Private equity in Japan: market and regulatory overview

A Q&A guide to private equity law in Japan.

The Q&A gives a high level overview of the key practical issues including the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.

To compare answers across multiple jurisdictions visit the Private Equity Country Q&A Tool.

This Q&A is part of the Practical Law multi-jurisdictional guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.

Contents

Market overview

1. How do private equity funds typically obtain their funding?

Japanese private equity funds obtain funding from a variety of sources, including:

  • Financial institutions.

  • Pension funds.

  • Operating companies.

  • Individuals.

Governmental agencies in Japan have also recently become major investors in PE funds, including:

  • Organisation for Small and Medium Enterprises and Regional Innovation, Japan (SMRJ). This is an independent administrative agency established in 2004 under legislation aimed at assisting management of small and medium enterprises.

  • Innovation Network Corporation of Japan (INCJ). This is a public-private fund aimed at promoting innovation and enhancing the value of businesses in Japan. INCJ was established in 2009 for a term of 15 years under legislation sponsored by the Ministry of Economy, Trade and Industry (METI). INCJ was capitalised by both the Japanese government (injecting JPY266 billion) and 26 private corporations (JPY14 billion). The Japanese government also provides guarantees up to a total of JPY1.8 trillion for INCJ investments, giving it an investment capability of about JPY2 trillion.

 
2. What are the current major trends in the private equity market?

Because the Japanese private equity market is still relatively young, the most notable trend is its rapid growth from the end of the 1990s through to the global economic crisis from 2008. Private equity activity, like all other M&A activity in Japan, sharply declined as a result of the post-Lehman market disruption and the resulting recession. This downturn was further prolonged in Japan as a result of the impact of the Great East Japan Earthquake in March 2011. Therefore, after rapid growth, particularly from 2003 to 2007, activity became stagnated at a relatively low level from 2009 through 2012. However, the market began to pick up in 2013 and seems poised to continue its growth in 2014.

 
3. What has been the level of private equity activity in recent years?

Fundraising

After the post-Lehman disruption and economic recession, the amount of funds raised by PE funds declined sharply. However, fundraising has recently begun to increase. Many investment firms have established successor funds because the investment period of the predecessor funds expired. 

Investment

There is a very diverse and deep pool of medium-sized companies with competitive technologies or unique business models that are ideal targets for private equity funds in Japan. Opportunities for transactions involving these companies are increasing because of the ageing of owner-founders and also as a result of spin-offs or carve-outs of non-core businesses by struggling conglomerates. Therefore, private equity investments having a value below JPY30 billion comprise a significant portion of the Japanese private equity market, according to the Japan Buyout Research Institution.

Private equity funds are also acquiring non-core business assets of a larger size from major Japanese (electronics) companies, as illustrated by:

  • KKR's acquisition of a healthcare division of Panasonic.

  • Japan Industrial Partner's acquisition of an internet service provider division of NEC and its potential acquisition of the "Vaio" PC division of Sony.

Transactions

The private equity market in Japan grew significantly from its inception in 1998 through to the global financial crisis in 2008, after which it suffered several years of relatively low activity. However, with the recent implementation of an aggressive monetary and fiscal stimulus, Japan has begun to show early signs of escape from a prolonged period of deflation. There has also been an upward trend in private equity activity in general.

The data indicate that the volume of transactions structured as management buyout transactions has generally tracked that of other PE and M&A activity. However, unlike in the earlier 2000s when many MBO transactions were sponsored by funds, during the last few years there was an increase in the number of transactions using bank debt only, without fund sponsorship. This is partly because the size of recent MBO transactions was relatively small and the managers were also large shareholders of the target who reinvested in the acquisition vehicle.

Exits

A common method of exit is a trade sale of shares to a business operator who conducts a similar business of the target company. However, there has recently been an increase in second buyout transactions, notable ones being:

  • Bain's acquisition of Skylark from Nomura Principal Finance.

  • Permira's acquisition of a chain of sushi restaurants from Unison Capital.

Exiting through an IPO has not historically been very common. This is partly because the private equity industry is still relatively new in Japan and when many of the early funds were about to exit, the IPO market slumped (particularly after the 2008 financial crisis). However, because of the recent rebound of the Japanese IPO market, there will likely be more IPO exits, both in number and size.

 

Reform

4. What recent reforms or proposals for reform affect private equity in your jurisdiction?

An amendment of the Companies Act is expected to be approved during the first half of 2014 that could impact the private equity market through:

  • A new requirement of disclosure and, on an objection by shareholders with at least 10% voting power, shareholder approval for an issuance of new shares to a third party that would result in the third party holding a majority of total voting power.

  • New rules for squeeze-outs, including the introduction of a new procedure enabling a shareholder holding at least 90% of voting rights to force a cash-out acquisition of shares of the minority shareholders (not involving a merger) without a shareholder vote at the target.

 

Tax incentive schemes

5. What tax incentive or schemes exist to encourage investment in unlisted companies? At whom are the incentives or schemes directed? What conditions must be met?

Incentive schemes

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

  • The Angel Tax System.

  • Tax Incentives to Promote Venture Investment.

These are mainly targeted at investments in venture businesses.

Favourable treatment (that is, lower rate taxation for capital gains or dividends) for investments in listed companies was abolished at the end of 2013. Therefore, investments in unlisted companies and listed companies are treated in a more equal manner than before.

At whom directed

The Angel Tax System is generally aimed at individual investors.

Tax Incentives to Promote Venture Investment is aimed at corporate investors.

Conditions

To qualify for the Angel Tax System, an individual investor must purchase shares, either directly or indirectly through venture funds, 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:

  • A certain amount of the investment from its annual income at the time of investment.

  • The total amount of the investment from its annual capital gains income derived from the sale of stocks at the time of investment.

  • Carry forward losses for three years at the time of the sale of the investment.

To be qualified for the Tax Incentives to Promote Venture Investment, a corporation must enter into an agreement with an investment business limited partnership (venture fund) accredited by the government. That venture fund acquires shares or other interests in a venture business. The corporate investor can then accelerate its investment loss for corporation tax purposes. The claimable loss is limited to 80% of the investment's book value.

 

Fund structuring

6. What legal structure(s) are most commonly used as a vehicle for private equity funds in your jurisdiction?

A commonly used vehicle for private equity funds in Japan is the investment business limited partnership (toshi jigyo yugen sekinin kumiai), which is established under special METI-sponsored legislation. This type of partnership is managed by a general partner, which has unlimited liability for the partnership's debts. The limited partners do not engage in management, but have certain inspection rights and their liability is limited to the amount of their capital contribution.

The law limits the types of investment that can be made by an investment business limited partnership. In particular, this type of partnership cannot invest a majority of its assets in interests of non-Japanese companies. Therefore, a limited partnership is formed outside of Japan if the fund's main investment target is non-Japanese entities.

 
7. Are these structures subject to entity level taxation, tax exempt or tax transparent (flow through structures) for domestic and foreign investors?

PE funds formed as Japanese limited partnerships are pass-through entities for Japanese tax purposes, with taxes being levied on the investors in the fund rather than the fund itself. Also, PE funds formed as non-Japanese limited partnership are generally pass-through entities for Japanese tax purposes, except those described in Question 8.

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:

  • The non-Japanese investor is a limited partner in a partnership.

  • With respect to the business of the partnership, any partner (in most cases a general partner) has a permanent establishment in Japan.

However, if certain requirements are met then 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:

  • Owns 25% or more of the shares of the Japanese company.

  • Disposes of 5% or more of those shares in the same tax year ("25/5 Rule").

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.

 
8. What (if any) structures commonly used for private equity funds in other jurisdictions are regarded in your jurisdiction as being tax inefficient (whether by not being recognised as tax transparent or otherwise)? What alternative structures are typically used in these circumstances?

Whether or not a structure used for a private equity fund in other jurisdictions is treated as tax transparent will be 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. Various factors, including whether such an entity is treated as a separate legal entity under the governing law, are taken into account in determining the entity classification.

For example, 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. It is currently unclear whether US limited partnerships can be treated as tax transparent entities for Japanese tax purposes, but there are cases now pending at the Japan Supreme Court that will hopefully resolve this issue.

 

Investment objectives

9. What are the most common investment objectives of private equity funds?

The average life of a fund is typically ten to 12 years. The hurdle rate is typically 5% to 8%.

 

Fund regulation and licensing

10. Do a private equity fund's promoter, principals and manager require licences?

Any person who manages the investment of a partnership-type collective investment fund must register as a "financial instruments firm" and comply with certain restrictions applicable to its activities (Financial Instruments and Exchange Act (FIEA)). Also, any person who offers interests in a partnership-type fund must register as a "financial instruments firm". Foreign PE funds should note that, even if the general partner is located and the limited partnership is established outside Japan, a general partner of a limited partnership may be required to register with the Japanese regulator, both in respect of its:

  • Offering activities in Japan or to Japanese investors.

  • Activities as an investment manager of a fund with Japanese investors.

To be registered, a party must be organised as a corporation and meet other qualitative requirements. Once registered, the party has considerable ongoing reporting obligations to the Japanese regulator. However, if certain statutory exemptions are met, a simple notification to the Japanese regulator may be sufficient.

Supervision by the Securities and Exchange Surveillance Commission has become increasingly strict in recent years, and there are many cases where fund managers have been accused of raising funds and managing investments without proper registration or notification.

 
11. Are private equity funds regulated as investment companies or otherwise and, if so, what are the consequences? Are there any exemptions?

Regulation

See Question 10.

Exemptions

One of the key factors in the registration exemption is whether the Japanese fund investors are qualified institutional investors (QIIs). The different categories of QIIs are listed in the FIEA and include, for example, Japanese banks and insurance companies. A general partner 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 both:

  • The investors in the fund include at least one QII and do not include more than 49 non-QII investors.

  • The investors comply with certain other requirements (such as certain transfer restriction as detailed in Question 12).

Many PE funds operate in reliance on this exemption.

A general partner of a non-Japanese fund may also be able to rely on the De Minimis Japanese QII Exemption. In general terms, this exemption requires all of the following:

  • The non-Japanese fund, directly or indirectly, has fewer than ten Japanese fund investors.

  • All Japanese direct and indirect fund investors are QIIs.

  • The aggregate capital contributions to the fund of the Japanese fund investors represent less than one-third of the aggregate capital contributions of all investors in the fund.

If the requirements of this exemption are met, the general partner is exempted from both registering and filing notice (but, only with respect to the investment management of the fund).

 
12. Are there any restrictions on investors in private equity funds?

To qualify for the QII-Targeted Fund Exemption with respect to the offering of partnership interests, the partnership agreement must include certain transfer restrictions, including:

  • A QII must transfer its partnership interest only to other QII(s).

  • A non-QII must not transfer its partnership interest other than as a transfer of the entire partnership interest to a single transferee.

Also, if a limited partner is organised as one of certain types of collective investment vehicle, such as an investment business limited partnership or a silent partnership (tokumei kumiai), then the upper-tier investors in the vehicle must also be considered for the purposes of the QII-Targeted Fund Exemption. For example, if an investor is a tokumei kumiai and any investor in the tokumei kumiai is a non-QII, then the exemption will be lost. If another investment business limited partnership is an investor, then there is a look-through to upper-tier investors in the investment business limited partnership. These upper-tier investors must be counted among the 49 non-QII investors (see Question 11, Exemptions). Investors in a partnership are often required to make certain representations, warranties and covenants with regard to their own investors.

 
13. Are there any statutory or other limits on maximum or minimum investment periods, amounts or transfers of investments in private equity funds?

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

  • 5% in the case of a bank.

  • 15% in the case of a bank holding company.

  • 10% in the case of an insurance company.

These limitations do not apply to indirect interests in portfolio companies of a limited partnership in which a bank, bank holding company or insurance company holds a limited partnership 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.

 

Investor protection

14. How is the relationship between the investor and the fund governed? What protections do investors in the fund typically seek?

The general partner 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 matters, such as a transaction involving a conflict of interest (in some cases the veto right is exercised through an LP advisory board).

In many cases, a general partner can be dismissed if either:

  • The general partner materially breaches the partnership agreement or relevant laws and regulations.

  • Limited partners having a certain percentage of partnership interests approve the dismissal.

In addition to the partnership agreement, it is increasingly common for investors to request a general partner to execute side letters. In these side letters, the parties agree, among other things, on prohibitions on investing in certain fields. Some investors also request an observation right in the fund's investment committee.

 

Interests in portfolio companies

15. What forms of equity and debt interest are commonly taken by a private equity fund in a portfolio company? Are there any restrictions on the issue or transfer of shares by law? Do any withholding taxes or capital gains taxes apply?

Most common form

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

  • Enables direct control through exercise of voting rights.

  • As opposed to debt interests, allows participation in the increase in corporate value.

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

Other forms

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 preferred stock (see Question 23).

Restrictions

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 does not currently require a shareholder resolution unless either the:

  • Subscription price is particularly favourable to the subscriber.

  • Number of shares to be issued exceeds the remaining number of authorised shares.

After the enactment of a proposed amendment of the Companies Act, a shareholder resolution is required in principle if both:

  • The issue of new shares to a third party would result in it holding a majority of voting power.

  • Shareholders with at least 10% voting power object to the issue.

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 (whether private or listed) to provide the terms and conditions of the preferred stock. The amendment must be approved by a shareholder resolution.

Taxes

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.

 

Buyouts

16. Is it common for buyouts of private companies to take place by auction? If so, which legislation and rules apply?

An increasing number of buyouts of private companies are conducted through an auction process. The auction process is governed by general rules of contract law and there are no laws or regulations specifically applicable to the auction process.

 
17. Are buyouts of listed companies (public-to-private transactions) common? If so, which legislation and rules apply?

While the number of transactions per year fluctuates depending on the economic situation in each respective year, buyouts of listed companies by private equity funds are generally common. These public-to-private transactions are typically conducted through a two-step acquisition:

  • A first step tender offer.

  • A back-end squeeze-out of the remaining minority shareholders.

The FIEA applies to the first step tender offer described in Question 15, and the Companies Act applies to the back-end squeeze-out.

While this two-step acquisition is similar to those common in other jurisdictions, a cash merger is not commonly used in Japan for the back-end squeeze-out, because it would lead to a realisation of capital gains on the target company's assets (including goodwill).

Instead, a "fractional share squeeze-out" is currently most commonly used. In this type of squeeze-out, the target company, after adoption of a shareholder resolution, obtains an option to call all outstanding shares in exchange for new shares. The exchange ratio is set to result in minority shareholders holding fractional shares. There is a procedure by which the fractional shares are not actually issued but sold to the acquirer with court approval, with the cash proceeds distributed proportionately to the minority shareholders. Minority shareholders who are not satisfied with the amount of cash consideration can file a petition to the court to determine the fair value of their shares.

A proposed amendment of the Companies Act will introduce an alternative procedure for the back-end squeeze-out, by which a 90% shareholder can force a cash acquisition of the remaining shares (see Question 4). This alternative would not require a shareholder resolution of the target company (which typically takes a couple of months) and will therefore significantly expedite the squeeze-out procedure. While there is no definitive tax ruling, it is intended that there will be no resulting tax gain with the new procedure.

 

Principal documentation

18. What are the principal documents produced in a buyout?

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 principal documents for buyouts of public companies are the tender offer documents, such as the:

  • Tender offer registration statement filed by the offeror (buyer).

  • Position statement filed by the target company (which usually expresses the target's position on the tender offer).

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.

 

Buyer protection

19. What forms of contractual buyer protection do private equity funds commonly request from sellers and/or management? Are these contractual protections different for buyouts of listed companies (public-to-private transactions)?

The contractual buyer protections commonly sought by private equity funds include:

  • Conditions precedent.

  • Representations and warranties.

  • Covenants.

  • Indemnification.

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 private equity 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.

 
20. What non-contractual duties do the portfolio company managers owe and to whom?

Company directors owe a fiduciary duty to the company. Particularly, the Tokyo High Court recently ruled on 17 April 2013 that, in the case of management buyouts by means of a two-step acquisition, directors of the target company owe a fiduciary duty to take account of the shareholders' common interests, specifically:

  • The duty to ensure a fair transfer of corporate value among the shareholders.

  • The duty to disclose adequate information.

 
21. What terms of employment are typically imposed on management by the private equity investor in an MBO?

The private equity investor in a management buyout can enter into, or cause the target company to enter into, an executive service agreement with the management. Typical contractual restrictions imposed on the management under an executive service agreement include non-competition, non-solicitation and confidentiality.

 
22. What measures are commonly used to give a private equity fund a level of management control over the activities of the portfolio company? Are such protections more likely to be given in the shareholders' agreement or company governance documents?

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

 

Debt financing

23. What percentage of finance is typically provided by debt and what form does that debt financing usually take?

In typical leveraged buyouts by private equity funds, the debt to equity ratio generally ranges from 2:1 to 1:1.

The debt financing package typically consists of a:

  • Syndicated senior term loan.

  • Revolving facility for working capital purposes (if needed) provided by banks.

Typically, one or more arranger banks underwrite these facilities on the acquisition. The arranger banks then syndicate these facilities within a general syndication period, which is usually the period of six months to one year after the signing or first use. It is also becoming more common to 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 a sweetener. Interest payments under mezzanine financings often include payment-in-kind (PIK) interest, which is usually structured as compounded interest that will become due on the maturity date (after full repayment of senior debt).

 

Lender protection

24. What forms of protection do debt providers typically use to protect their investments?

Security

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. From the time when there is to be no other shareholder in the target than the acquiring entity, the target company and its wholly owned subsidiaries also provide guarantees and security over their assets (see Question 25 with regard to fiduciary duties of directors of the target company).

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" that is available in some jurisdictions is not available 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 choose 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, and in that case those assets are sometimes excluded from the security package.

Contractual and structural mechanisms

In acquisition financing, lenders usually request a long list of representations (which are repeated on each use), covenants (including financial covenants and capex restrictions) and events of default. These can allow lenders to closely monitor the financial condition and operations of the target company. They are usually heavily negotiated between the lenders and the private equity fund, which would like to maintain maximum operational flexibility.

There are two types of subordination (apart from structural subordination):

  • Deep subordination (zettai retsugo) in accordance with bankruptcy laws.

  • Contractual subordination (sotai retsugo), which is a contractual arrangement among creditors.

With contractual subordination, creditors can agree to flexible arrangements. However, there is a risk that contractual subordination may be disregarded or treated differently by a court or trustee in insolvency proceedings.

 

Financial assistance

25. Are there rules preventing a company from giving financial assistance for the purpose of assisting a purchase of shares in the company? If so, how does this affect the ability of a target company in a buyout to give security to lenders? Are there exemptions and, if so, which are most commonly used in the context of private equity transactions?

There are no specific rules on financial assistance in Japan. However, the general fiduciary duty owed by the directors of the target company to its shareholders should be considered when the target company provides a guarantee or security to secure the acquisition financing loans. It is generally understood that directors of the target company could 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:

  • Acquiror purchases 100% of the shares in the target company.

  • Borrower obtains consents from all of the minority shareholders in the target (in the case of a partial LBO).

 

Insolvent liquidation

26. What is the order of priority on insolvent liquidation?

Secured claims have certain priority 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 equal to that valuation are given priority over unsecured claims, but payment is subject to a repayment plan approved by the court.

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

  • Common benefit claims (such as costs or expenses, or other types of claims that have common benefit for all creditors).

  • Preferred general claims (such as wages of employees or certain tax claims).

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

 

Equity appreciation

27. Can a debt holder achieve equity appreciation through conversion features such as rights, warrants or options?

It is not common for senior lenders to have instruments with rights to achieve equity appreciation. However, mezzanine finance providers can obtain equity appreciation by providing finance through:

  • Convertible bonds (shinkabu yoyakuken tsuki shasai).

  • Preferred shares that can be converted to common shares.

Also, it is not uncommon to grant equity kickers to mezzanine finance providers. These equity kickers are usually structured as stock options (shinkabu yoyakuken) that are exercisable on or after exit of the private equity fund.

 

Portfolio company management

28. What management incentives are most commonly used to encourage portfolio company management to produce healthy income returns and facilitate a successful exit from a private equity transaction?

Typical incentive structures include performance-based annual bonuses and stock options. In some cases, private equity funds enter into agreements with management to set out pre-determined performance targets for annual bonuses, to incentivise the management. Stock options are also sometimes subject to performance vesting features. In many cases, stock options become exercisable on exit of the private equity fund (for example, through an IPO or trade sale).

 
29. Are any tax reliefs or incentives available to portfolio company managers investing in their company?

Companies can offer qualified stock options (zeisei-tekikaku stock options) that are taxed at capital gains rates (about 20%) when the shares are sold. No tax is due when they are exercised, whereas non-qualified stock options are taxed at the time of exercise and at other tax rates (for example, as salary income). Although it depends on the level of income of the person who exercises 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:

  • Stock options must be granted to a director, officer or employee of the company issuing the stock option (or its subsidiary).

  • A stock option grant agreement must provide certain conditions, for example the:

    • stock option must be exercised after two years and before ten years from the date of the corporate resolution to grant the stock option;

    • stock option's total exercise price must not exceed JPY12 million per year.

 
30. Are there any restrictions on dividends, interest payments and other payments by a portfolio company to its investors?

Interest payments are subject to Japanese usury laws, including the Interest Rate Limitation Act. Under this, the maximum interest rate (for the loan with a principal amount of at least JPY1 million) is 15% per annum. 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.

 
31. What anti-corruption/anti-bribery protections are typically included in investment documents? What local law penalties apply to fund executives who are directors if the portfolio company or its agents are found guilty under applicable anti-corruption or anti-bribery laws?

It is not very common to:

  • Conduct anti-corruption due diligence.

  • Include in relevant documents 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 (whether by conspiracy, aiding or abetting) a bribery of a domestic or foreign public officer, 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.

 

Exit strategies

32. What forms of exit are typically used to realise a private equity fund's investment in a successful company? What are the relative advantages and disadvantages of each?

Forms of exit

The most common forms of exit are:

  • Trade sale.

  • Secondary buyout.

  • IPO.

The trade sale is most common, although there has recently been an increase in secondary buyouts. The IPO has not been a popular exit, but it is expected that its use will increase in the near future.

Advantages and disadvantages

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 may 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.

 
33. What forms of exit are typically used to end the private equity fund's investment in an unsuccessful/distressed company? What are the relative advantages and disadvantages of each?

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

  • Refinancing, restructuring or rescheduling, or another sponsor fund.

  • The possible use of a private arrangement scheme under Turnaround Alternative Dispute Resolution to stop the exercise of rights by the financial lenders (though consent of all the lenders is required).

If these efforts are not successful, 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 not likely 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 equityholder.

 

Private equity/venture capital associations

Japan Private Equity Association

W www.japanpea.jp/english/index.html

Status. The Japan Private Equity Association (JPEA) is a non-governmental organisation founded in August 2005 with eight member companies. Its aim is to raise the quality and status of Japan's private equity industry, promote the healthy growth of the industry, and also contribute to the development of Japanese economic society.

Membership. The principal members of the JPEA are the managing partners of private equity investment partnerships and their advisers. They aim to:

  • Achieve strong management through active management assistance and investment with the provision of management resources.
  • Serve the overall interests of all stakeholders, including employees.

Currently the number of members has increased to more than 30 companies.

Principal activities. Its principal activities are to:

  • Improve the understanding of private equity practices in Japan.
  • Enhance the quality of the entire private equity industry.

It does this by working to promote activities such as:

  • Research on overall industry activities.
  • Public relations.
  • Advertising.
  • Publications to enhance the status of the industry, give policy recommendations to government offices, and request amendments to laws.

Published guidelines. Based on the JPEA's website, there are no published guidelines issued by the association.

The Japan Venture Capital Association

W http://jvca.jp/english

Status. The Japan Venture Capital Association (JVCA) is a non-governmental organisation.

Membership. The members of the JVCA consist of venture capital members and supporting partners. The requirements for membership are:

  • The firm, organisation or individual must have venture capital-related business stipulated in their articles of incorporation.
  • Demonstrated experience in investment or support for pre-IPO companies.

Enterprises, groups or individuals wishing to support organisations with activities similar to those stated above can become supporting members.

Principal activities. Its principal activities are:

  • Making suggestions regarding regulations and accounting standards.
  • Public relations.
  • Hosting or sponsoring conferences or events.
  • Co-ordinating government, institutional investors, securities exchange and academics.
  • Providing training programmes to venture capitalist and entrepreneurs.
  • Co-operating with overseas venture capital associations.

Published guidelines. The JVCA has a principle of conduct consisting of five articles that is available in Japanese on their website.



Online resources

Ministry of Internal Affairs and Communications

W http://law.e-gov.go.jp/cgi-bin/idxsearch.cgi

Description. Website operated by the Ministry of Internal Affairs and Communications containing official and up-to-date information on the legislation in effect.

Ministry of Justice

W www.japaneselawtranslation.go.jp/?re=02

Description. Website operated by the Ministry of Justice containing unofficial and potentially out-of-date English language translations. The translations are for guidance only and the original Japanese language version is always binding.



Contributor profiles

Hajime Tanahashi, Partner

Mori Hamada & Matsumoto

T +81 3 5223 7733
F +81 3 5223 7633
E hajime.tanahashi@mhmjapan.com
W www.mhmjapan.com/en

Professional qualifications. Japan, 1992; New York, 1997

Areas of practice. Corporate; mergers and acquisitions; private equity; venture finance; corporate governance.

Non-professional qualifications. LL.B, University of Tokyo, 1990; LL.M, Harvard Law School, 1996.

Recent transactions

  • Acting for Bain Capital in its purchase of Skylark from Nomura Principal Finance; its purchase of a 50% stake of Jupiter Shop Channel from Sumitomo Corporation; and its purchase by a tender offer of Macromill, a listed internet marketing research company.
  • Acting for Japan Industrial Partners in its purchase of Biglobe from NEC; its purchase of Kyowa Hakko Chemical from Kyowa Kirin; its sale of Alphana Technology to Samsung Electro-Mechanics; and its sale of Optrex to Kyocera.
  • Advising domestic and overseas funds on formation and ongoing management.
  • Advising for domestic and overseas investors on investments in private equity funds.

Languages. Japanese, English

Publications

  • "Cross-Border M&A - Laws, Regulations and Practical Considerations" , Hitotsubashi Business Review 2013, Spring, 21 March 2013.

  • "Venture capital financing in Japan: a combination of the familiar and the unique" Practical Law, February 2010 (English).

Shuhei Uchida, Partner

Mori Hamada & Matsumoto

T +81 3 5220 1859
F +81 3 5220 1759
E shuhei.uchida@mhmjapan.com
W www.mhmjapan.com/en

Professional qualifications. Japan, 2003; New York, 2009. Seconded to the Civil Affairs Bureau at the Ministry of Justice (specialising in the Companies Act) from 2010 to 2013.

Areas of practice. Mergers and acquisitions; private equity; corporate governance; LBO finance.

Non-professional qualifications. LL.B, University of Tokyo, 2002; LL.M, Columbia University School of Law, 2008.

Recent transactions

  • Acting for Bain Capital in its purchase by a tender offer of Macromill, a listed internet marketing research company.
  • Acting for LIXIL Corporation in its joint acquisition of GROHE Group with Development Bank of Japan.
  • Advising private equity funds on their purchase of public or private companies.
  • Advising domestic listed companies on their corporate restructuring and mergers and acquisitions.

Languages. Japanese, English

Publications.

  • "Drafter's Commentary: Summary of the Interim Proposal Concerning the Revision of the Companies Act" (co-author), Kinyu Homu Jijo, January 2012.

  • "Theoretical Analysis of 'Fair Price'" Commercial Law Review, January 2010.

Mitsue Tanaka, Of Counsel

Mori Hamada & Matsumoto

T +81 3 5223 7788
F +81 3 5223 7688
E mitsue.tanaka@mhmjapan.com
W www.mhmjapan.com/en

Professional qualifications. Japan, 2000; New York, 2006

Areas of practice. Private equity; venture finance; structured finance; banking; mergers and acquisitions; Asia Practice (Indonesia).

Non-professional qualifications. LL.B., University of Tokyo, 1998; LL.M., Columbia University School of Law, 2005.

Recent transactions

  • Advising Japan Industrial Partners, Unison Capital and other domestic and overseas funds on structuring, formation, registration and ongoing management of their partnerships.

Languages. Japanese, English

Publications

  • "Private Equity Investment Funds and the Financial Instruments and Exchange Act" in Lexis Nexis "Business Issues" November 2011 (English).

  • "A Regulatory Revolution", IFLR, The 2007 Guide to Private Equity Venture Capital, April 2007 (English, co-author).

Makoto Sakai, Associate

Mori Hamada & Matsumoto

T +81 3 6212 8357
F +81 3 6212 8257
E makoto.sakai@mhmjapan.com
W www.mhmjapan.com/en

Professional qualifications. Japan, 2004; New York, 2010. Seconded to Tokyo Regional Taxation Bureau from 2011 to 2013 working in department that handles audits of large businesses.

Areas of practice. Tax; mergers and acquisitions; private equity.

Non-professional qualifications. LL.B., University of Tokyo, 2003; LL.M., Cornell Law School, 2009.

Recent transactions

  • Advising Japan Industrial Partners, Bain Capital and other domestic and overseas funds on their investments or structuring and formation of their partnerships.

Languages. Japanese, English

Publications

  • "Recent Trends in Tax Litigation and Noteworthy Court Decisions", Accounting & Auditing Journal, October 2013.
  • "Protecting the Minority", IFLR, 2011 Guide to Japan 9th Edition, February 2011 (English).

Naoya Shiota, Associate

Mori Hamada & Matsumoto

T +81 3 6266 8524
F +81 3 6266 8424
E naoya.shiota@mhmjapan.com
W www.mhmjapan.com/en

Professional qualifications. Japan, 2005; New York, 2012

Areas of practice. LBO finance; mergers and acquisitions; private equity.

Non-professional qualifications. LL.B., University of Tokyo, 2004; LL.M., Cornell Law School, 2011.

Recent transactions

  • Acting for Softbank Corporation in its financings for the acquisition of Sprint Nextel Corporation.
  • Acting for LIXIL Corporation in its financings for the joint acquisition of GROHE Group with Development Bank of Japan.
  • Acting for Japan Industrial Partners in its financing for the purchase of Biglobe from NEC.
  • Advising LBO financings both for private and public deals.

Languages. Japanese, English

Publications. "Trends in Executive Compensation in the U.S." (co-authored), Commercial Law Review, April 2013.


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