(Summary) Korea plans to introduce business development companies (K-BDCs) to expand funding for non-listed companies by benchmarking similar schemes implemented in foreign countries. The introduction is likely to have a significant impact on Korea’s venture capital market. In this respect, it is worth exploring the BDC of the US, from which Korea’s BDC scheme has originated, and the venture capital trust (VCT) of the UK. In the US, the BDC has been operated as a debt-focused investment vehicle while the UK’s VCT has been used as a tax benefit oriented equity-focused investment vehicle. Such divergence has arisen from distinct features of each country’s venture capital market and specific regulations. The cases of the US and the UK offer the following implications for the BDCs in Korea. First, the mandatory ratio for investment in qualified companies and the equity investment ratio should be set up to achieve a relevant policy goal. Second, the level of tax benefits to K-BDCs should be determined by the level of mandatory investment ratio and equity investment ratio in view of the existing tax benefits applicable to venture capital investment in Korea. Third, given that conflicts of interest issue may arise from a firm operating both a private venture capital fund and a public K-BDC, regulatory safeguards should be put in place to minimize the possibility of conflicts of interest and protect individual investors.
Introduction of Business Development Companies
In 2019, the Financial Service Commission (“FSC”) announced its plan to introduce business development companies (“K-BDCs”) by benchmarking the Business Development Company scheme of the US, with an aim of facilitating venture capital funding and building a regulatory framework that allows individuals to invest in promising, non-listed companies.1) The relevant amendment to the Financial Investment Services and Capital Markets Act (“FSCMA”) has been officially published (as of March 31, 2022). The amendment aims to prescribe the definition, requirements for establishment, regulations on operation and licensing requirements of K-BDCs. Currently, discussions are underway to determine details of the K-BDC operation.
The K-BDC is an exchange-listed, closed-end investment vehicle. It is designed to invest its collective investment asset, equivalent to a certain proportion (more than 40%) of the gross assets, in startups and other non-listed companies by means of extending loans and purchasing securities. As a publicly-offered investment vehicle, the K-BDC is subject to a range of operational requirements. First, any single investment is limited to below 20% of gross assets to facilitate portfolio diversification. Second, it is banned from investing in over 50% of aggregate equity securities issued by startups and other key investee companies. Third, over 10% of collective investment assets should be put into stable investment instruments such as government debts to better manage liquidity. Fourth, the K-BDC is able to raise funds from borrowings within the limit of 100% of its equity capital. In addition, the K-BDC should be set up and established as a non-redeemable investment vehicle for the term of 5 years or longer with the minimum capital amount of KRW 50 billion or less. It is also required to list on the exchange within 90 days from the establishment. Lastly, the K-BDC is subject to the licensing requirements for financial investment businesses prescribed by the FSCMA but relaxed regulations on major shareholders would apply to allow venture capital firms to operate K-BDCs.
A wide range of venture capital business entities such as asset management firms, securities firms and venture capital management firms are likely to operate K-BDCs. Accordingly, the introduction of K-BDCs is expected to bring about significant changes across Korea’s venture capital market. Given that Korea has decided to adopt a similar scheme being currently implemented in foreign countries, it is necessary to examine their experience to figure out how to operate the K-BDC scheme to accommodate the circumstances specific to Korea.
Business Development Companies of the US vs. Venture Capital Trusts of the UK
As mentioned above, Korea plans to adopt BDCs by benchmarking similar schemes of other countries including the Business Development Company of the US and the Venture Capital Trust (“VCT”) of the UK. The BDC introduced by the US is a publicly-offered, closed-end investment fund that is allowed to invest in privately-placed securities under the 1980 Small Business Incentive Act. The UK adopted the VCT in 1995 to enable individual investors to make indirect investments in small, non-listed companies, which is characterized by favorable tax treatment. As public or exchange-listed venture capital funds, the BDC and the VCT were introduced to increase equity investment in non-listed, small- and medium-sized firms but how they are operated has varied according to features of the venture capital markets and specific regulations. As a result, the BDC of the US has evolved into a debt-focused investment vehicle mostly lending funds while the UK’s VCT has served as an equity-focused investment vehicle aiming to invest in common shares. Against this backdrop, this article intends to take a look at how the US and the UK are operating the BDC and the VCT, respectively and to explore their characteristics and operational requirements.
The US has introduced the BDC as a closed-end investment company to support funding for startups and innovative firms under the Small Business Incentive Act that was enacted as an amendment to the Investment Company Act. In other words, the BDC of the US is an investment vehicle that has been created through relaxed regulations based on the investor protection mechanism specified in the Investment Company Act, aiming for boosting venture capital investment. Since its introduction in 1980, BDCs have continued growth in the US, driven by several deregulation measures. As of the end of 2020, a total of 115 BDCs are in operation with $89 billion in AUM, among which 50 BDCs are public. The US requires BDCs to invest in eligible portfolio companies that are either private companies or public companies with market capitalizations under $25 million. Also, BDCs must provide significant managerial assistance to the companies in their portfolio. These requirements are imposed to ensure that BDCs are operated in the same way as private venture capital firms. BDCs can opt for investing in equity or bonds issued by eligible portfolio companies. If a BDC meets conditions for diversified investment and distributes over 90% of its profits as dividends to shareholders, it would be exempted from corporate tax. In addition, they are subject to relaxed regulations regarding leverage and related-party transactions, compared to an ordinary closed-end investment vehicle specified in the Investment Company Act. The leverage ratio2) of 200% applies to BDCs whereas an ordinary closed-end investment vehicle is subject to the 50% ratio. In an analysis of 48 listed BDCs of which financial data are available, the average leverage ratio reaches 95%3)anddebtsaccountfor82.2%oftheirportfoliosonaverage.OutoftheBDCs,only four are operated as an equity-focused fund, indicating that BDCs are primarily operated as private credit funds focused on loans in the US.
Ontheotherhand,theVCTisaformofinvestmenttrusts4) that are closed-end, listed investment vehicles. As a tax-saving investment tool,5) the VCT offers an income deduction of 30% with a maximum limit of ￡200,000 to encourage individual investors to invest in small unlisted companies. Since being first introduced to the UK in 1995, VCTs have secured an aggregate amount of ￡9.69 billion assets, with ￡670 million amassed for 2021 alone and a total of 57 VCTs being listed as of the end of 2021. Like eligible portfolio companies in which BDCs of the US are required to invest, eligible investment targets of the VCT are non-listed companies or companies listed on the Alternative Investment Market (AIM). In return for generous tax benefits, the VCT is subject to a detailed operational regulation regarding investee companies, such as the asset size and number of employees, the single investment size and gross investment amount, proportion of ordinary shares in the portfolio, firm age, funding purposes, etc. Under the regulation, an investee company must be less than seven years old and have the asset of ￡1.5 million and 250 employees at the maximum. For each investee company, the maximum investment amount per arrangement is limited to ￡1 million with the aggregate investment for the past 12 months of ￡5 million, and the investment limit for the entire period is ￡12 million. As relevant regulations require VCTs to make equity investments in early-stage companies, they rarely use leverage in their portfolios. As a means of making up for high investment risk, corporate tax exemption is granted to VCTs while VCT investors could receive favorable tax treatment including income tax deduction and are exempted from both income tax from dividends and capital gains tax from VCT share trading.
Implications from foreign schemes
The introduction of K-BDCs is of significance in that it can contribute to creating a venture capital ecosystem that enables investment in non-listed innovative firms through the public capital markets. This suggests the key to the successful operation of K-BDCs lies in achieving a balance between venture capital expansion through the public capital markets and investor protection designed for the sustainable regulatory framework. In this respect, the cases of the US and the UK offer the following implications for how to properly manage K-BDCs.
First, considering that Korea aims at boosting investment in non-listed innovative companies by adopting K-BDCs, the mandatory ratio of investment in qualified companies should be set up to achieve that goal. It is notable that the US and the UK have applied 70% and 80% of the mandatoryinvestmentratiotoBDCsandVCTs,respectively.Ontopofthat,theminimum equity investment ratio should be determined to achieve a policy goal of promoting venture capital investment. It is worth noting that BDCs in the US are practically operated as a debt-focused investment vehicle with no specific regulations regarding investment tools in place. In particular, the minimum equity investment ratio is important in that it serves as the criteria for the following tax benefits.
Second, most countries generally grant favorable tax treatment to either equity investment in high-risk, non-listed innovative firms or venture capital funding. Korea also gives tax benefits to individuals who engage in venture capital investment and funding. However, loans extended to non-listed companies are rarely eligible for such tax benefits. Accordingly, what level of tax benefits should be offered to K-BDCs is likely to depend highly on how they are operated. If certain tax benefits are given to K-BDCs to make up for high investment risk and accelerate the establishment of the K-BDC scheme, the levels of favorable tax treatment should be determined by the mandatory equity investment ratio in view of the existing tax benefits applicable to venture capital investment in Korea.
Third, it is noteworthy that a wide range of venture capital business entities is expected to operate K-BDCs, including asset management firms, securities firms and venture capital funds. Under the circumstance, if a firm manages both a private venture capital fund and a public K-BDC, a variety of conflicts of interest may arise out of investment and exit process. For instance, the issue of which fund gets to invest in an attractive target, and co-investment and related party transactions between the two funds could give rise to conflicts of interest.
In a private venture capital fund, potential conflicts of interest can be inhibited by institutional limitedpartners.Onthecontrary,itisdifficultforindividualinvestorstocontroltheasset manager. Accordingly, relevant regulatory measures should be put in place to minimize the possibility of conflicts of interest and protect individual investors. 1) FSC, October 7, 2019, Introduction of Business Development Companies (BDCs), press release.
2) The leverage specified in the Investment Company Act is regulated by the asset coverage, the ratio of debts to the combined amount of net capital and debts. The maximum asset coverage ratios for an ordinary closed-end investment firm and a BDC stand at 300% and 150%, respectively, which can be translated into 50% and 200% based on equity capital.
3) Based on CEFData as of March 22, 2022
4) As a legal entity, the UK’s investment trust is an investment company.
5) As for VCTs, the income deduction rate of 20% was applied between 1996 and 2004 while the rate stood at 40% between 2005 and 2006 and has remained in the range of 30% since 2007.