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.
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This Q&A is part of the global guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.
Japanese private equity funds obtain funding from a variety of sources, including:
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.
The Japanese private equity market has shown signs of recovery from its decline and downturn after the global economic crisis that began in 2008. The Japanese private equity market has been active in 2013 and 2014, and it looks likely to continue its growth in 2015. This is partly as a result of the surge in the Japanese stock market that followed the implementation of "Abenomics" by the Abe administration,
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.
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. Also, Japan Industrial Partners acquired "Biglobe" an internet service provider division of NEC, as well as the "Vaio" PC division of Sony.
In general, the Japanese private equity market is now fairly active. 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.
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. 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 have been more IPO exits, both in number and size, notable ones being:
IPO of Japan Display whose main shareholder is INCJ, a public-private fund.
IPO of Skylark that was owned by Bain Capital.
An amendment of the Companies Act effective as of 1 May 2015, will 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 (see Question 15).
New rules for squeeze-outs, including:
the introduction of the Squeeze-Out Right (kabushiki-tou uriwatashi seikyuken) which enables 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 company;
the introduction of appraisal rights of the shareholders dissenting to a share consolidation, which would give minority shareholders an appropriate level of protection and enable a share consolidation to be used for squeeze-outs in practice (see Question 17).
As a result of the 2015 tax reform, the effective corporate tax rate for a company will be reduced from 34.62% to 32.11% (and in Tokyo from 35.64% to 33.10%) for fiscal years starting on or after 1 April 2015. The effective corporate tax rate will be further reduced to 31.33% (32.34% in Tokyo) from the fiscal years starting on or after April 1 2016.
In addition, as a result of the 2015 tax reform, the carry forward-period of net operating losses (NOLs) will be extended to ten years (from nine years) which will be applicable to the NOLs incurred in fiscal years starting on or after 1 April 2017. However, the maximum amount of taxable income that can be offset by NOLs will be reduced to 65% (from the fiscal years starting from 1 April 2015) and 50% (from the fiscal years starting from 1 April 2017). The revisions will affect the amount of corporate tax of portfolio companies.
Tax 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.
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.
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.
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.
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.
Private equity funds generally seek to achieve long-term capital gain by investing in a number of companies, improving the management and operations of the invested companies and realising an exit. The average life of a private equity fund is typically ten to 12 years. Investors are usually required to make a capital contribution to fund the investment over an investment period of generally four to six years. The preferred annual return (hurdle rate) is typically 5% to 8%.
Fund regulation and licensing
Any person who manages the investment of a partnership-type collective investment fund must register as a "financial instruments business operator" 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 business operator". 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. 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.
See Question 10.
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 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.
The government is currently moving forward to narrow the criteria for non-QIIs who can acquire the interests in a QII-Targeted Fund, and also to set new criteria and create new obligations for a party who relies on this exemption, (such as ongoing reporting obligations) (see Question 12).
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).
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).
The QII-Targeted Fund Exemption was mostly intended to be used by funds targeting professional investors (with only a small number of non-professional investors). However, there have been a number of reported cases of individual investors with less investment experience (especially the elderly) having suffered losses from investments in a QII-Targeted Fund. As a result, in May 2014, the Financial Services Agency (FSA) proposed to amend the relevant regulations of the FIEA in order to narrow the criteria for non-QIIs who can acquire interests in a QII-Targeted Fund. After a period of public comment, a Working Group was established and submitted a report on 28 January 2015, which proposed to strengthen the regulations on the QII-Targeted Fund Exemption. The report also:
Suggested stricter criteria for non-QII investors who can acquire an interest in the QII-Targeted Fund (in terms of minimum paid-in capital, net assets, and the relationship with the GP) as well as stricter criteria for the GP itself.
Proposed that fund General Partners (GPs) of a QII-Targeted Fund must provide the FSA with more information, including a summary of the fund's business, some of which would be made publicly available.
Calls for the GP of a QII-Targeted Fund to have similar obligations to those of a registered financial instruments business operator, including periodic reporting obligations to the authorities and preparing and keeping books and records.
On 24 March 2015, the Cabinet proposed to the Diet an amendment of the FIEA, which is in line with the report. The proposed amendment:
Stipulates the category of the persons who are disqualified from conducting business under the QII-Targeted Fund Exemption. Importantly, a non-Japanese legal entity will now be disqualified from conducting business under the QII-Targeted Fund Exemption unless it appoints a representative in Japan. Existing non-Japanese entities operating under the QII-Targeted Fund Exemption (without a Japan representative) will be required to appoint a representative within six months from the effective date of the amendment.
Requires additional information to be filed in or with the notification for the QII-Targeted Fund Exemption, including the name and address of offices where business is conducted under the QII-Targeted Fund Exemption and other information to be stipulated in cabinet order (not yet publicly available). This is in addition to a copy of the entity's articles of incorporation and certificate of registration (or equivalent documents) and a covenant letter stating that the entity does not fall under the category of disqualified persons (see above). Existing entities that have already filed a notification for the QII-Targeted Fund Exemption will have six months from the effective date of the amendment to file an amendment to provide the newly required information and supporting documents.
Strengthens the enforcement provisions of the FIEA concerning persons who conduct business under the QII-Targeted Fund Exemption.
The new criteria for non-QII investors will be provided under the Cabinet Order and Cabinet Office Ordinance, the drafts of which are not yet publicly available. It is expected that the amendment of the FIEA will be enacted within one year from the promulgation date.
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.
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 and participation in an LP advisory board. Some investors also request an observation right in the fund's investment committee. Some financial institutions that fall into the category of a banking entity under US law also request certain representations to the effect that the fund is not subject to the Volcker rule of the US banking regulations.
Interests in portfolio companies
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.
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).
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).
Before the effectiveness of the Companies Act amendment in May 2015, the issue of shares of a public company did not 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 amendment, a shareholder resolution is also 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.
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.
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). This is because the cash merger is classified as "non-qualified" business combination, and therefore is treated as a taxable transaction, usually resulting in unfavourable tax treatment at the level of the target company.
Instead, a "fractional share squeeze-out" by means of "wholly callable stock" has been most commonly used. In this type of squeeze-out, the target company, after adoption of a shareholder resolution, reclassifies all outstanding shares as shares that are subject to a call option, which are referred to in Japanese as "wholly callable stock" (zenbu shutoku joukou tsuki shurui kabushiki). Upon exercise of the call option, the wholly callable stock is then exchanged for a new class of stock. However, the exchange ratio for the new shares is set at a level that results in minority shareholders being entitled to receive only fractional shares. This is because there is a procedure under the Companies Act by which the fractional shares are not actually issued but sold to the acquirer on court approval, with the cash proceeds distributed proportionately to the minority shareholders. Minority shareholders who are not satisfied with the amount of cash consideration are entitled to appraisal rights (that is, the right to file a petition to the court to determine the fair value of their shares).
The recent amendment of the Companies Act added two practical alternatives for the back-end squeeze-outs:
A Squeeze-Out Right that is available to a Special Controlling Shareholder (see below).
A fractional share squeeze-out by means of a share consolidation.
Squeeze-Out Right that is available to a Special Controlling Shareholder
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 would only require a resolution of the board of directors, instead of a shareholder resolution (which typically takes a couple of months), of the target company, and will therefore significantly expedite the squeeze-out procedure. This makes it possible to complete the back-end squeeze-out as early as 20 days 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 with respect to the existing shares would also have the right to force a cash acquisition of these equity securities. On exercise of the Squeeze-Out Right, the relevant shares and other equity securities are transferred directly to the Special Controlling Shareholder, significantly reducing the complexity involved under the fractional share method by use of "wholly callable stock".
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) would 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.
A transfer of shares on exercise of the Squeeze-Out Right takes the legal form of a direct sale and purchase between the minority shareholders (or the potential shareholders) and the Special Controlling Shareholder (without involvement of the target company as a transaction party). This is unlike a cash merger, which has been categorised by the tax authority as an activity of the target company that is organisational in nature. Therefore, it is expected that there would be no resulting tax gain for the target company on exercise of the Squeeze-Out Right.
A fractional share squeeze-out by means of a share consolidation
The Companies Act amendment also granted appraisal rights to the shareholders dissenting to a share consolidation used to effect a fractional share squeeze-out. Before the amendment, a share consolidation was not commonly used in practice for squeeze-outs because minority shareholders were not entitled to appraisal rights. In the absence of any comparable measure to protect minority shareholders, the use of a share consolidation to effect a fractional share squeeze-out had been seen by practitioners as involving a significant risk that the entire squeeze-out transaction would be challenged as being unfair. Due to this concern, the method of using wholly callable stock had been the only realistic option to conduct a fractional share squeeze-out (see above). The amendment eliminates this concern and enables a share consolidation to be used in practice as another alternative for a fractional share squeeze-out.
The 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). Still, to some extent, it would reduce the complexity of fractional share squeeze-outs by simplifying the procedure for changing the shares held by minority shareholders into fractional shares, because the target company can simply consolidate the shares by a ratio that would result in minority shareholders holding only fractional shares. Although the use of wholly callable stock continues to be available, a consolidation of shares may come to be preferred by practitioners due to this simplicity.
A fractional share squeeze-out, including those conducted by means of a share consolidation (see above) does not have a 90% voting rights requirement (unlike the Squeeze-Out Right). 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 by means of either a consolidation of shares or wholly callable stock would be still available as long as it is approved by a shareholder resolution with a supermajority vote (two-thirds of the votes cast).
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.
The contractual buyer protections commonly sought by private equity funds include:
Representations and warranties.
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.
Company directors owe a fiduciary duty to the company. Particularly, the Tokyo High Court 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.
In addition, a recent ruling by the Kobe District Court on 16 October 2014, in the case of a management buyout that failed in the middle of the process, held that the directors of a target company contemplating a management buyout owe a duty to prepare a plan for the management buyout that would contribute to the enhancement of the corporate value and make efforts toward the realisation (completion) of the plan. It was also held that, as part of the duty, the directors are:
Prohibited from planning management buyouts for the benefit of the directors themselves or any third party or conducting significantly unreasonable management buyouts.
Obliged to ensure the fairness of the process to determine the amount of consideration for squeeze-outs. This is so that shareholders would not doubt whether the directors are manipulating information to enjoy inappropriate benefit through abuse of their position involving a conflict of interest.
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.
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.
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).
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. Some transactions also make use of 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).
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, a lien that gives a creditor the entitlement to take possession of any or all of the debtor's property to cover a loan) 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.
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).
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.
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
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, 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).
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.
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.
It is not very common to:
Conduct anti-corruption due diligence.
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 (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.
Forms of exit
The most common forms of exit are:
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 due to the recent strong stock market the IPO looks attractive exit as seen by Japan Display and Skylark.
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.
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
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.
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
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.
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.
Ministry of Internal Affairs and Communications
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
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.
Hajime Tanahashi, Partner
Mori Hamada & Matsumoto
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.
Acting for Bain Capital in its purchase of Skylark from Nomura Principal Finance and its sale of Skylark in Skylark’s IPO; its purchase of a 50% stake of Jupiter Shop Channel from Sumitomo Corporation; its purchase by a tender offer of Macromill; and its purchase of Ooedo-Onsen.
Acting for Japan Industrial Partners in its purchase of Biglobe from NEC; its purchase of Kyowa Hakko Chemical from Kyowa Kirin; its purchase of Vaio PC division of Sony; and its sale of ITX to Nojima.
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
"Chambers Legal Practice Guide Corporate M&A Japan"(co-authored), Chambers & Partners, December 2014.
"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
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.
Acting for Bain Capital in its purchase by a tender offer of Macromill, a listed internet marketing research company.
Acting for Mizkan Holdings Co., Ltd. in its acquisition of the Ragú and Bertolli pasta sauce brand portfolio from Conopco, Inc., a subsidiary of Unilever.
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
"Minority squeeze-outs under the amended Japanese Companies Act" , Euromoney Asia-Pacific Banking and Finance Review 2014/15, Euromoney Yearbooks, October 2014.
"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.
Makoto Sakai, Partner
Mori Hamada & Matsumoto
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.
Advising Japan Industrial Partners, Bain Capital, Elliott Advisors Asia Limited and other domestic and overseas funds on their investments or structuring and formation of their partnerships.
Languages. Japanese, English
"The Private Wealth and Private Client Review, Edition 3, Japan Chapter" (co-authored), Law Business Research Ltd, September 2014.
"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, Partner
Mori Hamada & Matsumoto
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.
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
“The Acquisition and Leveraged Finance Review – Edition 1, Japan Chapter” (co-authored), Law Business Research Ltd, November 2014.
"Trends in Executive Compensation in the U.S." ( co-authored), Commercial Law Review, April 2013.
Mitsue Tanaka, Of Counsel
Mori Hamada & Matsumoto
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.
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
"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).