Market Overview

Year in review

The leveraged buyout market in Japan has remained active in contrast to the global market, which experienced a steep decline in M&A activity in 2023. The continuing trend is 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. Additionally, in 2023, there were a record number of management-led "going private" transactions, which included Japan’s largest-ever management buyout of Taisho Pharmaceutical Holdings. Although the global pandemic resulted in a temporary slowdown in M&A activities in 2022, the market has made a robust recovery to its pre-pandemic levels in various indicators, led by foreign investors and listed companies with a relatively low-interest rate environment in 2023.

According to a research report published by Japan Buyout Research Institute Corporation, there were:

• 68 leveraged buyouts involving leveraged financing of JPY978 billion in 2018;
• 81 leveraged buyouts involving leveraged financing of JPY750 billion in 2019;
• 92 leveraged buyouts involving leveraged financing of JPY845 billion in 2020;
• 108 leveraged buyouts involving leveraged financing of JPY1,160 billion in 2021;
• 120 leveraged buyouts involving leveraged financing of JPY1,634 billion in 2022; and
• 120 leveraged buyouts involving leveraged financing of JPY3,220 billion in 2023.

Additionally, some of the aforementioned are followed by refinancing or recapitalisation after the closing.

Notable market trends

Upon closer examination, the data reveal [four] primary trends.

• The number of mega deals remains relatively high, as a result of which the deal value of leveraged buyouts for each of the years between 2018 to 2022 was generally higher compared to preceding years, and 2023 experienced the record deal value ever.
• There has been a decline in the number of mid-sized deals, but this was accompanied by a disproportionate rise in small-sized deals in 2023, such that both the number of leveraged buyouts and their aggregate deal value were higher compared to many of the preceding years.
• There has been a gradual increase in the number of mezzanine financing in each of the years between 2018 and 2023, compared to preceding years; the number of corporate carve-outs, on the other hand, has been gradually stabilising.
• The total deal values of management buyouts reach a record high in 2023.

As mentioned, 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.

Management buyouts

In Japan, the volume of management buyouts increased to the highest on record in 2023, driven by various factors, including pressure on listed companies from activist investments pushing Japanese companies for higher returns and the Tokyo Stock Exchange’s campaign to improve corporate governance. External financial contributors are often involved in management buyouts and, typically, the management accepts co-investments from PE funds and procures financing from financial institutions because the existing management of the target company generally intends to purchase all or significant portions of ownership in the target company and need external financial support to achieve acquisitions.

In contrast to typical leveraged buyout transactions, there are various issues specific to management buyouts. For example, the interests of the management conflict with those of its target companies because the management as a buyer of the target companies is inclined to acquire the target companies for less amounts, while it might be in the best interests of the target companies that the target companies are either not sold, or is sold for more. To address such a concern, the Ministry of Economy, Trade and Industry (METI) has introduced various guidelines relating to management buyouts, which proposes various fairness-ensuring measures, including the formation of a special committee of independent persons, the retention of external advisors, the introduction of majority-of-minority condition, etc.

From a financing perspective, Lenders often request to set forth various condition precedents and information undertakings relating to fairness-ensuring measures that have been implemented in a deal. In addition, co-investment structures often adopted in this type of transaction involve some practical issues, such as how certain values can be ascertained in the event of deadlock situations. In such a case, lenders might request appropriate arrangements to be implemented to secure their interests, such as ensuring that share pledges and other security interests can be enforced.

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 and managements intending to conduct management buyouts but has a limited cash available. 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 unless no guarantee or security interest over senior borrower or target group companies is provided in favor of the 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 holdco mezzanine lenders, in order to avoid any conflict with security interests in favour of senior lenders. In some transactions, holdco mezzanine 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

Overview

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 waivers 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 includes, among others:

• absence of any breach by the borrower and target group companies of the relevant finance documents, including related undertakings;
• absence of any event of default;
• absence of any material adverse change in the assets, financial condition, business or prospects of the target group companies ("Target MAC"); and
• absence of any material adverse change in financial or market conditions ("Market MAC").

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:

• exclusion of matters related to the target companies and their businesses from the scope of representations, undertakings and events of default in the conditions precedent; and
• elimination of the absence of Target MAC and Market MAC from the conditions precedent.

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.

Permitted actions

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.

Other topics

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.

Legal Updates

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 only been employed in the Japanese market 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, the 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 report by the Financial System Council published in February 2023, 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

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 domestic green loan deals has increased from one in 2017 to 221 in 2023. The Japanese government is also encouraging the 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. However, this is expected to change as ESG concerns grow in significance. One feature of ESG finance is linking the financial terms with the borrower’s performance against the pre-agreed sustainability performance targets (SPTs). For example, some loan agreements introduce a margin ratchet mechanism, where the interest rate fluctuates depending on the borrower’s operational performance against ESG-related criteria. The lender also often requires Information undertakings that oblige a borrower to submit ESG-related key performance figures.