Alternative Funds 2020

Last Updated October 13, 2020

Japan

Law and Practice

Authors



Nagashima Ohno & Tsunematsu is the first integrated full-service law firm in Japan and one of the foremost providers of international and commercial legal services based in Tokyo. While representing leading domestic and international clients, it has successfully structured and negotiated many of the largest and most significant corporate, finance and real estate transactions related to Japan. In addition to its capabilities in key commercial areas, the firm is known for pioneering domestic and cross-border risk management/corporate governance cases and large-scale corporate reorganisations. The approximately 500 lawyers at the firm work together in customised teams to provide clients with the expertise and experience specifically required for each matter. The lawyers advise both domestic and international clients on the structuring, formation and offering of alternative funds from legal, regulatory and tax perspectives, and also provide regulatory and ongoing compliance advice to investment managers. Simpson Thacher & Bartlett LLP is a global law firm with more than 1,000 lawyers working across 32 major practice areas and almost every industry sector. Its multidisciplinary private funds practice has advised clients for over 40 years, playing a prominent role in the development of the private funds industry. Working closely with the firm’s other practice areas, the private funds team advises many of the world’s best-known institutional alternative asset managers, as well as smaller funds and independent boutiques. In addition to comprehensive fund formation advice, the firm provides sponsor and adviser clients with practical solutions to complex regulatory, compliance and enforcement issues, and advises sponsors of private funds worldwide. Simpson Thacher also has substantial experience in M&A transactions involving private investment firms, IPOs of alternative asset managers, credit facilities for funds and managers, and secondary transfers of private fund investments. In Tokyo for over three decades, the firm advises both Japanese and international clients on capital markets, M&A and cross-border private fund formation transactions.

Japan is the world’s third largest economy by GDP and has sophisticated and well-developed debt and equity capital markets, with many leading global corporations. However, outside of the real estate sector, Japanese private funds have generally lagged behind other regions including, in particular, North America and Europe, from both a transactional and fundraising perspective. According to M&A advisory services firm, RECOF, M&A penetration relative to GDP has hovered near 2% in Japan in recent years, compared to 9–10% in the United States and the United Kingdom, and outside of real estate and infrastructure, average fund sizes tend to be quite small (approximately USD270 million in 2019, according to Asia Private Equity Review – APER). Japan-domiciled hedge funds are very uncommon, with industry tracker eVestment reporting that less than 1% of all hedge funds globally have their primary physical location in Japan. Real estate is the main exception, where Japan ranks second only to the United States in Morgan Stanley Capital International's (MSCI) estimated share of the global professionally managed real estate investment market.

Although generally smaller than in North American and Europe, alternative private funds are active, growing and becoming an increasingly important part of finance in Japan. According to Deloitte, at least 170 private equity firms are now active in Japan, with many global firms focusing on larger corporate carve-out transactions, and a burgeoning domestic industry focusing on small and mid-cap deals, playing a vital role in founder successions. 

There is a wide range of alternative funds established in Japan. The main fund structures are summarised in 2.2 Fund Structures. (Note that retail funds and investment trusts are not discussed, as they are beyond the scope of this chapter.) By class, real estate and private equity are most common, with an increasing number of venture capital funds, and increasing amounts of capital raised by infrastructure funds. Conversely, domestic hedge funds are not particularly prevalent.

For legal, regulatory and tax reasons, different fund structures are used for different types of alternative funds. This section outlines six of the most common domestic structures and discusses their applicability with respect to different strategies.

Investment Business Limited Partnerships (Toshi Jigyo Yugen Sekinin Kumiai)

The Investment Business Limited Partnership Act permits funds to be formed as investment business limited partnerships (IBLPs), with a general partner that manages the fund and limited partners having limited liability. The IBLP has become a common domestic entity used by alternative funds, particularly in the private equity, venture capital spaces, and in some cases, for infrastructure funds. The use of the IBLP structure is limited, however, due to restrictions on the types of assets in which an IBLP fund is permitted to invest. In particular, subject to certain limited exceptions, an IBLP may not invest 50% or more of its assets in non-Japanese securities, making the IBLP relatively unsuitable for funds that invest substantial portions of their capital outside of Japan. Additionally, IBLPs may present complexities for non-Japanese investors, including potential Japanese tax issues (discussed below). As offshore fund structures can generally be used for investments in Japanese assets, it is not uncommon for Cayman Islands exempted limited partnerships (ELPs) and similar offshore vehicles to be used for alternative funds that invest in Japan.

General Partnerships (Nin’i Kumiai)

A general partnership (nin’i kumiai or NK) may be used when an IBLP is unsuitable, eg, due to the asset class restrictions mentioned above. An NK can be managed in a manner similar to an IBLP, by appointing an executive partner who will manage the NK, but all the partners, including those that may have only passive roles, will have unlimited liability.

GK-TK Structures

A GK-TK is a structure unique to Japan that is often used for making domestic real estate and infrastructure investments. In essence, a godo kaisha (GK), which is a form of limited liability company that acts as a property-holding company, enters into a bilateral contract, called a tokumei kumiai agreement (TK agreement), with the investor (TK investor). Pursuant to the TK agreement, the TK investor makes a commitment to contribute capital to the GK, to be used for the GK’s investment activities (as set forth in the TK Agreement) in exchange for profit rights with respect to such activities. In a GK-TK structure, only the GK is permitted to take an active role in the management of the GK.

Although more commonly used as an investment acquisition structure, the GK-TK structure may also be used as an aggregating arrangement for multiple TK investors, effectively creating a fund-like collective investment scheme. In such a case, while the TK agreements remain bilateral contracts between the TK investor and the GK, certain rights may be conditioned upon the collective actions of other TK investors, thereby providing for governance and co-ordination among the TK investors in a manner similar to more common alternative fund arrangements (eg, by providing for removal of the GK, a key-person event, conflict of interest protections, synchronisation of drawdowns and distributions, etc). Despite the creation of a partnership-like relationship for the TK investors with respect to the GK, the GK-TK itself is a contractual arrangement and there is no actual legal GK-TK entity.

TMK (Tokutei Mokuteki Kaisha)

A tokutei mokuteki kaisha (TMK), literally a special purpose company, is a form of limited liability company established under the Act Concerning Asset Liquidation. It is used exclusively for the securitisation of assets and is often used as a vehicle for investment in real estate. Property rights can be securitised via a TMK through the issuance of asset-backed securities to investors, usually in the form of equities or bonds.

J-REITs

Japanese REITs (J-REITs) are established as investment corporations under the Act on Investment Trusts and Investment Corporations. Many J-REITs are listed and publicly traded in Japan, although an increasing number of J-REITs are private. The rules and regulations applicable to the formation and management of J-REITs are significantly more complex and onerous than those applicable to the other fund structures discussed above.

Investment Trusts (Toshi Shintaku)

Investment trusts are established under the Act on Investment Trusts and Corporations. They are a popular form of investment fund for both retail and institutional investors, but as noted above, are beyond the scope of this chapter and are therefore not discussed in detail.

In Japan, the regulatory regime applicable to an alternative fund depends in the first instance on the organisational structure of the fund – primarily, whether the fund is organised as a partnership, corporate or other entity form.

Partnership-Type Alternative Funds

For partnership-like entities, including IBLPs, foreign partnerships, NKs and GK-TKs (referred to collectively here as “funds”), the relevant regulatory regime will generally be the Financial Instruments and Exchange Act of Japan (FIEA), which sets forth the rules applicable to both the offering of securities and regulation of the managers of the relevant fund. The FIEA is generally applicable where an investor in a fund or the fund’s manager is located in Japan. This section considers the FIEA regulations applicable to marketing and investment management separately.

Marketing regulations

As a general rule, if a general partner of a partnership, including an IBLP or a foreign partnership (or a person acting in a similar capacity in a partnership-type fund such as a GK in a GK-TK structure, which is referred to collectively here and in 4.2 Marketing of Alternative Funds and 4.5 Regulatory Regime as a “general partner”), solicits investors in Japan, the general partner must generally either be registered as a financial instruments business operator engaged in Type II financial instruments business under the FIEA (ie, hold a Type II licence) or perfect an exemption from registration for this. Alternatively, it may be possible for the general partner to solicit investors in Japan without a Type II licence if the general partner delegates all solicitation activities relating to the fund to a third party holding a Type II licence. In such cases, the general partner must not itself engage in any solicitation relating to the fund.

QII Exemption (for marketing)

One of the most common exemptions from the registration requirement in connection with marketing interests in a partnership-like fund under the FIEA is the special business exemption for qualified institutional investors (QII Exemption). The QII Exemption is available to qualified general partners where the fund’s partners include at least one qualified institutional investor (QII) solicited in Japan and 49 or fewer non-QIIs that meet certain statutory qualifications (ie, non-QII qualified purchasers). If a general partner qualifies for the QII Exemption, it must make an Article 63 notice filing on Form 20 (Article 63 Notice) with the applicable Local Finance Bureau prior to having a closing with the investors who are solicited in Japan. Certain transfer restrictions and asset segregation requirements will apply, and the general partner will be subject to certain other requirements, including the requirement for a non-Japanese general partner to appoint a local representative in Japan, compliance with certain code of conduct rules and disclosure requirements, and certain record-keeping obligations.

Investment management regulations

In addition to marketing regulations, a partnership-type fund will also need to comply with certain investment management regulations under the FIEA. To the extent that the fund will invest mainly in securities and/or derivatives, the general partner will need to register as a financial instruments business operator engaged in investment management business under the FIEA (ie, an “investment manager” registration).

QII Exemption (for investment management)

Helpfully, the QII Exemption discussed above with respect to marketing is also generally available with respect to investment management requirements. There are some slight differences in the requirements for the QII Exemption for the purposes of investment management regulations compared to the exemption for marketing, including the absence of transfer restrictions and additional ongoing compliance obligations, but otherwise the exemptions are fairly similar. By filing an Article 63 Notice, the general partner will be exempt from registration asan investment manager under the FIEA.

De minimis exemption

An alternative exemption from the investment manager regulations under the FIEA, which is available solely for funds established outside Japan, is the so-called “de minimis exemption” (also sometimes referred to as the “foreign funds exemption”). This exemption is available when:

  • the fund’s direct investors in Japan (Japanese direct investors) are limited to QIIs and persons who have submitted an Article 63 Notice with respect to the investment management of the fund;
  • the fund’s indirect investors, who invest through partnerships formed under Japanese law (indirect investors), are limited to QIIs;
  • the fund has fewer than 10 investors who are either Japanese direct investors or indirect investors resident in Japan; and
  • aggregate contributions from the fund’s Japanese direct investors make up one third or less of the aggregate contributions to the fund from all investors.

For the purposes of the de minimis exemption, an investor will be deemed to be a “direct Japanese investor” if the investor is a resident of Japan and directly holds its interest in the foreign fund, and will be considered an “indirect Japanese investor” if the investor is a resident of Japan and holds its interest in the foreign fund indirectly through a partnership-type entity formed under Japanese law (eg, an IBLP, NK or GK-TK).

Additional regulations, including regulations under the Act on Specified Joint Real Estate Ventures and/or the Act on Regulation of Commodity Investment, may also apply depending on the type of investments made by the fund.

Regulations Applicable to TMKs, J-REITs and Investment Trusts

Marketing regulations

Marketing of interests in a TMK, a J-REIT or an investment trust, may only be made by persons who either hold a Type I financial instruments business operator licence or satisfy an available exemption.

Separate and apart from the registration requirements for the person who engages in the marketing of the relevant interests, unless the offering qualifies under an applicable private placement exemption, the offering will be considered a public offering, and will therefore require the filing of a securities registration statement as well as additional requirements under the FIEA. Two private placement exemptions are available:

  • a private placement for a small number of investors; and
  • a private placement for QIIs.

The requirements for such exemptions differ depending on the type of interest.

Investment management regulations

Under the applicable law, investment management of a J-REIT must be delegated to an investment manager registered under the FIEA, and investment trusts may only be established by an investment manager registered under the FIEA to engage in investment trust management business. There are additional rules and regulations that apply to investment management of J-REIT and investment trusts.

Investment decisions for TMKs may be made by the TMK itself, based on investment advice from a registered investment adviser. Alternatively, the TMK may delegate investment management to an investment manager registered under the FIEA.

It is technically possible to originate loans in Japan if the funds comply with applicable laws, rules and regulations. Direct lending to any person in Japan is generally regulated under the Money Lending Business Act and requires that money lenders be registered thereunder. These regulations are also applicable to alternative funds and, depending on the legal structure of the alternative fund, the fund or its general partner will usually need to be licensed as a money lender in order to originate loans to a person in Japan, if the lending activities are considered to take place in Japan and lending is considered to be conducted as a business.

In determining whether lending activities take place in Japan, the applicable facts and circumstances would be taken into consideration, including factors such as the location of the lender and the borrower, where the loan agreement is negotiated and executed, and the location of the bank accounts from which the money is sent and received.

There are limited exemptions from the requirement to register as a money lender, and if an alternative investment fund holds 50% or more of voting rights in a Japanese portfolio company, direct lending to such portfolio company is exempt from this registration requirement.

IBLPs are subject to assets class restrictions under which they are not permitted to invest in cryptocurrency assets. Such restrictions are not, however, applicable to NKs or GK-TK structures, subject to compliance with other applicable requirements under the FIEA.

J-REITs and investment trusts are also subject to assets class restrictions and may not invest in cryptocurrency assets.

As discussed in 2.3 Regulatory Regime, generally where funds are structured as partnerships, the fund operator would make an Article 63 Notice filing with respect to marketing and/or investment management, subject to the application of other exemptions from registration requirements. No regulatory approval is required to make an Article 63 Notice filing, although the Japanese regulators will review the Article 63 Notice and request that revisions be made to the filing if they consider such revisions necessary.

A TMK can be established without regulatory approval, but it must be established under the Act on Securitisation of Assets and a business commencement notification must be filed pursuant to this. Pre-review procedures are not required.

J-REITs can usually be established as investment corporations under the Act Concerning Investment Trusts and Investment Corporations. If the investment manager is newly established with the J-REIT, the investment manager will be required to obtain certain licences and registrations prior to the establishment of the investment corporation. The time required to complete the process varies and may take anywhere from several months to over a year.

For IBLPs, the general partner must be a domestic entity. If the general partner delegates investment management in securities or derivatives to an investment manager, such investment manager must be a registered investment manager under the FIEA. A non-Japanese entity can be registered as an investment manager under the FIEA, but must have an office in Japan.

For NKs, there is no requirement for the executive partner to be a Japanese entity or person. For a GK-TK structure, as discussed in 2.2 Fund Structures, the GK is typically a Japanese limited liability company, although it is possible, though rare, for a non-Japanese entity to enter into a TK agreement with an investor. However, as with IBLPs, if investment management in securities or derivatives is delegated to an investment manager, the investment management must be registered under the FIEA. 

An investment manager or investment adviser to a TMK must be registered as an investment manager or investment adviser under the FIEA. For J-REITs and investment trusts, as discussed in 2.6 Regulatory Approval Process, the investment manager must be registered in this capacity under the FIEA.

While there is no particular local substance rule other than as discussed in 2.7 Requirement for Local Investment Managers, Japanese alternative fund vehicles are generally established and managed by local entities.

There are no specific rules applicable to service providers of IBLPs, NKs or GK-TK structures, or the operators of such fund vehicles, other than the requirement regarding delegation of investment management as discussed in 2.7 Requirement for Local Investment Managers.

As J-REITs and investment trusts are strictly regulated, service providers need to meet certain requirements under the Act on Investment Trusts and Investment Corporations.

Generally, if services that are regulated under Japanese law are provided to Japanese funds or fund operators, Japanese laws and regulations would apply. However, other than as discussed in 2.7 Requirement for Local Investment Managers and 2.9 Rules Concerning Other Service Providers, customary services provided by administrators, custodians and director services providers are generally not regulated in Japan.

Taxation of Alternative Funds Established in Japan

Japan is a relatively high-tax jurisdiction and an important consideration for non-Japanese investors investing in alternative funds in Japan is ensuring that the structure is tax optimal, so as to minimise the exposure of non-Japanese investors in connection with their Japanese investments through such alternative funds. 

Under applicable Japanese tax laws, non-Japanese resident investors without a permanent establishment in Japan (Offshore Investors) are generally not subject to tax on capital gains from the sale of shares of a Japanese company, unless certain enumerated exceptions apply. There are three main exceptions that are relevant to Offshore Investors:

  • being deemed to have a permanent establishment in Japan (eg, by virtue of being a partner in a fund vehicle that itself has a permanent establishment in Japan);
  • becoming subject to the so-called “25/5 Rule” by owning, or being deemed to own, 25% or more of the shares of the Japanese company during an applicable holding period in which the Offshore Investor sells, or is deemed to have sold, 5% or more of such company’s shares; or
  • becoming subject to the so-called “Real Estate Holding Company Rule”, by owning, or being deemed to own, more than 2% of the shares of the Japanese company (or more than 5% of shares, if the company is listed on an exchange), the value of which is predominantly derived, directly or indirectly, from real estate in Japan, on the day preceding the first day of the fiscal year in which the Offshore Investor sells, or is deemed to have sold, all or part of such company’s shares.

In addition to capital gains, certain types of income (eg, dividends, interest and distribution under a TK agreement) derived by the Offshore Investors will be subject to withholding tax at varying rates. Both capital gains and other income may be subject to reduction or exemption under applicable tax treaties as discussed in 2.12 Double-Tax Treaties.

These tax consequences for Offshore Investors vary depending on the type of vehicle used by the alternative fund, as summarised below. See 4.7 Tax Regime for taxation of investors in Japan.

Tax treatment of NKs

An NK is transparent for Japanese tax purposes and, as such, each partner in an NK is viewed as earning its allocated share of income derived by the NK. However, since the NK is typically managed in Japan and has one or more partners that are resident in Japan, there is generally a high risk that Offshore Investors in an NK will be deemed to have a permanent establishment in Japan. This is because the Japanese tax authority takes the position that if even a single partner in an NK has a permanent establishment in Japan, then all of the Offshore Investors in the NK are deemed to have a permanent establishment, based on the view that an NK’s business is operated jointly by all partners. Unlike in the case of an investment made through an IBLP (discussed below), no statutory exemption is available to permit Offshore Investors in an NK to be exempted from being deemed to have a permanent establishment in Japan.

If an Offshore Investor investing through the NK is deemed to have a permanent establishment in relation to the business of the NK, the NK will be subject to withholding on distributions of the partnership profits to such partners at a rate of 20.42%. A non-resident partner who is deemed to have a permanent establishment in Japan will be required to file a tax return to report its share of income from the NK. This makes an NK relatively unsuited for use by Offshore Investors for Japan-focused investments.

Tax treatment of IBLPs

An IBLP is treated as being transparent for Japanese tax purposes and, as such, each partner in an IBLP is viewed as earning its allocated share of income derived from the IBLP. As mentioned above, while Offshore Investors are generally not subject to tax on capital gains from the sale of shares of a Japanese company, there are three exceptions under which their capital gains become subject to tax. Since it is uncommon to use an IBLP for investment in real estate (see 2.2 Fund Structures, regarding restrictions on the types of assets in which an IBLP is permitted to invest), the other two exceptions are discussed below.

Permanent establishment (PE)

The Japanese tax authority’s position discussed above with respect to NKs applies equally to an IBLP. As such, in the absence of an available exemption (discussed below), an Offshore Investor will be deemed to have a permanent establishment in Japan if it invests in an IBLP, a partner of which has a permanent establishment in Japan (eg, if its managing entity conducts business in Japan). 

In contrast to an IBLP, if a fund is established as a legal entity outside Japan and is not managed in Japan, it may be possible to structure the fund so that it does not cause Offshore Investors to be deemed to have a permanent establishment in Japan. As the analysis is complex, sponsors and Offshore Investors should discuss the tax implications of an investment in a fund organised as a non-Japanese legal entity carefully with their Japan tax advisers.

PE exemption filings

Pursuant to a proposal by the Japanese Ministry of Economy Trade and Industry (METI) intended to facilitate investment in Japanese alternative funds by Offshore Investors, the 2009 annual tax reforms introduced a safe harbour that permits Offshore Investors to invest through such funds notwithstanding the fact that they may be deemed to have a permanent establishment in Japan. To take advantage of the safe harbour, the Offshore Investors are required to make a filing to perfect the exemption. In order to qualify for the exemption, the Offshore Investor must:

  • be a limited partner in the fund;
  • not be deemed to take part in certain aspects of the management or operation of the fund;
  • itself own less than a 25% share of the assets of the fund;
  • have no special relationship to the general partner of the fund; and 
  • not otherwise have a permanent establishment in Japan.

Three factors limit the use of the PE exemption filing (and the 25/5 Rule exemption filing discussed below) for Japan buyout funds:

  • in order to be eligible for the exemption, Offshore Investors must not take part in the management of the fund, effectively requiring such investors seeking the benefit of the safe harbour to waive certain governance, oversight and consent rights (eg, participation in an LP advisory commitment), which tend to be important to private fund investors;
  • Offshore Investors relying on the filing would still be subject to the 25% limit (in the case of a 25/5 Rule exemption filing, without application of the aggregation principle discussed below), which could pose difficulties for smaller funds and/or funds with a concentrated investor base, such as co-investment funds, bespoke funds and fund-of-one arrangements; and
  • sponsors and some investors may find the filing requirements to be burdensome, particularly fund of funds, which may be required to make such filings on behalf of their underlying investors, and other investors who find such filings to be intrusive.

The 25/5 Rule

Under the 25/5 Rule, an Offshore Investor will become subject to tax on capital gains from the sale of shares of a Japanese company, if the Offshore Investor owns, or is deemed to own, 25% or more of the shares of the underlying Japanese company during an applicable holding period in which the Offshore Investor sells, or is deemed to have sold, 5% or more of such company’s shares. While an IBLP is treated as transparent for Japanese tax purposes, where the Offshore Investor invests through a fund structure as a pass-through partnership (eg, as an IBLP), an aggregation rule applies for the purposes of calculating the 25% and 5% thresholds under the 25/5 Rule. Under this aggregation rule, an Offshore Investor’s holdings are aggregated with all of the Offshore Investor’s “specially related shareholders”, which are deemed to include all of the other partners in the fund in which the Offshore Investor invests. As with a permanent establishment, the analysis is complex, and sponsors and Offshore Investors should discuss the tax implications of an investment in a fund organised as a pass-through partnership carefully with their Japan tax advisers.

There are two safe harbours from capital gains taxation under the 25/5 Rule which may potentially be available for Offshore Investors investing through a fund structured as an IBLP: (1) a safe harbour perfected through a statutory exemption filing, and (2) reliance on treaty benefits under an applicable tax treaty.

25/5 Rule exemption filings

The 2009 annual tax reform that introduced the PE exemption safe harbour, also introduced a separate safe harbour to permit Offshore Investors to invest through such funds notwithstanding the fact that the fund in the aggregate owns or is deemed to own 25% or more of the shares of any underlying Japanese portfolio company. To take advantage of the safe harbour, an Offshore Investor is required to make a filing to perfect the exemption. In order to qualify for the exemption, the Offshore Investor must:

  • be a limited partner in the fund;
  • not be deemed to take part in certain aspects of the management or operation of the fund; and
  • itself own less than 25% of the shares of the underlying Japanese portfolio company in which the fund invests (without application of the aggregation principle under the 25/5 Rule).

This exemption does not apply if the relevant fund has held the shares for a period of less than one year at the time of sale. Note also that the limitations applicable with respect to PE exemption filings (discussed above) also apply to 25/5 Rule exemption filings.

Tax treaty benefits

Even if capital gains derived by the Offshore Investors become taxable under the 25/5 Rule, Offshore Investors may still be able to rely on an available tax treaty between Japan and the jurisdiction in which the Offshore Investor is considered to be resident under such tax treaty. This is discussed in more detail in 2.12 Double-Tax Treaties.

Tax treatment of GK-TK structures

A GK itself is opaque for Japanese tax purposes and the GK is therefore required to file a tax return to report its income each fiscal year. However, under a GK-TK structure, profits allocated to the TK investors are deductible in calculating the taxable corporate income of the GK, and such profits would therefore be subject to tax only once at the level of TK investors, not at the level of the GK. A GK conducting its business in Japan will have withholding tax obligations for the distribution of its profits to TK investors at a rate of 20.42%.

Tax treatment of TMKs

A TMK is opaque for Japanese tax purposes and is therefore required to file a tax return to report its income each fiscal year. However, dividends paid out to its investors are deductible in calculating the taxable corporate income of the TMK, subject to the TMK satisfying certain conditions, including a requirement to distribute as dividends more than 90% of the distributable profits of the TMK in the same fiscal year. As long as all such conditions are met, profits earned and paid out as dividends by a TMK would be subject to tax only once at the level of its investors, but not at the level of the TMK itself. A TMK will have a withholding tax obligation for dividends at a rate of 20.42%. Non-resident investors in a TMK may, depending on its particular circumstances, be required to file tax returns to report capital gains from alienation of their interest in the TMK.

Tax treatment of the investment corporation of a J-REIT

The investment corporation of a J-REIT is itself opaque for Japanese tax purposes and therefore required to file a tax return to report its income each fiscal year. However,as with a TMK, dividends paid out to its investors are deductible in calculating the taxable corporate income of the investment corporation if the investment corporation meets certain conditions, including a requirement to distribute as dividends more than 90% of the distributable profits of the investment corporation in the same fiscal year. As long as all such conditions are met, profits earned and paid out as dividends by the investment corporation will be subject to tax only once at the level of its investors, but not at the level of the investment corporation itself. An investment corporation will have a withholding tax obligation for such dividends (applicable withholding tax rates differ depending on whether the investment corporation is listed on an exchange and whether the recipient is a corporate entity or individual). Non-resident investors in the investment corporation may, depending on its particular circumstances, be required to file tax returns to report capital gains from alienation of their interest in the investment corporation.

Japan has an extensive double-tax treaty network, and the Japanese government is actively seeking to expand it further. Not every jurisdiction has a tax treaty with Japan, however, and the benefits may vary significantly between jurisdictions, so any investor seeking to invest in Japan while relying on tax treaty benefits, should consult with its own tax adviser to understand whether and to what extent such benefits may be available. Whether alternative funds established in Japan qualify for benefits under an applicable double-tax treaty generally depends on whether the relevant vehicle used for such funds is transparent or opaque for Japanese tax purposes, as explained below. It should be noted, however, that where an alternative fund established in Japan derives income from a foreign jurisdiction (Source Jurisdiction), whether such fund would be entitled to benefits under the applicable double-tax treaty for such income is ultimately a question of tax law in the Source Jurisdiction (including interpretation of the treaty in that jurisdiction).

Where the Vehicle Used for the Alternative Fund is Opaque for Japanese Tax Purposes

Depending on the terms of the double-tax treaty between Japan and the Source Jurisdiction, the fund may qualify for benefits under such treaty (eg, reduction in or exemption of withholding tax in the Source Jurisdiction).

Where the Vehicle Used for the Alternative Fund is Transparent for Japanese Tax Purposes

The fund itself would not generally qualify for benefits under the double-tax treaty between Japan and the Source Jurisdiction. Investors in the fund may, however, qualify for benefits under the double-tax treaty between the jurisdiction of their residence and the Source Jurisdiction, depending on the terms of such treaty.

It is common for alternative funds (particularly private equity funds, real estate funds and infrastructure funds) to use subsidiaries for investment purposes. The primary reasons for use of subsidiaries are, among other reasons, to take advantage of debt-to-equity leverage at the subsidiary level and to segregate liabilities within each investment.

Generally speaking, blind-pool alternative funds established in Japan tend to be established predominantly by domestic sponsors. Some of the larger buyout funds that invest in Japan, whether as a Japan-focused, pan-regional or global investment strategy, are established in off-shore jurisdictions due to legal, tax and regulatory considerations. Such larger funds are most commonly established by North American or European sponsors.

For real estate and infrastructure funds, an offshore feeder fund is commonly established, with investors investing into the offshore feeder, which then invests in a GK-TK or TMK arrangement when investing in particular transactions. Sponsors of these funds are typically a mix of domestic and overseas players, where these firms are established and operate in multiple jurisdictions including Japan.

Subject to applicable international sanctions and other eligibility requirements, there are generally no restrictions on the domicile of investors investing in Japanese alternative funds. Japanese investors naturally make up a significant proportion of investors in Japanese alternative funds, but investors from many foreign jurisdictions commonly invest in these funds as well. Investors from Asia, Europe, North America, Oceania, and occasionally the Middle East and other jurisdictions are not uncommon.

Many Japanese alternative funds are formed to invest in Japan and, as noted in 2.2 Fund Structures (eg, with respect to IBLPs), may in some cases be required to invest predominantly in Japan. Subject to applicable international sanctions, Japanese managers and sponsors also invest globally, including in Asia, the United States, the Americas, Oceania and elsewhere.

Please refer to Trends and Developments for information on key trends.

As discussed in 2.3 Regulatory Regime, if an offering falls under a public offering under the FIEA, securities registration requirements and other disclosure requirements apply.

Also, in addition to the requirement to provide sufficient information for the investor to make an investment decision, the following is required:

  • a document which includes certain matters required under the FIEA, including an explanation of the fund structure, an outline of the terms of the fund, and disclosure of certain risks and fees that may be payable in connection with an investment in such alternative fund, which document should be provided prior to the investor signing a subscription agreement or similar agreement; and
  • a document summarising the subscription by the investor may apply if the investor is not a professional investor (tokutei toshika) under the FIEA. Moreover, if an Article 63 Notice is filed by the general partner, the general partner will be required to:
    1. provide an investment management report if the investor is not a professional investor;
    2. make certain matters indicated in such Article 63 Notice publicly available;
    3. file an annual business report; and
    4. make certain matters included in the annual business report publicly available.

Additional reporting requirements are applicable to J-REITs and investment trusts.

No substantial changes to the regulations relating to alternative funds are expected in the short term.

In the case of IBLPs, the general partner is often established as a joint stock company (kabushiki kaisha or KK under the Companies Act), a GK or an LLP. In the case of a GK-TK arrangement, the GK is a limited liability company (godo kaisha) established under the Companies Act, but it is possible for an entity other than a GK to enter into a TK agreement with the investor.

To the extent that investment managers of J-REITs, investment trusts and TMKs are Japanese corporations, they would be KKs, as required under the FIEA. If a TMK is simply a client receiving investment advice, the investment adviser need not be a KK, as long as it is registered as an investment adviser under the FIEA. 

See 2.2 Fund Structures and 2.3 Regulatory Regime for the outline of the regulatory regime applicable to alternative fund managers. If investment management in securities and/or derivatives is delegated to an investment manager, the investment manager must be registered as such under the FIEA. 

Taxation of Alternative Fund Managers in Japan

In Japan, there is no special tax regime applicable to fund managers, whether alternative funds of otherwise, and tax treatment of management fees and carried interest received from the fund are determined in accordance with the general rules of Japanese tax law. In practice, managers of alternative fund are typically either:

  • vehicles that are opaque for Japanese tax purposes (eg, a KK and a GK, if such vehicle is established in Japan); or
  • vehicles that are transparent for Japanese tax purposes (eg, an NK, an IBLP or an LLP, if such vehicle is established in Japan).

In each case, individual managers receive their management fees and carried interest from such vehicle. Below is a tax summary of the treatment in each case.

Where the vehicle used for the alternative fund manager is opaque for Japanese tax purposes

Such vehicle is subject to corporation tax on the management fees and carried interest at the effective tax rate of approximately 30%. When such management fees and carried interest are further paid from such vehicle to individual managers who are officers or employees of such vehicle, such management fees and carried interest would be treated as “salary income” of such individual managers, since such remuneration is paid in consideration for services provided in their capacities as officers or employees of such vehicle. As a result, such remuneration would be subject to tax under progressive tax rates (up to a maximum rate of 55.945%). There is a deduction limitation rule for remuneration paid to officers, and under this rule, all or part of the remuneration paid to individual managers may not be deductible in the calculation of taxable corporate income of such vehicle, if individual managers are officers of such vehicle.

Where the vehicle used for the alternative fund manager is transparent for Japanese tax purposes

Management fees received by individual managers are viewed as remuneration paid in consideration for provision of their services. As a result, such remuneration would be treated as “business income” or “miscellaneous income” of such individual managers, both of which are subject to tax under progressive tax rates (up to a maximum rate of 55.945%). For tax treatment of carried interest allocated to individual managers, see 3.5 Taxation of Carried Interest.

In order to encourage foreign funds to invest in Japanese securities, the Financial Services Agency published guidelines for an “independent agent exemption” with respect to fund managers, in consultation with the Tax Bureau of the Ministry of Finance and the National Tax Agency. While these guidelines are not prepared specifically for alternative funds, it would not be unreasonable to refer to them in analysing any “agent permanent establishment” issues in the context of alternative funds.

Under the guidelines, when a foreign fund enters into a discretionary investment agreement with a domestic investment manager and the domestic investment manager conducts certain investment activities in Japan under the discretionary investment agreement on behalf of such fund, that domestic investment manager would be considered to be an “independent agent”, thereby not constituting an “agent permanent establishment” of such fund, if all of the following conditions are met:

  • discretion delegated to the domestic investment manager is not so limited that such fund would be considered, in substance, to be directly conducting investment activities in Japan;
  • the number of officers of the domestic investment manager who concurrently serve as officers or employees of the foreign general partner or foreign investment manager of the fund is less than half the total number of officers of the domestic investment manager;
  • the amount of remuneration of the domestic investment manager is linked to the amount of the total assets to be invested under the discretionary investment agreement or the investment income, with the contributions of the relevant parties appropriately taken into account; and
  • in cases where the domestic investment manager exclusively or almost exclusively deals with such fund, the domestic investment manager has the capacity to diversify its business or acquire other clients without fundamentally altering the way it conducts its business or losing economic rationality for its current business.

It is also possible for the Offshore Investors to rely on the PE exemption filing discussed in 2.11 Tax Regime.

In Japan, there is no special rule for taxation of carried interest and therefore its tax treatment is determined by applying the general rules of Japanese tax law.

Where the Vehicle Used for the Alternative Fund Manager is Opaque for Japanese Tax Purposes and Individual Managers Receive Carried Interest from Such Vehicle

Since it can be assumed that individual managers receive carried interest from such vehicle in consideration for their services provided in their capacities as officers or employees of such vehicle, carried interest can be expected to be treated as “salary income” of such individual managers, and would therefore be subject to tax under progressive tax rates, up to a maximum rate of 55.945% (see also 3.3 Tax Regime).

Where the Vehicle Used for the Alternative Fund Manager is Transparent for Japanese Tax Purposes and Individual Managers Receive Carried Interest from Such Vehicle

With respect to tax treatment of carried interest in this case, there are two different views. One view is that, as with management fees discussed in 3.3 Tax Regime, carried interest received by individual managers would be viewed as remuneration paid to them in consideration for their services and thus treated as “business income” or “miscellaneous income” of such individual managers, both of which are subject to tax under progressive tax rates (up to a maximum rate of 55.945%). The other view is that, since the vehicle is tax transparent, individual managers would be viewed as having directly earned their allocated shares of the income derived by the fund, and the character of such income at the fund level would be respected in determining tax treatment of carried interest at the level of individual managers. Under this view, where the source of carried interest is capital gains from alienation of securities by the fund, carried interest received by individual managers would also be treated as capital gains from alienation of securities, which are subject to tax at a flat rate of 20.315%.

There is no judicial precedent that provides clarification or other meaningful guidance on this point. At present it is therefore unclear which view would prevail in court should this issue be litigated, and the outcome may differ depending on the specific facts and circumstances of the case.

Managers of alternative investment funds are permitted to appoint sub-advisers and delegate their investment management functions or outsource other operations of the funds to third parties. To the extent that the fund documents permit such delegation or outsourcing, there are no particular laws or regulations that restrict or regulate such delegation or outsourcing, subject to the service provider holding appropriate licences and registrations, if the provision of such services requires any such licence or registration. For example, if the function of investment management in securities or derivatives is outsourced, such investment functions may only be delegated to an investment manager registered under the FIEA.

An investment manager registered under the FIEA is required to have an office in Japan and personnel capable of appropriately conducting the investment management business in compliance with the applicable laws and regulations.

See 2.7 Requirement for Local Investment Managers and 2.9 Rules Concerning Other Service Providers for requirements regarding the general partner of an IBLP or NK, or the TK operator of a TK.

When a non-local manager wishes to act as sub-manager in Japanese alternative fund schemes, such non-local manager will need to have the appropriate licence or registration under Japanese law, which differs depending on the assets in which the fund invests. Even if the ultimate investment target of the fund is not securities, if the fund nonetheless invests in securities, a sub-manager will need to be registered as an investment manager under the FIEA. See 3.7 Local Substance Requirements for those requirements applicable to registered investment managers.

See also 2.7 Requirement for Local Investment Managers to 2.9 Rules Concerning Other Service Providers with respect to the appointment of non-local managers.

See 2.15 Origin of Investors in Alternative Funds.

For IBLPs, NKs, GK-TKs and foreign partnerships, if the general partner chooses to rely on QII Exemption for marketing as discussed in 2.3 Regulatory Regime, which tends to be common in practice, an Article 63 Notice filing must be made. To qualify for the QII Exemption for marketing, a fund can be marketed to an unlimited number of QIIs and non-QIIs that satisfy certain criteria (in that they are qualified purchasers), but the fund must have at least one QII and may not have more than 49 non-QII qualified purchasers who will commit to invest in it.

A different set of rules apply to marketing of J-REITs, investment trusts and TMKs. As discussed in 2.3 Regulatory Regime, there are two types of private placement exemptions available, ie, (i) the private placement for QIIs exemption, and (ii) the private placement to a small number of investors exemption. Funds can only be marketed to QIIs if the J-REIT, investment trust or the TMK relies on the private placement for QIIs exemption; for the private placement to a small number of investors exemption and public offerings, there is no restriction under the private placement exemption on the types of offerees to which the funds can be marketed, but the marketing cannot be made to more than 49 investors. Note that for the purposes of determining the number of investors in the case of J-REITs and TMKs, one counts the number of investors solicited, whereas for partnership-type funds, one counts the number of investors who subscribe for interests in the fund.

See 2.3 Regulatory Regime.

Subject to applicable marketing rules, local investors may invest in alternative funds established in Japan. However, if a partnership-type alternative fund relies on the QII Exemption for marketing and/or investment management, or a J-REIT, an investment trust or a TMK relies on one of the private placement exemptions, the types of investors that may invest in such alternative funds would be restricted.

For partnerships-type funds, general partners that rely on the QII Exemption for marketing must make an Article 63 Notice filing prior to the first closing with any investor solicited in Japan. Certain conduct rules apply once an Article 63 Notice filing for marketing is made. These conduct rules include a duty of good faith, advertising regulations, prohibitions on providing false information, a principle of suitability and a requirement to segregate assets, some of which are not applicable if the investors are “professional investors.” Also, providing any kind of discount or benefit, as well as compensation for any loss, may also be prohibited and require careful legal analysis.

For marketing of J-REITs and TMKs, a different set of rules apply and marketing is typically conducted through a placement agent registered as a Type I financial instruments business operator. Unless marketing of interests is made by way of a public offering, there would not be a filing requirement for the marketing of such interests. See also 2.3 Regulatory Regime for filing requirements for the formation of J-REITs and TMKs.

Any person (eg, a general partner which has filed an Article 63 Notice or a placement agent) soliciting investors that are not “professional investors” (tokutei toshika) under the FIEA with respect to a prospective investment in an alternative fund must deliver to such non-professional investors:

  • a document that includes certain matters required under the FIEA, including an explanation of the fund structure, an outline of the terms of the fund, and disclosure of certain risks and fees that may be payable in connection with an investment in such alternative fund, prior to the investor signing a subscription agreement or similar agreement, and
  • a document summarising the subscription by the investor if the investor is not a professional investor.

Also, any person soliciting investors who are not “professional investors” (tokutei toshika) under the FIEA (or certain other investors), with respect to an investment in an alternative fund, must provide explanation of certain important matters relating to such prospective investment under the Act on Sales of Financial Products.

See also 2.18 Disclosure/Reporting Requirements.

There are no special or preferential tax regimes in Japan that might be available to investors in alternative funds, and thus tax treatment of such investors is determined under general Japanese tax laws and principles. See also 2.11 Tax Regime for the tax treatment of Offshore Investors.

Taxation of Corporate Investors in Japan

Corporate investors resident in Japan are generally subject to Japanese taxation on their worldwide income. One exception is that a certain portion of dividends received from the fund may, depending on the circumstances and whether such dividends are deductible at the level of the distributing entity, be excluded from the amount of such investor’s taxable corporate income. Income of a corporate investor is taxed at the effective tax rate of approximately 30%, without regard to type of income.

Taxation of Individual Investors in Japan

While the income of individual investors resident in Japan is in general taxed under progressive tax rates (up to a maximum rate of 55.945%), capital gains from alienation of securities are taxed at a flat rate of 20.315%. Individual investors that receive dividends from a fund vehicle, the equity interest of which is listed on an exchange, may, depending on the circumstances, be able to opt to be taxed at a flat rate of 20.315%.

Timing of Taxation

Where the alternative fund is opaque for Japanese tax purposes (eg, a TMK or an investment corporation established in Japan), Japanese investors are subject to tax upon receipt of profit distributions from the fund or alienation of their interest in the fund.

Conversely, where the alternative fund is transparent for Japanese tax purposes (eg, an NK or a partnership-type entity established in Japan), Japanese investors are subject to tax on their allocated share of the income derived by the fund each fiscal year, regardless of whether such income has been distributed. Since the fund is transparent, the character of such income at the fund level would generally be respected in determining tax treatment at the investor level. But see 3.5 Taxation of Carried Interest.

In the case of a GK-TK structure, while the GK itself is opaque for Japanese tax purposes, TK investors would be subject to tax for profits allocated to them each year, whether distributed or not; however, unlike an NK or a partnership-type fund, income from such allocated profits would generally be treated as “miscellaneous income”, regardless of the character of the income at the GK level.

FATCA

Japanese alternative funds are “financial institutions” under the US Foreign Account Tax Compliance Act (FATCA). Japan and the United States have entered into a Model 2 intergovernmental agreement (IGA) with respect to FATCA. Under the IGA, Japanese alternative funds are required to comply with certain due diligence, reporting and withholding obligations. Information with respect to US investors and non-compliant investors must be reported to the US Internal Revenue Service on an annual basis, and payments of interest and dividends from certain US sources must be withheld at a rate of 30%.

The CRS

The Japanese government has also amended domestic law to implement the Common Reporting Standard (CRS) published by the Organisation for Economic Co-operation and Development. Under the amended law:

  • general partners of NKs and IBLPs (in the case of alternative funds):
  • GKs of GK-TK structures;
  • TMKs; and
  • investment corporations of J-REITs,

are each subject to certain compliance obligations, including identification and reporting of the tax residence and beneficial owners of their clients (ie, their investors) to the Japanese tax authorities, which will then exchange this information with tax authorities in other relevant jurisdictions under the automatic exchange of information (AEOI) framework.

Nagashima Ohno & Tsunematsu

JP Tower, 2-7-2 Marunouchi
Chiyoda-ku
Tokyo 100-7036

Simpson Thacher & Bartlett LLP
Ark Hills Sengokuyama Mori Tower 41st Floor
9-10, Roppongi 1-Chome
Minato-Ku, Tokyo 106-0032

+81 3 6889 7000 / +81 3 5562 6200

+81 3 6889 8000 / +81 3 5562 6202

DAzcue@stblaw.com www.noandt.com / www.stblaw.com
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Trends and Developments


Author



Simpson Thacher & Bartlett LLP is a global law firm with more than 1,000 lawyers working across 32 major practice areas and almost every industry sector. Its multidisciplinary private funds practice has advised clients for over 40 years, playing a prominent role in the development of the private funds industry. Working closely with the firm’s other practice areas, the private funds team advises many of the world’s best-known institutional alternative asset managers, as well as smaller funds and independent boutiques. In addition to comprehensive fund formation advice, the firm provides sponsor and adviser clients with practical solutions to complex regulatory, compliance and enforcement issues, and advises sponsors of private funds worldwide. Simpson Thacher also has substantial experience in M&A transactions involving private investment firms, IPOs of alternative asset managers, credit facilities for funds and managers, and secondary transfers of private fund investments. In Tokyo for over three decades, the firm advises both Japanese and international clients on capital markets, M&A and cross-border private fund formation transactions.

Overview

The year 2020 has been one of disruption, challenges and opportunities. While fundraising has so far remained remarkably robust, setting records and generally meeting or exceeding expectations, the twin shocks of the global COVID-19 pandemic and the sudden resignation of Prime Minister Shinzo Abe have created more uncertainty for alternative funds in Japan than at any time since the end of the Global Financial Crisis (GFC). Nonetheless, alternative funds as a whole seem to have planted strong roots over the past decade and appear to be better positioned to weather a crisis than they were in 2007. The challenges faced by the disruptions of 2020 are real, but rather than chilling the entire Japanese alternative funds industry the way the GFC did a little over a decade ago, the current crisis seems more likely to accelerate existing trends towards diversification and a "flight to quality".

Background

Entering 2020, expectations could not have been higher for alternative funds in Japan. At least half a dozen significant buyout funds were publicly reported to be in the market, targeting over USD7.5 billion in commitments. Several real estate and logistics/infrastructure funds were closing in on their hard caps, approaching or clearing the USD2 billion mark. The previous year had been another banner year for venture capital, with financial data company Preqin reporting 597 Japan-based VC funds with total commitments of JPY2.5 trillion at the end of December. The Tokyo Olympics were scheduled to start in July, with over 600,000 foreign visitors expected. Both equities and alternatives were attracting attention from foreign investors, with a 62.8% IRR and 3.6x MoC on 93 exits in 2019, according to Asia Private Equity Review (APER). “Abenomics”, the economic policies of Prime Minister Shinzo Abe, had seemingly broken through decades of resistance to M&A, creating opportunities for private equity through legal and tax reforms. Fundraising was buoyed by an influx of commitments from new players, including the Japanese Government Pension Investment Fund (GPIF), with JPY163 trillion in assets (USD1.45 trillion) as of 2017, which had recently revised its long-standing conservative investment guidelines to permit investments in alternative assets; Japanese mega banks; and the newly privatised Japan Post. These changes also attracted the attention of overseas investors, leading KKR co-founder Henry Kravis to remark that Japan had become the global investment company’s “highest priority” outside the United States. The future for alternatives looked bright in the land of the rising sun.

The Impact of COVID-19

The worldwide COVID-19 pandemic has adversely impacted commercial activity globally, and Japan has been no exception. Measures taken to contain the initial outbreak in Japan were similar to those taken in other countries, including restrictions on international travel, closures of schools, restaurants, retail stores, offices, businesses and public venues, and the cancellation of public events, including the postponement of the Tokyo Olympics, now tentatively rescheduled for the summer of 2021. The outbreak has disrupted supply chains and adversely impacted a broad range of businesses in Japan, including travel, hospitality, dining, entertainment and other industries that depend on in-person interaction. Consumption is estimated to have declined by 20% in April according to the Bank of Japan, and GDP is estimated to have fallen by 7.8% in April–June from the previous quarter, or 27.8% on an annualised basis, according to the BBC, the biggest decline since figures became available in 1980. These disruptions have made valuations highly uncertain, increased investment risks, and presented unprecedented challenges for managers seeking to raise alternative funds. New investments have been significantly impacted, with buyers and sellers having difficulty agreeing on valuations, muting deployment of capital.

Despite these challenges, fund managers appear to have been remarkably adaptable and resilient. Heeding the lessons from the GFC, private equity firms in Japan seem to have been generally less leveraged than in 2007–2008, minimising exposure to loan defaults and liquidity risks. The rebound in global financial markets also seems to have softened the blow from the initial downturn, and so far there have been no signs of a wave of investor defaults or sell-downs. Conversely, the COVID-19 outbreak appears to have created winners as well as losers, permitting managers who constructed a more diversified portfolio to balance investments in exposed industries with investments in industries that have grown as a result of the disruptions, such as online and e-commerce-related businesses. The disruptions may have also created unique buying opportunities in a market that was seen as promising but over-valued before the COVID-19 outbreak. This seems to apply not just in the buyout sector, but in real estate, distressed and special opportunity investments, as well.

From a fundraising perspective, COVID-19 has been challenging, particularly for sponsors raising capital from non-Japanese investors for the first time. Some investors in fiduciary positions, such as pension funds, were at least initially limited by policies requiring in-person meetings prior to investing with a sponsor for the first time, and the travel restrictions put in place during the outbreak have effectively reduced the pool of prospective investors. Nonetheless, the industry appears to have adapted through innovation and use of new technologies. New videoconferencing apps and pre-recorded interviews and presentations have become the new normal and have allowed fundraising to continue in the face of these challenges, allowing sponsors to connect with prospective investors.

Alternative fund sponsors have also been concerned, particularly during the initial market downturn in March and April, that investors would cut back their allocations for alternatives and become more selective. In particular, there were concerns that the denominator effect might reduce allocations from Japanese financial institutions that had expanded heavily into alternatives in recent years, some of which had begun facing constraints even prior to the COVID-19 outbreak. Other investors expressed hesitation about permitting managers to make investments during the peak of turbulence in the financial markets. Buoyed by momentum from 2019, however, fundraising remained remarkably resilient, with multiple major buyout and real estate funds successfully reaching their hard caps during 2020, and not infrequently as “one-and-done” fundraisings. The road has not necessarily been easy, though, as the COVID-19 outbreak seems to have made fundraising more difficult even for stronger sponsors. Investors appear to be more cautious than ever in evaluating and negotiating their investments in alternatives, conducting more extensive, probing and time-consuming due diligence and legal reviews of fund documentation. Their caution has also likely led them to become more intransigent on certain terms.

The Resignation of Prime Minister Abe

Prime Minister Abe, who began his second term as prime minister in late September 2012, is generally credited with steering Japan out of the end of the GFC and two decades of deflation. Through his “three arrows” of expansionist monetary policy – increased government spending and legal reforms aimed at stimulating private sector investment to achieve long-term growth – Abe laid a foundation that was hospitable to the expansion of private equity and alternative funds generally. In particular, corporate governance reforms and the introduction of a stewardship code, cuts in corporate tax rates, and other reforms that facilitated M&A transactions paved the way for corporate carve-outs, attracting attention from major global private equity investors. Mr Abe became Japan’s longest-serving prime minister in 2020, shortly before he announced his resignation for health reasons. While it is believed that his pro-investment policies are unlikely to change under a new administration, his resignation creates some uncertainty about the ability of future administrations to sustain the pro-investment environment Mr Abe cultivated. With a few notable exceptions, the position of prime minister has largely been a revolving door where the office holders have, more often than not, failed to have any meaningful positive impact on Japan. It remains to be seen whether the leaders who will take Mr Abe’s mantle going forward will be as effective in fostering the vitally needed pro-investment reforms in a rapidly ageing society that has historically excelled at preserving harmony and resisting change.

Long-Term Trends in Alternative Funds: Diversification and Flight to Quality

Two key trends that have shaped the development of alternatives in Japan are diversification of the industry and the so-called “flight to quality”. To varying degrees, these trends have only been accentuated by the COVID-19 pandemic.

Diversification

The Japanese private equity buyout industry has developed significantly since its inception at the end of the late 1990s. With a few notable exceptions (eg, Softbank), since the GFC, the domestic industry has largely focused on small and mid-cap deals, while the larger deals, including the headline-grabbing corporate carve-out transactions, have been driven by corporates and global private equity firms. This segmentation of the domestic industry was due in large part to the relatively small fund sizes of domestic sponsors, which in turn was largely dictated by investors. After the GFC, Japanese investors expressed a clear preference for smaller funds, believing that the core competencies of domestic firms were in small-cap domestic buyouts, and that domestic sponsors had veered off course in the run-up to the GFC by trying to do larger deals in spaces best occupied by more experienced global buyout firms. This largely shaped the industry for the next decade, with smaller fund sizes and few fundraisings crossing the JPY100 billion threshold. Through 2018, according to APER, average private equity fund sizes in Japan ranged from USD75 million to USD150 million, nearly doubling to USD270 million in 2019. Despite the challenges of 2020, domestic Japanese private equity seems to be breaking out of that mould, with multiple fundraisings eclipsing the USD1 billion mark, and a handful of others closing or expected to reach final closings in close proximity. Moreover, an increasing number of domestic firms have raised their first funds with offshore vehicles for non-Japanese investors. A few domestic firms have expanded their sights beyond Japan, with third country-focused or pan-regional funds, while others have entered new niches domestically, raising regional development-focused funds in areas previously under-served and overlooked by traditional private equity. This differentiation is punctuated by the different sizes, targets, strategies and specialisations emerging in the market.

There is also growing diversification in private equity strategies outside of the buyout space. Real estate funds, and J-REITs in particular, have been a strong part of the alternatives landscape for years, but recent years have seen a wave of large infrastructure and logistics fundraisings. Asia-based logistics operators have recently raised multiple funds exceeding USD1 billion and 2020 saw the closing of a significant USD2.75 billion Japan-focused pan-Asia real estate fund and the seeding of a JPY280 billion (USD2.6 billion) open-ended logistics fund, with the potential to grow to up to USD10 billion in AUM according to Private Equity International. Growth, mezzanine and regional development funds, and minority activist funds, have also contributed to the diversity of alternatives in Japan. 

Two alternatives sectors that have not developed, at least to date, have been private credit and hedge funds. Private credit funds may find it more difficult to plant roots in Japan due to competition from traditional banks, who tend to have significant capital available for lending and are able to lend at very low interest rates. There are also relatively few hedge funds in Japan, with industry tracker eVestment reporting that less than 1% of all hedge funds globally have their primary physical location in Japan. This might seem surprising for the world’s third-largest economy by GDP, which has sophisticated and well-developed debt and equity markets, and around 3,500 publicly traded companies, but onerous tax and legal regimes, which can make it take over a year to obtain certain licences, have tended to make Singapore and Hong Kong more attractive as a hub for hedge funds in Asia.

Flight to quality

In North America and Europe, the flight to quality, whereby investors flock to fundraisings by stronger, proven sponsors, has tended to polarise the private equity market, leading to the rise of mega-funds and making fundraising more challenging for newer firms and firms without top track records. Historically, this trend has been less pronounced in Japan. There are a number of reasons for this, including the investment strategies employed by Japanese investors in private funds, domestic economic policies, and the generally small number and size of Japanese buyout funds. There are signs, however, that this may be changing, and the recent COVID-19 pandemic may be accelerating that change.

A confluence of factors broadly increased domestic investment in Japanese alternative funds after the GFC. Abenomics promoted investments and generated asset-price inflation, helping to reverse the long deflationary cycle that began after the end of the bubble era in the early 1990s. The revision to GPIF’s investment guidelines bolstered Japanese public equity markets and boosted alternative funds generally, with prospects for a substantial allocation to alternatives through domestic and international gatekeepers. Japanese mega-banks began to focus increasingly on alternative investments, and regional banks sought ways to invest in alternatives as opposed to the unprofitable business of lending at negative or near 0% interest rates. Reforms at the newly privatised post office, Japan Post, which sought to make more productive use of its prodigious cash reserves, also injected capital into domestic alternatives. Together, these factors created a vibrant domestic ecosystem for alternative funds. Particularly with many Japanese investors preferring to make smaller investments across a range of funds rather than placing their bets on one or two selectively chosen sponsors, the influx of cash into alternatives has floated many boats, spreading the benefits more evenly across a range of sponsors.

Time and the COVID-19 pandemic may alter these trends. There are signs that Japanese investors are becoming more selective with their portfolios as the economic consequences of outbreak have spread unevenly across Japan’s economic landscape, as investors have faced benchmarking and greater scrutiny of performance, and as allocations from financial institutions have been impacted by the denominator effect. As a result, particularly among buyout funds, firms with top performance and disciplined, well-managed fundraises have been able to hit or even increase their hard caps and hold one-and-done fundraisings, while firms outside of that band have had longer, more difficult fundraisings. It would not be surprising to see this trend accentuated by the continuing fallout from the COVID-19 pandemic.

Other Trends: Fund Finance

Like many aspects of alternative investments in Japan, fund finance was slow to arrive and develop compared to North America and Europe. There are a number of reasons for this, including Japan’s complex tax and regulatory system, the relatively small size of domestic private equity funds, and the apprehensiveness that domestic LPs have expressed over the use of leverage by domestic sponsors. Despite Japan’s complex tax and regulatory regime, some domestic private equity funds have nonetheless been able to implement subscription facilities for bridging drawdowns to make investments. Although developing a facility that serves both onshore and offshore fund platforms of a single fund has proved challenging due to the tax and regulatory constraints, with only a handful of banks able to lend against commitments from both Japanese and international investors, private fund sponsors have been able to put bridge facilities in place that separately serve their onshore and/or offshore platforms. The use of these platforms has been limited, however, as Japanese investors (and in some cases, non-Japanese investors) have initially been resistant to such fund-level borrowing. Addressing the concerns of US tax-exempt investors has also been challenging, particularly for smaller funds, where costs may not always justify the benefits of using blockers. Consequently, borrowing tenor under fund partnership agreements has tended to be quite short, with many facilities restricting the period for which loans may remain outstanding to no more than 30–90 days, and the purposes for which borrowing is permitted have generally not expanded under private-fund partnership agreements to the extent they have in other markets.

Nonetheless, fund finance seems to serve a clear need for growing domestic sponsors seeking to invest in larger deals. With increased competition for buyout deals from global sponsors and strategic buyers, domestic sponsors who require asset-level debt financing must, increasingly, be able to prove funding certainty and swift execution. Without a subscription facility in place to bridge funding, any delay in putting such asset-level debt financing in place could adversely impact funding certainty and leave a domestic sponsor at a competitive disadvantage. Subscription facilities help bridge these gaps, permitting sponsors to move quickly in competitive situations on larger ticket deals. Although convincing domestic (and, in some cases, overseas) investors of the need and benefits of such financing arrangements has required effort, there appears to be a clear need for such facilities in the market. As the competitive realities and the use of subscription facilities become better understood, it seems likely that they will become more ubiquitous going forward.

Simpson Thacher & Bartlett LLP

Ark Hills Sengokuyama Mori Tower
41st Floor
9-10, Roppongi 1-Chome
Minato-Ku, Tokyo 106-0032
Japan

+81 3 5562 6200

+81 3 5562 6202

DAzcue@stblaw.com www.stblaw.com
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Law and Practice

Authors



Nagashima Ohno & Tsunematsu is the first integrated full-service law firm in Japan and one of the foremost providers of international and commercial legal services based in Tokyo. While representing leading domestic and international clients, it has successfully structured and negotiated many of the largest and most significant corporate, finance and real estate transactions related to Japan. In addition to its capabilities in key commercial areas, the firm is known for pioneering domestic and cross-border risk management/corporate governance cases and large-scale corporate reorganisations. The approximately 500 lawyers at the firm work together in customised teams to provide clients with the expertise and experience specifically required for each matter. The lawyers advise both domestic and international clients on the structuring, formation and offering of alternative funds from legal, regulatory and tax perspectives, and also provide regulatory and ongoing compliance advice to investment managers. Simpson Thacher & Bartlett LLP is a global law firm with more than 1,000 lawyers working across 32 major practice areas and almost every industry sector. Its multidisciplinary private funds practice has advised clients for over 40 years, playing a prominent role in the development of the private funds industry. Working closely with the firm’s other practice areas, the private funds team advises many of the world’s best-known institutional alternative asset managers, as well as smaller funds and independent boutiques. In addition to comprehensive fund formation advice, the firm provides sponsor and adviser clients with practical solutions to complex regulatory, compliance and enforcement issues, and advises sponsors of private funds worldwide. Simpson Thacher also has substantial experience in M&A transactions involving private investment firms, IPOs of alternative asset managers, credit facilities for funds and managers, and secondary transfers of private fund investments. In Tokyo for over three decades, the firm advises both Japanese and international clients on capital markets, M&A and cross-border private fund formation transactions.

Trends and Development

Author



Simpson Thacher & Bartlett LLP is a global law firm with more than 1,000 lawyers working across 32 major practice areas and almost every industry sector. Its multidisciplinary private funds practice has advised clients for over 40 years, playing a prominent role in the development of the private funds industry. Working closely with the firm’s other practice areas, the private funds team advises many of the world’s best-known institutional alternative asset managers, as well as smaller funds and independent boutiques. In addition to comprehensive fund formation advice, the firm provides sponsor and adviser clients with practical solutions to complex regulatory, compliance and enforcement issues, and advises sponsors of private funds worldwide. Simpson Thacher also has substantial experience in M&A transactions involving private investment firms, IPOs of alternative asset managers, credit facilities for funds and managers, and secondary transfers of private fund investments. In Tokyo for over three decades, the firm advises both Japanese and international clients on capital markets, M&A and cross-border private fund formation transactions.

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Please select at least one chapter and one topic to use the compare functionality.