Japanese commercial banks, trust banks and government-related banks are major players as senior lenders. In particular, a substantial volume of Japanese acquisition finance is provided by Japan’s three mega banks:
The early period of Japanese acquisition finance saw US and European-based banks playing bigger roles, but fewer non-Japanese banks are currently active in the Japanese acquisition finance market.
Certain Japanese mezzanine funds, bank subsidiaries and lease companies are major players as mezzanine financers. The mezzanine funds include:
Recently, the three mega banks have started participating in mezzanine financing for large-cap deals.
The mandated lead arrangers of senior loan facilities for acquisition finance in Japan are predominantly the three Japanese mega banks and several other corporate banks, such as Sumitomo Mitsui Trust Bank, Ltd., SBI Shinsei Bank, Ltd., Resona Bank, Ltd., Aozora Bank, Ltd. and Kiraboshi Bank, Ltd. Corporate loans are also widely arranged by local banks and corporate banks other than the mega banks, as well as by the mega banks.
The local banks recently came to the acquisition finance market as mandated lead arrangers for small to mid-sized deals in particular.
There is no noteworthy geopolitical impact on LBO finance deals.
The effect of the COVID-19 pandemic on new LBO finance deals has been limited, but has had a more severe impact on the existing LBO borrowers.
In those industries that have been significantly affected by COVID-19, borrowers have been in difficult financial situations and have occasionally had to take measures such as:
Japanese law will always govern pure domestic transactions, regardless of whether they relate to a corporate loan or to acquisition finance. Where the lenders are foreign financial institutions, however, the loan facility agreements may be governed by English or New York law. If the secured assets relate to a jurisdiction other than Japan, the governing law of the security agreements may be the law of that jurisdiction, depending on the applicable conflict of laws rules.
In pure domestic transactions, there is no official form for definitive agreements for senior facilities of acquisition finance; however, in practice, many lenders in the market use a form based on the model syndicated loan agreement form published by the Japan Syndication and Loan-trading Association (JSLA), which is predominantly used for corporate loans.
In cross-border transactions in which the lenders are Japanese mega banks, the globally used forms are becoming more common. When the buyer is a US or European private equity fund, the LMA form is sometimes used (although the governing law is the law of Japan) and sometimes they use their own form, incorporating some globally used terms (such as certain funds) into the Japanese-style form. When the target company is based in jurisdictions where the LMA forms are commonly used, such as the UK, the loan agreement is usually drafted based on the LMA form.
The controlling language of definitive agreements is usually Japanese. However, when globally used forms are adopted, English is used as the controlling language (although the governing law is the law of Japan).
Legal opinions are almost always required to be issued by the borrower’s counsel. Mandated lead arrangers usually request the borrower’s counsel to cover the following items:
Usually, only senior loans are used for debt financing. However, if the deal is large or the leverage of the deal is high, mezzanine finance is used for the debt financing, in addition to the senior loans.
Senior loans usually consist of Term Loan A, Term Loan B and a revolver. A capital expenditure (CapEx) line is only used occasionally. Term Loan A is fully amortised, while Term Loan B is paid at maturity in lump sum. Term Loan A and Term Loan B are used to finance the closing of the acquisition, refinancing and the transaction costs. The revolver is used to finance working capital. The term is typically five to seven years. Financial covenants typically include:
An unusual feature of the syndication market is that investors typically participate in all tranches on a pro rata basis, although this may change in the future. Credit ratings for acquisition finance loans by rating agencies are not yet common in Japan.
Senior loans are secured by a security package.
Mezzanine financing is provided by way of non-voting preferred shares or subordinated loans.
The preferred shares used for acquisition financing are usually non-voting, cumulative and non-participating shares, because the intention of mezzanine investors is to secure the agreed spread. In addition, to secure the mezzanine financer’s position, conversion rights to the voting shares are usually attached to the preferred shares so that the financer can exercise the conversion right and seize control of the company in the event of the company’s financial distress. In addition, it is common for redemption rights to be granted to the mezzanine financer to secure its exit.
Since dividends to shareholders are paid out after the company repays all creditors of the company, the mezzanine financer – as a preferred shareholder – is structurally subordinated to the senior lenders.
Subordinated loans are secured by a security package, which is almost the same as the security package for senior lenders except that it is second-ranking, subordinate to the first-ranking securities created for senior lenders. The subordinate nature of the subordinated loans is also created through an intercreditor agreement among senior lenders, mezzanine financers and the borrower.
Bridge loans are not commonly used in the context of acquisition finance.
Bonds are not commonly used in the context of acquisition finance. One of the reasons for this is that, if secured bonds are used, an issuer of secured bonds is required to comply with a range of regulations under the Secured Bond Trust Act (Act No 52 of 1905), which are costly and burdensome.
A high-yield bond market has not yet developed in Japan and, as such, high-yield bonds are not used to finance acquisitions.
Since loans for acquisition finance typically do not accompany an issuance of notes, loans are receivables and do not fall under the definition of securities under the Financial Instruments and Exchange Act (Act No 25 of 1948) (FIEA), which is the Japanese securities law. Accordingly, private placement rules are irrelevant.
On the other hand, preferred shares used for mezzanine financing are securities, and the issuer typically relies on the small number private placement, which limits the number of offerees of solicitation to fewer than 50.
In Japan, asset-based financing is rarely included in the tranches of LBO finance. LBO lenders usually see the asset owned by the target company as a part of the security package for the LBO finance, and take the value of such asset into consideration when they decide on the debt capacity.
If mezzanine finance is provided in the form of a subordinated loan, an intercreditor agreement is almost always executed between the borrower, the senior lenders and the mezzanine financers.
It is very common to use contractual subordination arrangements, which are achieved by entering into an intercreditor agreement between the borrower, the senior lenders and the mezzanine financers. The contractual subordination arrangement is valid only among these parties, and cannot be claimed against third parties such as general creditors.
Another way to create the contractual subordination of the subordinated loans is to make the subordinated loan a statutory subordinated claim by agreement between the borrower and the mezzanine financers. Such statutory subordinated claims were introduced in 2005 by amendments to:
However, since statutory subordinated claims are subordinate even to general claims under the insolvency procedures, in practice the mezzanine financers do not prefer them and they are not used for mezzanine loans in acquisition finance.
Structural subordination whereby the mezzanine financer provides loans to a holding company of the borrower was historically rarely used in Japan, since the mezzanine finance player in Japan usually sought a position that was at least equal to the general creditors (in a structural subordination arrangement, the position of the mezzanine financer is inferior to the general creditors and equal to the equity holders). However, due to strong demand from private equity funds (especially US or European private equity funds), structurally subordinated mezzanine loans (usually called HoldCo loans) are starting to be used more frequently.
Payment of Principal
Usually, the agreement provides that the maturity of the principal payment of the subordinated loans must be six months or one year later than the maturity of the senior loans. If the senior loans are not fully repaid at the time of maturity of the subordinated loans, the principal of the subordinated loans will not become due and payable until the senior loans are fully repaid.
Usually, the agreement provides that:
If an event of default under both the senior loan agreement and the mezzanine loan agreement occurs, or if any breach of certain financial covenants occurs, a common negotiation point is whether mezzanine financers may accelerate the mezzanine loan after the expiration of a certain agreed period of time (standstill period).
In practice, in Japan, an upfront fee is paid to the mezzanine financer only at the time of the drawdown of the subordinated loans under a fee letter. Therefore, there is no provision relating to the payment of such fees in the intercreditor agreement.
Under Japanese law, it is generally possible to grant ranks of security interest, so it is common for only second-rank security interests to be given to the mezzanine financer. If the enforcement of the security interests is conducted through statutory enforcement procedures, no distribution is made to the second-rank security interest holders until and unless the first-rank security interest holders are fully repaid. However, this distribution rule does not apply if the enforcement of the security interests is conducted through private auction or private sale. Therefore, it is common for the intercreditor agreement to provide that the mezzanine financer must release its second-rank security interests if the security interests are enforced through private auction or private sale, and the senior lenders request this.
In addition, if any distribution is made to the mezzanine financer before the full repayment of the senior loans, it is usually provided under the intercreditor agreement that any such distributions received by the mezzanine financer must be turned over to the senior lenders.
Subordination of Equity/Quasi-equity
It is common for the senior lenders and the mezzanine financers to enter into an intercreditor agreement, even where the mezzanine finance is provided in the form of preferred shares. The dividend claims or the monetary claims arising from the exercise of the redemption rights of the preferred shares are treated as the subordinated claims under the intercreditor agreement. Usually, the agreement provides that:
As mentioned in 3.4 Bonds/High-Yield Bonds, a high-yield bond market has not yet developed in Japan, and therefore bank/bond deals do not exist.
In the Japanese acquisition finance market, it is not a prerequisite for borrowers to enter into interest rate swap arrangements, unlike in the EU/US market. Because of this, hedge counterparties are typically not parties to intercreditor agreements in the Japanese market.
Types of Security
A grant of one security interest over all of a borrower’s assets is called "corporate collateral" (kigyo-tanpo-ken) in Japan, but corporate collateral is not used in acquisition finance transactions. One reason for this is that the use of corporate collateral is limited by statute to secure corporate bonds only, which are not commonly used for acquisition finance in Japan. Another weakness of corporate collateral is that, as a general security interest, it is subordinated to other types of security interests that are created on more specific assets. Accordingly, a lender who holds corporate collateral cannot assert priority over a creditor who subsequently obtains a security interest over particular assets, which makes corporate collateral inappropriate for the purpose of acquisition finance.
Due to the weakness of corporate collateral, an acquisition finance lender in Japan usually creates security interests over each asset of the target and its wholly owned subsidiaries, and perfects these security interests. As opposed to the use of floating charges in other jurisdictions, this process incurs extra time and costs in completing the creation of the security interests and their perfection.
There are various kinds of security interests under Japanese law, such as:
The kind of security interest used depends on the type of assets. As another classification, if the secured loan is a revolving facility, revolving security interests (such as revolving pledges – ne-shichi-ken) are used; if the secured loan is a non-revolving facility such as a term facility, ordinary (non-revolving) security interests (such as ordinary pledges – futsu-shichi-ken) are used.
The lenders typically create a pledge over shares.
First, when the issuer of the shares is not a listed company and the articles of incorporation of the issuing company provide that share certificates are to be issued, the execution of a pledge agreement and delivery of the share certificates to the pledgee are required in order to create the pledge. Continuous possession of the share certificates by the pledgee is then required in order to perfect the pledge against the issuing company and third parties. Usually, the security agent receives delivery of the share certificates and keeps them as proxy for all the pledgees.
Second, when the issuer of the shares is not a listed company and the articles of incorporation of the issuing company do not provide that share certificates are to be issued, the execution of a pledge agreement is sufficient to create the pledge. The pledge must be recorded in the share ledger in order for it to be perfected against the issuing company and third parties.
Third, if the issuer of the shares is a listed company, the pledge becomes effective when the pledgee has the increase in the number pertaining to the pledge described or recorded in the pledge column of the pledgee’s account through application for the book-entry transfer (the Act on Book-Entry Transfer of Corporate Bonds and Shares (Act No 75 of 2001)).
A pledge of shares of partially owned subsidiaries, such as joint ventures, may require the other shareholders' consent, as this is typically required by the shareholders’ agreement.
See Receivables, below. One additional note on bank account receivables is that, while a credit party can validly create a pledge over its receivable with respect to a fixed deposit account, it is unclear under Japanese law whether a credit party can validly create a pledge over its receivable with respect to an ordinary savings account because the deposits vary over time through withdrawals, transfers and additional deposits.
Receivables (such as trade receivables and bank account receivables) are included in the security package by the use of a pledge or by creating a security interest by way of assignment.
The execution of a security agreement is sufficient to create either a pledge or a security interest by way of assignment. Before the amendments to the Civil Code (Act No 89 of 1896) that came into force on 1 April 2020, if the underlying contract prohibits the assignment of the receivables or the creation of a security interest over the receivables (Non-assignable Receivables), it was necessary to obtain the third-party debtor’s consent in order to legally and validly create a pledge or a security interest by way of assignment; as such, the lenders usually excluded such Non-assignable Receivables from the security package. Currently, after the enforcement of the amendments to the Civil Code, the lenders are able to legally and validly create a security interest over the Non-assignable Receivables without obtaining the third-party debtor’s consent. However, since such creation of security still constitutes the borrower’s breach of the underlying contract, the lenders usually allow exclusion of the Non-assignable Receivables from the security package, imposing an obligation to use commercially reasonable efforts to amend the underlying contract to remove the non-assignment covenant on the borrower.
There are three ways to perfect either a pledge or a security interest by way of assignment against third parties (other than third-party debtors):
There is no additional requirement for notice or consent to perfect either a pledge or a security interest by way of assignment against the third-party debtor (rather, notarisation is not required for this purpose). However, for registration under the Registration Act, it is necessary to also deliver a certificate of registration to the third-party debtor in order to perfect either the pledge or a security interest by way of assignment against the third-party debtor.
If the third-party debtor is located in a foreign jurisdiction, it is recommended that perfection be made both in Japan and in the foreign jurisdiction. This is because the local conflict of laws rules in the foreign country might require the security holder to comply with the perfection process in the jurisdiction in order to enforce the security interest there.
It is possible to create a security interest by way of assignment over future receivables. However, following a series of Supreme Court decisions from 1999 onwards, creating a security interest on future receivables by way of assignment is only valid if the scope of receivables to be assigned is clearly stated in the security agreement, by specifying, among other things:
In addition, although there is no specific Supreme Court decision, it is widely believed that creating a pledge over future receivables is also possible.
Intellectual property rights
Intellectual property rights may be included in the security package by use of a pledge, or by creating a security interest by way of assignment. However, since the assignee of a security interest over intellectual property is subject to a risk of infringement by the secured intellectual property, the lenders tend to avoid using the security interest by way of assignment.
For trade marks and patents, the execution of a pledge or assignment agreement and the registration of such is required in order to create and perfect the security interest. However, for copyrights, only the execution of a pledge or assignment agreement is required to create the security interest, and registration is required for perfection against third parties. A registration tax of 0.4% of the amount of the secured claim is imposed when registering the security interest over registrable intellectual property rights, which tends to be costly, so measures to mitigate the registration tax are often used in practice.
Lenders typically create mortgages (teitou-ken) over owned real property.
The execution of a mortgage agreement is sufficient to create a mortgage, and the registration of the mortgage is required in order to perfect the mortgage against third parties. The mortgage agreement is typically drafted to additionally create security interests over the proceeds from the real property. For example, a typical mortgage agreement creates a pledge over any future claim of fire insurance proceeds in connection with the real property. A registration tax of 0.4% of the amount of the secured claim is imposed when creating a mortgage over a real property asset, which tends to be costly, so measures to mitigate the registration tax are often used in practice.
Movable assets (including inventory) are typically included in the security package by creating a security interest by way of assignment.
The execution of an assignment agreement is sufficient to create a security interest by way of assignment. To perfect the assignment against third parties, the borrower must deliver possession of the movable assets to the security interest holder, but the borrower can constructively deliver them by:
As an alternative, under the Registration Act, the security interest holder can perfect the assignment against third parties by registering the transfer with the competent legal affairs bureau.
The lenders can perfect a security interest by way of assignment over not only particular assets but also a group of movable assets (including future ones, such as inventory in a particular storehouse), provided that the scope of the movable assets subject to the security is clearly specified.
In the case of movable assets, perfection is not sufficient to block a bona fide third party from obtaining the right to the movable asset from the borrower by statute (sokuji shutoku). To avoid this, the security interest holder should have a notice indicating the creation of the security interest attached to the movable assets.
Generally, there is no statutory requirement with regard to forms such as deeds for security agreements. However, for mortgages created over real property, a deed with enforcement acceptance language will enable lenders to enforce the mortgage without obtaining a court decision.
Please see 5.1 Types of Security Commonly Used.
There is no specific restriction on providing upstream security in Japan. While the directors of the security provider are subject to fiduciary duty, providing security over a subsidiary’s assets to its direct or indirect parent company in acquisition financing does not contradict the fiduciary duty of the subsidiary’s directors if and to the extent the subsidiary will receive direct and indirect benefits, such as financing through intercompany loans, from the acquisition financing as a group company of the parent. On the other hand, if the subsidiary is directly or indirectly wholly owned by the parent (or if all the minority shareholders consent to the creation of a security interest over the assets of the relevant company), the interests of the parent and the subsidiary align completely, and the fiduciary duty of the subsidiary’s directors does not matter in terms of providing upstream security.
There is no statutory financial assistance restriction in Japan. However, the same discussion on the directors’ fiduciary duty as noted under 5.4 Restrictions on Upstream Security applies to providing security interests on behalf of the acquirer.
In the typical LBO structure, the target does not provide any security interest to the lenders until the target becomes the wholly owned subsidiary of the borrower acquisition vehicle.
Please see 5.4 Restrictions on Upstream Security.
Statutory enforcement will be implemented pursuant to the Civil Enforcement Act (Act No 4 of 1979), and the law provides specific methods of enforcement for each type of asset. However, in practice, the enforcement of security created for acquisition financing is primarily not supposed to be implemented by statutory method, but rather by way of private disposition. The security agreements and the intercreditor agreement typically provide the agreements among the parties when they proceed with the private disposition of the security assets, such as general guidelines on the sales price, how to proceed with the auction process, and the repayment waterfall. Having said that, it is still very rare for securities created for acquisition financing to actually be enforced in Japan.
Joint and several guarantees are typically provided by each credit party other than the borrower because they extinguish any structural subordination and make it possible to collect the loans from each credit party by way of set-off.
Providing a guarantee is also subject to the directors’ general fiduciary duty. In principle, providing guarantees for the benefit of directly or indirectly wholly owned or wholly owning companies does not raise a fiduciary duty issue because the interests of the guarantee receiver and the guarantor are deemed to be aligned. However, providing a guarantee for the benefit of another group company without receiving corresponding benefits (such as guarantee fees or financing through intercompany loan) or obtaining consent from all the shareholders raises a fiduciary duty issue.
Other than the directors’ general fiduciary duty, there are no restrictions on upstream guarantees or financial assistance as seen in other jurisdictions.
Please see 6.2 Restrictions.
In Japanese terminology, lenders’ liability in the broad sense means any liability of a financial institution in connection with its lending in the process of negotiation, closing, administration and collection. The lenders’ liability in the narrow sense means the liability of a financial institution due to its excessive control of the borrower. There have been many court precedents about the former and a couple about the latter, but these are lenders’ general obligations, and no special consideration on lenders’ liability in the context of acquisition finance has yet been actively addressed in Japan. The application of equitable subordination rules to acquisition financers has also not been actively discussed in Japan.
Unlike in the US, the claw-back risk for LBO lenders under insolvency procedures in cases where a target company of a certain acquisition that has closed by using the proceeds of LBO finance goes into bankruptcy because of the heavy debt under the LBO has not been actively discussed in Japan.
The types of documents to which stamps must be affixed and the amount of stamp tax for each such document are provided in the Stamp Tax Act (Act No 23 of 1967). In a term loan agreement, a stamp is required on each original copy, in the amount of JPY600,000 if the amount of the loan is JPY5 billion or more. In the case of a revolving loan agreement, a stamp is required on each original copy, in the amount of JPY200. If any original copy of a loan application is issued, the same tax will be applied, so typically the loan application is submitted to the lenders by facsimile or by email (on which tax will not be imposed because it is a copy for the purpose of the Stamp Tax Act). For guarantee agreements, a stamp is required on each original copy, in the amount of JPY200. For securities agreements, a stamp is required on each original copy if the agreement falls under a continuous agreement defined under the Stamp Tax Act in the amount of JPY4,000.
Under Japanese domestic tax laws, the interest payable by the borrower to a foreign lender would be subject to withholding tax at a rate of 20.42%. Such withholding tax can be reduced or exempted under applicable tax treaties where the conditions for treaty benefits are met.
Japanese thin-capitalisation rules are applicable to interest that is:
A certain portion of such interest would not be deductible if both the gross amount of debts (whether interest-bearing or not) owed by a domestic entity exceeds three times the amount of capital of the domestic entity, and the gross amount of debts owed by a domestic entity to its foreign controlling shareholders and such third-party lenders exceeds three times the amount of capital of the domestic entity multiplied by the ownership percentage of the foreign controlling shareholders.
In addition to the thin-capitalisation rules, Japanese tax laws also contain earning-stripping rules, which would generally deny the deduction of interest if and to the extent that the total amount of the interest that is paid to (both related and third-party) lenders and not subject to Japanese taxation at the hands of the recipients exceeds 20% of EBITDA of the domestic entity as calculated for this purpose.
Certain industries are heavily regulated in Japan, including financial services, aviation, transportation, telecommunications, broadcasting companies, securities exchanges and utility companies. The laws that regulate these businesses often require prior approval from, or advance notice to, the regulator for a change of control or other types of acquisition.
In addition, the Foreign Exchange and Foreign Trade Act (Act No 69 of 1951) (FEFTA) requires a foreign acquirer to obtain advance approval from the government and to be subject to a 30-day waiting period (unless shortened) before being able to acquire shares in a Japanese company whose business relates to:
Certain exceptions were introduced in 2019 in case the foreign acquirer satisfies certain requirements, which vary depending on whether the target business is a “core business’” as defined in the FEFTA or not. The competent Japanese authorities may issue a recommendation or order the amendment of the terms of the acquisition, or even suspend it. The only example to date of a Japanese authority suspending an acquisition occurred in 2008 when London-based hedge fund The Children’s Investment Fund (TCI) was ordered to refrain from acquiring up to a 20% stake in J-Power, a domestic electricity company that operates power plants, including nuclear power plants. This was because there was a concern that TCI’s shareholding could negatively affect the supply of electricity and the nuclear power policy in Japan, and thereby potentially endanger public order. In addition, the FEFTA more broadly requires ex post facto reports for share acquisitions conducted by foreign investors, but such reports are mere formalities.
Effect on Transaction
When the target is conducting a regulated business, it may affect the terms of the acquisition finance. For example, obtaining the necessary regulatory consent may be added as a condition precedent and some of the assets owned by the credit parties may not be provided as security.
Specific Regulatory Rules
Where the target is listed, the acquirer must follow the mandatory tender offer rules under the FIEA, which apply to the following:
In addition, where the holding ratio of the acquirer reaches two-thirds or more after acquisition, a tender offer is always required, and the tender offeror must purchase all classes of equity securities of the target offered in the tender without setting any limit on the number and the class of shares to be purchased (commonly known as the two-thirds rule).
Methods of Acquisition
If a tender offer is required for an acquisition, the tender offeror must file a tender offer registration statement with the regulator, describing a wide variety of matters, including:
To support the existence of funds to close the tender offer, the tender offeror is required to attach the following to the tender offer statement:
The Financial Services Agency of Japan (FSA) has published its view that such certificates must be supported by a certainty of funding and has provided examples of what will be required of such certificates in order to support a certainty of funding. The FSA also requires full disclosure on such certificates of the conditions precedent provided in the commitment letters. Generally speaking, the FSA’s view on certainty of funding is less restrictive than the "certain funds" requirements in the UK. In particular, business and market material adverse change provisions that are usually included in the commitment letters from banks are not viewed as impairing the certainty of funding.
Two methods are typically used in order to squeeze out minority shareholders following a tender offer. The first method uses stock consolidation and requires a special resolution (requiring a two-thirds voting majority) at a shareholders’ meeting. The second method is a statutory squeeze-out procedure. While this method is available only to a controlling shareholder holding 90% or more of the voting rights of its subsidiary, its process is simpler and does not require a shareholdersmeeting (a board resolution suffices), significantly expediting the squeeze-out process.
Although a squeeze-out transaction can still be completed by securing two-thirds through a stock consolidation, it does not necessarily mean that the transaction will not be blocked by minority shareholders. While no reliable court precedents yet exist in this regard, the general understanding is that a cash-out transaction can be blocked if the relevant shareholders' resolution was made as a result of an abuse of rights of the majority shareholders, thereby making that resolution extraordinarily unfair. The most important factor to measure such extraordinary unfairness is the fairness of the purchase price offered to the minority shareholders. A high holding ratio of the majority shareholders after the tender offer would also be a significant factor.
Minority shareholders also have appraisal rights under the Companies Act, and exercising such rights is the most practical recourse for minority shareholders who are not satisfied with the purchase price. With an appraisal right, minority shareholders may request the target to purchase their shares, and a fair purchase price is determined by the courts if no agreement is made between the minority shareholders and the target. In some lawsuits, the courts have decided in favour of minority shareholders. The rules are gradually being established, but how the courts will decide future cases is not yet perfectly predictable due to a lack of abundant precedents.
Unlike in the USA or Europe, the number of players in the LBO loan market is limited in Japan, and the secondary market for LBO loan has not yet matured. For example, hedge funds that invest mainly in distressed debts are not active in Japan. Because of this, an exit by assigning the loan receivables in case of the borrower’s default is usually not a practical option for LBO lenders in Japan. Rather, the lenders usually have to give a waiver for an event of default to the borrower in exchange for requesting additional capital injection from the sponsor or adding or tightening the borrower’s covenants. In such context, LBO lenders in Japan tend to broadly scrutinise the borrowers’ business, assets and governance, and make their initial lending decisions very deliberately.
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Year in review
The leveraged buyout market in Japan has remained active throughout the COVID-19 pandemic. Recent transactions include a number of divestitures or carve-outs by Japanese conglomerates of their assets or non-core businesses to global and domestic private equity (PE) funds and other third parties. These transactions take a number of forms, including the sale of shares in subsidiaries (both private and public) that operate such non-core businesses or otherwise. Although the global pandemic resulted in a temporary slowdown in M&A activities, the market has made a robust recovery, led by foreign investors with surplus funds against the backdrop of a depreciating yen and a relatively low interest rate environment in 2022.
According to a research report published by Japan Buyout Research Institute Corporation, there were:
Additionally, some of the aforementioned are followed by refinancing or recapitalisation after the closing.
Notable market trends
Upon closer examination, the data reveal three primary trends:
The Japanese market has also seen a growing number of privatisations by way of tender offers. Some of these transactions have been initiated by PE funds, which tend to look at potential enterprise values as opposed to current share prices. In some other cases, tender offers were made by the management of target companies (ie, management buyouts) with co-investments from third parties, including PE funds.
Additionally, the number of M&A transactions triggered by business succession concerns is on a steep uptrend, and in recent years these have accounted for approximately half of the total number of buyout transactions in Japan. A number of business succession transactions also involve leveraged finance from financial institutions such as banks and private equity funds.
Residual influence of COVID-19
Since 2020, due to the global pandemic, numerous portfolio companies have been facing financial difficulties. Consequently, many have had to seek waivers of their financial covenants under the terms of their existing leveraged financing, or procure emergency credit facilities from banks. In some cases, portfolio companies, including those with some of the largest-scale leveraged financings in Japan, have been forced into bankruptcy or civil rehabilitation. Due to this development, the terms of financing offered by lenders, including minimum equity requirements, interest margins, upfront fees and financial covenants, have become more stringent compared to the pre-COVID era.
There are signs that lenders, including the Japanese “mega banks” (MUFG Bank, Sumitomo Mitsui Banking Corporation and Mizuho Bank) are now gradually returning to pre-pandemic lending terms, but they are still seeking various ways to transfer credit risk. A large number of leveraged financing transactions consist of “club deals” due to the limited number of market participants in the Japanese market, but for middle-to-large cap deals in particular, syndication is a key to a successful arrangement of leveraged financing.
Mezzanine holdco finance
In Japan, multiple tranche senior loans (with both amortisation and bullet repayment features) are the most typical method by which to finance leveraged acquisitions. Mezzanine financing is also a valid option for sponsors wishing to limit the amount of their equity contributions. Typically, mezzanine financing is provided in the form of subordinated loans or preferred shares (whether convertible or otherwise).
Over the last few years, with more sponsors seeking higher leverage or opportunities for recapitalisation before full repayment of senior loans, mezzanine loans to the holding companies of borrowers in senior loans have been gaining in popularity. Often, the main source for repayment of such holdco mezzanine loans comes from the proceeds of an IPO or a trade sale of shares in the target (including its management companies). In this regard, an overseas shareholding vehicle, such as a limited partnership organised in the Cayman Islands is often designated as the borrowing entity of such holdco mezzanine loans.
Such holdco mezzanine loans are structurally subordinated to senior loans, as a result of which no intercreditor agreement is generally required between senior lenders and holdco mezzanine lenders. While the structure of holdco mezzanine loans varies depending on the time at which such holdco mezzanine loans are obtained, it is often the case that no security interest over shares in the senior borrower or target group companies is created in favour of the lenders of holdco mezzanine loans, in order to avoid any conflict with security interests in favour of senior lenders. In some transactions, lenders have the right to require a borrower to dispose of its shares in the senior borrower upon the occurrence of an event of default, to the extent that the exercise of such mandatory disposal right does not conflict with the interest of the senior lenders.
Adoption of LMA-Based Facility Terms
In the Japanese market, a substantial part of acquisition finance transactions is documented based on the standard forms of facility agreements published by the Japan Syndication and Loan-Trading Association (JSLA).
Compared to the global form of the facility agreement (including the model form provided by the Loan Market Association (LMA)), traditional forms of facility agreements in Japan require negative undertakings on the part of borrower more generally, without default carve-out provisions. This allows for a broader range of authority and discretion on the part of lenders in their decision-making on loan disbursement and waiver of contractual breaches. For example, leading arranger banks in Japan tend to hold a substantial portion (of 30% to 40%, and sometimes more) of the loan facilities even after syndication. Such leading arrangers also often take on the roles of facility agent and main bank of the target group (ie, the role of relationship bank) and are generally amenable to approving exemptions and waiver of non-material contractual breaches.
In recent years, with the increase in inbound investments by global PE funds, sponsors often request for facility agreements to be based on the LMA template, or to incorporate borrower-friendly terms commonly adopted in the global acquisition finance market.
Certain funds provision
One of the most heavily negotiated provisions in loan documentation is the conditions precedent provision for loan disbursement. In Japanese acquisition finance transactions, such conditions precedent typically include, among others:
In recent years, sponsors (including in Japan) have been increasingly inclined to negotiate limitations to the number of conditions precedent in loan documentation by incorporating certain funds (or “Sungard)” provisions, which are commonly adopted in acquisition finance transactions in the USA and UK. More specifically, sponsors now often ask for, among other things:
Although the terms and conditions of financing differ from transaction to transaction, the concept of “certain funds” is gradually being adopted mainly for transactions involving global sponsors (including major co-investors) and foreign-based sellers.
Internationally, facility agreements often contain a certain range of permitted actions, typically incorporated in the definitions section or appendices, that constitute exemption from borrower contractual undertakings. These commonly include permitted financial indebtedness, security interest and guarantee, loans, distributions, disposal, acquisitions, joint ventures and corporate reorganisations. Nevertheless, such general carve-out provisions are not ordinarily found in facility agreements in the traditional Japanese market. Such general and presupposed carve-out provisions are not usually acceptable to lenders in Japan unless individually justified by operational and financial forecasts. In recent years, however, global PE funds have increasingly been requesting the inclusion of permitted actions in facility agreements in Japan. In this regard, a significant point of contention is the concept of permitted acquisition and the capacity to raise an incremental (accordion) facility as permitted financial indebtedness, which allows the borrower to acquire new subsidiaries or businesses, and to obtain new loans for funding such acquisitions. Recently, roll-up transactions have also become more prevalent in Japan.
In addition to the above, negotiations in global sponsor deals are likely to include the scope of repeating representations, borrowers’ capacity for equity cure of a breach of financial covenants, and conditions (including the requirement for borrowers’ consent) for loan assignments.
Security trust and parallel debt structure
Under Japanese law, it is a commonly accepted doctrine that the holder of a security interest must be the same person as the creditor of the claims that are secured by the security interest. Accordingly, the practice in Japan is for each lender in a syndicated loan transaction to be a secured party because a security agent is not permitted to hold a security interest securing claims owed to the lenders on their behalf. This has presented an obstacle to general syndication as an assignment of secured loans requires changes to be made to the security interest already created.
One way of circumventing this difficulty is the concept of the security trust, introduced by an amendment to the Trust Act of Japan in 2006, allowing a trust company licensed under the Trust Business Act of Japan to act as a security trustee that is permitted to hold a security interest securing claims held by lenders. Under a security trust, no individual transfer and perfection procedures are necessary in respect of a security interest when a secured creditor assigns its secured claims. This is because the security holder will continue to be the security trustee even in the event of any change in the holder of the secured claims. In practice, however, security trust schemes are frequently used for syndicated loan transactions in Japan. This is presumably, to some extent, due to the lack of conformity of the security trust system with other relevant laws and practices in Japan, including the registration procedures required for real estate mortgages. The fact that a large part of syndicated loans are “club deals” (as opposed to “general syndications”) may be another contributing factor to the infrequent use of security trusts.
Another alternative is a debt structure under which a security agent holds a security interest securing a debt owed by the borrower to the security agent, where such security interest is created in parallel with the actual debts owed by the borrower to the lenders. Debt structures of this kind may be common in some jurisdictions, especially where a security trustee structure is not available. With that being said, this structure has not been employed in the Japanese market except in cases where parallel debt structures are governed by the law of a jurisdiction other than Japan (such as English law or New York law).
However, use of the parallel debt structure in Japan could be boosted by the amendments to the Civil Code of Japan that came into effect in April 2020, which explicitly introduced the concept of joint and several claims among multiple creditors created by a contract with features similar to a parallel debt structure. Although it was generally understood, even before the Civil Code amendments, that joint and several claims of this kind could be validly created, the Civil Code amendments have prompted discussion of the feasibility of a parallel debt structure under Japanese law. In view of these developments, it is anticipated that the Civil Code amendments will soon be used in practice as the legal basis for a parallel debt structure in future transactions.
Discussion concerning business floating charge
Under Japanese law, there is no concept of a blanket security interest over all assets of a person or entity, such as a floating charge. Accordingly, security interest needs to be created individually over every secured asset.
In this connection, discussions on the establishment of a new regime of “business growth charge” (jigyou seichou tampo ken) to create a floating charge over all assets, including intangible assets (such as goodwill), have been ongoing within the Financial System Council (a working group within the Financial Services Agency of Japan) since 2022. The main purpose of the business growth charge is to facilitate smooth fundraising for small and medium-sized enterprises and start-ups that do not possess substantial tangible assets. However, it also presents the possibility of a new security regime for acquisition finance. According to the latest report by the Financial System Council, the chargee in a business growth charge is contemplated to be a security trustee specifically granted with a special trust licence. Needless to say, industry players are closely monitoring these developments.
ESG finance is getting more attention in the Japanese finance market. For example, according to the Ministry of the Environment (MOE) of the Government of Japan, the number of green loan deals has increased from one in 2017 to 179 in 2022. The Japanese government is also encouraging expansion of ESG finance transactions through various initiatives, including the issuance of MOE guidelines for green loans, green bonds, sustainability-linked loans and sustainability-linked bonds.
So far, the impact of ESG-related issues on the terms and conditions of acquisition finance documentation in Japan has been limited, but this is expected to change as ESG concerns grow in significance.
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