[DEBRIEFING] The curious case of the missing trillions

In-depth

Published: 29 Nov. 2020, 14:10 Updated: 29 Nov. 2020, 14:11

[DEBRIEFING] The curious case of the missing trillions

Investors that suffered losses from Lime funds stage a protest in front of the FSS building, where a sanctions review against the sellers of Lime funds is being held. [YONHAP]

In Debriefings, the Korea JoongAng Daily discusses a topical issue in depth in a Q. and A. format. In this Debriefing, we look at the history of private equity funds, the financial and political scandals involving them and what regulators are doing to prevent problems with them.

An investment product previously unfamiliar to many has been in the headlines following a series of massive financial scandals.

Some 2 trillion won ($1.8 billion) of investment funds has not been returned to investors, as two asset management firms — Lime Asset Management and Optimus Asset Management — engaged in unethical and possibly illegal practices, with an intriguing Blue House angle.

Last year, Lime Asset Management suspended billions of won in redemptions as investor funds seem to have been burned through maintaining what appears to have been a Ponzi scheme.

In the summer of 2020, Optimus Asset Management investors were also unable to retrieve their money, and it appears the company never used the capital the way it claimed it would, and the managers may have just embezzled it.

But what are private equity funds and why did they turn into such hotbeds of financial shenanigans?

And are the regulators doing anything to fix the problems?

In this Debriefing, the Korea JoongAng Daily explains what happened with the funds from Lime and Optimus, the political scandals and reforms underway.

What is a private equity fund?

A fund is money pooled for investment. Asset management firms gather investors and bundle their money, or principal, to invest in various financial products, such as bonds, stock, real estate and private companies. The investment is managed by individual fund managers.

There are two types of funds: public equity funds and private equity funds. The biggest difference between the two is the number of investors. According to Korean law, a fund has to have more than 50 investors to be considered “public," while less than that, or up to 49 investors is considered as “private equity." Private equity also has a required minimum investment of 100 million won.

Redemption is when investors claim their investments, minus any losses or plus any gains. An asset management firm is required to return the principal adjusted for performance upon the request of investors, except under special conditions mentioned in the private equity fund manual from the Korea Financial Investment Association (Kofia). This happens when “the collective investment property is impossible to be disposed of.”

Private funds are closed and are relatively lightly regulated, which also means there’s not much of a safety net in place to protect investors. On the upside, it gives fund managers freedom to make aggressive investment decisions and potentially yield more in return to investors.

Tell me about the history of private equity funds.

Private equity funds were first introduced in Korea in 1998. Hedge funds, which invest mainly in liquid assets, were introduced to the market in 2011.

In 2015, the Financial Services Commission (FSC) eased regulations on such products to invigorate the capital markets and increase investment into small- and medium-sized companies. It lowered the entry barrier to open asset management funds that handle private equity products, reducing the capital required and easing other restrictions.

With this support, the industry grew rapidly, from 48 firms registered in 2015 to 310 firms as of June this year, according to data from the Korea Capital Market Institute.

What happened with Lime?

One of Korea’s largest asset management funds, Lime Asset Management, slammed the brakes on a rapidly growing private equity fund market.

It sent a letter to brokerages in October last year saying the firm could not pay back investors requesting redemptions for a large number of funds. More than 1.6 trillion won of investor money has been frozen since. Of that, some 46 percent was from retail investors over 60 years of age, suggesting that retirement funds may be at risk.

Fund managers at Lime were alleged engaged in a Ponzi scheme to make up for losses generated from bad investments by increasing the number of “feeder funds” to bring in new investors and use that money to pay back existing investors.

Lime reportedly did not inform investors their funds were suffering liquidity problems and continued marketing them to new investors, and sellers failed to check their accounts.

Lime Asset Management has been ordered to close, and some retired brokerage CEOs involved in the selling of the funds have been prohibited from taking new executive positions in the finance sector. Next in line are banks that sold Lime funds, as they are waiting for a sanctions review from the Financial Supervisory Service (FSS).

Brokerage firms have claimed the punishment is too harsh, while civic groups are saying it’s not enough.

Whether the level of punishment was appropriate is still up for debate.

A delivery worker takes a peek at the closed doors of Optimus Asset Management's office in Gangnam, southern Seoul on October 13. [NEWS1]

What happened with Optimus?

Optimus unraveled in much the same way.

In July, Optimus Asset Management sent a letter to brokerage firms notifying them of the suspension of withdrawals of some 90.6 billion won of investments in four of their funds, just days before their maturity.

The public was in shock, especially as the Lime fiasco was so recent, but also because funds from Optimus were marketed as “safe” investments and were supposed to be invested into accounts receivable of public institutions. Fund managers have explained they “cannot go broke unless the country goes bankrupt” according to testimonies from investors.

The FSS’s investigation found that most of the money was invested into bad assets, and some were used in Ponzi schemes or embezzled by owners through multiple paper companies. To cover its tracks, Optimus Asset Management fabricated documents and hid computers along the way.

Recent investigation results were even more depressing. A third of the 515.5 billion won of investment originally put into Optimus funds has vanished and only some 10 percent of the remaining two-thirds is considered recoverable.

Are there any other cases to mention?

There are too many.

Discovery funds, AlpenRoute funds and German Heritage funds, just to name a few.

In the case of Discovery, two funds from Discovery Asset Management worth 91.4 billion won suspended withdrawals this year. A U.S. asset management firm that managed the investment was accused of fabricating the asset values and returns. The funds were mainly sold through banks, mostly by the Industrial Bank of Korea. The maturity date on the funds was over a year ago, but not a single investor has received their investment back.

Another case is the AlpenRoute scandal. In late January, AlpenRoute Asset Management froze three of its funds worth some 100 billion won after stock brokerages tried to retrieve money they loaned to AlpenRoute in total return swap deals — where a firm mortgages client money to raise additional capital. It’s a common method utilized by private equity firms to raise more money and punt for bigger returns.

The ugly truth is those two examples are just a few among the 276 funds in Korea that have suspended of repayments as of May this year, according to a report from the main opposition People Power Party lawmaker. In total, they hold around 3.6 trillion won of investments.

Did the rapid growth cause problems?

It sure did. Asset management firms started investing in overly risky assets for high returns, devised complicated fund structures and created novel investment products unprecedented in the market.

Some experts say that financial regulators are also at fault since they failed to surveil illicit activities, which may be a consequence of the aggressive deregulation efforts in 2015.

The FSC made it easier to open asset management firms by lowering capital requirements from 6 billion won to 2 billion won, and later to 1 billion won in 2019. Underqualified fund managers started coming into the private equity fund space as the FSC simplified the process for firms to receive business licenses.

Asset management firms were relieved of the responsibility to explain in detail what assets were in their funds, which allowed them to target a dangerously wide range of investments — real estate finance, mezzanine financing and private bonds. Lime’s Pluto Fund reportedly carried 85 different assets, and it took dozens of accountants months to sort out.

The bigger problem was the FSC allowing firms to slice and dice their funds into smaller bits, or “feeder funds.” This allowed a single fund to be sold to thousands of investors, instead of the maximum 49 stipulated by the law. Private equity funds were operating like public funds but without the layers of regulatory restrictions public funds have to protect investors.

Some 1,200 investors suffered losses in the Optimus scandal. The number was 4,000 in Lime, of which more than 60 percent were individual investors.

Shouldn’t the trust banks have caught this?

Yes, in theory.

Because a trust bank is a custodian and has the responsibility to cross-check the actual assets it's holding with the assets on paper. In Korea, commercial banks usually become custodians of asset management firms. Hana Bank was the trust bank in the Optimus scandal responsible for keeping the assets. Another important party is the depository, which was the Korea Securities Depository (KSD) in the case of Optimus.

Trust banks and the depository have been criticized for failing to cross-check each other and let illegal activities happen right under their noses.

The depository reportedly kept the books exactly as told by Optimus without questioning if the assets on paper match with the ones held by the custodian. KSD refuted this, saying that the depository is "merely an assistant to calculate the basic value of fund products."

Hana Bank was also criticized for not keeping an eye on the activities of Optimus Asset Management. The bank said the Capital Markets Act was revised in 2015 to remove a custodian's obligation to keep monitoring asset management firms and request changes if a fund manager's decisions do not correspond with what's said on paper.

Some lawyers have argued trust banks should be responsible too, citing the "fiduciary duty" stipulated in Act 244 of the Capital Markets Act, which says a trust business entity "shall exercise a fiduciary duty of due care in custody and managing collective investment property, and shall protect investor interests.”

This was also a topic of debate at the National Assembly this year.

Employees from KB Securities waits to attend the third round of sanctions reviews by the FSS dealing with the sellers of Lime funds on Nov. 10. [NEWS1]

What are the regulators doing to deal with these problems?

Following the Lime scandal and growing distrust for private equity fund products, the FSC decided to apply stricter regulations on such products in April this year. It promised to conduct an inspection of 10,000 private equity funds to sort out the bad ones from the good ones.

The required minimum investment will be increased from the current 100 million won to 300 million won. Kofia, an interest group for financial companies, said it will give counseling and training to fund managers so they can better manage client assets.

The FSC pledged to keep a watchful eye on sellers of fund products to prevent mis-selling of products. Investors in both Lime and Optimus said they were misled by bankers to think the products were safer than they actually were.

Financial regulators also came up with a compensation plan for investors in Lime. Sellers of Lime's Pluto TF-1 trade finance funds were obliged to pay back investors their entire principal. Other sellers in both the Lime and Optimus case said they will voluntarily pay back investors a portion of their original investment.

Tell me about the politics of these scandals.

The Lime and the Optimus cases share another similarity. Multiple high-profile people — lawmakers from the ruling Democratic Party (DP), former government officials and top-level financial regulators — have been mentioned in their investigations.

Lime and Optimus have touted their connections with influential figures in government to give the impression to potential clients their products are worth investing in. Some have raised suspicions that the asset management firms have had the help of top-level accomplices.

Media reports mention some shreds of evidence to back this claim. A secret document seized by the prosecution was said to have contained contents suggesting fund managers from Optimus were able to avoid a crackdown with the help of former government officials and lawmakers that spent time in the Blue House.

Another media outlet claimed there were audio recordings that prove Lime Asset Management’s former Chairman Kim Bong-hyun gave hundreds of millions of won in bribes to DP politicians.

It’s unclear at this point whether the two cases are just about unethical practices of greedy fund managers or a massive corruption scandal.

BY KANG JAE-EUN AND RICH MEYER [kang.jaeeun@joongang.co.kr]