National Assembly on Dec. 27, 2019, the Act on Special Measures broadens and bolsters the previous law (Act on Special Measures for the Promotion of Specialized Enterprises, etc., for Materials and Components, Previous Law, hereinafter), enacted as a temporary act back in 2001. Earlier in August 5, 2019, the government also came up with the Measures to Strengthen Competitive Edge of Materials, Parts, and Equipment Industries (Measures, hereinafter) with the aim to shift away from heavy external dependence of the current industrial structure. The Measures set three essential core tasks purposed to secure stable supplies of 100 materials, parts, and equipment items that are of strategic importance. The first task is to secure stable supplies of core items in a timely manner by diversifying suppliers, addressing difficulties in domestic production, and securing core technologies as fast as possible. Second, a cooperative ecosystem model should be established between suppliers and buyers, which will enable a secure domestic supply chain. Third, a competitiveness committee is established to give omnidirectional support, with an all-out reform on the previous, temporary law. 

What’s notable in the Measures and the Act on Special Measures is their relevance to the capital markets. The Measures include a series of supply-stabilizing plans, e.g., building a support system for M&A targeting global technology firms, establishing a large-scale fund that will invest in Korea’s MPE industries, etc. To give a legal basis for such policy support, the Act on Special Measures sets out various provisions, e.g., designating a specialized MPE firm, establishing a legal basis for registering a specialized investment fund, fleshing out incumbent laws and regulations on MPE M&A, etc. to add details on policy support. 


Scope and significance of MPE industries

MPE industries are broad-ranged, including virtually every manufacturing sector. Article 2 of the Previous Law lists industries governed by the law as follows, according to which materials include textiles, pulp and paper, chemicals, rubber, plastic products, non-metallic mineral, basic metal industries, whereas components include fabricated metal, machinery, computers, electrical and other machinery equipment, electronic components, radio, television and communication apparatuses, medical, precision and optical instruments, transport equipment, manufacture of furniture, etc. Among the listed, materials and components should meet one of the following three conditions. First, they should contribute significantly to adding value to the end products. Second, they should involve advanced or core technology whose spillover or value-added effect is significant. Third, they should help create an industrial foundation or a substantial industrial linkage. As shown in Table 1, Korea’s materials and components industries take up a significant portion as large as half the manufacturing industry. Furthermore, a substantial number of materials, parts, and equipment firms are SMEs, so-called ‘small but strong’ firms. Hence, a policy focus on strengthening MPE competitiveness is perfectly in line with the policies nurturing SMEs and small but strong firms.
  In general, materials and parts, equipment, process, and manpower are known as the four core elements in the manufacturing industry. This well demonstrates that MPE competitiveness is an essential element for securing the competitiveness edge of the overall manufacturing industry.¹⁾ As the MPE technology becomes standardized globally, there has been a growing tendency in the global market where MPE firms try to bolster competitiveness, grow in size, and forge strategic partnerships. Under the circumstances, Korea’s MPE industries thus far have failed in terms of industrial sophistication due to their heavy external dependence, and lack of the cooperative model between buyers and suppliers, among others. In particular, there’re high calls for Korea to overcome its ‘cormorant economy’ where a substantial part of gains from Korea’s materials and parts exports goes to Japan due to Korea’s heavy dependence on Japan in this area.


Characteristics of MPE firms

MPE products are injected into the manufacturing process for a variety of end products. Although their wide diversity in products and features make it hard to find common features, the followings are viewed common from the perspective of the capital markets. First, MPE products are intermediate goods that are essential to producing end products. Their market size is in many cases limited and determined by the demand of customer industries. Second, MPE industries have a high entry barrier because they require significant upfront investments and long-term track records of accumulating know-hows in technologies and processes, meeting customer needs, etc. Third, MPE providers who are once proven competitive are highly valued in the market thanks to their established demand and supply networks, high switching costs, and core technologies.
 
As such, the stable market environment and high entry barrier are making MPE firms highly valued in the global capital markets although the market size could be relatively limited. MPE firms’ strategic value in the supply chain appeals to strategic investors, whereas the solid market dominance and stability in investment help attract financial investors.


Cooperative models for investing in overseas MPE firms

Towards stronger competitiveness in Korea’s MPE in the mid- to long-run, Korea needs to focus on technological development via R&D and stronger alliances between suppliers and buyers. However, in a shorter run, it’d better stabilize supplies via more aggressive tactics such as overseas M&A and investment. That rationale was behind the August Measures that pledged to give financial support to projects purposed to secure stable supplies from overseas MPE firms. More concretely, the support includes a series of tax benefits, e.g., corporate tax credits for acquisitions of overseas MPE firms; policy financing support to acquisition financing; and capital gains and dividend income tax exemptions for venture capital investment in MPE firms. 

Korean firms’ investment in and acquisitions of overseas targets require not only the effort of those acquirer firms, but also the supportive role of capital market investors. Although large corporations with abundant experiences in overseas M&A and investments are expected to tap into policy financing and global investment banks in seeking to stabilize supplies, most Korean MPE firms are small in size and lack experiences in overseas investment and M&A deals. Also noteworthy is the high technology intensity in MPE areas, as mentioned above. This is expected to limit investment activities of financial investors who lack technological expertise. Simply put, M&A and investment in MPE firms require an investment model requiring strategic and financial investors to put their heads together. Such a cooperative investment model can be divided into two types, a passive model involving investment in venture capital and private equity funds (private equity funds, hereinafter) and a proactive model carrying out matching investments where a firm co-invests with separate private equity funds. 

With regard to the first model, a private equity fund are a private fund that invests capital of institutional investors such as pension funds. Thus far, a firm’s investment in a private equity fund has been limited in scope. However, with the growth of technology-focused innovative firms in IT, bio, high precision products, etc., the market sees an increase in cooperative investment activities where firms with specialized technologies meet with private equity funds that lack technological expertise and know-hows but have business improvement experiences via revenue growth and structural improvement. A firm investing in a private equity fund can minimize risks of direct investment, while keeping track of recent technologies and product trends and often forming a business relation with portfolio investee firms. If needed, the investor firm could grab a chance to acquire the investee firm when the fund tries to exit the investment. Under the passive model, an investor firm could forge a close cooperative relationship with private equity funds by working together to carry out a due diligence or to provide advising or management resources. The government-sponsored fund recently established to aim to facilitate MPE industries could double the effect of such cooperative effort.
 
The second model opting for matching investment is a scheme where a private equity fund enters into a shareholder agreement with an investor firm in seeking to acquire a target firm. Based on investment experiences, private equity funds could contribute to M&A deals in many aspects, e.g., increasing investment size, improving bargaining power, preventing diverse investment risks that are easily overlooked by less-experienced investor firms, facilitating post-merger integration, etc. Because many M&A deals use acquisition financing, a matching investment model, if combined with policy-based acquisition financing included in the Measures, is expected to help form an efficient investment cooperation body. 

Also worth noting is that it could be impossible or too costly to acquire overseas MPE firms that are part of supply chains used by competitor buyers. In such a case, a more realistic approach would be equity participation. For buyouts, it’s worth considering a strategic approach that targets an MPE firm owned by a soon-to-mature overseas private equity fund. Such a situation provides another rationale for a cooperative investment model between strategic investors and financial investors that are more familiar to how peer private equity firms manage investments. 
 

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1) Regarding the importance of MPE, there have been concepts such as the related and supporting industries by Michael Porter, one of the world’s most legendary thinkers on management, and Japan’s supporting industry, both of which are regarded as one of the key determinants to national competitiveness. Porter’s supporting industries refer to an industry that is broadly purposed to produce inputs important for innovation and internationalization. According to the concept, a nation’s competitiveness depends on whether such industries exist or not. In addition, Japan’s supporting industry can be used to broadly refer to all industries producing intermediate goods, as well as to narrowly indicate MPE industries.