Foreigners visiting Seoul can find it a harsh experience at the best of times, so the imminent prospect of the city’s first snowfall of the season could make a trip over the next few days feel even bleaker.

South Korea’s attitude towards foreign investment has, however, been turning frosty for a while. Unless there is a thaw, increasing amounts of overseas capital will search elsewhere in the region for a hospitable welcome.

The country’s business community is gripped by the soap opera that has engulfed Lone Star’s ownership of Korea Exchange Bank. The US buy-out fund acquired a controlling stake in the lender in 2003 for $1.2bn, rescuing it from the brink of bankruptcy in the aftermath of the Asian financial crisis.

Lone Star now wants to exit and had agreed to sell KEB to Kookmin, the country’s largest lender, for $7.4bn. However, the sale was pulled last month, following ongoing investigations by financial authorities.

Public opinion has been inflamed by the realisation that Lone Star would net $4bn, tax-free, on the KEB sale. Sentiment had started to turn uglier last year after US private equity funds Carlyle and TPG/Newbridge sold their investments in KorAm and Korea First banks respectively, netting billions of dollars in tax-free profits.

Financial authorities began investigations, searching for ways to levy taxes on the sale. Auditors looked into whether KEB’s finances had been manipulated to allow Lone Star to buy the bank on the cheap.

Last week, South Korea’s Supreme Prosecutors’ Office ruled the sale of Lone Star was illegal, but it has yet to find evidence linking the fund to manipulation of financial data prior to the sale. Mention “witch-hunts” and you will be struck off the prosecutors’ Christmas card list.

The authorities intend to indict or extradite several local and overseas Lone Star executives and others involved who are suspected of wrongdoing.

The saga has been nothing short of a PR disaster for Korea Inc. Foreign private equity firms, awash with both funds and expertise, are now giving any auctions or sales involving the government a wide berth.

In the short term, at least until after presidential elections next December, foreign private equity funds will concentrate on smaller, non-public deals.

One example is CCMP Capital Asia, a private equity group that was formerly part of the JPMorgan empire, which in July bought the By The Way convenience store chain. In October, Carlyle of the US bought a one third stake in Hyundai’s cable television unit.

However, foreign groups will have to compete against start-up local private equity groups such as MBK Partners and Vogo, which have sprung up to take advantage of tax-breaks not offered to their foreign-based rivals.

The irony of the Lone Star situation is that South Korea remains among the more open of Asia’s economies. Around 40 per cent of the shares traded on the stock market are held by foreign investors, although that figure dropped this year when investors booked profits following the 54 per cent rise in the stock market in 2005. Unlike China, South Korea has allowed some of its major banks to be acquired by overseas groups.

There are also different ways of judging the outcome of Carl Icahn’s battle with KT&G, during which the US billionaire this year threatened a $10bn takeover of the tobacco and ginseng maker unless it spun off under-performing assets. The company stood firm but did commit to returning up to $2.9bn to investors by 2008.

Mr Icahn last week sold most of his remaining shares, and is estimated to have netted more than $120m for his troubles. The Korean press sent him on his way last week, accusing him of being a short-term investor.

This is a bit rich given that the average Korean punter turns over stocks more regularly than most people change their bedding.

Nevertheless, Mr Icahn’s battle demonstrates how open the local stock market is to overseas investors, activist or not, who reckon they’ve spotted a bargain.

The benchmark Kospi index is now trading at a price/earnings ratio of 12.5x, below its historical median of 15.1x, so analysts are expecting bargain hunters to return to the market next year.

But at the government level Korea still lacks an integrated approach to attracting foreign investment. As Korea could find out to its cost, investors, whether buy-out funds or retail punters, can easily switch their attention to India or China, whose economies are both growing at nearly twice its own rate.

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