The Japanese private equity (PE) market has continued to be quite active as the overall number of mergers and acquisitions (M&A) transactions involving Japanese parties has been robust. After the number of M&A transactions and total transaction value decreased in 2020 due to the pandemic, the Japanese M&A market recovered both in 2021 and 2022. The number of transactions increased from each prior year, making both years a record year.

A continuing trend is the sale by Japanese companies of non-core businesses, and buyout funds are active as desirable buyers in this type of transaction. For example:

Another trend is the need for succession of ownership and management of relatively mid- or small-sized founder/family-controlled Japanese companies. In particular, Japanese mid-sized domestic buyout funds are very active as potential buyers of those businesses.

Fundraising has been quite robust in recent years and many PE funds have succeeded in establishing larger sized successor funds. It is widely perceived that there will be many opportunities for investment in Japanese listed companies or their businesses, partly due to significant recent reforms of Japanese corporate governance and the increased influence of shareholders.

Buyout funds target established businesses that have stable cashflow, as the funds usually use leverage. Buyout activity is seen in a wide range of industries, including the pharmaceutical, health care, consumer, financial, chemical, electronics and IT service/technology sectors.

Many large Japanese companies have continued to focus on their core businesses and dispose of non-core businesses. There are also a number of companies, both listed and non-listed and of all sizes, that have ageing owner-founders and are facing succession issues. These types of companies have been a particular focus of PE investment in Japan.

In addition, PE firms continue to be active in management buyout (MBO) transactions.

A common method of exit is a trade sale of shares to a business operator that conducts a business similar to that of the target company and this method continues to be commonly used by PE firms.

IPOs have also become key means of exit for many PE funds. The Japanese IPO market appears to be still active as the number of IPOs in 2023 was expected to be at least at the same level as recent years, but there may be some weakening in the valuation and size of offerings due to current uncertainties in the global economy and a cautious attitude towards investment by many institutional investors.

PE usually invests in established businesses with stable cashflow, while venture capital (VC) invests mainly in early stage or start-up companies that have large growth potential. Naturally, VC targets companies with novel and cutting edge technology or business models, in fields such as artificial intelligence, IT technology, space technology, health care, and "deep" technology. PE usually acquires 100% or at least a majority of the business with use of the leverage of debt financing, while VC makes a minority investment without this leverage. There are no significant differences in fund structure.

Japanese PE funds obtain funding from several sources, including:

Governmental agencies in Japan are major investors in PE funds, including the Organisation for Small and Medium Enterprises and Regional Innovation, Japan. This is an independent administrative agency established in 2004 under legislation aimed at assisting management of small and medium enterprises.

There are two types of tax incentives to encourage investment in unlisted companies:

The Angel Tax System is generally aimed at individual investors. Tax Incentives to Promote Open Innovation are aimed at corporate investors, including corporate venture capitals (CVCs).

To qualify for the Angel Tax System, an individual investor must purchase shares, either directly or indirectly through VC funds or certified crowdfunding operators, in a venture business that meets certain conditions. Where an eligible investment is made, depending on the type of investment, an individual investor can deduct:

To be qualified for the Tax Incentives to Promote Open Innovation scheme, a corporation or a CVC must purchase shares in a venture business that meets certain conditions. The corporate investor can deduct a certain amount (25%) of the investment from its annual income at the time of investment.

The most commonly used vehicle formed in Japan for PE funds is the investment business limited partnership (toshi jigyo yugen sekinin kumiai) (IBLP), which is established under the Investment Business Limited Partnership Agreement Act (IBLP Act).

An IBLP is managed by a general partner (GP), who has unlimited liability for the IBLP's debts. The limited partners do not engage in management but have certain rights to inspect the business of the IBLP. Their liability is limited to the amount of their capital contribution.

The investment target of an IBLP is restricted under the IBLP Act. The principal types of assets in which an IBLP may invest are:

Real assets such as real property and personal property are not included in the list of eligible assets, except that an IBLP can acquire such property as collateral for loans or securities held by the IBLP.

Also, an IBLP cannot invest a majority of its assets in interests of non-Japanese companies, except for some limited cases, such as the case where an IBLP obtains approval from the Minister of Economy, Trade and Industry (METI) of its business plan for promoting investment by using outside managerial resources or for corporate restructuring under the Act on Strengthening Industrial Competitiveness. Therefore, a limited partnership is formed outside of Japan if the fund's main investment target is non-Japanese entities.

A PE fund formed as an IBLP (see Question 5) is a pass-through entity for Japanese tax purposes, with taxes being levied on the investors in the fund rather than the fund itself. Also, a PE fund formed as a non-Japanese limited partnership is generally pass-through for Japanese tax purposes, except those described in Question 7.

A non-Japanese investor is deemed to have a permanent establishment in Japan, has tax filing obligations in Japan and is subject to withholding tax on distributions from the partnership's business if both:

However, if certain requirements are met, a non-Japanese investor can become a limited partner in a limited partnership without being deemed to have a permanent establishment in Japan (even if another partner has a permanent establishment in Japan). These requirements include a notification to the tax authorities and certain provisions in the partnership agreement.

Japan does not generally impose tax on capital gains from the sale or other disposition of shares of a Japanese company by a non-Japanese individual or foreign corporation, unless the foreign shareholder both:

In determining whether either the 25% ownership or 5% disposition is met, all shares held by the partnership are attributed to the foreign partner. However, if certain requirements are met, the shares held by the partnership do not have to be attributed to the foreign partner for 25/5 Rule purposes and only that portion of the shares pro rata to its partnership interest ratio is attributed to the foreign partner.

Whether or not a structure used for a PE fund in other jurisdictions is treated as tax transparent is determined by the Japanese tax authorities for Japanese income/corporation tax purposes. If such an entity is treated as a foreign corporation from a Japanese legal perspective, it will not be regarded as a tax-transparent entity.

On 17 July 2015, the Japan Supreme Court ruled that a Delaware limited partnership was treated as a corporation, instead of a tax-transparent entity, for Japanese tax purposes. The Supreme Court laid out two key criteria to take into account in determining the entity classification:

In addition, the Japanese tax authorities generally treat US limited liability companies as non-transparent entities for Japanese tax purposes, as they are considered to be foreign corporations from a Japanese legal perspective.

Despite the Supreme Court's ruling above, the National Tax Agency announced in February 2017 that it would not challenge the tax-transparent treatment of US limited partnerships. This announcement was issued to address Japanese investors' concerns that the income derived through US limited partnerships from US portfolio companies would be taxed in the US if US limited partnerships are treated as non-tax-transparent entities for Japanese tax purposes.

The average life of a PE fund is typically ten to 12 years. Investors must usually make a capital contribution to fund the investment over an investment period of generally four to six years.

Buyout funds generally seek to achieve long-term capital gain by investing in several companies, improving the management and operations of the invested companies and realising an exit. The preferred annual return (hurdle rate) is typically 5% to 8%. VC funds also seek to achieve long-term capital gain, but they invest in a larger number of start-ups with the expectation that some of them will have greater returns while some investments will result in failure. The hurdle rate is not always set for VC funds.

The following must register as a "financial instruments business operator" and comply with certain restrictions under the Financial Instruments and Exchange Act (FIEA):

For foreign PE funds, even if the GP is located and the limited partnership is established outside Japan, a GP of a limited partnership may be required to register with the Japanese regulator, in respect of its:

To be registered, a party must be organised as a corporation and meet other qualitative requirements. However, if certain statutory exemptions are met, a simple notification to the Japanese regulator can be sufficient (see Question 10).

Persons who offer fund interests or manage investment for PE funds are regulated and must comply with the requirements discussed in Question 9, unless an exemption applies (see below, Exemptions).

One of the key factors in the registration exemption is whether there is a fund investor that is a qualified institutional investor (QII). The different categories of QIIs are listed in the FIEA and include, for example, Japanese banks and insurance companies.

A GP of a partnership-type fund can manage investments and offer its interests without registration, with a prior notification to the authorities (QII-Targeted Fund Exemption) if the following conditions are met:

Many PE funds operate in reliance on this exemption.

A GP of a non-Japanese fund may also be able to rely on the de minimis Japanese QII Exemption. This exemption generally requires that:

If the requirements of this exemption are met, the GP is exempted from both registering and filing notice (but only for the investment management of the fund and it is still subject to the regulations for offering fund interests).

In 2016, the FIEA was amended to narrow the criteria for non-QIIs that can acquire interests in a QII-Targeted Fund (Eligible Non-QII). The scope of Eligible Non-QIIs is limited to certain types of investors and persons that are closely related to the QII-Targeted Fund Operator, including:

The scope of Eligible Non-QIIs is broader for a QII-Targeted Fund that meets certain criteria as a VC fund.

Japanese anti-monopoly, banking and insurance laws provide maximum percentage limitations on the direct and indirect holding voting rights of another Japanese company by a bank, a bank holding company and an insurance company:

These limitations do not apply to indirect interests in portfolio companies of an IBLP in which a bank, bank holding company or insurance company holds an IBLP interest. However, the exemption does not apply if the limited partner can exercise or instruct the exercise of the voting rights of the portfolio companies or the partnership holds those voting rights for more than ten years. Therefore, in many cases, it is agreed that a partnership cannot hold securities for more than ten years.

The GP of a fund makes the investment decisions. The limited partners monitor those decisions. The limited partners usually receive ongoing reports and have a veto right over certain limited matters, such as a transaction involving a conflict of interest (in some cases the veto right is exercised through an LP advisory board, which often consists of several selected members that represent limited partners).

In many cases, a GP can be dismissed if either:

In addition to the partnership agreement, it is increasingly common for investors to request a GP to execute side letters. In these side letters, the parties agree on prohibitions on the GP investing in certain fields and the right of a limited partner to have a representative selected as a member of an LP advisory board. Some investors also requests a right to participate as an observer in the fund's investment committee.

In offering fund interests, QII-Targeted Fund Operators are subject to principles of suitability and, if the prospective investors are not professional investors (tokutei toshika), the QII-Targeted Fund Operators must explain certain matters and deliver certain disclosure documents, and are subject to certain restrictions on advertising under the FIEA.

Also, the limited partnership agreement or other documents for the fund must include certain provisions on separate management of monies of the fund and the GP. With regard to investment activities, QII-Targeted Fund Operators must prepare and send a semi-annual investment report to non-professional investors and are prohibited from engaging in certain transactions, including trading of securities between the QII-Targeted Fund Operator and the fund or between one fund and another fund operated by the same QII-Targeted Fund Operator.

Some categories of non-professional investors are eligible to change their status to professional investors under the FIEA. Due to a recent amendment of the regulations under the FIEA which became effective as from 1 July 2022, a wider range of individual investors have become eligible to change their status to professional investors.

Buyout funds usually take equity interests in portfolio companies, most commonly in the form of common stock, which:

However, the subordinated nature of common stock usually results in a total loss in its value in an insolvency proceeding or distressed liquidation.

Preferred stock is sometimes used and generally ranks between debt and common stock, giving holders priority in the distribution of dividends or residual assets over the holders of common stock. Preferred stock also offers flexibility in its terms and may be structured so that the holders have a certain level of control through the exercise of voting rights or conversion into common stock. A mezzanine investor often takes non-voting preferred stock (see Question 23).

VC funds have increasingly used voting preferred stock. Preferred stock that VC funds take usually carries:

The issue of new shares by a private company typically requires a resolution of shareholders under the Companies Act and in accordance with the company's articles of association. Also, the transfer of shares of a private company requires approval of the board of directors (or shareholders, in the absence of a board of directors).

The issue of shares of a public company requires a shareholder resolution adopted by a supermajority vote if the:

In addition, a shareholder resolution adopted by a simple majority vote is required in principle if both:

A buyout of a public company typically requires compliance with tender offer procedures under the FIEA. For example, a tender offer is required if a transfer of listed shares results in the acquirer holding more than one-third of the voting rights of the listed company.

The issue of new preferred stock requires an amendment of the issuer's articles of association to provide the terms and conditions of the preferred stock, regardless of whether the issuing company is private or listed. The amendment must be approved by a shareholder resolution with a supermajority vote.

Dividends paid to a shareholder are generally subject to withholding taxes. Japanese individuals and corporations are subject to capital gains taxes when they dispose of the shares in a portfolio company.

An auction process is increasingly common in buyouts of private companies, in particular in the potentially large transactions. There are no laws or regulations specifically applicable to the auction process and it is governed by general rules of contract law.

A typical auction process has two stages:

While the number of transactions per year fluctuates depending on the economic situation in each respective year, buyouts of listed companies by PE funds are generally common. PE funds usually contemplate acquiring all shares in the target company, resulting in the target company being delisted. Acquiring all shares and taking full control is important for PE funds to achieve their investment objectives post closing. These public-to-private transactions are typically conducted through a two-step acquisition:

The FIEA applies to the first step tender offer (see Question 15) and the Companies Act applies to the back-end squeeze-out.

The squeeze-out right enables a shareholder holding (directly or through one or more wholly owned subsidiaries) at least 90% of the total voting rights (special controlling shareholder) to force a cash acquisition of the remaining shares held by the minority shareholders. This alternative only requires a resolution of the board of directors of the target company, and therefore significantly expedites the squeeze-out procedure. Practically, it is possible to complete the back-end squeeze-out as early as one month after completion of the first-step tender offer.

The squeeze-out right also applies to other equity securities, including stock options and convertible bonds. The special controlling shareholder seeking to exercise the squeeze-out right for the existing shares also has the right to force a cash acquisition of these equity securities. The effect of the squeeze-out right is that the relevant shares and other equity securities are transferred directly from the minority shareholders to the special controlling shareholder.

On exercise of the squeeze-out right, the special controlling shareholder notifies the target company of the amount of cash consideration for the remaining shares (and other equity securities, if applicable). The amount must be approved by the board of directors of the target company. In making a decision on the approval, directors of the target company owe a duty of care to consider the shareholders' interests (that is, the fairness of the amount of cash consideration). Minority shareholders (and holders of other equity securities) also have appraisal rights to seek fair consideration in a court procedure. Also, if the price of the cash consideration is found to be extremely inappropriate, the minority shareholders (and holders of other equity securities) are entitled to seek an injunction of the entire squeeze-out transaction.

Due to its simple and expedited procedure, the squeeze-out right has been most commonly used for back-end squeeze-outs where the acquirer satisfies the 90% voting rights requirement.

Another alternative available in 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 shareholders of the target company adopt a shareholder resolution consolidating the target company's shares by a ratio that results 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 on court approval, with the cash proceeds distributed proportionately to the minority shareholders.

A fractional share squeeze-out could also be conducted by means of wholly callable stock (zenbu shutoku joukou tsuki shurui kabushiki), which is a class of stock that is subject to a call option exercisable by the issuing company. The target company can, with approval of a shareholder resolution, reclassify all outstanding shares into a wholly callable stock and exercise the call option, on which the wholly callable stock is then exchanged for a new class of stock. The exchange ratio for the new shares is set at a level that results in minority shareholders being entitled to receive only fractional shares. Wholly callable stock was commonly used in the past, but due to the complexity, it is now less often adopted as a method for a fractional share squeeze-out.

A fractional share squeeze-out using either method requires a shareholder resolution of the target company and cannot be used to force a cash acquisition of other equity securities (unlike the squeeze-out right). However, a fractional share squeeze-out does not have the 90% voting rights requirement that the squeeze-out right has. Therefore, if the acquirer fails to obtain 90% of total voting rights on completion of the first-step tender offer, making the squeeze-out right unavailable, a fractional share squeeze-out is still available as long as it is approved by a shareholder resolution with a supermajority vote (two-thirds of the votes cast).

A cash merger (or a stock-for-cash exchange) can be used as another squeeze-out mechanism.

Under Japanese tax law, a merger or stock exchange is not generally tax qualified if any cash is included in the merger or stock exchange consideration. However, delivering cash to minority shareholders is disregarded when determining whether a merger or a stock exchange is tax-qualified or not, if the corporation acquiring the target company already owns two-thirds of the total issued shares of the target company before the squeeze-out transaction. In a squeeze-out context, the requirements for tax exemption include an expectation of, after the squeeze-out:

In the case of buyouts of private companies, a stock purchase agreement entered into between the seller and the buyer is the principal document providing the transaction's terms and conditions. The stock purchase agreement is not required to be made publicly available. However, if the seller is a listed company, certain major terms such as the acquisition price could be made public in accordance with the timely disclosure requirements under stock exchange rules applicable to the seller.

These documents are made publicly available. 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.

The contractual buyer protections commonly sought by PE funds include:

These are typically provided in the stock purchase agreement.

For buyouts of listed companies, the tender offer registration statement is prepared in accordance with the FIEA and relevant regulations, and therefore allows a narrower variety of contractual arrangements. Therefore, the contractual buyer protections available to PE funds tend to be much more limited in buyouts of public companies than those available for buyouts of private companies.

In particular, due to the strict restriction on withdrawal of a tender offer under the FIEA and relevant regulations, it is difficult to effectively provide conditions precedent as broad as those typically provided in a stock purchase agreement for buyouts of private companies. While the buyer and the major shareholder(s) can enter into a tender offer acceptance agreement, that agreement is typically simple and straightforward, with only a limited scope of contractual buyer protections.

A VC fund often becomes a minority shareholder through an investment in preferred stock with terms that protect the investor's interest, including an anti-dilution mechanism, and typically also requests information rights, rights of refusal or co-sale rights and drag along rights. Anti-dilution protections are typically on a weighted average basis unless the company is financially troubled, in which case they would be on a full ratchet basis.

In Japan, the use of representation and warranty (R&W) insurance had not been common until recently, partly due to the time and cost of purchasing the insurance. However, the situation is beginning to change. While foreign insurance companies have been dominant in this area, an increasing number of domestic insurance companies have started to provide R&W insurance.

Unlike the R&W insurance provided by foreign insurance companies, domestic R&W insurance requires neither an English translation of relevant documents (such as the due diligence report and the acquisition documentation) nor communication in English in the underwriting call.

With an increased capacity of the underwriters, domestic R&W insurance could now be available for larger transactions including those with a transaction value of more than JPY100 billion. The use of domestic R&W insurance is getting more common, particularly for domestic transactions where the relevant documents are mostly in Japanese. It is generally recognised that such insurance could be beneficial where:

Company directors owe the duty of care of a good manager to the company, which is substantially equivalent to a fiduciary duty (Companies Act). In particular, the Tokyo High Court ruled on 17 April 2013 that, in MBOs by a two-step acquisition, directors of the target company owe a duty of care to take account of the shareholders' common interests, specifically the duty to:

Consistent with that ruling, a ruling by the Osaka High Court on 29 October 2015, in the case of a management buyout that failed during the process, held that the directors of the target company contemplating the MBO breached the duty to ensure a fair transfer of corporate value among the shareholders and found them liable for the damages incurred by the target company.

In addition, a landmark 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 (see Question 17), 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 (Jupiter Telecom Case, Saikō Saibansho [Sup. Ct.], Decision, 1 July 2016; 70 Saikō Saibansho Minji Hanreishū [Minshū], 6, 1445 (Japan)).

While the Supreme Court ruling on the Jupiter Telecom Case 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 (that is, conflict-of-interest transactions such as MBOs).

Following this Supreme Court ruling, the Fair M&A Guidelines formulated by METI on 28 June 2019 emphasised the need to take appropriate measures to ensure a fair process for conflict-of-interest transactions such as MBOs and acquisitions of listed companies by controlling shareholders (including parent companies) (see Question 33).

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 transactionsIn this regard, there have been an increasing number of transactions involving PE 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 PE investor in a MBO can enter into, or cause the target company to enter into, an executive service agreement with the management. Typical terms and conditions under an executive service agreement include management compensation incentive structures (see Question 28) and management obligations such as non-competition, non-solicitation and confidentiality.

Directors can be replaced on a resolution adopted by a simple majority vote at a shareholders' meeting (Companies Act). On the acquisition of a majority of shares with voting rights, a PE fund obtains the power to replace all members of the board of directors at any time, theoretically. However, in friendly buyouts, a PE fund often relies on the incumbent management and nominates only a small number of non-executive directors, reserving the power to replace other directors.

The debt financing package typically consists of a senior facility (often a syndicated loan) and a mezzanine financing (if any). The senior facility typically consists of:

Senior term loans usually consist of term loan A with amortisation repayment and term loan B with bullet repayment. Typically, one or more arranger banks underwrite these facilities on the acquisition. The arranger banks then syndicate these facilities within a general syndication period. The syndication period is usually six months to one year after the signing or first use.

There has been a growing trend in the usage of mezzanine financing, especially in highly leveraged transactions. Mezzanine financing is usually structured as subordinated loans, subordinated bonds, subordinated convertible bonds or preferred shares. Interest payments under mezzanine financings often include, together with cash interest payments, payment-in-kind interest (PIK interest). This is usually accrued on a compounded basis that will become due on the maturity date, after full repayment of senior debt. If mezzanine financing is structured as preferred shares, the preferred shareholder will have a put option, exercisable on or after the maturity date, to sell the preferred shares to the issuer at a price equal in the aggregate to the subscription price and the equivalent of the PIK interest (if any dividend is paid during the term, it will be deducted from the put option price).

In acquisition finance, lenders usually take security over the shares in the target company (and the shares in the acquiring entity, in most cases). The acquiring entity usually provides security over its assets, such as bank accounts and inter-company loans. Where there is to be no other shareholder in the target company than the acquiring entity (or when all remaining shareholders in the target company agree for the target to provide a guarantee or security interests to secure the acquisition loan), the target company and its wholly owned subsidiaries also provide guarantees and security over their assets.

In leveraged buyout financing, lenders often request security over substantially all assets owned by the target company, but the security package is eventually determined based on a cost-benefit analysis, legal feasibility and other factors. A blanket lien is unavailable for bank loans in Japan. Therefore, it is necessary to individually attach security interests over each type of asset.

Floating security interests are permitted only for movable assets and claims, such as trade receivables. In addition, the registration of security over certain assets, such as real estate, requires payment of a registration tax. Therefore, in some cases lenders agree not to register until certain pre-acceleration events occur. Also, granting a security interest over some assets, for example, trade receivables and deposits under lease agreements, requires consent from a third party under the underlying trading or lease agreements. Those assets are sometimes excluded from the security package.

In acquisition financing, lenders usually request:

These requests allow lenders to closely monitor the financial condition and operations of the target company. They are usually heavily negotiated between the lenders and the PE fund, which seeks to maintain maximum operational flexibility.

There are two types of subordination, excluding structural subordination:

With contractual subordination, creditors can agree to flexible arrangements. Although there is believed to be a risk that contractual subordination can be disregarded or treated differently by a court or trustee in insolvency proceedings, contractual subordination is commonly used in leveraged financings in Japan.

There are no specific rules on financial assistance in Japan. However, the general fiduciary duty owed by the directors of the target company must be considered when the target company provides a guarantee or security to secure the acquisition financing loans. Directors of the target company can be found to breach their fiduciary duties if the target company provides guarantees, security or other financial assistance solely for the benefit of a majority shareholder.

Therefore, it is common for the target company to refrain from providing this financial assistance before either the:

Secured claims are prioritised in insolvency proceedings. In bankruptcy (hasan) and civil rehabilitation (minji saisei) proceedings, the secured creditors can proceed to foreclose or sell their collateral without court approval.

In corporate reorganisation (kaisha kousei) proceedings, secured creditors cannot exercise their rights outside the proceedings. After the valuation of the collateral, secured claims equivalent to that valuation are prioritised over unsecured claims. However, payment is subject to a court-approved repayment plan.

In insolvency proceedings, non-secured bank loans are usually treated as general claims, which are subordinated to:

Debtor-in-possession financing after the commencement of these proceedings can be treated as common benefit claims.

It is uncommon for senior lenders to have instruments with rights to achieve equity appreciation. However, mezzanine finance providers can obtain equity appreciation by providing finance through:

Further, mezzanine finance providers are sometimes granted equity kickers. These equity kickers are usually structured as stock options (shinkabu yoyakuken) that are exercisable on or after exit of the PE fund.

Typical incentive structures include performance-based annual bonuses and stock options. In addition, top management can hold minority shares in the company. In some cases, PE funds or the target company enter into agreements with management to set out pre-determined performance targets for annual bonuses, to incentivise the management.

Stock options are occasionally subject to performance vesting features. Stock options often become only exercisable on exit of the PE fund (for example, through an IPO or trade sale). Minority shares held by top management are subject to transfer restrictions and are released only after an IPO, or are subject to a drag-along right of the PE fund in the case of a trade sale.

The management incentive structures of a private corporation are not subject to regulatory oversight or public disclosure requirements.

Companies can offer qualified stock options (zeisei-tekikaku) taxed at capital gains rates (about 20%) when the shares are sold. No tax is due when they are exercised. Non-qualified stock options are taxed at the time of exercise and at other tax rates (for example, as salary income). The tax is dependent on the income level of the person exercising the stock options. The tax rate for salary income is generally higher than the capital gains rates.

To be classified as qualified stock options, certain conditions must be met, including:

Interest payments are subject to Japanese usury laws, including the Interest Rate Limitation Act. Under this, the maximum interest rate for a loan with a principal amount of at least JPY1 million, is 15% per annum. Also, generally, the interest rate must be on arm's length terms to avoid any tax issues. Dividend payments are subject to certain procedural requirements (including a shareholder resolution in certain cases) and availability of distributable profit computed under the Companies Act.

Investment documents sometimes include special conditions, representations or covenants in relation to anti-corruption, other than those relating to compliance with laws in general and certain boilerplate representations about non-affiliation with organised crime.

An individual director who is involved in a bribery of a domestic or foreign public officer, whether by conspiracy, aiding or abetting, is subject to criminal penalties (Criminal Law and the Unfair Competition Provision Law). Penalties include imprisonment and/or a fine. Unless conspiracy, aiding or abetting is found, the other directors are not subject to a criminal penalty.

The most common forms of exit for buyout funds are:

The trade sale is the most common exit form, although there has recently been an increase in secondary buyouts. The IPO has also become a popular exit, but this is subject to the IPO market environment.

For VC funds, the most preferred form of exit is IPO. This is because the level of return is historically higher than other forms of exit, and an even relatively small-sized IPO is available.

A trade sale to a strategic buyer is a simple and straightforward exit. The fund usually obtains an immediate return on the entire investment, although there may remain indemnity obligations or a balance of payment held in escrow. The secondary buyout is an attractive option where, for example, the initial buyout fund's holding period is about to end but the IPO of the portfolio company is expected in a few more years.

An exit through an IPO can realise greater value in some cases. However, the possibility of this exit largely depends on the market environment and the IPO preparations require time, resources and cost. Usually, the fund cannot sell out all of the investment at the IPO and is subject to market risk and some difficulties in finding opportunities to sell the remaining stake at a favourable price and timing.

Following a leveraged buyout of the target, if the target becomes unable to make its scheduled debt payments, the fund usually seeks either or both:

If these efforts are unsuccessful, the lenders are likely to exercise their security interest on the company's stock. If the value of stock exceeds the total amount of debt financing, the residual is returned to the fund. The fund is unlikely to seek a bankruptcy filing of the target because in almost all cases the bankruptcy court finds that there is no remaining equity in the company and therefore no return to the equity holder.

The Fair M&A Guidelines formulated by METI on 28 June 2019 emphasised the need to take appropriate measures (Fairness Ensuring Measures) to ensure the fair process for conflict-of-interest transactions such as MBOs and acquisitions of listed companies by controlling shareholders (including parent companies).

The Fairness Ensuring Measures referred to in the Fair M&A Guidelines include:

The measures are recommended as best practices and are not a mandatory condition to realise fair transaction terms.

Parties to M&A transactions should therefore consider which, and to what extent, Fairness Ensuring Measures should be taken based on the specific circumstances of each transaction. Also, the measures taken should be evaluated in their entirety to determine whether they are sufficient to ensure the fairness of transaction terms.

In the light of the recommendations by the Fair M&A Guidelines, currently special committees are almost always established in conflict-of-interest transactions. However, majority-of-minority conditions are still uncommon due to concern about the potential risk of deterring value-creating transactions, particularly in acquisitions of listed companies by controlling shareholders, where other shareholders of a relatively small investment can block the transactions.

While the scope of direct application of the Fair M&A Guidelines is limited to conflict-of-interest transactions described above, it is generally understood that they could help to ensure the fairness of the other types of M&A transactions, including a sale of a listed subsidiary by the parent company.

Even where there is no inherent conflict of interest, listed target companies are inclined to establish a special committee to review the deal terms more carefully. In the light of the Fair M&A Guidelines, there have been an increasing number of transactions involving a PE fund as the buyer where a special committee is established or an active market check is conducted through an auction process or solicitation to multiple buyer candidates.

The Foreign Exchange and Foreign Trade Act (FEFTA) obliges a foreign investor contemplating a foreign direct investment (FDI) in certain restricted businesses (Restricted Businesses) to make a pre-transaction notification.

FDIs subject to the pre-transaction notification requirements are reviewed by the Ministry of Finance and other relevant ministries and are subject to a statutory waiting period of 30 days. The waiting period can be extended by up to four or five months in certain cases, but is often shortened to two weeks or less if the FDI does not raise any regulatory concern.

A series of amendments to the pre-transaction notification requirements under the FEFTA became effective in August 2019. Most importantly, 20 types of businesses (Newly Added Businesses) were added to the list of Restricted Businesses and pre-transaction notifications are required for FDIs targeting the Newly Added Businesses.

Newly Added Businesses are divided into the following categories:

The pre-transaction notification requirements may apply to a wider range of businesses, particularly those engaged in by start-ups and technology companies.

Also, under the amendment of the FEFTA effective in May 2020, a general partnership, an IBLP and other similar partnerships under foreign laws constitute a foreign investor if either:

PE funds falling within these criteria will therefore be required to make pre-transaction notifications. On the other hand, individual partners of these partnerships are not required to make a pre-transaction notification in connection with the investment by such partnerships even if the individual partner itself would be categorised as a foreign investor.