Introduction of Measures to Prevent Recurrence of the 'Lime Fund Incident'... Mandatory Stress Tests and External Audits for Assets Over 50 Billion Won

[Asia Economy Reporter Park Jihwan] Open-end funds will be required to conduct liquidity stress tests going forward. Additionally, funds with more than 50% investment in illiquid assets will be prohibited from being established as open-end funds that allow frequent redemptions. Private equity funds with total assets exceeding 50 billion KRW will be subject to mandatory external audits, similar to public funds.

On the 26th, the Financial Services Commission and the Financial Supervisory Service announced the "Final Plan for Evaluation of Private Equity Fund Status and Institutional Improvement Measures," which includes these provisions. This measure adds investor protection measures such as "holding a general meeting of collective investors when private equity fund redemptions are deferred" and "mandatory external audits for funds above a certain scale, such as those exceeding 50 billion KRW," to the Lime incident recurrence prevention plan announced by financial authorities in February.

The Financial Services Commission stated, "The principle is to establish market discipline and selectively introduce minimum regulations to protect investors and prevent systemic risks." Previously, the Lime Management Incident was fundamentally attributed to a 'mismatching' structure where funds were set up as open-end funds allowing frequent redemptions while primarily investing in illiquid assets.

According to the finalized plan, a liquidity risk management system will be established to address maturity mismatch structures that cause restrictions on redemption and repayment. In particular, from now on, it will be prohibited to set up open-end funds if the proportion of investment in non-marketable assets is 50% or more, applicable to both public and private funds. Even if set up as closed-end funds, fund establishment will be restricted if the fund's maturity is shorter than the weighted average maturity of the fund assets.

Investor information provision related to liquidity risk and supervisory monitoring will also be strengthened. Investors must be notified in advance that redemptions may be delayed or redeemed at prices lower than expected due to maturity mismatch, and the status of liquidity risk and management plans must be regularly reported to investors and supervisory authorities.

A Financial Services Commission official said, "Liquidity stress tests will be introduced for open-end funds," adding, "They will be piloted for one year starting in the fourth quarter and then made mandatory." Based on the test results, fund managers must prepare liquidity risk contingency plans, including risk response measures.

For multi-layered investment structure funds involving parent-subsidiary-grandchild layers, investor information provision will be significantly enhanced. Information on the investment structure, final underlying assets, and costs and risks associated with the structure must be provided to investors. Regulations will also be established to prevent regulatory evasion using multi-layered investment structure funds in public offerings. Additionally, mutual circular investments among affiliated funds will be prohibited.

If a private equity fund targeting general investors defers redemptions, a general meeting of collective investors must be held within three months to decide on redemption matters. Specifically, investors must be informed in detail about the timing and method of redemption payment and any additional redemption deferral periods.

At the same time, the scale of self-dealing transactions will be limited to within a certain proportion of assets (20%), and external audits will be mandatory for private equity funds above a certain scale. Funds with total assets exceeding 50 billion KRW will be subject to external audits under the same standards as public funds.

Regarding total return swap (TRS) transactions, which were problematic in the Lime Management Fund, TRS contracts for leverage purposes will be limited to prime brokerage service (PBS) securities firms that have exclusive brokerage agreements. The PBS's risk management function for private equity fund leverage will also be strengthened.

Furthermore, leverage arising from TRS contracts will be clearly reflected in the private equity fund leverage limit (400% of fund assets). To prevent investor damage caused by early contract termination by one party in TRS transactions, mutual agreement between parties will be mandatory at least three business days prior to early termination.

The financial authorities will also strengthen the exit of insolvent specialized private equity managers. A grace period of six months will be granted first for violations of capital maintenance requirements. If the issues are not resolved within this period, a "registration cancellation system" will be introduced to immediately remove them from the market. Additionally, the self-regulatory organization (SRO) function will be activated to strengthen market monitoring of private equity funds related to fund liquidity and multi-layered investment structures by the Korea Financial Investment Association.

A Financial Services Commission official stated, "For the institutional improvement measures, such as conducting liquidity stress tests and restricting the establishment of open-end funds when the proportion of non-marketable assets exceeds 50%, legislative notices will be issued in the second quarter."

This content was produced with the assistance of AI translation services.