An interview with Baker McKenzie discussing non-public fairness in Japan

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Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Private Equity volume featuring discussion and analysis of emerging trends and hot topics within key jurisdictions worldwide.

1 What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?

As the number of multibillion-dollar buyout opportunities is increasing in Japan in recent years, as well as the fact that the Japanese market is becoming more receptive to private equity funds, we have recently observed a number of multinational private equity firms establishing their Japanese footprint. The continuing trend of debt financing being available at favourable rates contributes to this as well. Regarding this, in 2019 Blackstone signed their first private equity deal by acquiring a portfolio company from a major domestic private equity fund since they established a local private equity team a few years ago. Carlyle also announced earlier this year that they successfully raised a Japan buyout fund of US$2.3 billion, more than double the size of its previous fund.

We are also seeing an increasing number of non-solicited takeover deals in Japan. This used to be a trend led by activist funds before the global financial crisis. However, recently there have been non-solicited takeover attempts by Japanese listed companies as well. As a result, there is increasing demand for target companies to seek white knights to bid against these non-solicited takeover offers. We are seeing private equity funds playing a key role in this aspect as well. On the other hand, deals that may inherently involve conflict of interest issue will be scrutinised by the market, particularly by reference to the recently updated guideline regarding fair M&A process issued by the Ministry of Economy, Trade and Industry (METI). A recent potential billion-dollar management buyout led by a major global private equity firm has attracted a lot of scrutiny in this regard; the firm having been trying to take private a listed company, together with the management, at a price that was alleged by an investment fund holding a sizeable stake in the target to be significantly cheaper than the intrinsic value of the company. This resulted in the offer price being raised by more than 10 per cent through the tender offer process.

We are also continuing to observe transactions where prominent Japanese companies are starting to offload their high-value non-core assets as a result of their strategic review and private equity funds are viewed as the potential acquirers of such non-core assets. KKR’s acquisition of Hitachi Koki and Calsonic Kansei are recent examples of this and reflect the reception of private equity funds in the Japanese market.

2 Looking at types of investments and transactions, are private equity firms primarily pursuing straight buyouts, or are other opportunities, such as minority-stake investments, partnerships or add-on acquisitions, also being explored?

Private equity investments in Japan are, in most cases, structured to acquire full control or a controlling stake in the target company.

This is particularly the case where small and medium-sized enterprises in Japan are facing succession issues and the private equity firm is becoming one of the potential avenues for exit. In these circumstances, the incumbent owner of the company often expects a full exit from the business at the shareholding level. This owner, who often is the founder of the business, sometimes tends to prefer being acquired by private equity firms rather than a strategic buyer. This is because if they are bought by a strategic buyer, the target business may end up only being a mere division within the strategic buyer, whereas if they are bought by a private equity firm, the target business is more likely to maintain independence.

In the past, when there were a number of billion-dollar private equity investment opportunities in Japan, there were cases where a private equity firm teamed up with another private equity firm or a strategic investor so that the team could show commitment and competitiveness in the auction process. As we are starting to see more multibillion-dollar private equity investment opportunities in the market compared to past years, we are starting to see private equity funds forming consortiums for those mega-deals.

Add-on acquisitions are also frequently explored for value creation. Given the covid-19 pandemic, we are observing a decline in the level of outbound M&A activities by Japanese companies. This may lead to a potential focus on the domestic market for add-on acquisitions.

3 What were the recent keynote deals? And what made them stand out?

A notable deal is the various take private attempts concerning Unizo Holdings, a Tokyo Stock Exchange (TSE)-listed company that engages in the real estate and hotel business. After the launch of an unsolicited tender offer in July 2019 by HIS, a TSE-listed travel agency company, Unizo sought for Fortress Group, an investment fund ultimately managed by Softbank group, as a white knight. Fortress launched another tender offer in August, but after HIS withdrew their tender offer, Unizo asked Fortress to increase the tender offer price. Meanwhile Blackstone indicated their interest to launch a tender offer for a price that was significantly higher than that offered by Fortress. Unizo then announced that the company would be taken private in the context of a management buyout, with the management being backed up by Loan Star. As a result of various rounds of increases to the tender offer price proposed by various players, the management buyout was rendered successful. The final offer price was nearly double of what HIS had originally offered.

4 Does private equity M&A tend to be cross-border? What are some of the typical challenges legal advisers in your jurisdiction face in a multi-jurisdictional deal? How are those challenges evolving?

While small deals tend to be domestic, mid-sized to large-cap deals tend to attract the interest of foreign private equity buyers. Also, private equity deals often become cross-border as attractive Japanese target companies tend to have operations in multiple jurisdictions with growth opportunities. Some Japanese companies that are keen to expand their businesses outside of Japan are receptive to investment by foreign private equity firms in order to obtain these foreign firms’ assistance with their overseas expansion.

Multi-jurisdictional deals require seamless legal support in multiple jurisdictions and in various practice areas such as corporate, labour, tax and regulatory matters, but there are few law firms in Japan that are capable of providing such a variety of services sufficiently. This will be a challenge, particularly in large deals involving multiple jurisdictions and bidders. This is more so becoming an issue in the context of multi-jurisdictional carve-out transaction which we observe are increasing.

Also, the rather unique approach of Japanese companies to negotiating M&A transactions sometimes evolve into a difficult situation during negotiation. For instance, deal teams of Japanese companies tend to have less authority and lower levels of discretion compared to their counterparts from foreign jurisdictions during negotiation. As a result, deals sometimes do not proceed as smoothly as their foreign counterparties expect, which may lead to frustration and may even become a deal-breaker.

In addition, warranties and indemnity insurance is still at its early stage in Japanese M&A practice. This may lead to longer timelines within which to negotiate insurance, which may potentially impact transaction timelines. However, we foresee that this situation is gradually changing, as the practice in Japan is evolving, partly driven by the evolving underwriting practice in other markets.

5 What are some of the current issues and trends in financing for private equity transactions? Have there been any notable developments in the availability or the terms of debt financing for buyers over the past year or so?

Market practice for financing private equity transactions has not changed dramatically in recent years. Since domestic banks are struggling to lend money, competition among banks for financing leveraged buyout deals continue to be intense and severe, which leads to lower spreads, and private equity sponsors are able to benefit from such market circumstances. Generally speaking, between 60 to 70 per cent of the transaction value of private equity deals in Japan are secured by debt financing. In some cases, mezzanine loans or preferred shares are used to partly finance private equity deals in Japan, in addition to senior loans.

The domestic ‘megabanks’ – MUFG, Mizuho and SMBC – will often arrange for a senior portion of financing leveraged buyout deals. However, other banks such as SMTB, Aozora, Tokyo Star and DBJ are also keen to do the same.

We also often see cases where acquisition finance loans are refinanced within a short period after the closing of such loans. Some of these refinancing activities occur as a result of refinancing with corporate loans that have less restrictive covenants and security packages, leading to more freedom with which to manage the target business. This includes cases where the target company aims to go public through initial public offerings.

6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?

The recent amendment to the Foreign Exchange and Foreign Trade Act (FEFTA) lowered the threshold (from 10 per cent to 1 per cent) that above which prior notification is needed for foreign investors to hold an equity stake in Japan-listed companies in certain key industries. The list of the Japan-listed companies that are considered to be engaged in such key industries has already been released by the Japanese government, which is subject to ongoing regular updates. Private equity firms will need to keep an eye on this list in order to confirm if their contemplated transaction may be subject to a prior notification requirement under the FEFTA.

METI has also recently released an updated version of a guideline titled ‘Guideline Regarding Fair M&A Process’. Although this guideline does not have a legally binding nature, its earlier version released in 2007 provided certain guidance on how to protect minority interest in the context of management buyouts, which was a growing trend in the Japanese market back then. This updated version, which was released in June 2019, takes into account the developments in the market practice since the release of the initial version. The updated version includes transaction by controlling shareholders of a listed company within the scope of the guideline, as well as management buyouts. Although the effect of the update version having impact on the market practice is to be seen, private equity firms will need to take this into account when they contemplate transactions that fall within the ambit of this updated guideline.

There has also been a recent amendment to the Japanese tax regime in 2017, which allows cash mergers to be implemented without any negative tax implications on the merging target company. This may potentially allow cash mergers to be used for the purpose of squeezing out minority shareholders in private equity buyouts in a straightforward manner compared to the prevailing market practice.

7 What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?

While private equity investments and shareholder activism were very active in the Japanese market in the early 2000s, policymakers and the public did not perceive private equity funds and activist funds very well. They were often referred to as vulture funds, which target the weak and take everything. A television programme that had the same title and aired in 2007 contributed to this common perception, which resulted in many Japan-listed companies adopting measures against takeovers around 2005 and 2006, such as ‘poison pills’ and the ‘advance warning mechanism’, which requires the management of the company to be informed in advance of any attempted unsolicited takeovers or acquisition of substantial stakes in a listed company.

A lot of shareholder activism has dissipated since then, but recently we are seeing more and more shareholder activism. Now that Japan-listed companies have been under more pressure to treat shareholders in an appropriate manner after the introduction of the corporate governance code by the TSE, we see more cases where proposals by activists are being seriously considered by the listed companies, when the proposals are in line with enhancing shareholders’ value and improving their mid-term strategy.

Also, with a number of disposals by prominent Japanese companies such as Nissan, Hitachi and Panasonic of their non-core assets to global private equity funds, Japan seems to be reaching a stage to be receptive to private equity funds as playing a key role in restructuring various industries.

8 What levels of exit activity have you been seeing? Which exit route is the most common? Which exits have caught your eye recently, and why?

Up until the recent covid-19 pandemic, private equity firms were viewing a fairly stable stock market and strong economy after the implementation of ‘Abenomics’, creating great opportunities for their exit activities. As the Japanese M&A market has been significantly impacted due to covid-19, exit activities may have been significantly impacted by this market change.

In terms of exit activities, trade sales to strategic buyers and secondary buyouts by other private equity firms continue to be most common for private equity firms in Japan.

9 Looking at funds and fundraising, does the market currently favour investors or sponsors? What are fundraising levels like now relative to the past few years?

Generally speaking, investors’ appetites still continue to be very strong, partly due to the quantitative easing by Prime Minister Shinzo Abe in recent years. This has also been encouraged by the introduction of the negative interest rate by the Bank of Japan since January 2016.

We have also seen several private equity funds raising significant amounts in the past 12 months for their targeted investments in Japan. This seems to impact the market by seeing multiple private equity firms showing interest in a sizeable investment opportunities. The various take private attempts concerning Unizo Holdings, described in question 3, was reported to have involved up to six foreign and domestic private equity firms at one time in the bidding process. This bidding war seems to have contributed to the tender offer price being nearly doubled throughout the process.

Despite the active market with increasing investment opportunities, we believe sponsors are struggling in terms of sourcing, in light of the level of fundraising taking place in the market. This is potentially leading their dry powder to heap up.

10 Talk us through a typical fundraising. What are the timelines, structures and the key contractual points? What are the most significant legal issues specific to your jurisdiction?

In most cases, when establishing a private equity fund in Japan, funds take the form of a Japanese investment limited partnership. With a standard form investment limited partnership agreement in place, which is now widely used as a market standard document in practice, setting up a Japanese investment limited partnership is not a very cumbersome process and can be completed within two to three weeks, depending on the nature of the investors.

One of the major negotiated matters is whether or not limited partners are allowed to opt out of certain investments to be made by the investment limited partnership. This is often an issue with financial institution investors with stringent internal investment policies. In such instances, the scope and criteria for allowing an opt-out would be heavily negotiated for the fund to achieve its investment activities to the maximum extent possible.

Another typically negotiated matter is the duration of the commitment period as well as the amount of the capital commitment for investors. These matters are usually negotiated in conjunction with the ability for follow-on investments as well as key man clauses.

11 How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?

Private equity sponsors would need to register as financial instrument business operators (engaging in Type II business or discretionary investment management business) under the Financial Instruments and Exchange Act of Japan (FIEA), unless certain exemptions under the FIEA are applicable.

In most cases, private equity sponsors are exempted from the registration requirement based on the qualified institutional investor exemption. Such sponsors are subject to less stringent supervision by the authorities than those registered as a financial instrument business operator.

However, it is worth noting that, a few years ago, there has been an amendment to the relevant legislation with respect to the licensing requirement of fund managers in Japan, which leads to greater scrutiny and monitoring of private equity sponsors by the relevant authorities.

12 What effect has the AIFMD had on fundraising in your jurisdiction?

In short, the AIFMD has a limited effect on fundraising in Japan so far as the domestic private equity funds are concerned. This is due to the fact that while the directive will only apply if you are managing or marketing alternative funds in the EU, there is a limited number of domestic private equity funds in Japan that engage in such activities.

As most Japanese private equity funds are formed as Japanese investment limited partnerships, which usually involves Japanese documentation, it is not too common for foreign investors to participate, although this is observed in some cases. The same applies to choosing fund managers, where usually domestic private equity funds tend to choose domestic fund managers.

13 What are the major tax issues that private equity faces in your jurisdiction? How is carried interest taxed? Do you see the current treatment potentially changing in the near future?

As a result of the recent 2017 Tax Reform, a merger between an acquiring company and a target company, which will result in squeezing out minority shareholders of the target company, by delivering cash as consideration shall be treated as tax-free merger if the acquiring company owns at least two-thirds of the shares in the target company before the merger. Such a ‘cash-out merger’ previously resulted in a recognition of taxable gain in the hands of the target company. The 2017 Tax Reform also provides certain tax-free spin-off transactions, which may facilitate Japanese companies restructure their business portfolio in a swift manner without any negative tax consequence. These tax reforms may further facilitate private equity transactions, as this may result in more portfolio management by Japanese companies, and also enables the squeezing out minority shareholders in a more simple and straightforward manner. From 2018, no gain or loss rule will apply to an exchange of shares in the target company with shares in another company that is approved by the government. Furthermore, the 2019 Tax Reform expands the qualified corporate reorganisation treatment to include the downstream merger of acquisition vehicles into the target company after certain minority shareholders squeeze-out transactions.

In relation to withholding tax on dividends, dividends paid by a Japanese company to foreign shareholders are subject to a final withholding tax at a rate of 20.42 per cent under Japanese tax law. This tax rate can be reduced by an applicable income tax treaty to which Japan is a party. Generally speaking, for income tax treaty purposes, a private equity taking the form of limited partnership is treated as fiscally transparent, and therefore, the residency of foreign investors of private equity funds will generally determine the availability of treaty protection for a domestic withholding tax.

With respect to capital gain tax, a gain derived by a foreign entity from the sale of a Japanese company will be imposed corporate tax at 23.2 per cent and local corporate tax at 4.4 per cent (10.3 percent for a fiscal year beginning on or after 1 October 2019) of corporate tax (ie, 24.22 per cent (25.59 per cent for a fiscal year beginning on or after 1 October 2019) altogether) if the foreign entity owned at least 25 per cent of the total issued shares and is selling at least 5 per cent of the total shares in a Japanese company (the 25 per cent/5 per cent rule). For the purpose of the 25 per cent/5 per cent rule, the ownership of a private equity fund is counted as that of a single shareholder, even though such private equity fund is fiscally transparent for Japanese tax purposes such as a limited partnership, unless the applicable tax treaty provides otherwise. Therefore, a foreign investor in a non-tax treaty jurisdiction investing in a Japanese company through a foreign private equity fund, which is a fiscally transparent entity, will be taxed on its share of capital gain to the extent the foreign private equity fund meets the 25 per cent/5 per cent rule. However, there is a special rule under Japanese law citing that a foreign limited partner of a private equity fund that satisfies certain conditions could still be exempt from such capital gain tax by filing relevant tax forms with the Japanese tax authority.

The benefits under the applicable income tax treaty discussed above would be lost if a foreign private equity fund is deemed to have a permanent establishment in Japan, and all income and gain in Japan will be taxed at the prevailing income tax rate of around 30 to 35 per cent (including local corporate income taxes such as local special corporate tax, enterprise tax and local inhabitant tax). Therefore, careful tax structuring is crucial in order for a foreign private equity fund to not be deemed to have a permanent establishment in Japan.

The availability of the tax treaty benefits could potentially change, as the multilateral instrument implementing the tax treaty-related provisions (to which Japan is a party), entered into force with respect to certain treaty partner countries.

14 Looking ahead, what can we expect? What might be the main themes in the next 12 months for private equity deal activity and fundraising?

The introduction of the negative interest rate by the Bank of Japan since January 2016 still continues to have a significant impact on the Japanese market as a whole. This has been pushing investors to consider making investments other than by purchasing Japan government bonds, which may positively impact the fundraising activities by private equity funds, as well as availability of debt financing for private equity funds.

Despite the increase in the VAT rates in Japan from 8 per cent to 10 per cent, which came into effect from October 2019, the Japanese economy had been relatively stable in anticipation of the upcoming Tokyo Olympics in 2020, which has now been postponed due the covid-19 pandemic. Given the travel restrictions across borders have a significant impact on the sourcing and execution of cross-border transactions, we expect to see players focusing on domestic deals including buyout opportunities in the Japanese market. With the potential distressed buyout opportunities as a result of the covid-19 pandemic, private equity activity in Japan is still expected to be relatively active despite covid-19.

The Inside Track

What factors make private equity practice in your jurisdiction unique?

The private equity market in Japan is relatively small, in proportion to the size of its economy, and, although significant improvement has been seen in recent years, the perception towards global private equity firms may still not necessarily be positive. Therefore, there is room for domestic private equity firms to play an important role where target companies are more receptive only for the reason that they are domestic. However, as the deal value for transactions that seek private equity involvement is becoming larger, there seems to be more room for global private equity funds to make significant investments to turn around a number of sectors in the Japanese economy, which may not have been performing too well in the past decade.

What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?

A deep understanding of the private equity industry. In addition, a close working relationship between the M&A team and the financing team. Last, counsels’ capability to assist on post-acquisition integration matters is also very important. This is particularly so when cross-border elements are becoming not uncommon.

What interesting or unusual issues have you come across in recent matters?

I have recently represented a foreign private equity fund for its successful participation in a bid process to acquire a Japanese portfolio company of a European private equity fund. Although the process letter indicated that the seller was expecting a clean exit from the transaction, which in my view hinted that the use of warranty and indemnity insurance could be crucial to maximise the competitiveness of our client’s bid, the first draft of the definitive agreement provided by the seller’s legal counsel were not quite consistent with this message set out in the process letter, as it offered a cap of 100 per cent of the transaction value. This may stem from the rather limited experience domestic law firms may have for using warranty and indemnity insurance. We have successfully managed to allow our client to win the bid process by using the warranty and indemnity insurance, which for the client was for the first time as well.