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1 Legal framework
1.1 Which general legislative provisions have relevance in the private equity context in your jurisdiction?
The Companies Act is important in the case of private equity investments, as most investments in Japan will be made to a company (kabushiki kaisha) and the Companies Act sets out general rules on companies.
In addition, the Financial Instruments and Exchange Act is important if the target is a listed company, as the target will be subject to financial regulation under this act.
The Foreign Exchange and Foreign Trade Act has also become more important for foreign private equity firms, as the regulations on foreign investors have become stricter in the last few years.
Any rules regulating the target industry will also be relevant. For example, financial regulations such as the Payment Services Act and the Financial Instruments and Exchange Act must be considered for investments in the fintech space; and the Pharmaceutical and Medical Device Act must be considered for investments in the biotechnology space.
With respect to the formation of private equity funds, private equity funds are typically formed as a partnership, which is recognised as a ‘collective investment scheme’ under the Financial Instruments and Exchange Act. Collective investment schemes are further considered to be ‘deemed securities’ under the Financial Instruments and Exchange Act. Therefore, a private equity fund which is subject to investment by Japanese investors is subject to regulation under this act.
1.2 What specific factors in your jurisdiction have particular relevance for and appeal to the private equity market?
Japan is becoming an increasingly attractive market for private equity investment. Japanese companies are more actively divesting non-core businesses and selling them to financial investors. In addition, there are various small and medium-sized companies whose owners wish to retire because of their age, but who have no one to succeed them. Many of these businesses and companies have recently been acquired by private equity firms.
From the perspective of establishing and marketing a fund, Japan is appealing to private equity firms, as reflected in the fact that there are many Japanese investors with huge assets under management which are increasingly investing in private equity funds.
2 Regulatory framework
2.1 Which regulatory authorities have relevance in the private equity context in your jurisdiction? What powers do they have?
The Financial Services Agency (FSA) regulates and monitors private equity funds. If a private equity fund violates the fund regulations under the Financial Instruments and Exchange Act, the FSA may execute various enforcement powers, such as a report order or cancellation of registration.
The Ministry of Economy, Trade and Industry (METI) provides guidance on the corporate governance of Japanese companies. METI’s Fair M&A Guidelines – a complete overhaul of the Guidelines for Management Buyouts, effected in June 2019 – should be considered when private equity firms make a tender offer for a Japanese listed company.
METI and the Ministry of Finance are responsible for overseeing foreign investments made in Japanese companies. If filing under the Foreign Exchange and Foreign Trade Act is required for the transaction, the closing of the transaction may be postponed until the competent authority has given the green light to the transaction.
2.2 What regulatory conditions typically apply to private equity transactions in your jurisdiction?
If a private equity firm intends to streamline the operations of the target after taking control, it should be aware that Japanese employees enjoy strong protection under the Japanese labour laws, which impose restrictions on layoffs and unfavourable changes to labour conditions.
In a going-private deal, where the target of a private equity transaction is a listed company, the transaction will likely be subject to the tender offer regulations of the Financial Instruments and Exchange Act. The purchaser will thus be required to comply strictly with the disclosure rules and offering procedures set out in these rules. Once the tender offer is complete, the Companies Act allows for the squeeze-out of minority shareholders, either by:
- a reverse stock split, which requires a super-majority resolution of the shareholders; or
- a ‘request for sale of shares’ scheme, introduced under the Companies Act in 2015. This requires that 90% or more of the voting rights be held by the parent company (ie, the purchaser).
3 Structuring considerations
3.1 How are private equity transactions typically structured in your jurisdiction?
Many private equity firms establish a fund in the form of partnership. Typically, the partnership does not invest directly in the target, but rather invests indirectly through a special purpose vehicle (SPV) established solely for the transaction. The SPV is normally established in the form of a kabushiki kaisha, which is a very common entity used by most businesses in Japan.
Private equity transactions in Japan typically take the form of a stock deal, which means that the shares of the target are transferred from the original owner to the purchaser (usually an SPV).
However, some transactions take the form of asset deal, which means that the business assets of the target are transferred to a new company. Two main methods are used for an asset transfer:
- a company split, which is a corporate reorganisation method stipulated in the Companies Act; or
- a business transfer, in which the target business is transferred by executing an agreement between the relevant parties.
In certain transactions, the transferee of the assets is a wholly owned subsidiary of the seller and the purchaser will acquire the shares of the new subsidiary, which ends up as a stock deal from the purchaser’s point of view.
3.2 What are the potential advantages and disadvantages of the available transaction structures?
Stock deals versus asset deals: Stock deals are favoured in Japan for their simplicity. The advantage of an asset deal (including an asset deal combined with a stock deal) is that the purchaser can choose which assets and liabilities should be transferred to the purchaser and which should remain with the seller. Thus, if there is a significant contingent risk in the target and the purchaser wants to ensure that this risk is left to the seller side, an asset deal may be an effective option. It may also be an effective option if the purchaser did not have the opportunity to thoroughly evaluate the target’s risk in the due diligence process.
However, in an asset deal, the purchaser must consider how to obtain the necessary regulatory licences in the new company, because most regulatory licences will not be automatically transferred in the case of an asset deal. Consent from the employees and clients of the target must further be obtained. In addition, asset deals may result in taxation of the target itself, which may affect the economics of the whole deal.
Indirect investment (using SPV) vs. direct investment
An indirect investment using an SPV provides flexibility in many respects, such as:
- leveraging the investment by bank loans; and
- reforming the group structure at a later stage.
The disadvantage of the use of an SPV is increased transaction costs.
Direct investment in a target benefits from the simplicity of this structure, which is often used for minority investments.
3.3 What funding structures are typically used for private equity transactions in your jurisdiction? What restrictions and requirements apply in this regard?
Private equity transactions typically involve an indirect investment using an SPV, especially if the private equity firm seeks to buy out the entire company. The funding structure can be flexible in this case; and in many transactions, the equity portion will be provided by private equity firms and senior loans will be provided by banks. In some transactions – especially larger transactions – mezzanine finance (by loans or by equity investments) will also be used.
3.4 What are the potential advantages and disadvantages of the available funding structures?
If the private equity firm decides to leverage its investment through borrowings in the SPV, this will provide it with an opportunity to pursue higher returns on investment. On the other hand, using leverage normally requires the full acquisition of the target. This is because leveraged financing typically requires the assets of the target to be collateralised, which may lead to a potential conflict of interest with other shareholders if the private equity firm does not wholly own the target.
If mezzanine finance is used in the funding structure, this will boost the leverage of the equity investors; but the overall cost of the funding for the private equity firm will increase because of the higher level of return required for mezzanine investments.
3.5 What specific issues should be borne in mind when structuring cross-border private equity transactions?
New regulations on foreign inbound investments under the amended Foreign Exchange and Foreign Trade Act (FEFTA) are an important factor for foreign private equity firms to consider. The new regulations require that a pre-filing to the government be made in advance of foreign investment in specific enumerated industries. Therefore, an assessment must be conducted of the type of filing required under FEFTA if a cross-border inbound investment by a foreign private equity firm in a Japanese company is contemplated.
The tax structure will also require careful consideration by a foreign private equity firm, and should inform the decision on the type of vehicle used for the transaction and the jurisdiction in which it is based.
3.6 What specific issues should be borne in mind when a private equity transaction involves multiple investors?
Co-investment by multiple investors is usually accompanied by a shareholders’ agreement and other agreements between the relevant parties. It is important that the co-investors agree on exit strategies and the allocation of returns achieved through the investment.
Sometimes, the private equity firm requests the participation of a strategic investor as a shareholder of the portfolio company. Especially in carve-out deals, the private equity firm may also ask the original shareholder to retain a certain portion of the ownership and support the improvement of the business.
4 Investment process
4.1 How does the investment process typically unfold? What are the key milestones?
Private equity firms typically have a pipeline of potential deals. How a specific transaction process unfolds will vary from case to case. Some of these are exclusive deals with the seller, which may start with direct communication between the top management of both parties. Others involve an auction process, with several private equity firms invited to join the auction by the financial adviser of the seller; other financial investors or strategic investors may also compete in the auction. The winning bidder will then enter into final negotiations with the seller.
In any case, a confidentiality agreement will be executed at the beginning of the transaction and due diligence (eg, business, finance, legal) will be undertaken thereafter. During or after the due diligence, drafts of the definitive agreements will be negotiated and the transaction will be executed at the signing date. After signing, both parties will take the necessary steps to fulfil the closing conditions; and closing will take place once both parties have fulfilled the closing conditions.
After closing, there may be a purchase price adjustment to revise the purchase price based on the changes in the closing balance sheet. Some transactions require a transition of operations between the parties and a transition services agreement will often be executed between the parties in such case.
4.2 What level of due diligence does the private equity firm typically conduct into the target?
Most private equity deals involve due diligence of the target in various areas, such as business, finance, tax and legal. Depending on the nature of the target, environmental, IT and HR due diligence may also be conducted.
The extent of the due diligence will depend on the intent of both parties. If the level of documents disclosed by the target is limited, it is difficult for the purchaser to conduct thorough due diligence. On the other hand, the purchaser may want to limit the scope of due diligence due to the cost.
Typically, documents are disclosed in a data room, and interviews (including management interviews) and Q&As will take place as part of the due diligence. Due diligence will normally be conducted over several weeks and confirmatory due diligence may be requested if the purchaser subsequently desires an update on the disclosed information.
4.3 What disclosure requirements and restrictions may apply throughout the investment process, for both the private equity firm and the target?
Transactions may need to be disclosed if either of the parties is a listed company and the size or impact of the transaction exceeds certain thresholds stipulated in the relevant laws or regulations of the stock exchange. In addition, if the target is a listed company and the transaction is subject to tender offer regulations, the details of the transaction – including the negotiation process and the rationale for the tender offer price – must be disclosed.
With regard to disclosure between the parties, disclosure requested by the purchaser may be restricted by confidential obligations borne by the target. In addition, the target may decide not to disclose some information in the early stage of due diligence if disclosure could materially harm its business should the transaction fail to close.
If the transaction is subject to competition laws, the parties must be careful not to disclose sensitive information which may lead to gun-jumping issues. In such case, certain information will be disclosed only to the purchaser’s clean team and the seller may decide to redact the most sensitive information from the documents disclosed in the data room.
4.4 What advisers and other stakeholders are involved in the investment process?
Private equity firms usually retain financial advisers on large transactions to advise on the negotiation and valuation of the transaction. They also retain consulting firms, accounting firms and law firms for business, financial and legal due diligence; as well as other specialists as necessary in the due diligence process. Legal advisers will also be involved in the documentation of the contracts for the transaction.
Private equity firms often send a team to join the management team of the portfolio company. Some members of this team will be employees of the private equity firm; while others may be turnaround professionals hired by the private equity firm for that specific deal.
5 Investment terms
5.1 What closing mechanisms are typically used for private equity transactions in your jurisdiction (eg, locked box; closing accounts) and what factors influence the choice of mechanism?
In most transactions, the purchase price will be adjusted based on the target’s closing account (closing balance sheet) as of the closing date.
A locked box mechanism (together with the concept of leakage) is sometimes used in Japan, especially where one of the parties is a European-based entity. However, purchase price adjustment based on closing accounts is the prevailing closing mechanism for transactions in Japan.
In an asset deal where the inventory is the material asset of the target, the purchase price is sometimes adjusted based on a stock-take performed around the time of the closing date. Some transactions also have a fixed purchase price and thus do not use a closing adjustment mechanism at all.
5.2 Are break fees permitted in your jurisdiction? If so, under what conditions will they generally be payable? What restrictions or other considerations should be addressed in formulating break fees?
Break fees/termination fees are permitted in Japan. While there are no specific restrictions on break fees, if the break fees are unreasonably high based on the nature of the transaction, they may be considered to be non-compliant with the general rule to obey public order and good morals as stipulated in the Civil Code, and may thus be found void.
5.3 How is risk typically allocated between the parties?
The risk allocation of the transaction will depend on the parties’ respective bargaining power. For instance, if a transaction involves an auction and several participating bidders have shown strong interest in the target, the risk of the transaction will likely be allocated to the purchaser side for the most part. On the other hand, if the seller is in a difficult financial situation and is keen to cash out the target, the purchaser will have strong bargaining power and the risk allocation will tend to be favourable to the purchaser.
5.4 What representations and warranties will typically be made and what are the consequences of breach? Is warranty and indemnity insurance commonly used?
Representations and warranties are made in most transactions. Representations on fundamental issues (eg, capacity, enforcement and title of shares) and other general representations are often treated differently in the indemnification clause; and fundamental representations are often given a higher indemnification cap and longer indemnification period. Caps and floors of indemnification are often heavily negotiated between the parties.
Warranty and indemnity (W&I) insurance has been used in many cross-border transactions, but is not yet commonly used in domestic transactions between Japanese parties. However, W&I insurance products for domestic transactions were launched by a major Japanese insurance company in 2020; and W&I insurance may become more common in domestic transactions in the coming years.
6 Management considerations
6.1 How are management incentive schemes typically structured in your jurisdiction? What are the potential advantages and disadvantages of these different structures?
Where executive managers are hired by a private equity firm, many will sign an executive services agreement with the private equity firm or the target. This agreement often contains a bonus scheme for the manager, such as an annual bonus based on the achievement of key performance indicators.
As an alternative, the management team is often incentivised by stock options or actual shares. These equity incentives have an advantage over the bonus compensation described above, in that they align the interests of the management team more directly with those of the private equity firm. In addition, the capital gain arising from the sale of granted shares usually enjoys a tax advantage over the same amount of compensation paid as a bonus. The disadvantage of equity incentive is that giving shares and voting rights in the portfolio company may cause trouble for the private equity firm in the future should its relationship with the manager break down.
6.2 What are the tax implications of these different structures? What strategies are available to mitigate tax exposure?
From the viewpoint of the portfolio company, the disadvantage of incentivising the managers by annual bonus is that if the managers are directors of the portfolio company, the bonus paid by the portfolio company to the directors will likely be paid from after-tax profit. This is because compensation of directors is not tax deductible under Japanese tax law, unless certain exemptions apply (eg, fixed monthly compensation which is paid in the same amount throughout the year).
From the viewpoint of the managers, if a manager is granted an actual stock or stock option, gains earned by selling the shares will be treated as capital gains, which usually has a tax advantage over compensation paid as a bonus. However, stock options are usually taxed at the time the stock option is exercised on the unrealised gain, calculated as the difference between the fair value of the share and the exercise price. In order to avoid this taxation on unrealised gain, a stock option can be structured as a tax-qualified stock option by fulfilling certain requirements. If the stock option qualifies as a tax-qualified stock option, the taxation on unrealised gain earned at the time the stock option is exercised will be deferred until the shares granted through such exercise are eventually sold.
6.3 What rights are typically granted and what restrictions typically apply to manager shareholders?
Key manager shareholders sometimes execute shareholders’ agreement with private equity firms and are sometimes granted certain rights, such as the right to be appointed as a board member. On the other hand, the rights of manager shareholders are sometimes restricted by the shareholders’ agreement. For example, the transfer of shares held by the management shareholder is typically restricted by the shareholders’ agreement. In addition, manager shareholders are sometimes bound by other obligations, such as:
- a non-compete clause;
- a non-solicitation clause; or
- an obligation to devote their full working time to the business of the portfolio company.
6.4 What leaver provisions typically apply to manager shareholders and how are ‘good’ and ‘bad’ leavers typically defined?
The concept of good and bad leavers is not yet commonly used in Japan. However, the concept is adopted in some transactions, especially where the private equity firm is a foreign investor. In such case, death and other termination events in which the management shareholder has no fault are typically categorised as good leaver events; while termination for cause is categorised as a bad leaver event.
7 Governance and oversight
7.1 What are the typical governance arrangements of private equity portfolio companies?
Portfolio companies typically take the form of a kabushiki kaisha, which is normally governed by the board of directors. If the portfolio company is wholly owned by the private equity firm, the private equity firm will typically nominate multiple directors of the portfolio company (and in many cases, a majority of the directors). The statutory auditor of the portfolio company is also often nominated by the private equity firm.
7.2 What considerations should a private equity firm take into account when putting forward nominees to the board of the portfolio company?
The private equity firm often appoints several managers as board members of the portfolio company. Until 2015, a company was required to have at least one representative director who was a Japanese resident. However, this restriction no longer exists and private equity firms are free to choose talent from anywhere in the world.
The directors of a company are subject to a duty of care and should serve in the best interests of the company. Therefore, if a director is seconded from a private equity firm, the director and the firm should be aware that a conflict of interest may occasionally arise – especially if there are minority shareholders holding the portfolio company’s shares in addition to the private equity firm.
In order to mitigate the risk of the seconded directors, the private equity firm should consider executing liability limitation agreements between the directors and the portfolio company. According to the Companies Act, a liability limitation agreement can be executed if the articles of incorporation of the company allow for this. The private equity firm may also consider obtaining directors’ and officers’ liability insurance for the seconded directors.
In many cases, the private equity firm recruits talent from outside the firm to appoint to the portfolio company. When sending a director nominee recruited from outside the private equity firm, the private equity firm should bear in mind that if a board member is dismissed from his or her position as a director, pursuant to the Companies Act, he or she may claim against the company for damages incurred as a result of the dismissal, except where there are justifiable grounds for such dismissal. The concept of ‘justifiable grounds’ is narrowly interpreted in the precedents.
7.3 Can the private equity firm and/or its nominated directors typically veto significant corporate decisions of the portfolio company?
Under the Companies Act, some corporate decisions are made by shareholders’ resolution and some are made by board resolution. The directors nominated by the private equity firm should bear in mind that their decisions as directors should be determined based on the best interests of the portfolio company, and not of the private equity firm.
From the shareholders’ viewpoint, no duties under the Companies Act are currently imposed on the controlling shareholder of a company. However, if there are minority shareholders in the portfolio company, it is advisable that when making strategic decisions on the portfolio company, the private equity firm ensure that such decisions will not harm the interests of the minority shareholders.
7.4 What other tools and strategies are available to the private equity firm to monitor and influence the performance of the portfolio company?
In many cases, the private equity firm acquires 100% of the shares of the portfolio company. This means that the private equity firm takes full control of the company and thus has broad discretion on the strategies adopted by the portfolio company.
However, if there are other shareholders in the portfolio company, the private equity firm may not necessarily have controlling power and in such case will needs to secure its monitoring rights through contracts. For example, a private equity firm may seek information request rights against the portfolio company. While it is true that company shareholders have the legal right to receive annual financial statements under the Companies Act, further detailed information such as monthly financial information and updates on key performance indicator results should be obtained through contracts with the company. Inspection rights and access rights are also frequently contractually given to the private equity firm by the portfolio company.
8.1 What exit strategies are typically negotiated by private equity firms in your jurisdiction?
There are various ways for a private equity firms to exit in the Japanese market. These include sales to a strategic partner, initial public offerings (IPO) and secondary buyouts.
Each private equity firm has its own strengths in terms of exit measures. Some funds have strengths in the re-IPO of previously listed companies which went private at the time of the acquisition by the fund; while others have expertise in selling to strategic investors.
8.2 What specific legal and regulatory considerations (if any) must be borne in mind when pursuing each of these different strategies in your jurisdiction?
If the portfolio company is being sold in an M&A transaction to a foreign investor, such sales will be subject to the foreign investment regulations of the Foreign Exchange and Foreign Trade Act of Japan and pre-filing to the government prior to the transaction may be required. After this pre-filing, a 30-day waiting period applies before the new investor can acquire the portfolio company. In practice, however, depending on the nature of the transaction and the nature of the new investor, this waiting period is often shortened, and it is seldom extended.
9 Tax considerations
9.1 What are the key tax considerations for private equity transactions in your jurisdiction?
Tax considerations are a key factor in determining the investment structure for private equity transactions.
When acquiring a target, if the purchase price is higher than the net asset of the target, this may cause ‘goodwill’ to be incurred by the transaction on the purchaser side. The private equity firm should be aware that goodwill should be amortised within 20 years under Japanese generally accepted accounting principles.
In pursuing an effective investment structure, private equity firms may seek to effect a merger between the portfolio company and the special purpose vehicle used for the acquisition; or may utilise a company split or other corporate reorganisation measures stipulated in the Companies Act. It is important to check that such corporate reorganisation will be tax qualified, as otherwise the portfolio company may be taxed as a result of the reorganisation – especially if the fair market value of its assets materially deviates from the book value.
9.2 What indirect tax risks and opportunities can arise from private equity transactions in your jurisdiction?
Most private equity transactions are stock deals, which are not generally subject to consumption tax. However, if a transaction is an asset deal, the transfer of certain assets may be subject to consumption tax.
In addition, stamp duty may be imposed on an asset purchase agreement, whereas no stamp duty is required for a stock purchase agreement.
9.3 What preferred tax strategies are typically adopted in private equity transactions in your jurisdiction?
Several recent M&A acquisition transactions have combined a partial share buy-back by the target with a share acquisition by the purchaser. This is because share buy-backs have a tax advantage over share transfers for certain shareholders under Japanese tax law. Dividend distributions may also have a similar tax effect to share buy-backs and are sometimes combined with a share acquisition by the purchaser.
10 Trends and predictions
10.1 How would you describe the current private equity landscape and prevailing trends in your jurisdiction? What are regarded as the key opportunities and main challenges for the coming 12 months?
Notwithstanding the COVID-19 situation, private equity activity in Japan remains robust. According to a report published by RECOFDATA, the total deal size of M&A transactions in Japan for the first three quarters of 2020 increased by 12% on the same three quarters in 2019, with private equity firms making a significant contribution to this result.
Another emerging trend worth noting is that activists have increased their presence in M&A transactions in the Japanese market in the last few years. Hostile takeovers – which were previously very rare in Japan – have also become more common and we anticipate that this trend will continue in the future.
10.2 Are any developments anticipated in the next 12 months, including any proposed legislative reforms in the legal or tax framework?
Recently, the Companies Act was amended to introduce a new corporate reorganisation measure called ‘stock allocation’, which will become available from June 2021. This will allow the acquiring company to issue its own shares to shareholders of the target, as long as the target becomes a subsidiary of the acquiring company pursuant to the transaction.
However, under current tax law, a shareholder of the target will be subject to taxation if it receives the acquirer’s shares pursuant to the stock allocation. It is expected that the deferral of taxation under this scheme will be discussed and considered by the government.
11 Tips and traps
11.1 What are your tips to maximise the opportunities that private equity presents in your jurisdiction, for both investors and targets, and what potential issues or limitations would you highlight?
Over the past two decades, the Japanese private equity market has gradually expanded and M&A transactions involving private equity firms have become much more common. Although Japan as a whole has abundant financial assets – in particular, given the high volume of assets managed by pension funds – there was previously relatively little investment in the private equity market, in part because of regulations that restrict investments in ‘riskier’ asset class by pension funds and other public organisations. However, pension funds and other bodies in public sector have become more active in investing in the private equity market, and it is likely that the market will continue to grow for at least the next few years – regardless of the very difficult economic environment that we currently face globally.
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