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 global guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-guide.
Japanese private equity funds obtain funding from several sources, including:
Governmental agencies in Japan have also recently become major investors in private equity funds, including the:
Organisation for Small and Medium Enterprises and Regional Innovation, Japan. This is an independent administrative agency established in 2004 under legislation aimed at assisting management of small and medium enterprises.
Innovation Network Corporation of Japan (INCJ). This is a public-private fund aimed at promoting innovation and enhancing the value of businesses in Japan. The INCJ was established in 2009 for a 15-year term under legislation sponsored by the Ministry of Economy, Trade and Industry. The INCJ was funded by both the Japanese Government (injecting JPY266 billion) and 26 private corporations (JPY14 billion). The government also guarantees up to 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 in 2008. The Japanese private equity market has been active between 2014 and 2015, and continued growth is expected in 2016. This is partly as a result of the surge in the Japanese stock market following the implementation of "Abenomics" by the Abe administration. Furthermore, there has been more competition, particularly in auction deals, among private equity funds and strategic buyers.
After the post-Lehman disruption and economic recession, funds raised by private equity funds have 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.
Many diverse medium-sized companies have competitive technologies or unique business models that are ideal targets for private equity funds in Japan. There are therefore increasing opportunities for investments in medium-sized companies. Further, the ageing of owner-founders, and spin-offs or carve-outs of non-core businesses by struggling conglomerates also makes these companies attractive. Private equity investments valued 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. Notable examples include:
KKR's acquisition of a healthcare division of Panasonic.
Japan Industrial Partners' acquisition of Biglobe, as well as the Vaio PC division of Sony.
The Japanese private equity market is now fairly active. With regard to management buyout (MBO) transactions, 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 been historically uncommon. This is partly because the private equity industry is still relatively new in Japan and early funds that were about to exit, were disrupted by the erratic IPO market, particularly after the 2008 financial crisis.
Since the revival of the Japanese IPO market, there have been more IPO exits, both in number and size:
Japan Display whose main shareholder is INCJ, a public-private fund.
Skylark, formerly owned by Bain Capital.
Dexerials (formerly Sony Chemical), formerly owned by DBJ and Unison Capital.
Bellsystem24, formerly owned by Bain Capital.
Tsubaki Nakashima, formerly owned by the Carlyle Group.
An amendment of the Companies Act 2014, which became effective as of 1 May 2015, had a significant impact on 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 resulting 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) 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 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 2016 tax reform, the effective corporate tax rate will be reduced from 32.11% to 29.97% on or after 1 April 2016. The effective corporate tax rate will be further reduced to 29.74% on or after April 1 2017.
In addition, as a result of the 2016 tax reform, the extension of the carry-forward period of net operating losses (NOLs) to ten years (from nine years) will be postponed by one year and will now commence with NOLs incurred on or after 1 April 2018. Also, the maximum amount of taxable income that can be offset by NOLs will be reduced to 60% (from 1 April 2016), 55% (from 1 April 2017) and 50% (from 1 April 2018). The revisions will affect the amount of corporate tax of portfolio companies.
Tax incentive schemes
There are two types of tax incentives 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 more equally 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 capital 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 his or her annual income at the time of investment.
The total amount of the investment from his or her 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 capital fund) accredited by the government. That venture capital 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) (LPS), which is established under the Investment Business Limited Partnership Agreement Law (LPS Law). An LPS is managed by a general partner, who has unlimited liability for the LPS's debts. The limited partners do not engage in management, but have certain rights to inspect the business of the LPS. Their liability is limited to the amount of their capital contribution.
The investment target of an LPS is restricted under the LPS Law. The principal types of assets in which an LPS may invest are:
Stocks, warrants and bonds of a Japanese joint-stock company (kabushiki kaisha).
Equity shares in a business partnership (kigyo kumiai).
Certain other securities specified under the LPS Law.
Monetary receivables from a business entity (which is defined to mean a Japanese corporation or an individual conducting business).
Monetary receivables owned by a business entity.
Loans to a business entity.
Anonymous partnerships (Tokumei kumiai) with a business entity.
Beneficiary interests in a trust.
Industrial property rights and copyrights held by a business entity.
Interest in an LPS or general partnership doing investment business.
Real assets such as real property and personal property are not included in the list of eligible assets, except that an LPS can acquire such property as collateral for loans or securities held by the LPS.
Also, an LPS 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.
Private equity 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, private equity funds formed as non-Japanese limited partnerships 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, 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.
On 17 July 2015, the Japan Supreme Court ruled that a Delaware limited partnership was treated as a corporation, instead of a tax-transparent entity, for Japanese tax purposes. The Supreme Court laid out two key criteria to take in account in determining the entity classification:
Whether or not it is apparent, from the provisions of the governing law or the legal system of the entity in question, that the entity is granted a status of legal person equivalent to a corporation under Japanese laws.
Whether or not the entity has legal rights and obligations (for example, if the entity can itself be a party to legal acts or the legal effect can be attributable to the entity itself) under the relevant laws and regulations.
Also, 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.
Fund duration and investment objectives
The average life of a private equity fund is typically ten to 12 years. Investors must usually make a capital contribution to fund the investment over an investment period of generally four to six years.
Private equity funds generally seek to achieve long-term capital gain by investing in several companies, improving the management and operations of the invested companies and realising an exit. The preferred annual return (hurdle rate) is typically 5% to 8%.
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 that offers interests in a partnership-type fund must register as a "financial instruments business operator". For foreign private equity funds, 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 can 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 Financial Instruments and Exchange Act (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-QIIs.
The investors comply with certain other requirements (such as certain transfer restriction) (see Question 12).
Many private equity funds operate in reliance on this exemption.
From 1 March 2016, amendments to the FIEA narrow the criteria for non-QIIs that can acquire the interests in a QII-Targeted Fund, and also set new criteria and create new obligations for a party that relies on this exemption and filed notification (QII-Targeted Fund Operator), 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. This exemption generally requires that:
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 for the investment management of the fund).
If a limited partner is organised as one of certain types of collective investment vehicles, such as an investment business limited partnership or an anonymous 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 an anonymous partnership (tokumei kumiai), and the investor in the anonymous partnership 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-QIIs (see Question 11, Exemptions).
The QII-Targeted Fund Exemption was mostly intended to be used by funds targeting QIIs (with only a small number of non-QIIs). However, there have been several 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, the Financial Instruments and Exchange Act (FIEA) has been amended to narrow the criteria for non-QIIs that can acquire interests in a QII-Targeted Fund (Eligible Non-QII), effective as from 1 March 2016. The scope of the Eligible Non-QIIs is now limited to certain types of investors and persons that are closely related to the QII-Targeted Fund Operator, including:
Legal entities with JPY50 million or more of paid-in capital.
Legal entities with JPY50 million or more of net assets.
Foreign legal entities (without any particular asset or capital threshold).
Officers or employees of the QII-Targeted Fund Operator and their family members.
The investment adviser of the QII-Targeted Fund Operator or their officers or employees.
The scope of the Eligible Non-QIIs is broader for a QII-Targeted Fund which meets certain criteria as a venture capital fund.
To qualify for the QII-Targeted Fund Exemption for the offering of partnership interests, the partnership agreement must now 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 who is a QII or Eligible Non-QII.
Furthermore, in response to a concern regarding the lack of substance of certain QIIs that were used by some QII-Targeted Fund Operators to satisfy the minimum QII requirement, under the amended FIEA, if the only QII is an LPS, the reasonably expected amount of assets that such LPS manages for the LPS's investors must be at least JPY500 million (excluding loan proceeds).
Furthermore, if 50% or more of the assets of the fund have been contributed by certain types of investors (including those which are typically considered as having a close relationship with the GP), then such fund may not rely on the QII-Targeted Fund Exemption.
The amended FIEA also stipulates the category of the persons that are disqualified from conducting business under the QII-Targeted Fund Exemption. Importantly, a non-Japanese QII-Targeted Fund Operator will be disqualified from conducting business under the QII-Targeted Fund Exemption unless it appoints a representative in Japan. Any corporation or natural person, that is Japanese-resident, including a lawyer, can be appointed as such representative. Existing non-Japanese QII-Targeted Fund Operators (without a Japan representative) must now appoint a representative by 31 August 2016.
Although the notification for the QII-Targeted Fund Exemption had been historically relatively simple, the information required under the amended FIEA for the notification will be substantially increased and each applicant will be required to provide certain additional information, including:
Name and type of all QIIs that subscribe interests in the fund.
Telephone number of its office and website address.
Contents of the business operated by the fund.
Whether the interests of the fund are being offered to or held by non-QIIs.
If the applicant is a foreign entity, the address and telephone number of its representative in Japan.
The FSA will make available to the public certain information in the notifications (which does not include the name of QIIs) filed by the QII-Targeted Fund Operators on the FSA's website, and the QII-Targeted Fund Operators will also be required to make available to the public such information in a certain form at their relevant office in Japan or on their website (or by other means where such document is always easily available to the public) without delay after such filing.
Additionally, the applicant must submit certain documents, including:
A declaration letter of no disqualifying factors for the QII-Targeted Fund Operator.
The articles of incorporation (or equivalent document) of the QII-Targeted Fund Operator.
Documents for each director/officer and "important employee" (who is in charge of compliance or investment management) of the QII-Targeted Fund Operator, such as:
a certificate of residency (juminhyo) and a certificate of legal competency issued by the Japanese local government or (in case of non-residents) an affidavit in respect of his residency and legal competency; and
a declaration letter of no disqualifying criminal/administrative sanctions and no relationship with any anti-social forces.
Existing QII-Targeted Fund Operators must file an amendment to provide the newly required information and supporting documents by 31 August 2016.
QII-Targeted Fund Operators will also be required to file annual business reports with the authorities and to create, maintain, and make available to the public explanatory documents concerning the annual business reports at its offices in Japan or on their website (or by other means where such document is always easily available to the public). Such annual business reports will need to be filed within three months from the end of each business year which starts after 1 March 2016 and will include a significant amount of information, such as the:
Summary of the business of the fund.
Management of the QII-Targeted Fund Operator.
Financial status of the fund.
Status of investors.
QII-Targeted Fund Operators need to create and maintain certain books and records with respect to the business of a QII-Targeted Fund.
Enforcement provisions concerning QII-Targeted Fund Operators have been strengthened under the amended FIEA.
Japanese anti-monopoly, 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 limited matters, such as a transaction involving a conflict of interest (in some cases the veto right is exercised through an Limited Partnership (LP) advisory board, which often consists of several selected members that represent limited partners).
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, in practice, it is increasingly common for investors to request a general partner to execute side letters. In these side letters, the parties agree on prohibitions on the general partner investing in certain fields and the right of a limited partner to have a representative selected as a member of an LP advisory board. Some investors can also request a right to participate as an observer 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.
Under the amended FIEA, in offering fund interests, QII-Targeted Fund Operators are subject to principles of suitability and, if the prospective investors are non-professional investors (tokutei toshika), the QII-Targeted Fund Operators are required to explain certain matters and deliver certain disclosure documents (as required under the amended FIEA) and are subject to certain restrictions as to advertisements.
Also, the limited partnership agreement or other documents for the fund must include certain provisions on separate management of monies of the fund and the general partner. With regard to investment activities, QII-Targeted Fund Operators must prepare and send a semi-annual investment report (as required under the amended Financial Instruments and Exchange Act) to non-professional investors and are prohibited from engaging in certain transactions, including trading of securities between the QII-Targeted Fund Operator and the fund or between one fund and another fund operated by the same QII-Targeted Fund Operator.
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 Financial Instruments and Exchange Act applies to the first step tender offer (see 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, two practical alternatives are commonly used for the back-end squeeze-outs:
A squeeze-out right that is available to a special controlling shareholder.
A fractional share squeeze-out.
Squeeze-out right that is available to a special controlling shareholder
The squeeze-out right, which was newly introduced with the recent amendment of the Companies Act, enables a shareholder holding (directly or through one or more wholly owned subsidiaries) at least 90% of the total voting rights (special controlling shareholder) to force a cash acquisition of the remaining shares held by the minority shareholders. This alternative only requires a resolution of the board of directors, instead of a shareholder resolution (which typically takes a couple of months), of the target company, and therefore significantly expedites the squeeze-out procedure in comparison with the other alternatives. Practically, it is possible to complete the back-end squeeze-out as early as one month after completion of the first-step tender offer.
The squeeze-out right also applies to other equity securities, including stock options and convertible bonds. The special controlling shareholder seeking to exercise the squeeze-out right for the existing shares also has the right to force a cash acquisition of these equity securities. The effect of the squeeze-out right is simple and straightforward; the relevant shares and other equity securities are transferred directly from the minority shareholders to the special controlling shareholder.
On exercise of the squeeze-out right, the special controlling shareholder notifies the target company of the amount of cash consideration for the remaining shares (and other equity securities, if applicable). The amount must be approved by the board of directors of the target company. In making a decision on the approval, directors of the target company owe a duty of care to consider the shareholders' interests, that is, the fairness of the amount of cash consideration. Minority shareholders (and holders of other equity securities) also have appraisal rights to seek fair consideration in a court procedure. Also, if the price of the cash consideration is found to be extremely inappropriate, the minority shareholders (and holders of other equity securities) are entitled to seek an injunction of the entire squeeze-out transaction.
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 understood that there will be no resulting tax gain for the target company on exercise of the squeeze-out right.
Due to the simple and expedited procedure and the favourable tax treatment, since its introduction under the amended Companies Act, the squeeze-out right has been most commonly used for back-end squeeze-outs where the acquirer satisfies the 90% voting rights requirement.
A fractional share squeeze-out
Another alternative available in the back-end squeeze-out is a fractional share squeeze-out. In this type of squeeze-out, the target company, after adoption of a shareholder resolution, changes the shares held by minority shareholders in fractional shares. In accordance with a procedure provided under the Companies Act, these fractional shares are not actually issued but sold to the acquirer on court approval, with the cash proceeds distributed proportionately to the minority shareholders.
Technically, a fractional share squeeze-out can be conducted by either a "wholly callable stock" or a share consolidation.
Wholly callable stock (zenbu shutoku joukou tsuki shurui kabushiki) are shares that are subject to a call option. The target company can, with approval of a shareholder resolution, reclassify all outstanding shares into a wholly callable stock and exercise the call option, on which the wholly callable stock is then exchanged for a new class of stock. The exchange ratio for the new shares is set at a level that results in minority shareholders being entitled to receive only fractional shares.
The other method used to effect a fractional share squeeze-out is a share consolidation. Through a share consolidation, the target company can simply consolidate the shares by a ratio that would result in minority shareholders holding only fractional shares. While a share consolidation also requires a shareholder resolution of the target company, it reduces the complexity of the fractional share squeeze-out by simplifying the procedure for changing the shares held by minority shareholders into fractional shares. Before the recent amendment of the Companies Act, 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 was seen by practitioners as involving a significant risk that the entire squeeze-out transaction would be challenged as being unfair. The amendment eliminated this concern and enabled a share consolidation to be used in practice as another alternative for a fractional share squeeze-out. Although the use of a wholly callable stock continues to be available, a share consolidation is becoming more preferred by practitioners due to its simplicity.
A fractional share squeeze-out using either method requires a shareholder resolution of the target company and cannot be used to force a cash acquisition of other equity securities (unlike the Squeeze-Out Right). However, a fractional share squeeze-out does not have the 90% voting rights requirement that the squeeze-out right has. Therefore, if the acquirer fails to obtain 90% of total voting rights on completion of the first-step tender offer, making the squeeze-out right unavailable, a fractional share squeeze-out by means of either a share consolidation or a wholly callable stock would still be available as long as it is approved by a shareholder resolution with a supermajority vote (two-thirds of the votes cast).
In 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 Financial Instruments and Exchange Act 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 Financial Instruments and Exchange Act (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 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.
Consistent with that ruling, a recent ruling by the Osaka High Court on 29 October 2015, in the case of a management buyout that failed in the middle of the process, held that the directors of the target company contemplating the management buyout breached the duty to ensure a fair transfer of corporate value among the shareholders and found them liable for the damages incurred by the target company.
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). On the 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 at any time, theoretically. 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.
Typically, one or more arranger banks underwrite these facilities on the acquisition. The arranger banks then syndicate these facilities within a general syndication period. The syndication period is usually six months to one year after the signing or first use. Some transactions also use mezzanine financing, which is usually structured as subordinated loans, subordinated bonds, subordinated convertible bonds or preferred shares.
Equity kickers, typically in the form of stock options, are sometimes granted to mezzanine finance providers as an incentive. Interest payments under mezzanine financings often include, together with cash payment interest, payment-in-kind interest, which is usually 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.
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, which gives a creditor the entitlement to take possession of any or all of the debtor's property to cover a loan, is available in some jurisdictions, but unavailable for bank loans in Japan. Therefore it is necessary to individually attach security interests over each type of asset.
Floating security interests are permitted only for movable assets and claims, such as trade receivables. In addition, the registration of security over certain assets, such as real estate, requires payment of a registration tax. Therefore, in some cases lenders agree not to register until certain pre-acceleration events occur. Also, granting a security interest over some assets, for example, trade receivables and deposits under lease agreements, requires consent from a third party. Those assets are sometimes excluded from the security package.
Contractual and structural mechanisms
In acquisition financing, lenders usually request:
A long list of representations. These are repeated with each use.
Covenants, including financial covenants and capex restrictions.
Events of default.
These requests allow lenders to closely monitor the financial condition and operations of the target company. They are usually heavily negotiated between the lenders and the private equity fund, which seeks to maintain maximum operational flexibility.
There are two types of subordination, excluding 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 can 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 must be considered when the target company provides a guarantee or security to secure the acquisition financing loans. Directors of the target company can be found to breach their fiduciary duties if the target company provides guarantees, security or other financial assistance solely for the benefit of a majority shareholder.
Therefore, it is common for the target company to refrain from providing this financial assistance before either the:
Acquirer purchases 100% of the shares in the target company.
Borrower obtains consents from all of the minority shareholders in the target, for partial leveraged buyouts.
Secured claims are prioritised in insolvency proceedings. In bankruptcy (hasan) and civil rehabilitation (minji saisei) proceedings, the secured creditors can proceed to foreclose or sell their collateral without court approval.
In corporate reorganisation (kaisha kousei) proceedings, secured creditors cannot exercise their rights outside the proceedings. After the valuation of the collateral, secured claims equivalent to that valuation are prioritised over unsecured claims. However, payment is subject to a court-approved repayment plan.
In insolvency proceedings, non-secured bank loans are usually treated as general claims, which are subordinated to:
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 financing after the commencement of these proceedings can be treated as common benefit claims.
It is uncommon for senior lenders to have instruments with rights to achieve equity appreciation. However, mezzanine finance providers can obtain equity appreciation by providing finance through:
Convertible bonds (shinkabu yoyakuken tsuki shasai).
Preferred shares that can be converted to common shares.
Furthermore, mezzanine finance providers are sometimes granted equity kickers. These equity kickers are usually structured as stock options (shinkabu yoyakuken) that are exercisable on or after exit of the 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 in agreements with management to set out pre-determined performance targets for annual bonuses, to incentivise the management. Stock options are occasionally subject to performance vesting features. Stock options often become exercisable on exit of the private equity fund, for example, through an IPO or trade sale.
Companies can offer qualified stock options (zeisei-tekikaku) taxed at capital gains rates (about 20%) when the shares are sold. No tax is due when they are exercised, whereas non-qualified stock options are taxed at the time of exercise and at other tax rates, for example, as salary income. The tax is dependent on the income level of the person exercising the stock options. The tax rate for salary income is generally higher than the capital gains rates.
To be classified as qualified stock options, certain conditions must be met, including:
The stock options must be granted to a director, officer or employee of the company issuing the stock options or its subsidiary.
A stock option grant agreement must provide certain conditions, for example:
the stock options must be exercised more than two years but less than ten years after the date of the corporate resolution granting the stock options; and
the total exercise price of the stock options granted to an individual grantee must not exceed JPY12 million per year.
Furthermore, following the 2016 tax reform, there will be more flexibility for Japanese companies in adopting profit-based compensation and certain equity incentive plans, such as restricted stock or performance shares, to their directors. Equity incentive plans, excluding stock options, and profit-based compensation have not been commonly used in Japan as there were restrictions on deducting the costs for tax purposes by companies granting such incentives to their directors.
Interest payments are subject to Japanese usury laws, including the Interest Rate Limitation Act. Under this, the maximum interest rate, for a loan with a principal amount of at least JPY1 million, is 15% per annum. 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 uncommon to conduct specific anti-corruption due diligence. On the other hand, investment documents sometimes include special conditions, representations or covenants in relation to anti-corruption, other than those relating to compliance with laws in general and certain boilerplate representations about non-affiliation with organised crime.
An individual director who is involved in a bribery of a domestic or foreign public officer, whether by conspiracy, aiding or abetting, is subject to criminal penalties (Criminal Law and the Unfair Competition Provision Law). Penalties include imprisonment and/or a fine. Unless conspiracy, aiding or abetting is found, the other directors are not subject to a criminal penalty.
Forms of exit
The most common forms of exit are:
The trade sale is the most common exit form, 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 exit seems attractive, 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 can realise greater value in some cases. However, the possibility of this exit largely depends on the market environment and the IPO preparations require time, resources and cost. Usually, the fund cannot sell out all of the investment at the IPO and is subject to market risk and some difficulties in finding opportunities to sell the remaining stake at a favourable price and timing.
Following a leveraged buyout of the target, if the target becomes unable to make its scheduled debt payments, the fund usually seeks either or both:
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. Although consent of all the lenders is required.
If these efforts are unsuccessful, the lenders are likely to exercise their security interest on the company's stock. If the value of stock exceeds the total amount of debt financing, the residual is returned to the fund. The fund is unlikely to seek a bankruptcy filing of the target because in almost all cases the bankruptcy court finds that there is no remaining equity in the company and therefore no return to the equity holder.
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.
Kanto Local Finance Bureau
Description. Website operated by the Kanto Local Finance Bureau containing information on the amendment of the FIEA.
Hajime Tanahashi, Partner
Mori Hamada & Matsumoto
Professional qualifications. Japan, Lawyer, 1992; New York, US, Lawyer, 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
"Comprehensive Analysis of M&A Laws of Japan" (co-authored), Yuhikaku Publishing Co., Ltd., December 2015.
"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.
Shuhei Uchida, Partner
Mori Hamada & Matsumoto
Professional qualifications. Japan, Lawyer, 2003; New York, US, Lawyer 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
"Comprehensive Analysis of M&A Laws of Japan" (co-authored), Yuhikaku Publishing Co., Ltd., December 2015.
"Minority squeeze-outs under the amended Japanese Companies Act", Euromoney Asia-Pacific Banking and Finance Review 2014/15, Euromoney Yearbooks, October 2014.
"Implications of 2014 amendment of the Companies Act for M&As in Japan", Commercial Law Review, December 2014.
"Drafter's Commentary: Summary of the Interim Proposal Concerning the Revision of the Companies Act" (co-author), Kinyu Homu Jijo, January 2012.
Makoto Sakai, Partner
Mori Hamada & Matsumoto
Professional qualifications. Japan, Lawyer, 2004; New York, US, Lawyer, 2010; Japan, Licensed Tax Accountant, 2015. 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, Elliott Advisors Asia Limited and other domestic and overseas funds on their investments or structuring and formation of their partnerships.
Languages. Japanese, English
"Comprehensive Analysis of M&A Laws of Japan" (co-authored), Yuhikaku Publishing Co., Ltd., December 2015.
"The Private Wealth and Private Client Review: Edition 4, Japan Chapter" (co-authored), Law Business Research Ltd, September 2015.
"M&A Strategies from both a Tax and Legal Perspective: Second Edition" (co-authored), Chuokeizai-sha, October 2015.
Naoya Shiota, Partner
Mori Hamada & Matsumoto
Professional qualifications. Japan, Lawyer, 2005; New York, US, Lawyer, 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
"Comprehensive Analysis of M&A Laws of Japan" (co-authored), Yuhikaku Publishing Co, Ltd, December 2015.
"Mergers and Acquisitions Law Guide 2016: Japan", LexisNexis, December 2015.
"The Acquisition and Leveraged Finance Review:Edition 2, Japan Chapter" (co-authored), Law Business Research Ltd, November 2015.
Mitsue Tanaka, Of Counsel
Mori Hamada & Matsumoto
Professional qualifications. Japan, Lawyer, 2000; New York, US, 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.
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).