The acquisition finance market in Japan has shown much development in recent years. Multibillion-dollar deals are no longer a rarity, as evidenced by the proliferation of deals such as those Japan Telecom, DDI Pocket, World Co, Skylark Co, and others. There are several views as to when this trend began, but the general consensus is that it started with the ICS International Culture and Education Centre deal in 1998. Jafco financed the deal (¥1.9 billion (about $16 million)). The Mine Mart deal followed in 2000, with senior facility of ¥11.7 billion and a mezzanine facility of ¥2 billion. At that time, the subordinated loan concept was not as well developed in Japan as the concept of subordinated bonds. However, the basic legal structure of the two was the same.

Subordination structure

In a subordinated loan agreement, the subordinated lender and the borrower agree that, in the event of bankruptcy, the effectiveness of the loan will be temporarily suspended and will be revived when the specified senior loan has been repaid in full. This is a kind of conditional loan structure (teishi joken tsuki saiken). There is, to date, no Supreme Court judgment regarding this structure and no bankruptcy court case involving it. But many authoritative figures, such as Professor Hideki Kanda of Tokyo University, support this structure. The Financial Services Agency (Kinyucho) has also issued a general guideline to banks wherein this conditional loan structure is cited as a recognized Tier II financing structure under the Basel Capital Accord published by the Basel Committee on Banking Supervision.

New Bankruptcy Law

Article 99(2), of the new Bankruptcy Law (Law 75, 2004, as amended), allows a lender and borrower to enter into a subordination arrangement (agreed subordination) under which the loan is subordinated to credits subordinated by law (such as interest accrued and damages suffered after commencement of bankruptcy proceedings). However, in this agreed subordination structure, the subordinated lender is treated as a super-subordinated creditor who is junior to most other creditors. As a result, this agreed subordination structure is not used in mezzanine finance transactions, and the conditional loan structure enjoys continued popularity.

Intercreditor agreements

Under either the conditional loan structure or agreed subordination structure, a subordinated loan is legally characterized as subordinated and is treated as junior by the bankruptcy trustee. In these structures, senior lenders are legally protected as senior creditors and can maximize their portion of the bankruptcy distribution. However, if the senior lenders can accept the credit risk of the mezzanine or subordinated lenders, a more favourable arrangement for the senior lenders is contractual rather than legal subordination. Contractual subordination is achieved by way of a well-drafted intercreditor agreement, under which the mezzanine (subordinated) lenders agree to turn over to the senior lenders any distributions they receive from the borrower unless those distributions are permitted under the intercreditor agreement. In this structure, the senior lenders can enjoy not only distributions to themselves but also distributions to the mezzanine lenders. To strengthen the senior lenders' position, they can negotiate the creation of a pledge over the mezzanine loan for the benefit of the senior lenders. In this structure, the mezzanine lenders, as pledgors, lose their right to petition for the bankruptcy of the borrower (Supreme Court (1999)).

Negotiation of intercreditor agreements

In addition to the subordination arrangements, the intercreditor agreement also regulates several other aspects of the financing arrangements. Some aspects are particularly important to the senior lenders (such as ensuring the senior ranking of their claims and limiting cash leakage), while others are more important to the mezzanine lenders (such as ensuring that they are not placed in a quasi-equity position).

Specifically, it is important that mezzanine lenders:

• ensure that the mezzanine debt ranks senior to any intra-group and/or shareholder debt, as well as any unrelated senior loans (such as working capital facilities);
• limit the rights of holders of any debt ranking junior to the mezzanine debt;
• ensure that the concept of permitted mezzanine payments is as broad as possible (including scheduled interest payments);
• limit the scope of any payment blockages (for example, after a senior event of default or a breach of applicable financial covenants);
• limit the application of any standstill period or restructuring period during which enforcement action cannot be taken by the mezzanine lenders even in the case of an event of default under the mezzanine loan;
• limit any postponement of rights of subrogation arising as a result of the subordination of the mezzanine lenders;
• regulate treatment of amounts set off between the borrower and the mezzanine lenders;
• limit the ability of senior lenders to increase the amount of the senior facility (that is, new money), applicable interest rate, fees, period of loan, or repayment schedule (for example, through voting/veto rights);
• limit the scope of any negative covenants given by the mezzanine lenders to the senior lenders to not increase the amount of the mezzanine facility, applicable interest rate, or fees without the prior written consent of the senior lenders;
• maintain transferability of the mezzanine facility;
• address any transaction-specific arrangements;
• ensure that the representations, warranties and covenants in the mezzanine facility agreement substantially mirror those in the senior facilities agreement;
• obtain voting rights (or veto rights if possible) regarding any sale of the borrower's major assets, the release of any security, or any change in the cash waterfall (for example, if the debt coverage ratio falls below certain prescribed levels);
• limit the manner in which security interests can be released or foreclosed and regulate how the proceeds are shared; and
• limit the extent to which the senior lenders are involved in matters affecting only the mezzanine lenders (and vice versa).

Intercreditor agreements with preference shareholders

Mezzanine finance can be extended in the form of preference shares rather than a loan. These preference shares usually have redemption rights, a conversion right to common shares with normal voting rights, veto rights with respect to major decisions of the issuer (that is, the borrower), preferred distribution rights and preferred residual asset distribution rights. Senior lenders seek to restrict these preference shareholder rights to some extent in the intercreditor agreement. Often, the most controversial point during negotiation is a share pledge over the preference shares. Usually, preference shareholders will refuse to offer their shares as security for the senior lenders as it affects the transferability of their position. From the view point of the senior lenders, however, preference shares that can be converted to common shares are a dangerous animal because they dilute, if converted, the ratio of shares pledged to the senior lenders in relation to the total number of common shares. Depending on the ratio, the preference shareholders may, after conversion, hold more than 50% of the voting rights and so might be in a position to deprive the share pledgee (senior lender) of its controlling interest.

Acquisition finance structure

Loan agreements

A standard term loan agreement prepared by the Japan Syndication and Loan-trading Association (JSLA) is often used in the domestic acquisition finance market. This standard agreement, however, was prepared for use in a corporate context rather than an acquisition or project finance context. So the proper representations and covenants must be present. In particular, certain financial covenants should be added to meet the specific considerations involved in acquisition finance. In larger deals involving Japanese and foreign financial institutions and foreign funds, a standard acquisition finance agreement prepared by the Loan Market Association in London is often used, though governed by Japanese law and with some Japan-specific amendments to certain clauses.

Security packages

Full security packages over all tangible and intangible assets of the target company, as well as over all the issued shares of the target company held by the acquisition company, are part of the standard structure for acquisition finance transactions in Japan. After the acquisition company purchases all issued shares of the target company, the target company provides its assets to the lenders as security for the borrower's obligations. If the target company is a listed company and is subject to takeover bid (TOB) procedures, it is possible that minority shareholders will remain in the target company post-TOB. In these cases, the directors face difficulties in granting a security interest to the lenders of the majority shareholders before squeezing out the minority shareholders due to their fiduciary duties owed to all shareholders. In these circumstances the only security interest available to the lenders before the squeeze-out is a pledge over the issued shares of the target company, which are held by the acquisition company.

The acquisition company will often merge with the target company after the acquisition, allowing lenders direct access to the cash flows of the (post-merger) target company. However, to give lenders access to the cash flows of the target company before merger, the target company can provide an inter-company loan to the acquisition company if the dividend payments from the target company to the acquisition company will not be enough to meet the interest and principal payments owed to the lenders.

Under Japanese law there is no blanket security interest, such as a floating charge. The closest security interest under Japanese law is a mortgage over basic factory assets, including immovable assets such as real estate and movable assets such as machines and cable lines. A security interest over shop or warehoused inventory can be provided as a collective movable asset security interest, whereby individual goods can be transferred for ordinary business purposes without cancelling the security interest.

Existing receivables and future receivables are important assets over which security interests can be provided under Japanese law.

Favourable judgment expected

The Tokyo High Court held, on July 21 2004, that unpaid tax credits have priority over the assignment of future receivables for security purposes (joto tampo), even if the assignment is perfected before the tax default, as long as the future receivables come into existence after the tax default. This judgment shocked financial market practitioners handling securitization transactions, real estate non-recourse finance transactions, project finance transactions, and PFI transactions. This was an especially troublesome decision for lenders involved in acquisition finance because the borrowers in that context are not mere special purpose companies (assuming completion of a merger); they are operating companies, generating revenue and paying taxes, and there is a risk that those taxes are not properly paid. Of course, under the loan agreement, a facility agent should be monitoring the cash waterfall and ensuring that taxes are paid as operating expenses from the top of the waterfall, but strict monitoring of the cash flows is not practical. If the borrower defaults on its taxes on Day 2, without informing the facility agent, and then sells goods to purchasers and obtains receivables on Day 3, the tax authority can effectively attach those receivables and collect in priority to lenders who have a security interest over future receivables, even though the lenders' security interest was perfected on Day 1.

The reasoning of the High Court is that, while a party can assign future receivables on Day 1, the legal nature of future receivables dictates that the legal right only comes into existence and is transferred to the assignee at the time the individual purchase and sale agreement with respect to the specified goods is entered into on Day 3. If a seller is in default of tax on Day 2, before the purchase and sale agreement becomes effective on Day 3, the future receivable has not come into existence at the time of the tax default and is not subject to the security interest. Therefore, in accordance with paragraphs 1 and 6 of Article 24 of the National Tax Collection Law, national taxes are given priority over assigned receivables not yet subject to a security interest.

This is an unacceptable result for secured lenders and investors in securitized financial products and also for borrowers who would like to use their receivables as security for borrowing. One of the famous professors in this field, Masao Ikeda of Keio University, strongly opposes this judgment. The case was appealed immediately after the High Court judgment. In late November 2006, the Supreme Court informed the appellant that it would hold hearings on January 18 2007.

This is an indication that the Supreme Court will not simply uphold the High Court judgment and will scrutinize the case in detail. There is a chance that the High Court judgment will be revoked and the Supreme Court will render a judgment more favourable to secured lenders. Assuming the process goes smoothly, the Supreme Court is expected to rule on this issue sometime around March 2007.

Private equity in Japan

M&A activity surged in 2005 in Japan, capturing the attention of the world's largest private equity firms. According to Thomson Financial, announced deals in Japan doubled in 2005, with a record 3,002 deals making Japan the second-largest market by volume and the third largest by value. Softbank's acquisition of Vodafone Japan represented the largest M&A deal in Japanese history. Although the average size of all M&A deals in Japan is half the size of the average deal in the US or the UK, this activity reflects a big change in Japanese corporate management compared to five years ago.

The growth of private equity in Japan is no less remarkable, having been almost non-existent as late as 1998. According to Nihon Keizai Shinbun, there are over a 100 private equity funds in Japan with over ¥2 trillion ready for investment. Total investments in 2005 and the first half of 2006 were $7.9 billion in 120 deals and $5 billion in 161 deals, respectively. Total investment in 2005 reached a historic high representing a 13% increase over 2004. While the private equity market in the late 1990s until recently was dominated by distressed deals by a limited number of global players, it has entered a new stage. Once the private domain of established local private equity firms and a few global players such as Advantage, Unison, MKS and Carlyle, Japan has seen a growth in the number of global players, including KKR, Bain Capital, Texas Pacific Group and Permira, which have all recently entered the market. Large foreign investment banks are also active in the market.

One of the driving factors behind renewed interest in Japan by these global players has been the high returns in Japan. The Centre for Asia Private Equity Research calculates in 2005 that divestments returned just over ¥1 trillion yen on invested capital of ¥340 billion, a roughly threefold return on investment. They are also attracted by Japan's inefficient market for capital, which leads to opportunities for increased value compared to the US or the UK.

Distressed deals were the main driver in the early stages of the development of the buyout market, with two of Japan's long-term credit banks, The Long-Term Credit Bank and Nippon Credit Bank, being sold to foreign private equity funds or consortiums with foreign involvement.

Over the years, the market expanded to encompass corporate restructuring and turnaround deals, and also deals driven by succession issues in family-owned companies. Nissan Motors is a good example of the former kind of deal. Under a rehabilitation programme executed in the early 2000s, Nissan divested itself of a large number of subsidiaries and several were by way of management buyouts.

In 2005, turnaround/distressed deals still dominated the market; the most notable examples being Goldman Sachs' investment in Sanyo Electric Co and Cerberus' investment in Seibu Railway Co. On the other hand, the private equity market recently witnessed a new trend with going-private transactions such as World Co by Chuo Mitsui Capital and Pokka by Advantage Partners and CITIC Capital. The tide turned in the first half of 2006 and buyout deals including going-private transactions dominated the market; the prime example being the investment in Skylark Co. by CVC Asia and Nomura.

There are two schools of thought about the future of private equity in Japan. Some point to the fact that sustained economic recovery and increased stock market valuations have taken pressure off companies to dispose of non-core assets and the disappearance of distressed assets. Others perceive an opportunity in the economic growth and rebound in the financial markets for non-financial firms to grow their businesses through M&A activity, with the expectation that these firms will be more willing to sell off non-core or unprofitable operations. This school of thought points to firms with strong prospects for growth, firms in mature industries requiring consolidation or new synergies, and firms in industries where deregulation and other factors are causing changes.

But the question still remains whether private equity firms will prevail over more strategic buyers. The offer by private equity firms to preserve managers' independence and senior positions and their emphasis on confidentiality and exclusivity has struck a responsive cord within the boardroom. Management in Japan today is much more willing to discuss the possibility of management buyout than ever before. Convincing shareholders, however, might be a different story. Regardless of the outcome, private equity firms have raised the level of discussion within Japanese companies about what is core and non-core to their business.

The law stated in this article is as of December 11 2006.

Author biographies

David Deck Baker & McKenzie GJBJ Tokyo Aoyama Aoki Law Office David Deck is a partner of Baker & McKenzie GJBJ Tokyo Aoyama Aoki Law Office (Gaikokuho Joint Enterprise) and is an expert in cross-border mergers and acquisitions and private equity transactions, securitization transactions, and leveraged lease financings. He regularly represents major US, foreign and Japanese companies and financial institutions. Deck was named a leading securitization lawyer in Japan by Chambers & Partners' Guide to the World's Leading Lawyers and a leading individual in Japan in banking and finance and corporate/M&A by Asia Pacific Legal 500. Deck received his JD from UCLA Law School in 1988 and was admitted in New York the same year. In 1999, he was admitted as a foreign registered lawyer (gaikokuho jimu bengoshi) in Japan. Deck also received an MA in east Asian Languages and Culture from Columbia University in 1985, and studied at the International Division of Waseda University in 1977. Naoaki Eguchi Baker & McKenzie GJBJ Tokyo Aoyama Aoki Law Office Naoaki Eguchi is a partner of Baker & McKenzie GJBJ Tokyo Aoyama Aoki Law Office (Gaikokuho Joint Enterprise) and focuses his practice in the areas of acquisition finance (MBO/TOB/LBO), project finance and PFI, finance with export credit agencies, securitization, real estate finance, limited recourse loan and NPL transactions. Eguchi has extensive experience representing Japanese and foreign banks, investment banks and other financial institutions, sponsors and originators, and he has been actively involved in implementing foreign financial techniques into the Japanese legal environment. He has represented on more than 12 acquisition finance deals and more than 100 project finance and PFI projects for lenders, sponsors, and governments. He acted for senior lenders in refinancing Universal Studios Japan with preferred share contributions from Goldman Sachs and an entity related to the Development Bank of Japan. Eguchi has organized and participated in various seminars and written many articles. In addition, he was named a leading individual in Japan in the area of banking and finance by Asia Pacific Legal 500. Eguchi was admitted to practise law in Japan in 1988. He graduated from Hitotsubashi University's Faculty of Law in Tokyo in 1986 and from London University (University College London) in 1992 with an LLM in international business law.