M&A Report 2023: Japan
Sponsored byK&L Gates
J Ryan Dwyer III, Tsuguhito Omagari and Andrea Ng, K&L Gates
The Japanese M&A market experienced a decrease from the previous year in terms of total deal value in 2022. According to data from Dealogic, Japan’s total M&A deal value in 2022 was $53 billion. This is only a little over half of Japan’s total deal value of $100 billion in 2021.
While healthcare-sector M&A grew from $6.7 billion in 2021 to $9.7 billion in 2022, the financial services, consumer goods and technology sectors slowed down and brought in around half the deal value compared with the previous year. The financial services sector brought in over $37 billion and the consumer goods sector brought in $7.9 billion in 2021 compared with $15 billion and $1.4 billion, respectively, in 2022.
Technology-sector M&A was valued at over $26 billion in 2021 and dropped to less than half that in 2022 – $10 billion. The drop in the technology sector is likely due to a slowdown in outbound deals by Japanese companies, as there were $23 billion of outbound deals in 2021 compared with $8.5 billion of outbound deals in 2022.
Although there has been a decrease in the total deal value, the number of inbound and outbound deals has largely remained the same, with 572 deals in 2021 and 556 deals in 2022. This suggests that while the deal value may have dropped, the number of small(er) deals has risen.
Japan is still largely driven by private M&A transactions in terms of deal value and the number of deals. In 2022, 465 private transactions between Japanese companies and foreign companies resulted in over $39 billion in deal value, compared with 31 public transactions between Japanese companies and foreign companies, with $4.9 billion in deal value. Interestingly, there are 1,071 Japanese companies acquired by domestic and foreign investment entities or funds, which is the highest since 1998.
The two largest inbound deals in 2022 were KKR’s tender offer of around $4.9 billion for a Hitachi Ltd. (Hitachi) subsidiary (Hitachi Transport System, or HTS) and Bain Capital Private Equity’s acquisition of the Olympus scientific solutions business for $3.1 billion.
KKR’s tender offer was concluded on November 29 2022 and settlement of the tender offer began on December 6 2022, which resulted in KKR acquiring approximately 51.11% of the common shares in HTS. KKR’s purchase of the remaining shares is expected to give KKR 100% ownership of HTS by April 1 2023.
Olympus’ sale of its scientific solutions business, a unit producing life science and industrial use instruments (for example, microscopes and testing equipment), will allow Olympus to focus solely on its medical technology offerings.
The Hitachi and the Olympus deals reflect a similar trend in 2022 where many Japanese companies are choosing to concentrate their resources and streamline their business focus and strategies.
Economic recovery plans
While 2021 was a year full of transformative M&A deals, Japan had a general pause in transformative M&A in 2022 and, instead, a surge in smaller deals, both cross-border and domestic. Also, while there were still some transformative deals, the deal value was on a smaller scale – other than the Hitachi and Olympus divestiture deals – which meant that the typical value of these transformative deals was smaller in comparison with previous years.
With the combined impact of 2022’s interest rate hikes in Europe and the United States and the weakening yen, Japanese companies are slowing down the pace of deals that involve European and US companies, especially in the technology sector, though acquisitive interest remains strong.
Despite the slowdown, many Japanese companies have continued the trend of streamlining their business portfolios by selling businesses or subsidiaries that are no longer considered to be core businesses.
Furthermore, US private equity investments increased in Japan in 2022 despite a general decline in that category in the rest of the Asia-Pacific region. This increase may be linked to the large amounts of uninvested capital (i.e., ‘dry powder’) held by funds launched within the past three years. Combined with the high interest rates in the United States, it seems likely that US private equity firms will continue to look towards Japan for investment targets.
In Japanese outbound M&A, with travel resuming, the number of deals may continue to increase among Japanese companies that built up war chests during COVID, but the weakened yen and general economic uncertainty may lead to smaller deal sizes and more private deals.
In 2022, the decline of outbound deals and the increase of smaller deals were largely driven by a combination of high interest rate hikes in Europe and the United States, exchange rate movements, global geopolitical shifts caused by the invasion of Ukraine and US–China tensions, and the resulting disruption of global supply chains.
Despite these factors, with its huge reserves of cash, Japan is positioned to expand its M&A activities. Hints of this can be seen where certain sectors (for example, healthcare) retained a strong appetite for outbound acquisitions in 2022, resulting in deal values outperforming 2021 almost threefold despite the weakened yen. Combined with the trend among Japanese companies of continuing to sell non-core businesses to refocus business strategies and, ultimately, dispose of costly assets, and companies starting to look beyond China to gain access to Asian markets, this positions Japan extremely well for future M&A activity.
The private equity market in Japan remains strong. With funds focused on investing in the Japanese domestic market growing, coupled with comparatively low interest rates in Japan, borrowing for deals is affordable. This catalyses interest from overseas financial investors and, as we saw in 2022, most often in Japanese company carve-out deals.
Developments at the Tokyo Stock Exchange
With the exception of the energy sector, which has continued to show interest in acquisitions, the weakened yen makes it unclear when other Japanese companies will resume outbound deals at pre-pandemic levels. As for special purpose acquisition companies, the Tokyo Stock Exchange (TSE) has held study group meetings, and announced a summary in February 2022, but there has been no progress since then.
On April 4 2022, the TSE reorganised its markets into a “Prime Market”, a “Standard Market” and a “Growth Market”, but allowed some companies that do not meet the listing criteria for a specific market to remain for a transitional period. On January 25 2023, the TSE announced that the transitional period will end in March 2025. As of December 2022, there are:
1,838 companies on the Prime Market;
1,451 companies on the Standard Market; and
516 companies on the Growth Market.
Among them, 269 companies on the Prime Market, 200 companies on the Standard Market, and 41 companies on the Growth Market, accounting for 13.4% of listed companies, do not meet the relevant listing criteria. These companies are required to take certain actions to remedy their deficiencies. Some may go private in collaboration with financial investors.
Legislation and policy changes
The Financial Services Agency (FSA) and the Japan Fair Trade Commission (JFTC) are the key regulatory authorities in Japan that govern M&A activities.
The FSA is responsible for enforcing the Financial Instruments and Exchange Act (FIEA), and the JFTC is responsible for enforcing the Act on Prohibition of Private Monopolization and Maintenance of Fair Trade. After the implementation of the amendment of the Foreign Exchange and Foreign Trade Act in 2020, a foreign direct investment in 1% or more of a listed Japanese company engaging in certain covered businesses relevant to national security may require prior approval from the relevant ministries.
Companies Act requirements also affect M&A activity in Japan. Publicly listed companies are subject to the applicable rules and regulations of the stock exchange where their shares are listed.
Tax reform proposals were announced on December 16 2022 and will be implemented in stages from the 2024 Japanese fiscal year. The proposed tax reforms aim to increase investment in markets, industries, and people. The reforms also include amendments to tax incentives. These amendments target the promotion of open innovation, which will allow certain M&A to be eligible for such tax incentives.
On the global front, a global minimum tax that will be aligned with the OECD pillar two initiative will be implemented on April 1 2024, which will reduce international corporate tax competition in the hope of creating in a more level playing field.
The 2023 tax reform includes a tax deferral for shareholders affected by a ‘partial spin-off’ deal where less than 20% of the shares in the spun-off company continue to be held by the previous parent company, which aims to promote business divestment. This tax deferral benefit was initially planned to continue until March 2024, but the Ministry of Economy, Trade and Industry (METI) plans to request in the summer of 2023 that this benefit become permanent.
Increased focus on ESG
The importance of sustainability management in Japan continues to grow, as evidenced by the 2021 revision of the Japanese Corporate Governance Code and the 26th UN Climate Change Conference. In September 2022, METI released the Guidelines on Respecting Human Rights in Responsible Supply Chains, which encourage, as a best practice, Japanese companies to conduct human rights due diligence in their supply chains. This has led to Japanese companies – both buyers and sellers – engaging in longer due diligence and negotiations as companies make sustainability management a pillar of their management policies and business strategies.
In 2022, the Working Group on Corporate Disclosure of the Financial System Council, an expert council established under the FSA, published a report (the Report) on the proposed reform of corporate disclosure obligations for Japanese public companies. The Report emphasised:
The importance of reforms on non-financial disclosures by public companies;
The abolition of first-quarter and third-quarter securities reports under the FIEA due to overlapping quarterly disclosure rules of the Japanese stock exchanges; and
The expectation that Japanese public companies listed on the Prime Market of the TSE disclose English versions of sections addressing accelerated share repurchase programmes (especially risk factors), management discussion and analysis, corporate governance, and the status of shareholdings.
On January 31 2023, the FSA implemented an amendment to the Cabinet Ordinance, which requires the disclosure of information relating to sustainability, human resources, diversity and climate change, and more detailed disclosure about cross shareholdings, in annual securities reports. These reforms will affect buyers and target companies and the way they approach evaluations and negotiations.
Practice insight/market norms
Japanese companies are embracing remote negotiations and dealmaking, and to support these efforts, Japanese companies are investing in technology and updating their internal management practices. This is a markedly different approach from how Japanese companies behaved in the past. Buyers and investors should keep in mind that Japanese companies, perhaps in response to COVID and to pressures from global trends, are increasingly shifting their approach to dealmaking.
A sometimes overlooked set of issues for parties involved in deals with Japanese companies is post-merger integration (PMI). While many large consultancy firms offer PMI advice, in some cases Japanese companies may hesitate to request, or do not fully appreciate the value of, PMI advice that can help Japanese companies with the integration of overseas assets, operations, and personnel, which is where Japanese companies have historically experienced difficulties. Addressing PMI planning early on in the deal can help to prepare all parties and support the dealmaking process.
Technology became more critical in the dealmaking process during COVID, especially for Japanese companies that generally prefer face-to-face negotiations and on-site visits. Notably, communications technology has been embraced and used in lieu of in-person meetings. Even as we head into a post-pandemic era, Japanese companies largely remain comfortable using the same remote communication tools and methods developed during COVID.
In Japan, the primary means to obtain control of a public company are:
A stock purchase;
A stock-for-stock exchange;
The issuance of new stock;
A business transfer; and
A company split.
Furthermore, in a merger or stock-for-stock exchange situation, the target company must obtain an independent opinion that the contemplated merger or stock-for-stock exchange is not disadvantageous to its minority shareholders.
Shareholder activism has increased in Japan in recent years, in part as a result of the Japanese government’s policies encouraging dissolving cross shareholdings. Shareholder activists often urge companies to carve out non-core or non-profitable businesses, and distribute excess cash to shareholders, and it is increasingly common for Japanese companies to undertake a deal proposed by a shareholder activist.
A public takeover offer bid must be conducted in accordance with the FIEA. In addition, it has become more important to comply with various recommended procedures discussed in METI’s Guidelines that are designed primarily to address management buyouts and acquisitions by a controlling shareholder. In practice, the guidelines are taken into account in other public takeover offers as well.
The TSE’s amendment to the Corporate Governance Code also establishes high-level corporate governance standards that are seen to support the TSE’s establishment of new market segments. Some examples include:
Having a minimum of one-third outside directors;
The creation of management appointment committees; and
Ensuring diversity among key employees.
There is no COVID-related legislation that has an impact on this area. In 2021, a number of Japanese court decisions addressed the validity of takeover defence measures adopted by listed companies confronting hostile takeovers. Notably, the decision of Japan’s Supreme Court in a case between Tokyo Kikai Seisakusho Ltd. (TKS) and its top shareholder, Asia Development Capital (ADC), may have made it easier for Japanese companies to invoke a ‘poison pill’ defence against a hostile takeover.
TKS held a vote among its shareholders on whether to dilute ADC’s 40% stake in TKS, but excluded ADC from the voting process and the shareholders ultimately voted to issue new warrants to dilute ADC’s 40% stake. ADC filed for an injunction, claiming that such exclusion infringed on shareholder equality by excluding ADC from the vote. However, the lower courts determined that TKS’s actions were legitimate as the vote was used to assess whether the acquisition by ADC would hurt the interests of other shareholders, and this decision was ultimately upheld by Japan’s Supreme Court.
ADC built its stake in TKS through on-market trades, which fall outside the takeover bids (TOB) rules. On March 2 2023, the FSA announced that it would consider an amendment to the TOB rules to determine whether they apply to on-market trades.
The inclusion of break fees has steadily increased but they are still comparatively rare and even if a break fee is included in the deal terms, Japanese courts may not uphold a break fee on the ground that it goes against public interest if the amount is determined to be unreasonably high. While permitted, reverse break-fee arrangements have not gained much traction in Japan.
Earn-out clauses are still relatively rare in Japanese M&A deals and are generally only used in cross-border or large-scale transactions. The Japanese government, through METI, published a “Research Paper on M&A between Large Companies and Start-ups” in March 2021 that introduced the concept of using earn-out clauses when a company’s future performance is unpredictable and when an R&D-focused company has a high degree of uncertainty in achieving its performance goals. As such, Japan may begin to experience an increase in the inclusion of earn-out clauses in private M&A deals.
The FIEA tender offer rules do not apply to private company acquisitions as the target securities are not subject to the reporting requirement under the FIEA. Cash offers are dominant among private takeover offers. In place of a takeover offer, a company reorganisation (such as a merger, a statutory share-for-share exchange, a share-for-share transfer, or a company split), or a squeeze-out by way of reverse share split, is also frequently utilised.
Usually, the parties select the laws of Japan because agreements remain subject to certain mandatory provisions of the Companies Act, regardless of the choice of law. This choice of law provision is frequently seen in arbitration clauses, which also select Japan as the arbitral seat, or in other dispute resolution provisions.
In October 2022, a so-called business court was established in Tokyo, by combining the Intellectual Property High Court with certain departments of the Tokyo District Courts that had jurisdiction over commercial cases and insolvency cases. The aim in forming this court was to provide a venue to deal with the internationalisation and complexity of commercial cases involving overseas business.
There were very few large-scale IPOs in Japan 2022. The reduced number resulted from lowered activity among large foreign institutional investors. The impact of the invasion of Ukraine, global inflation, and monetary tightening causing the Japanese market to slump led foreign institutional investors to pursue less-risky investments. This – combined with cases where IPO prices were set too low, causing the IPO to fail to meet listing criteria – meant the amount of funds raised through 2022’s IPOs was on the lower side compared with recent trends.
However, despite the lack of large-scale IPOs and relatively low total amount of funds raised, there were 91 IPOs in 2022, which is close to the average figure over the prior 10 years.
In response to concerns raised by the government in June 2021 relating to IPO pricing mechanisms (for example, deep discount of an IPO price as compared with the post-IPO stock price), regulatory reform has been under way. This has included amending the relevant rules of the Japan Securities Dealers Association and the TSE listing rules, which is expected to improve and shorten the IPO process in Japan.
A steady increase of interest among overseas private equity funds is likely to continue in the Japanese market in 2023, despite a general decrease of private equity investments in the Asia-Pacific region. Japanese companies will likely continue to divest non-core businesses and refocus their resources on a few core pillars and seek to improve their balance sheets.
Law firms and companies alike should be prepared to answer questions on growth strategy and how M&A can help to accelerate growth.