Private equity

Author: | Published: 5 Jan 2004
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Expecting a wave of private equity investments and mergers and acquisitions activity, US and European investment banks, accounting firms, law firms and venture capital funds staffed up in Japan in the late 1990s and through early 2001. Renault's 1999 acquisition of over 40% of Nissan and Ripplewood Holding's acquisition early in 2000 of the then Long Term Credit Bank of Japan (now Shinsei Bank) were assumed to be the crest of what was invariably described as an impending tsunami of deals.

A few waves have since broken for international private equity investors but the overall dealmaking conditions have not been favourable enough to prevent many expatriate institutions and individuals from returning home in 2002 and 2003, humbled or angered.

The year 2003 opened with Bank of America joining many other foreign financial institutions or private equity funds in announcing a downsizing of their Japan operations, as well as with the oft-quoted statement of Nikko Salomon Smith Barney analyst Alexander Kinmont, who wrote: "Whereas 10 years ago a perspective on Japan was an integral part of a properly developed world view... today Japan is of no more general importance except as a laboratory experiment in deflation." Among those banks and funds that maintained their operations in Japan, many have voiced frustration over too much money chasing too few reasonably priced deals.

Despite the downsizings and bleak views on Japan, there is reason to be bullish about the mid- and long-term prospects for private equity activity in the country, especially for management buy-outs (MBOs) and for distressed corporate assets. Some financial institutions have downsized their Japanese operations, but the largest Wall Street firms have continued to increase their exposure and develop their capabilities and relationships in Japan. Many of the largest private equity funds remain committed to pursuing opportunities in the market.

Recent activity in Japan

Unsurprisingly, venture capital activity has fallen in Japan in the last two years, while MBO activity is increasing. Aggregate venture capital investment in Japan for 2003 is expected to be no more than one-third of what it was in the peak Japanese fiscal year ending March 31 2001. Both JAFCO, Japan's largest indigenous venture capital fund, and JAIC, the fourth largest, reported new venture investments for the fiscal year ending March 31 2003 that were about half the levels they had invested two years earlier (in neither case does this appear to be because of a decline in market share).

With the public markets depressed, the earnings of venture capital funds deteriorated as they lost capital gains and success fees, JAFCO reported net profits in the fiscal year ending March 31 2001 of ?14.8 billion ($135 million), a net gain of about one-third of the amount for the fiscal year ended March 31 2002 and a net loss of ?7.7 ($70 million) for the year ending March 31 2003.

Japan has not been alone, however, in suffering a decline in venture capital activity. In the US, venture capital investment in the fourth quarter of 2001 was about one-third what it had been in the fourth quarter of 2000, and fundraising across the same two periods fell by 80%. But it was not the down year of 2001 but the up year of 2000 that was the aberration. The year 2001 was still the third best year in US history for the amount of venture capital invested and represented a general continuing upward trend. Similar patterns hold true for Europe.

In Japan, venture capital activity in 2002 and 2003 has suffered together with the rest of the world, but activity appears to be increasing recently. Furthermore, as in the US, the down years still represent a generally favourable trend in venture capital activity in Japan - the aggregate amount of venture capital funding for the slow fiscal year ended March 31 2003 was still greater than most years of the 1990s.

Venture capital investment has declined over the last two years in Japan, but the amount of private equity directed at corporate restructurings has grown rapidly. MBOs essentially did not exist in Japan until 1998 but have quickly begun to take hold in Japan.

Foreign direct investment in Japan remains very low compared with other developed countries, but foreign private equity funds have been active participants in Japan's burgeoning restructuring market, capturing some of the largest deals. In addition to the acquisition of Long Term Credit Bank noted above, Ripplewood has acquired a large resort complex and recently announced that it will undertake the largest ever leveraged buyout (LBO) in Japan - the acquisition for $2.2 billion of the land-line business in Japan of Vodafone Plc (which Vodafone in turn acquired from what had been Japan's third largest telecommunications company). Lone Star Opportunity Fund has also acquired a failed Japanese bank, now known as Tokyo Star Bank. Venture capital leaders JP Morgan Partners (Rhythm Corporation) and 3i (Vantec) have acquired former Nissan subsidiaries in MBO transactions.

Among other sectors, foreign investors are pursuing many interesting opportunities in golf resorts, hotels and distressed retail assets. Over time, their investments will help show Japan that the foreign vultures (as foreign investors are still too often called) can bring jobs and economic development.

MBOs in Japan
Source: Mitsubishi Research Institute/ChuoAoyama Audit Corporation (available at

Legal reforms contributing to private equity activity

Multiple factors make an environment more or less favourable for private equity investment. Perhaps most critically, to stimulate both supply of and demand for private equity finance, there must be a well-developed market for exits through initial public offerings or trade sales. Transparency with respect to an enterprise's financial performance and liabilities is necessary to enable valuations. Suitable flexibility in company law to enable entrepreneurs to take advantage of the corporate form and existing stakeholders and investors to structure mutually agreeable corporate finance and governance mechanisms is critical. Availability of funding mechanisms such as the limited partnership structure used by US funds can be helpful and the ability of pension funds and other institutional investors to invest in private equity funds can increase the capital available for private equity investing.

Reducing capital gains rates has been shown to stimulate demand for venture financing. Lack of labour market rigidities is important for stimulating entrepreneurial activity and producing a class of professional private equity advisers. Finally, in the case of Japan, it is critical that banks are forced to resolve their non-performing loans and in turn force the reorganization of so-called zombie companies.

In most of these areas, Japan has made significant progress in recent years. Some of the main changes have been to Japan's principal company law, the Commercial Code, and insolvency law statutes. Developments have been rapid, recognizing that venture development and corporate restructuring require greater flexibility with respect to corporate finance, governance and changes of control. Whereas the Commercial Code has historically tended to be modified at 10- to 15-year intervals, in recent years there have been material modifications each year and sometimes even on the half-year. Similarly, Japan's insolvency law regimes went almost unchanged - and largely unused - for decades, but have in recent years seen major developments.

Commercial Code: mergers and acquisitions
Venture and other private equity investments require vigorous markets for both initial public offerings and M&A, to both stimulate demand for private equity investments and provide exits for investors. In recent years, in addition to making its public markets more friendly to entreprenurial companies and thereby stimlating the rate of initial offerings, Japan has adopted several new mechanisms for facilitating changes in corporate control. Both Japan's corporate conglomerates and foreign institutions have been quick to put these mechanisms to use.

The changes include: lifting the ban on holding companies in 1997; instituting stock transfer and stock swap mechanisms in 1999, with share exchanges able to be effected on a tax-deferred basis; and adopting a corporate spin-off process in 2001, whereby through a reverse merger an existing company can be divided along business lines into two separate companies, in a tax-deferred transaction.

These mechanisms have facilitated an increase in M&A activity in Japan as companies have at their own, or their lenders', initiative begun the process of corporate restructuring and unwinding of cross-shareholdings. There was a 40% increase in M&A transactions in Japan between 1998 and 1999 and another 33% increase in 2000 - the stock swap and corporate spin-off provisions were broadly used immediately after they were adopted. Many of these transactions have been purely domestic and have created wholly owned subsidiaries, thus creating few opportunities for private equity investors. But it is expected that many of these subsidiaries will eventually be sold in MBOs or trade sales, creating opportunities for private equity funds.

Although adoption of new mechanisms for facilitating changes of control has been encouraging, shortcomings persist. A critical one for foreign investors is that Japanese law does not allow for tax-deferment if a foreign company acquirer effects a share exchange with the shareholders of a Japanese target. It is also problematic that the Commercial Code lacks convenient mechanisms to cash-out small minority shareholders.

Commercial Code: corporate finance
Ready access to limited liability forms is necessary to reduce personal financial risks for entrepreneurs, and flexibility for corporate finance structures is necessary to facilitate bargaining between existing debt and equity stakeholders and private equity investors. Japan has made progress on this front in 2002 and 2003.

Firstly, amendments in 2002 offered greater flexibility to Japanese corporations in issuing stock reservation rights (warrants and stock options), replacing the old regime under which warrants could only be issued together with bonds and stock options were heavily restricted.

Secondly, requirements concerning dividend distribution rules and their specification in a corporation's articles were relaxed in 2002, thus facilitating tracking stocks.

Thirdly, a further amendment in 2002 enables a corporation to issue shares that it can subsequently convert to a different class by specifying the conversion conditions and rights of the converted class in its articles.

Fourthly, while Japan has retained its minimum capitalization requirement of ?10 million ($90,000) for its principal corporate form (kabushiki kaisha), an exception for new entrepreneurs enables the establishment of so-called one-yen companies. Although there are limitations on who qualifies to set up such a company and the standard minimum capital amount must still be paid within five years, many believe this exception may be a harbinger of elimination of the minimum capitalization system, which burdens entrepreneurs while offering no real benefit to creditors.

Finally, as a corollary to the Commercial Code's minimum capital requirement, provisions require a burdensome court-supervised appraisal process in the case of in-kind contributions for the shares of a company for which less than two years have passed since it was set up (an unseasoned company), or in the case of an unseasoned company acquiring assets that were in existence before the company was formed. This provision frustrates deals between venture capitalists and entrepreneurs, as well as the use of acquisition vehicles. Amendments to the Code in 2003 removed the requirement for a court-appointed inspector if an opinion is obtained from a suitable professional (such as a lawyer, CPA or tax accountant). More established institutions are reluctant to issue such opinions and the private equity community would have much preferred complete elimination of the valuation requirement. However, the relaxation of the process is again seen by many to signal the impending end of the minimum capital regime and the ancillary requirements concerning unseasoned companies.

Commercial Code: corporate governance
Changes to the Code in 2002 and 2003 enable more flexible corporate governance in Japan and offer protections desired by private equity investors.

Because of amendments that became effective in 2003, Japanese corporations may now elect, in their articles of incorporation, to adopt a US committee system. Under this system, rather than having the unification of oversight and execution of the corporation's business in the hands of the board of directors, execution of the day-to-day business of the company can be delegated to officers and management of the business to the board, which must set up nomination, compensation and auditing committees. This mechanism can be useful to private equity investors effecting MBOs, not only to streamline management of the target company, but also to facilitate necessary reorganization of what are often entrenched, large and unwieldy boards.

(The 2003 amendments also enable a governance form that requires at least 10 directors, at least one outside director and an important assets committee but it is not clear that this form, considered a sort of compromise between the US and traditional Japanese approaches to governance of large companies, offers special appeal for the private equity community).

Use of the committee system can also serve to reduce the liability exposure of the investor's board appointees (and amendments to the Commercial Code in 2002 also enable greater ability to reduce the liability exposure of directors).

Other amendments in 2002 enabled the issuing of class shares that have no voting rights, or have special voting rights, such as to fill specified directorships or vote on specified issues. This is a useful protection for minority private equity investors, who can now elevate protections usually stated in a shareholders agreement to the level of enforceable corporate law.

An unofficial interpretation of the Commercial Code by the Ministry of Justice now authorizes that board meetings may occur by telephone conference (the previous interpretation was that only video conferences could fulfil the Code requirement for actual meetings). Amendments to the Code in 2003 effectively allow shareholder resolutions to be passed by unanimous consent rather than at actual meetings. Many expect that future amendments to the Code will specifically authorize that board and shareholder resolutions can be passed by unanimous written consents rather than only at meetings.

Insolvency laws
As a supplement to its Bankruptcy Law (based on German law and the rough analogue of Chapter 7 of the US Bankruptcy Code) and Corporate Reorganization Law (the rough analogue of Chapter 11 of the US Bankruptcy Code), Japan adopted in 2000 the Civil Rehabilitation Law. Unlike a corporate reorganization filing, a civil rehabilitation filing is available with respect to Japan's close corporate form (yugen kaisha) and natural persons, is generally treated as a matter of right rather than privilege and has features more amenable to debtor-in-possession (DIP) financing.

In 2003 important amendments were made to Japan's Corporate Reorganization Law, largely in response to the experiences gained from a sudden wave of corporate reorganization and civil rehabilitation filings and from the study of the corporate reorganization process in the US and EU.

These amendments have been designed to: make it easier to petition successfully for entry into corporate reorganization; accelerate the development of reorganization plans, the resolution of disputes with or among creditors and the exit from corporate reorganization procedures; reduce the thresholds for approval of reorganization plans so as to reduce the power of hold-out creditors; give the court greater stay powers against secured creditors and the debtor greater flexibility to clear liens so as to facilitate successful reorganizations; provide the court greater flexibility to retain the existing management team if desired and a clearer process for evaluating any management liability to creditors; and reduce the risk of legal challenge to approved plans.

The amendments offer a further impetus to development of DIP financing in Japan and should generally facilitate development of restructuring activity in Japan, creating further opportunities for private equity investors focused on distressed assets.


Significant amounts of private equity funds targeted for Japan remain undeployed, and many private equity professionals in Japan remain underused. But the frustration this produces should be tempered by appreciation for how profoundly different the prospects and institutional support for private equity activity in Japan are from 10 or even five years ago.

Creating a favourable environment for private equity investment is not a matter of a grand proclamation or of a single body of legislation. Many factors - institutional and attitudinal - must coalesce. There are many uncertainties in Japan, especially with respect to macroeconomics and resolving the non-performing loan crisis, but there is also clear progress in developing a more favourable environment for private equity investing. Those that continue to invest in its development should be rewarded.

Author biographies

Yoji Maeda

Taiyo Law Office, in association with Paul Hastings Tokyo

Yoji Maeda is a member of Paul Hastings Janofsky & Walker's Asia-Pacific practice group. His practice focuses on general corporate matters and transactions for hi-tech and emerging company clients. He also practices in the area of international, domestic and cross-border litigation.

Maeda joined the Japanese law office of Anderson Mori in Tokyo in 1990 and became a partner in 1999. He was involved in a number of commercial and corporate litigation, technology transfer, licensing, and general corporate matters.

He joined Taiyo Law Office in 2000. He provides advice on Japanese law, including the Civil and Commercial Code, as well as other laws in the context of inward direct investments and other forms of Japanese business operations by non-Japanese clients.

Maeda received his BA degree in Law from the Faculty of law, Tokyo University in 1988. He also received his LLM degree from the University of Virginia Law School in 1994. He passed the pre-bar examination in 1987 and received his law degree from the Legal Research and Training Institute of the Supreme Court of Japan in 1990. He is a member of Daini Tokyo Bar Association. He is admitted to practice in Japan and New York.

Ted Johnson

Paul Hastings

Ted Johnson handles mergers and acquisitions, restructurings, investment platform structuring, private equity and venture finance and joint ventures and other strategic transactions for companies and institutional investors in them. He also has extensive experience with information technology outsourcing and licensing of intellectual property.

Johnson is a co-author of a casebook on Japanese law, Law and Investment in Japan: Cases and Materials (Harvard Univ. Press, 2d ed, 2001). He is a graduate of the University of North Carolina (BA, Interdisciplinary Studies, 1983) and Harvard Law School. He has been a Fulbright Scholar at Tokyo University, a Visiting Scholar in East Asian Legal Studies at Harvard Law School and has taught law school courses on Japanese business law. Johnson is licensed in California and Georgia. He is admitted to practice in Japan as a Gaikokuho Jimu Bengoshi (Licensed Foreign Law Specialist) and a member of Daini Tokyo Bar Association.

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