The Private Equity Review: Japan
i Deal activity
The Japanese private equity market continues to be quite active, taking advantage of the stability of the economy since 2013 despite the covid-19 pandemic. Also, as a result of monetary easing and the negative interest rate policy adopted by the Bank of Japan, it has become easier for private equity firms to raise acquisition financing from Japanese banks. According to the RECOF M&A database, 100 acquisition transactions by investment firms (most of which are private equity funds) were announced during 2020, with a significant increase from 81 deals in 2019. Among them, five deals were contemplated as public-to-private transactions.
There has been a growing number of small and medium-sized transactions involving succession of family-owned companies. Additionally, as a result of the continuous review of business portfolios as recommended under Japan's Corporate Governance Code, an increasing number of listed companies have been implementing divestitures of subsidiaries and non-core businesses.
According to the RECOF M&A database, there had been around 50 exit transactions per annum by investment firms through trade sales or secondary buyouts in recent years. In 2020, 37 deals were announced, with a slight decrease from 49 deals in 2019.
There are several types of private equity funds that are active in Japan. Many of the mega-deals are conducted by global funds such as KKR, Bain Capital, Carlyle and Blackstone. There are also independent domestic funds, such as Unison Capital, Advantage Partners and Integral, as well as funds managed by financial institutions such as banks and securities companies.
Further, government-related funds have recently been playing an increasingly important role in the private equity market. A remarkable example is the Japan Investment Corporation (JIC), which is a public–private fund sponsored by both the Japanese government (injecting ¥286 billion) and 25 private corporations (¥13.5 billion in total). Although JIC has been inactive following the resignation of all directors from the private sector as a result of a dispute with the government over their compensation, it is reported that it will restart investment activities under new management established in December 2019.
ii Operation of the market
Management incentive arrangements
Typical management incentive arrangements adopted in private equity deals in Japan include performance-based annual bonuses and stock options. In addition, top management can hold minority shares in the company. Private equity funds commonly enter into agreements (e.g., executive services agreement) with management to set out predetermined performance targets for annual bonuses to incentivise the management. Stock options are occasionally subject to performance vesting features. Stock options often become exercisable upon exit of the private equity fund.
The most common forms of exit by private equity funds are trade sales, secondary buyouts and initial public offerings (IPOs). Particularly, a trade sale of shares to a strategic buyer that conducts a business similar to that of the target company is the most common exit form, with its simple and straightforward nature enabling the private equity fund to obtain an immediate return on the entire investment (although there may remain indemnity obligations or a balance of payment held in escrow). To induce the most favourable terms for the sale, private equity funds as sellers tend to conduct an auction process before starting negotiations with the selected buyer on an exclusive basis.
There has recently been an increase in secondary buyouts. The secondary buyout is an attractive option where, for example, the initial buyout fund's investment period is close to expiry but the IPO of the portfolio company is expected to run for longer.
Also, since the revival of the Japanese IPO market, a growing number of private equity funds have been trying to exit through IPOs, which was once uncommon in the Japanese private equity market. While the possibility of an IPO largely depends on the market environment, and the preparation for an IPO usually requires much time, resources and cost, an IPO could be an attractive option in that it could realise greater value without imposing heavy post-closing liabilities on the seller.
II Legal framework
i Acquisition of control and minority interests
Buyouts of private companies
In the case of buyouts of private companies, the most common legal framework is a simple sale and purchase of shares in the target company. A stock purchase agreement entered into between the seller and the buyer is the principal document providing the terms and conditions of the transaction.
Buyouts of listed companies
Buyouts of listed companies (i.e., public-to-private transactions) are typically conducted through a two-step acquisition involving a first-step tender offer and a back-end squeeze-out of the remaining minority shareholders.
An acquisition of shares in the first-step transaction needs to be conducted pursuant to the tender offer regulations under the Financial Instruments and Exchange Act (FIEA), which require a tender offer for a transfer of listed shares resulting in the acquirer holding more than one-third of the voting rights of the listed company. The principal documents for buyouts of public companies are the tender offer documents such as the tender offer registration statement filed by the offeror (buyer) and the position statement filed by the target company. Terms and conditions of the tender offer are provided in the tender offer registration statement to be prepared in accordance with the FIEA and relevant regulations. Also, in cases where the target company has a major shareholder, a tender offer agreement may be entered into between the offeror and the major shareholder, which provides the offeror's obligation to commence the tender offer and the major shareholder's obligation to tender in the tender offer. The offeror and the target company are not prohibited from agreeing upon deal protection measures such as a no-shop clause and breakup fees, but tend to avoid doing so to ensure fairness of the transaction process.
For the back-end squeeze-out, two practical alternatives have been commonly used: (1) a squeeze-out right that is available to a special controlling shareholder, and (2) a fractional share squeeze-out through, among other things, a stock consolidation. The squeeze-out right, which was introduced with the 2016 amendment of the Companies Act, enables a shareholder holding (directly or through one or more wholly owned subsidiaries) at least 90 per cent of the total voting rights (special controlling shareholder) to force a cash acquisition of the remaining shares held by the minority shareholders. The effect of the squeeze-out right is simple and straightforward; the relevant shares are transferred directly from the minority shareholders to the special controlling shareholder. This alternative only requires a resolution of the board of directors of the target company instead of a shareholder resolution (which typically takes a couple of months), and, therefore, significantly expedites the squeeze-out procedure in comparison with the other alternatives. In practical terms, it is possible to complete the back-end squeeze-out as early as one month after completion of the first-step tender offer. Because of the simple and expedited procedure, since its introduction under the amended Companies Act, the squeeze-out right has been most commonly used for back-end squeeze-outs where the acquirer satisfies the 90 per cent voting rights requirement. Another alternative available for the back-end squeeze-out is a fractional share squeeze-out, which is typically conducted through a share consolidation. In this type of squeeze-out, the target company, pursuant to a shareholder resolution, consolidates its shares by a ratio that would result in minority shareholders holding only fractional shares. In accordance with a procedure provided under the Companies Act, these fractional shares are not actually issued but sold to the acquirer upon court approval, with the cash proceeds distributed proportionately to the minority shareholders. A fractional share squeeze-out does not require the acquiror to hold 90 per cent of the voting rights of the target. Therefore, if the acquirer fails to reach the 90 per cent threshold on completion of the first-step tender offer, making the squeeze-out right unavailable, a fractional share squeeze-out would still be available as long as it is approved by a shareholder resolution with a supermajority vote (two-thirds of the votes cast).
In contrast, cash mergers have not been commonly used for back-end squeeze-outs because, unlike the common alternatives above, a cash merger was treated as a taxable transaction at the level of the target company. However, this difference in tax treatment was eliminated after the amendment to the Corporation Tax Act in 2017. Given that cash mergers are available through a shareholder resolution of the target company with a supermajority vote even if the 90 per cent voting rights requirement is not satisfied, they may be used more commonly in the future.
Antitrust filing requirements
Under the Act on Prohibition of Private Monopolisation and Maintenance of Fair Trade (the Antimonopoly Act), a pre-transaction filing is required for an acquisition of more than 20 or 50 per cent of the voting rights of the target company if the aggregate amount of the domestic sales of the buyer group exceeds ¥20 billion or the aggregate amount of the domestic sales of the target company group exceeds ¥5 billion, respectively. In the case of an acquisition by a private equity fund, the domestic sales of the fund's portfolio companies may be included in the sales of the buyer group, depending on the fund structure. If the pre-transaction filing is necessary, a 30-day waiting period (which may be shortened if the transaction does not raise substantive antitrust issues) is applicable and could affect the closing schedule.
Foreign investment filing requirements
The Foreign Exchange and Foreign Trade Act (FEFTA) obliges a foreign investor contemplating a certain foreign direct investment (FDI) to make a pre-transaction notification if the FDI targets certain restricted businesses. FDIs subject to the pre-transaction notification requirements are reviewed by the Ministry of Finance and other relevant ministries and subject to a statutory waiting period of 30 days. The waiting period can be extended to up to five months, but would usually be shortened to two weeks or less as long as the FDI does not raise any regulatory concern.
Recently, there have been a series of amendments to the pre-transaction notification requirements under the FEFTA. Most importantly, an amendment that added 20 types of businesses (newly added businesses) to the list of restricted businesses became effective on 1 August 2019, and pre-transaction notifications are required for FDIs targeting newly added businesses consummated on or after 31 August 2019. The newly added businesses are divided into the following categories:
- manufacturing of information processing equipment and parts;
- software related to information processing; and
- information and communications services.
Among others, the software category is widely defined, and any business involving development of software that is not game software could be deemed to fall under this category. The authorities also tend to interpret the scope of internet use support services, which fall under the information and communications services category, widely, and any business providing internet services (including services that are not typically seen as support services) could be deemed to fall under this category. As such, the newly added businesses category may apply to a wide range of businesses, including start-up and technology companies. Additionally, it has been clarified that a general partnership, limited partnership for investment under the Limited Partnership Act for Investment of Japan, and other similar partnerships under foreign laws fall within the foreign investor category if 50 per cent or more of the contributions are made by non-residents, or a majority of the general partners are non-residents. Therefore, private equity funds satisfying these criteria are now required to make pre-transaction notifications in a much broader range of transactions than before.
ii Fiduciary duties and liabilities
Under Japanese law, it is commonly understood that a controlling shareholder does not owe any fiduciary duty to the minority shareholders. On the other hand, company directors owe a fiduciary duty to the company, which could include a duty to take account of the shareholders' common interests. Particularly, as the Tokyo High Court ruled on 17 April 2013, in the case of management buyouts by a two-step acquisition as described in Section II.i, directors of the target company owe the duty to ensure a fair transfer of corporate value among the shareholders and the duty to disclose adequate information.
In addition, a highly remarkable ruling by the Supreme Court on 1 July 2016, involving a public-to-private transaction conducted by certain major shareholders of the target company through a two-step acquisition, held that the squeeze-out price is generally considered fair if it equals the price offered in the first-step tender offer and is determined through a fair process.2 While the Supreme Court ruling in the Jupiter Telecom decision directly relates to the fairness of the squeeze-out price to be examined in an appraisal procedure, it also has a significant impact on the discussion regarding the duties of directors of the target company under similar circumstances (i.e., conflict-of-interest transactions).
Contractual duties and liabilities
Upon its entry investment, a private equity fund as buyer may owe certain (though limited) post-closing duties, including continued employment of the target company employees, under the stock purchase agreement (in the case of buyouts of private companies) or the tender offer agreement (in the case of buyouts of listed companies).
In contrast, upon exit, a private equity fund as seller would owe broader contractual liabilities under these agreements, including liabilities for indemnification in relation to any breach of representations and warranties or covenants. Depending on the bargaining power of the seller under the specific circumstances, the seller typically strives to limit the scope of its representations, warranties and covenants and to otherwise add contractual mechanisms to limit its post-closing liabilities, such as a limitation on the amount of indemnification (e.g., cap, de minimis, deductible or tipping basket) and a limitation on the period for indemnification (e.g., survival period of representations and warranties).
III Year in review
i Recent deal activity
On 28 June 2019, the Ministry of Economy, Trade and Industry (METI) formulated the Practical Guidelines for Group Governance Systems, which, among other things, pointed out the conflict-of-interest issues between the general shareholders of a listed subsidiary and its parent company. To address these issues, an increasing number of Japanese companies that have listed subsidiaries have been considering an acquisition of the remaining shares in the listed subsidiary (i.e., public-to-private transaction) or a sale of the listed subsidiary. In the latter case, private equity funds could be good candidates for buyers.
Also, the Fair M&A Guidelines formulated by METI on 28 June 2019 emphasised the need to take appropriate measures to ensure the fair process for conflict-of-interest transactions such as management buyouts and acquisitions of listed companies by controlling shareholders (including parent companies). These measures include market checks and the establishment of a special committee and majority-of-the-minority conditions. While the scope of direct application of the Fair M&A Guidelines is limited to the conflict-of-interest transactions described above, it is generally understood that reference to the Fair M&A Guidelines could contribute to ensuring the fairness of other types of M&A transactions, including the sale of listed subsidiaries by parent companies. In light of the Fair M&A Guidelines, there have been an increasing number of transactions involving private equity funds as buyers where special committees are established or active market checks are conducted through an auction process or an individual solicitation to multiple-buyer candidates.
The most significant deals in recent years include the acquisition of KIOXIA Holdings Corporation (formerly Toshiba Memory Corporation) by Bain Capital and other investors in 2017, and the acquisition of Marelli Corporation (formerly Calsonic Kansei Corporation) by KKR in 2017.
Typical leveraged buyouts by private equity funds are funded by the composition of debt and equity (typically in the form of common stock). The debt-to-equity ratio generally ranges from 2:1 to 1:1.
The debt financing package typically consists of a senior term loan facility and revolving facility for working capital purposes. Typically, one or more arranger banks underwrite these facilities upon the acquisition, and then syndicate these facilities within a general syndication period (which is usually six months to one year after the signing or first use). Some transactions also use mezzanine financing, which is usually structured as subordinated loans, subordinated bonds, subordinated convertible bonds or preferred shares. Equity kickers, typically in the form of stock options, are sometimes granted to mezzanine finance providers as an incentive. Interest payments under mezzanine financings often include, together with cash payment interest, payment-in-kind interest, which is usually accrued on a compounded basis that will become due on the maturity date, after full repayment of senior debt. High-yield debt is not commonly used.
In acquisition financing, the lenders usually request a long list of (1) conditions precedent for the drawdown, (2) representations and warranties that are repeated with each use, (3) covenants, including financial covenants and capex restrictions, and (4) events of default. Among other things, it is notable that the lenders usually require inclusion of an absence of material adverse change as a condition precedent for the drawdown. This means that a private equity fund as buyer usually needs to include the equivalent condition precedent for the completion of the acquisition under the stock purchase agreement (or, in the case of a tender offer, for the commencement of the tender offer).
iii Key terms of recent control transactions
We have recently seen an increasing number of transactions in which antitrust clearance in one or more jurisdictions is required prior to the closing. Particularly, global-based private equity funds often need to obtain clearance from the antitrust authorities in multiple jurisdictions. In some cases, it takes a long time to close the transaction as a result of these antitrust requirements. In this regard, it is notable that, in the case of a tender offer, the competent governmental authority (Kanto Financial Bureau) usually requires the necessary antitrust clearance to be obtained prior to the commencement (as opposed to the settlement) of the tender offer. This could further delay the commencement of the tender offer and cause the whole deal process to take an even longer time.
In transactions requiring antitrust clearance, obtaining such clearance by the buyer is usually included as a condition precedent in the stock purchase agreement or the tender offer agreement. On the other hand, the seller would request contractual arrangements to ensure deal certainty. In this context, we have recently seen some transactions that have included a reverse breakup fee payable by the buyer if it fails to obtain necessary antitrust clearance. Additionally, especially in a competitive auction process, private equity funds sometimes accept a 'hell-or-high-water clause' to enhance their position as compared to strategic bidders from an antitrust perspective.
In buyouts of private companies, the stock purchase agreement typically provides customary conditions precedent, such as absence of breach of representations, warranties and covenants; necessary approvals of relevant authorities (including the antitrust clearance discussed above); and third-party consent. In addition, a private equity fund typically requests the closing to be conditioned on the absence of any material adverse change. Depending on the buyer's negotiating leverage, a finance-out condition is also provided in some cases.
For buyouts of listed companies, the terms and conditions of the tender offer need to be in accordance with the FIEA. Therefore, a narrower scope of contractual scope is allowed, and the contractual buyer protections available to private equity funds tend to be much more limited than those available for buyouts of private companies. In particular, because of the strict restrictions on withdrawal of a tender offer under the FIEA, it is difficult to effectively provide conditions precedent as broad as those typically provided in a stock purchase agreement for buyouts of private companies.
Representation and warranty insurance
In Japan, the use of representation and warranty insurance has not been common, partly as a result of the time involved and the cost of purchasing the insurance. While domestic insurance companies have recently begun to provide representation and warranty insurance, foreign insurance companies are still dominant in this area. Therefore, it is usually necessary to prepare the due diligence report in English as well as provide an English translation of the acquisition documentation. Communication in English is also required in the underwriting call.
However, as the advantage of representation and warranty insurance is beginning to be broadly recognised among practitioners, we may see more transactions in which representation and warranty insurance is used. In particular, it is generally recognised that representation and warranty insurance could be beneficial where a private equity fund as seller desires to limit post-closing liabilities or where a private equity fund as a buyer candidate in the auction process desires to make its proposal more attractive to the seller.
A total of 37 exit transactions by private equity funds through a trade sale or secondary buyout were announced during 2020.
IV Regulatory developments
A control investment by a private equity fund may be subject to the pre-transaction filing or notification requirements under the Antimonopoly Act and the FEFTA. In particular, after the recent amendment to the FEFTA, a broader range of acquisitions by private equity funds are likely to be subject to the pre-transaction notification requirements (see Section II.i).
Given the currently stable market environment in Japan, continued growth of the Japanese private equity market can be expected going forward.
One of the potential changes we may see in the M&A market relates to hostile deals. Until recently, hostile takeovers, including competing tender offers after the announcement of originally friendly tender offers, had been uncommon in Japan, and there had been few precedents of successful hostile takeovers of Japanese listed companies. However, we have recently seen more cases of successful hostile takeovers (e.g., Itochu Corporation's partial tender offer for Descente Ltd and acquisition of Ootoya Holdings Co, Ltd by Colowide Co, Ltd) and of originally friendly tender offers failing because of a competing tender offer with a higher price (e.g., the failure of HIS Co, Ltd's tender offer for an acquisition of Unizo Holdings Company, Limited). As the negative perception against hostile takeovers is decreasing, we may see more cases of successful hostile takeovers in the near future.