Leveraged finance

Author: | Published: 5 Jan 2004
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Given the size of the Japanese economy and the need for many of Japan's large companies to restructure, foreign investors seem puzzled by the slow start of the private equity and leveraged finance market in Japan.

Looking first at some of the basic fundamentals, we can see that the conditions for the market are improving. In the past few years, mergers and acquisitions in Japan have become common; not only domestic transactions among Japanese companies, but also cross-border transactions between Japanese and non-Japanese companies. Foreign investment in Japan has increased substantially over the last five years. To revitalize the stagnant economy, Prime Minister Koizumi announced in 2003 the government's policy goal to double foreign capital investment into Japan over the next five years.

Merger and acquisition activity provides a catalyst for the development of the leveraged finance market as lawyers and investment bankers look at innovative ways to structure and finance deals. It is also indicative of changes in attitude and customs. The economic reality in Japan is such that many companies have had to restructure; banks have had to let go of tied relationships and sell off loans through the securitization and distressed debt markets; employees can no longer look to a lifetime commitment from even the biggest companies; and shareholders are looking for better returns and more accountability from management. Economic forces are causing a fundamental shift in the Japanese business culture to become more competitive.

In the US and Europe, leveraged finance plays an integral part in merger and acquisition transactions. In Japan, we are also starting to see the emergence of this financial tool in the market. In the past few years, there has been an increase in acquisitions by private equity funds and also management buyouts (MBOs). In 1998 nine deals with a total value of ¥5,111 million increased in 2001 to 22 deals with a total value of ¥1,165 billion, and in 2002 to 39 deals with a total value of ¥1,072 billion.

In tandem with such an increase in buyout activity, debt financing for acquisitions has gained in popularity. The percentage of leveraged deals as against the total buyout transactions involving buyout funds before 2001 was about 45%, but this ratio increased to about 70% in 2002. Even though it is still smaller in size compared to the leveraged finance market in the UK, the provision of leveraged finance by the four largest Japanese banks in fiscal 2002 was reported to reach ¥150 billion to ¥200 billion. One Japanese commercial bank was reportedly planning to triple its volume of leveraged finance up to ¥50 billion in fiscal 2002.

While the bulk of the financing may be made to small to mid-sized deals, there have been a few notable large deals, most often led by non-Japanese private equity players in the market. The biggest leveraged buyout in Japan in the year 2003, and among the largest ever in the market, was the purchase by Ripplewood, a US private equity fund, of Vodafone's equity interest in Japan Telecom, a fixed line operator, for about ¥261 billion. About 76% of this funding was comprised of debt (¥200 billion).

Foreign investment in Japanese equities
The amount of foreign investment in Japanese companies' equity in the six years from 1997 to 2002 were as follows:
Year Number Value
1997 1,244 ¥601 billion
1998 1,351 ¥815 billion
1999 1,612 ¥2,137 billion
2000 1,782 ¥2,736 billion
2001 1,438 ¥1,898 billion
2002 1,383 ¥1,727 billion
Source: Ministry of Finance of Japan, "Conditions on Outbound and Inbound Direct Investments"

Current trends in the Japanese buyout market
Source: Mitsubishi Research Institute and Chuo Aoyama Audit Corporation, Transaction Services Dept

Breakdown of buyout transactions
Types 2002 (number) 2002 (%)
MBO by leveraged finance 9 56.3
MBO by non-leveraged finance 2 12.5
MBI by leveraged finance 1 6.3
MBI by non-leveraged finance 1 6.3
MEBO by leveraged finance 1 6.3
MEBO by non-leveraged finance 1 6.3
Others 1 6.3
Total 16 100
Source: Mitsubishi Research Institute and Chuo Aoyama Audit Corporation, Transaction Services Dept


Management buyouts becoming more popular

To increase the productivity of businesses, many Japanese companies have been trying to shed non-core businesses and shift the focus to core businesses. In the context of corporate reorganizations and other insolvency proceedings, viable business operations are often split off and sold to financial investors or strategic buyers. Within this sector, MBOs are the most popular form of buyout. The view seems to be that MBOs ensure consistency of management and are a less drastic measure, and are thus the culturally preferred form of buyout in Japan. The difficulty of identifying and putting in place competent management from outside is also another reason why MBOs are popular.

Nevertheless, the concept of a MBO is still quite new to most Japanese businesses. As is the example of a success. It was only in December 2002 that the first success story of the MBO was reported — Japan Pure Chemical Co's (Nippon Koujundo Kagaku Kabushiki Kaisha) listing on the Jasdaq over-the-counter market, three years after the original MBO. This success story was covered widely by the press, drawing a lot of attention to such new possibilities from those who had never thought of using a MBO.

The Japan Pure Chemical transaction involved a listed exit route for the investors. In another deal in March 2003, on which Ashurst advised, the equity investors and management obtained a successful exit through the sale of the business to a strategic investor. This was the sale by Virgin Entertainment Group, Antfactory KK and management of their shares in Virgin Cinemas Japan to Toho Corporation. This is one of the first and most successful MBO exits to date in Japan through a strategic sale and hopefully will encourage more.

Buyout structures

There are several examples of the buyout methods available in Japan.

Share acquisition (private)
In this case the acquisition vehicle will purchase the target company's shares with the proceeds of a loan and equity investment from a private equity fund and the management. The target will usually provide a guarantee and collateral over its assets as there are no financial assistance prohibitions in Japan as there are in the UK for a target to give financial assistance to persons acquiring shares in the target. After the acquisition, the acquisition vehicle will merge with the target company, giving the private equity fund and management direct equity ownership of the target company.

Asset purchase
Another method involves the acquisition vehicle purchasing the assets, constituting the target's business with the proceeds of the equity and debt financing and employing (all or some of) the workers engaged in the operation of the target business, subject to obtaining the employees' consent. The acquisition vehicle will become the operating company after the business is purchased. For certain types of asset deals specific legal requirements must be followed. (See "Court procedure for asset purchase: court-appointed inspector's appraisal" below.)

Share acquisition (public)
In the case of an acquisition of a publicly traded company, the acquisition vehicle usually proceeds with the purchase of the target shares through a tender offer in accordance with the tender offer regulations pursuant to the Japanese securities and exchange law. As it is unlikely that the tender offer will succeed in the purchase of 100% of the shares of the target, the acquisition vehicle will need to engage in another transaction or series of transactions to acquire the remaining minority shareholdings, such as through a statutory share transfer scheme (Kabushiki iten), and subsequent sale to a vehicle of 100% of the shares in the target, the net effect being that the minority shareholders are squeezed out for cash.

In some jurisdictions this may be by way of compulsory acquisition once a threshold shareholding is reached. However, such a procedure is not yet available under Japanese regulations. As part of efforts to streamline and modernize Japanese company law, a compulsory acquisition method is proposed for consideration and is expected to be adopted in the next couple of years.

Court procedure for asset purchase: court-appointed inspector's appraisal
In the case of an asset purchase, there is a potential legal hurdle in the purchase procedure under the Commercial Code of Japan, commonly known as the court-appointed inspector's appraisal requirement, or jigosetsuritsu asset review.

The Code provides that if a corporation within two years of its incorporation plans to purchase assets for use in the operation of its business and at a price of 5% or more of the amount of its paid-in capital stock, then the corporation will be required to have the court appoint an inspector. The inspector will review the contemplated purchase price of the assets and, based on his report, the purchasing company will be required to have the purchase approved by the shareholders by at least a two-thirds affirmative vote.

This procedure is unpopular because it is costly to have the court-appointed inspector review the purchase price and, from the planning standpoint, it creates uncertainty as to the completion and the timing of the closing of the transaction. While there are exemptions from this requirement, such as a certificate as to the fairness issued by an attorney, certified public accountant or tax attorney, or the purchase being in accordance with a restructuring plan approved by the Ministry of Economy, Trade and Industry under the industry revitalization special measure law (sangyou katsuryoku saisei tokubetsusochi hou), the parties normally seek to use a dormant company that is more than two years old to avoid such procedural requirements.

While some may prefer this option, it also causes delay and expense while one searches for, investigates and purchases the dormant company. It also poses a potential risk of undisclosed liability in the dormant company being purchased.

This court-appointed inspector's appraisal requirement for certain asset purchase deals is expected to be abolished in the next couple of years, but this is yet to be confirmed.

Leverage ratio

The leverage ratio in Japanese leveraged finance is in the range of 50% to 70% (excluding mezzainine finance) (see below). This data is based on survey responses from banks, and the number of samples was small. Mezzanine finance is still seldom used in Japan, although there have been a few deals where subordinated loans or high-yield bonds have been made or issued.

By contrast the typical debt-to-equity ratio in UK deals without mezzanine is roughly 60:40 and in those with mezzanine finance it is roughly 70:30.

Ratio of equity and debt in leveraged buyouts
2000 2001 2002
Equity 31.5 50.0 40.8
Term loan 67.7 50.0 59.2
Others 0.8 0.0 0.0
Samples 5 2 4
Total 100 100 100
Source: Mitsubishi Research Institute and Chuo Aoyama Audit Corporation, Transaction Services Dept


Documentation

Japanese leveraged finance documentation was modelled after UK and US documentation when it was first introduced to the Japanese market. Except for the security issues, the basic document structure is still similar to that of UK loan documentation.

Typical covenants included in the loan agreement are: (a) restrictive covenants, including: (i) restriction on additional indebtedness (including guarantees); (ii) restriction on dividends and other distributions; (iii) restriction on sale of assets and granting of security interests (negative pledge); and (iv) restrictions on acquisitions, investments, mergers or consolidations; (b) affirmative covenants, including: (i) maintenance of corporate existence; (ii) compliance with laws; (iii) maintenance of governmental licences if applicable; and (iv) provision of periodic reports (monthly, quarterly, semi-annually, and annually); and (c) financial covenants, including: (i) debt service ratio; (ii) interest coverage ratio; (iii) leverage ratio; and (iv) net worth.

Debt finance components

Term loan
A term loan is used to fund the acquisition and sometimes to also repay the existing loans of the target. The repayment of the term loan usually starts after a grace period of one to one-and-a-half years, and it is typically repaid over five to seven years, depending upon the applicable cash-flow projections. Prepayment is usually mandatory if any excess cash arises, and for this purpose the lenders will closely monitor the cash management of the borrower. The interest rate and arranger fee level, although subject to change and differing in each deal, have been reported to be (in case of the former) in a range of TIBOR plus about 3% and (in the case of the latter) about 2.5% of the purchase price.

Credit facility
A credit facility will also often be put in place to provide funding for working capital and other business needs of the target after the transaction is complete. It may be a remote issue for a leveraged finance transaction, but lenders should not ignore the potential issue of Japanese usury law and availability of the exemption from the application of a broad definition of interest thereunder.

In Japan usury law provides that any money received by the lender in connection with the loan, regardless of the name attached to it (such as discount, fee, commission, gratitude), shall be deemed "interest" for the purposes of usury law. This provision could be problematic because the fees payable for the credit facility may result in a technical violation of the maximum lawful interest rate under the law if no or only small amount is drawn down from the facility relative to such fees. An exemption is available, among others, if the borrower is a corporation (kabushiki kaisha) with capital stock of ¥300 million or more. The lenders should therefore check the capital stock of the acquisition vehicle, which should rarely be below such a threshold.

Mezzanine finance
Mezzanine finance including subordinated loans (or in limited cases, high-yield notes), ranking between the senior, secured loan and equity, may be used. The Japanese market however does not use structural subordination. Rather contractual subordination provisions are used to give prior status to senior loans.

Stock options (shinkabu yoyakuken) as sweeteners
A typical equity sweetener attached to debt financing, if applicable, is a stock option to purchase new shares from the borrower. The stock options should provide for the mechanism of succession and adjustment in the case of the borrower merging with the operating company.

In respect of the payment upon exercise of options and also for new shares in general, it should be noted that the Commercial Code is stringent in ensuring that the issuing company actually receives payment of the full price for the new shares, and in the case of payment for new shares issuable upon exercise of the stock options, the actual payment in cash of the full price of shares issuable upon the options is required (except in the case of convertible bonds).

Collateral issues

Traditionally, Japanese banks used to look mainly to real property as the main means of security for bank loans. In a leveraged finance deal, the banks look to cash flow of the business operations and seek to secure the senior loans with all or substantially all of the target assets (to the extent practical).

In Japan, however, there is no comparable scheme to a floating charge for a bank financing, and the security interest has to be created and perfected with respect to each item of collateral. A security called corporate collateral (or kigyou tampoken), modelled after an English concept of a floating charge and encompassing all assets of the debtor corporation, can be used only for corporate bonds (shasai) issued by a corporation (kabushiki kaisha), but not for other types of debt obligations.

Real property
Security interests created over real property are commonly mortgages (teitouken) although pledges (fudousan shichi) may also be created over real property. In either case, such security interests need to be registered with the local legal affairs bureau for the perfection of the security interest over the real property. The registration procedure itself is straightforward, but because the registration fee is assessed at 0.4% of the principal amount of secured obligations (as opposed to the value of the property), the lenders and borrower often discuss whether it makes sense to have the whole of the debt obligations secured by the real property if the borrower has many pieces of real property of smaller value, or if there is significant difference in the value of a certain piece of real property and the principal of the loan to be secured.

Stock collateral
One of the most important classes of collateral is the pledge of shares of the acquisition vehicle (and upon the merger, the shares of the surviving entity). The perfection of a share pledge is as simple as that for the sale of shares — actual delivery of share certificates.

This form of share pledge is commonly called a simplified pledge (ryakushichi). If the pledge is also registered in the shareholder registry and is endorsed on the face of the share certificates (touroku shichi), then the pledgee will be entitled to assert its position as pledgee as against the issuer and can receive directly from the issuer the dividends and (upon liquidation) distribution of residual assets. In the case of a simplified pledge, the pledgee will need to present the share certificates to the company when exercising its rights against the company as pledgee.

A potential legal issue could occur at the time of an auction sale (private or public). It is likely that there is a share transfer restriction in respect of those pledged shares, requiring the company's board approval for the transfer of shares. It is legally uncertain whether the board can give a blanket approval at the time of creation of pledge (without knowing who will purchase the shares in the future).

Even though there is a procedure under the Commercial Code for the designation of a replacement transferee if the board declines to approve the proposed transferee, it would cause a delay and uncertainty in the sale of pledged shares. In some cases therefore, the share transfer restriction in the articles of incorporation of the company is taken out at the time the stock collateral is created. In others, the article is amended to provide for the exception from the restriction to the effect that share transfer restriction is applicable except to the transfer to creditor/share pledgee X, and the board approves in advance the transfer to creditor/share pledgee X if creditor X enforces the share pledge.

Collateral over inventory or other movables
The typical form of security interest over movables under the Civil Code of Japan is the pledge (shichiken). However, a pledge over a movable asset can only be created and perfected upon actual delivery of the movable asset to the pledgee.

This delivery requirement poses a difficulty in practice where the pledgor needs to keep custody of the movable assets, in particular in the case of inventory. The practical alternative to the pledge is the security assignment (jouto tampo) in which the title to the goods is transferred to the secured creditor as a security for the loan and the title transfer is perfected by way of either actual or constructive delivery of the goods. Under the constructive delivery method, the borrower may continue to keep custody of and use the goods, and in the case of the inventory, until the secured obligations become due or otherwise accelerated, the borrower is permitted to sell the goods and the new goods delivered to the borrower in the warehouse will be subject to this security interest.

While this is practical and convenient from the borrower's perspective, it is a weak form of security interest in that a third party may obtain the full title without any encumbrance if it is a bona fide purchaser and takes delivery of the goods. Therefore, historically, banks have not viewed inventory as an important collateral source, and this weakness needs to be duly noted.

Collateral over receivables
Collateral over a monetary claim takes the form of either a pledge (saikenshichi) or a security assignment (saiken jouto tanpo), but in the case of revolving trade receivables, a security assignment is the customary form of security interest. A practical issue concerning taking collateral over a receivable is that many agreements provide for non-assignability of loan or other receivables in Japan and to create valid collateral, the debtors' consent to the pledge or security assignment is required. The perfection of the pledge and security assignment is the same, and can be made by one of the following means: (i) notice to the debtor of the receivable with a certified date (kakutei hizuke); (ii) consent by such a debtor with a certified date; or (iii) filing with the legal affairs bureau.

Bank account pledge
The bank account security arrangement is important for the lenders. The most secure and common way is a pledge over the account to which the borrower credits cash to be received from its business or trade customers. Since the bank deposit agreement has a standard restriction for transfer or pledge of the bank account, the deposit bank's consent (that is, waiver) is first required to effectively create a pledge. A pledge can be perfected by one of the following means: (i) notice to the bank with which the account is opened with a certified date; (ii) consent by such a bank with a certified date; or (iii) filing with the legal affairs bureau.

Security trustee or security agent
What complicates the perfection procedure is that in Japan a security trustee is not commonly used because Japanese law does not permit creditors and security interest holder(s) to be separate entities (with the exception of bond trustees holding interests in corporate collateral on behalf of bondholders of collaterized corporate bonds).

As a consequence, each secured creditor will need to be a party to the security documentation and perfect its own security interests. The exercise by an individual lender alone of its security interest will normally be contractually restricted by the agreement among the creditors, but the restriction is not risk free and is excused in the case of bankruptcy of the borrower.

Since the history of syndicate lending in the domestic Japanese lending market is quite short (only in 2001 was a standard form of syndicate loan agreement publicized by the Japan Syndication and Loan-trading Associations) the efforts to date have not yet produced a practical solution to ensure collective action by a syndicate of secured creditors, and the market still relies on the contractual restrictions as among the secured lenders.

Guarantee

Japanese law has no special rule to invalidate an upstream guarantee given by a subsidiary in respect of a debt of its parent or affiliated company. The concept of financial assistance does not exist under Japanese law, and only the rules governing the validity of guarantees in general need to be satisfied. The rules governing guarantees in general are quite simple under Japanese law, and the valid formation of a guarantee agreement and valid existence of the indebtedness to be guaranteed are the main requirements. However, the issues under Japanese law relating to fraudulent conveyance or avoidance need to be noted.

Fraudulent conveyance or avoidance issue

If the borrower in a leveraged finance is highly leveraged, its asset position may easily come close to negative. The potential of avoidance of the transaction (or part of it) is worth serious consideration in many cases.

Avoidance of guarantee as gratuitous act (mushou hinin)
If a debtor engages in a gratuitous act during a period of six months preceding cessation of making payments as they fall due (shiharai teishi) or a petition for bankruptcy (or start of other insolvency proceeding), such act will be subject to avoidance by a bankruptcy trustee or other competent administrator or trustee in the proceeding.

If a guarantee is given without any guarantee fee (which is the case with almost all leveraged finance transactions), then there is a potential risk of avoidance of gratuitous act if a guarantor stops payment or a petition for insolvency proceeding is filed with respect to a guarantor within six months from the time of the giving of a guarantee. While a guarantee given with a guarantee fee is not subject to such gratuitous act avoidance, it may be subject to another category of intentional avoidance (koi hinin) if it is prejudicial to creditors in general and both the guarantor and creditor had requisite intent or knowledge.

Avoidance of granting of security interest
The granting of a security interest made concurrently with the borrowing is in general not viewed as prejudicial to creditors and not subject to avoidance. In regard to collateral provided by a subsidiary or an affiliate of the borrower (acquisition vehicle), the same discussion made with respect to guarantees will apply and such act will run a risk of gratuitous act avoidance unless such affiliate receives a fee for it.

Avoidance of perfection (taikouyouken no hinin)
Perfection of a security interest must be made no later than 15 days from the date of its creation. If the perfection is made later than the 15-day period from the creation of security interest and if a petition for insolvency proceedings or payment stoppage is filed or occurs before the perfection, such perfection itself will be subject to avoidance by the bankruptcy trustee (or other competent administrator or trustee in the proceedings).

Cautious optimism

Apart from the legal framework, leveraged finance deals are of course influenced by a number of factors, including the availability of private equity, the strength and prospects of the stock markets and the general economic outlook.

There also needs to be an availability of high-quality deals to give confidence to the market. Now the big four Japanese banks are entering the market with their superior network of company and industry contacts, combined with greater foreign investor interest, greater expertise in the services sector from lawyers and accountants that have gained experience internationally as well as locally, as well as the pick up in the economic outlook and stock markets, there is room for cautious optimism that the market in Japan is ripe for growth.

Author biographies

John McClenahan

Ashurst Tokyo

John McClenahan is managing partner of Ashurst Tokyo and head of Ashurst's Asia practice, having worked for Ashurst in Tokyo for more than eight years after relocating from the firm's international finance department in London. He specializes in banking and finance, private equity and structured finance transactions.

He has extensive experience in the banking and finance sector and has also worked on a number of private equity/leveraged finance transactions both in London and in Japan. He recently advised Virgin on the sale by Virgin Entertainment Group and other shareholders of their stake in Virgin Cinemas Japan, one of the most successful cases of an exit from a management buyout transaction in Japan to date. McClenahan also advises extensively on the establishment and setting up of private equity investment funds, both regional and country specific, in the Asia region targeted to invest in a variety of sectors.

As well as being qualified as a solicitor in England and Wales, he is also admitted as a solicitor to the Supreme Court of New South Wales and as a Gaikokuho Jimu Bengoshi in Japan. He is a member of the First Tokyo Bar Association of Japan.


Ken Kiyohara

Ashurst Tokyo

Ken Kiyohara is a partner of Ashurst Tokyo Law Office, which is the registered joint enterprise office with Ashurst in Tokyo. He has many years of experience in representing and advising both Japanese and international clients on a range of corporate and finance transactions, with particular emphasis on structured finance, leveraged finance, private equity and M&A deals.

He has worked and studied in the United States as well as Japan and has particular experience in large and complex cross-border transactions.

Kiyohara is admitted in Japan as bengoshi (since 1992) and also in New York (since 1998). He is a member of the Dai-ichi Tokyo Bar Association as well as other international professional organizations, including the American Bar Association, International Bar Association and Inter-Pacific Bar Association.



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