Private Equity 2023 Comparisons

According to Refinitiv, 2,347 Japanese M&A transactions were announced in the first half of 2023 with a deal volume of JPY10.8 trillion, which was an 0.9% increase and a 17.2% increase, respectively, compared to the first half of 2022 (M&A transactions with a deal volume over JPY100 billion amounted to JPY7.3 trillion, which was a 37.3% increase compared to the first half of 2022).

There has been recovery in outbound M&A deals by Japanese companies after a rapid decrease in cross-border transactions and a slowdown in outbound M&A deals in 2020 due to the COVID-19 pandemic. The deal volume of outbound transactions by Japanese companies in the first half of 2023 was JPY3.1 trillion, a 31.4% increase compared to the first half of 2022.

While the number of M&A transactions in Japanese target companies by financial sponsors decreased by 9.8% compared to the first half of 2022, the deal volume of such M&A transactions increased by 118.1% compared to the first half of 2022, which is a record high in the last 40 years. Notable deals include the public-to-private transaction of Toshiba launched in August 2023 by a consortium led by Japan Industrial Partners for JPY2.1 trillion and the public-to-private transaction of JSR Corporation launched in June 2023 by Japan Investment Corporation for JPY1 trillion.

Active Sectors

According to Refinitiv, the most active sector in terms of deal volume in the first half of 2023 was the hi-tech sector, with the deal volume of M&A transactions of Japanese target companies in the hi-tech sector reaching JPY3.2 trillion. The second was raw materials (JPY1.6 trillion in the first half of 2023) and the third was healthcare (JPY1.2 trillion in the first half of 2023).

Impact of Macro-Economic Factors

In response to the Japanese government’s policy to reduce the number of listed companies that are subsidiaries of listed parents, the last few years have seen an increasing number of domestic deals where the parent of a listed subsidiary either buys out the subsidiary or sells its holdings in the subsidiary to a third party.

In addition, Japan has seen a number of corporations reorganising their businesses to adjust to ESG demands, especially decarbonisation. Certain Japanese companies have also sold their non-core businesses in order to refocus their resources on future growth areas to ensure long-term sustainable success, generating value for shareholders and contributing to wider society. As a growing number of Japanese companies adopt the strategy of selling unprofitable sectors of their business portfolio and acquire new businesses to ensure sustainable growth amid the rapidly changing business environment, this trend of deals driven by the need to change or diversify business portfolios looks set to continue.

In the small to mid-cap market, domestic M&A deals of family-owned businesses are likely to continue as founders have difficulty in handing over their business to family members or employees and instead decide to sell the business to third-party buyers, including private equity buyers.

Another interesting and important development in recent years has been an increasing number of hostile transactions, including unsolicited tender offers by Japanese companies, which have historically been very cautious about making such offers.

The uncertainties experienced in the market in 2022 are expected to continue in 2023. Japanese companies are affected by the global geopolitical tensions caused by the invasion of Ukraine, deteriorating US–China relations and the resulting disruption of global supply chains. Global inflation is having an impact on costs for business and higher interest rates will bring down valuations. However, these uncertainties do not seem to have materially hindered private equity deal activities in Japan – see 1.1 Private Equity Transactions and M&A Deals in General. Factors such as the continued low interest rates and the yen falling to a 25-year low due to the Bank of Japan’s strong commitment to continue monetary easing (divergent from the approach of central banks in many other countries) may have contributed to this trend. However, it is worth noting that some portfolio companies of private equity sponsors have faced financial difficulties and underwent restructuring proceedings in the last few years.

Foreign Investment Regulations

Expanded scope of foreign investment review

In 2020, there was a major amendment to the Foreign Exchange and Foreign Trade Act (FEFTA), which regulates foreign direct investments in Japan, among other things. While Japan has long required foreign investors to make a prior notification and undergo screening prior to investing in designated business sectors, the amendment expanded the scope of covered transactions.

As a result of the amendment, the threshold for the prior notification requirement for the acquisition of shares of listed companies engaged in designated business sectors was lowered from 10% to 1%, while any acquisitions of shares of non-listed companies engaged in designated business sectors continue to be reportable regardless of the percentage of shares acquired (ie, the acquisition of even one share is reportable).

To strike a balance, the amended FEFTA concurrently introduced exemptions from the prior notification requirement, which may be available for passive investors who are not foreign governments, if they comply with certain exemption conditions to ensure that they remain passive investors. Such exemption conditions include requirements to not:

• cause their closely related persons to become a board member of the target;
• propose to the shareholders’ meeting any transfer of business in any designated business sector; and
• access any non-public technology information of the target relating to any designated business sector.

It should be noted that, because of these exemption conditions, the exemption is typically not available for a private equity buyer who intends to obtain control of a Japanese target.

Under the amended FEFTA, the designated business sectors triggering the prior notification requirement are classified into core sectors and others, where the core sectors cover more sensitive sectors such as weapons, dual-use technologies, nuclear, aircraft, certain forms of cybersecurity and telecommunications. If the target engages in a core sector business and is a non-listed company, no exemption is available. If the target engages in a core sector business but is a listed company, then the exemption will be available if the foreign investor is a regulated financial institution, or if the acquisition of shares is limited to less than 10% and the foreign investor complies with even more stringent exemption conditions.

Asset transactions (including statutory demergers and mergers) will also trigger the prior notification requirement under the amended FEFTA if it is an acquisition of a business in any designated business sector from a Japanese company by a foreign investor.

Review on exercise of voting rights

Under the amended FEFTA, a foreign investor is also required to make a prior notification before it exercises its voting rights at the shareholders’ meeting of a Japanese company engaged in any designated business sector to:

• approve the appointment of the foreign investor or its closely related person as a board member of the target; or
• approve a transfer of business in any designated business sector, if the agenda is proposed by such foreign investor.

Continued addition of designated business sectors

The list of designated business sectors subject to screening is continuously reviewed and new sectors are added from time to time. For example, manufacturing of medicines against infectious diseases and high risk medical devices was added in 2020 in response to the pandemic.

More recently, in 2023, in tandem with the government’s efforts to secure a stable domestic supply of certain critical materials through the Act on Promotion of National Security through Integrated Economic Measures (the “Economic Security Promotion Act”), business sectors relating to these critical materials were added to the list. As a result, while the government will provide subsidies to domestic suppliers of the critical materials under the Economic Security Promotion Act, it will also review foreign investments in these critical materials.

Stricter review

The Japanese government has continued to tighten its review of foreign direct investments, and this tendency will certainly continue following the war in Ukraine and heightened tension between Western countries and Russia and China. Foreign investors are recommended to analyse the implication of the FEFTA process on any deal-making in Japan at the outset of a potential transaction, especially if the investor is from China, Russia or other countries with which Japan has strained relations, or if it is funded or otherwise closely related to any foreign government.

New Guidelines

Corporate Governance Code and Stewardship Code

As part of the continued efforts to enhance the corporate governance of Japanese listed companies, the Tokyo Stock Exchange adopted the Corporate Governance Code in 2015, and revised it in June 2018 and June 2021. The Corporate Governance Code adopts the “comply-or-explain” approach and sets forth principles for effective corporate governance for Japanese listed companies, which, among other things, require listed companies to give weight to the cost of capital in determining their business portfolio and resource allocation. The emphasis on the cost of capital may encourage Japanese listed companies to dispose of their non-core businesses and focus on expanding their competitive edge through M&A.

In addition, the Japanese Financial Services Agency (FSA) introduced a Japanese version of a Stewardship Code in February 2014 and subsequently revised it twice, in May 2017 and March 2020. The Stewardship Code describes the principles considered to be helpful for institutional investors in fulfilling their stewardship responsibilities towards their clients, beneficiaries and companies when they engage with corporates. The FSA announced that 327 institutional investors have adopted the Stewardship Code as of 30 June 2023.

In the latest revised code, it is stipulated, among other things, that institutional investors should disclose not only the voting records for each investee company but also the reason why they voted for or against each agenda item, and that proxy advisers should dedicate sufficient management resources to ensuring sound judgement in the evaluation of companies and furnishing their services appropriately. These developments are affecting the stewardship activities of institutional investors, including the exercise of voting rights, which is also affecting M&A practices in Japan.

More than ten years after it formulated guidelines for management buyouts in 2007, the Ministry of Economy, Trade and Industry of Japan (METI) released fully revised guidelines for M&A transactions involving conflicts of interest in June 2019, titled the Fair M&A Guidelines: Enhancing Corporate Value and Protecting Shareholders’ Interest (the “Fair M&A Guidelines”), which cover not only management buyouts but also acquisitions of a controlled company by a controlling shareholder.

Private equity M&A in which incumbent management participates (management buyouts) will be within the scope of the Fair M&A Guidelines; as a practical matter, compliance with the guidelines is likely to have an impact on appraisal rights litigation brought by shareholders who dissent to squeeze-outs.

Furthermore, in response to the increase in hostile or unsolicited offers and the court rulings on defence measures, the METI adopted the new guidelines on directors’ conduct and defence measures, the Guidelines for Corporate Takeovers, on 31 August 2023, which provide guidance for directors in reacting to acquisition offers, including hostile or unsolicited ones. The FSA is also reviewing the mandatory tender offer rules and large shareholding reporting requirements, but it will take time for the law to be amended by the FSA.

Change in Tax Law

There were several M&A-related tax amendments in 2021, which could have a significant impact on M&A structuring. Among others, there were amendments to the taxation of stock-for-stock acquisitions.

The implications of the amendment to the taxation of a stock-for-stock transaction are discussed below.

Stock-for-stock acquisitions

A number of legal and tax changes have been made to facilitate stock-for-stock acquisitions by Japanese companies, and an increase in such acquisitions is expected. Not all private equity buyers would be able to propose a stock-for-stock acquisition, but these tax changes will add more options for acquisition consideration, and could affect the competitive landscape in the M&A market.

Under the Companies Act, there is currently a transaction called a “Stock-for-stock Exchange (kabushiki kokan)”, which can only be adopted when the acquirer intends to acquire all the issued shares of the target. An acquisition of only part of the issued shares of the target in exchange for the acquirer’s shares (eg, an exchange offer for a listed target) is theoretically permissible under the Companies Act by means of issuance of the acquirer’s shares in exchange for an in-kind contribution of the target’s shares. However, it is subject to a requirement that a court-appointed inspector investigates the value of the target’s shares prior to the issuance of the acquirer’s shares, and the target’s shareholders receiving the acquirer’s shares must indemnify the acquirer if it later turns out that the value of the target’s shares falls significantly short of the value on which the issuance of the acquirer’s shares was based. Such requirement tends to be prohibitively burdensome.

As part of the amendments to the Companies Act promulgated in December 2019, a transaction called a “Share Delivery (kabushiki kofu)” became available from March 2021, which allows a Japanese corporation to conduct a similar share exchange transaction with another Japanese corporation without the need for approval of the acquisition plan if the target is not a subsidiary of the acquiror prior to the transaction, but will become a subsidiary following it. Furthermore, tax law was amended in April 2021 to grant tax deferral on capital gains on the stock consideration received as a result of a Share Delivery, as far as the acquiror’s shares account for 80% or more of the total consideration.

Under the Act on Prohibition of Private Monopolisation and Maintenance of Fair Trade (the “Anti-Monopoly Act”), the acquisition of a company or business with Japanese domestic turnover can be subject to pre-transaction notification to – and clearance from – the Japan Fair Trade Commission (JFTC).

A stock acquisition is subject to such requirement if:

• the acquirer holds 20% or less of the voting rights prior to the transaction, but will hold more than 20% of the voting rights thereafter; or
• the acquirer holds 50% or less of the voting rights prior to the transaction, but will hold more than 50% of the voting rights thereafter; and
• the consolidated domestic turnover of the ultimate parent company of the acquirer (without taking into account the turnover of the target and its subsidiaries) exceeds JPY20 billion; and
• the consolidated domestic turnover of the target exceeds JPY5 billion.

There are comparable rules (with slightly different turnover thresholds) that apply to asset acquisitions, mergers, demergers and other types of business combination transactions. Depending on the fund structure, the domestic turnover of the portfolio companies of a private equity fund may be aggregated in applying the thresholds.

The statutory waiting period after the notification is 30 days, which may be shortened by the JFTC upon request, assuming there is no substantive competition issue. On the other hand, if the JFTC identifies any competition issue, it may extend the period and request additional information from the acquirer.

In addition to the mandatory filing, the JFTC recommends acquirers to consult the JFTC before the transaction if:

• the aggregate consideration of the transaction exceeds JPY40 billion;
• the thresholds for mandatory pre-transaction notification are met, except for the threshold pertaining to the consolidated domestic turnover of the target; and
• the transaction will likely affect domestic consumers – eg, if any one of the following is met:
1. the target has offices, R&D facilities or other business operations in Japan;
2. the target conducts sales activities targeting domestic consumers (eg, by maintaining a Japanese website or using Japanese brochures); and
3. the target’s consolidated domestic turnover exceeds JPY100 million.

As described in 2.1 Impact of Legal Developments on Funds and Transactions (Foreign Investment Regulations), the jurisdiction of the FEFTA (which regulates foreign inward investments in Japan) is now very broad following the amendment thereof.

A wide range of investments may be subject to the prior notification requirement. Furthermore, post facto reporting will be required in many cases, even if the relevant investments are not subject to the prior notification requirement, including when a foreign investor relies on the exemption from the prior notification.

Both the prior notification and post facto reporting will be submitted to the Bank of Japan, and will be circulated for review by the MOF and other ministries supervising the industries in which the target engages. A statutory waiting period of 30 days will apply for a prior notification, which can be extended up to five months, but may be shortened if the investment does not relate to national security. A post facto reporting must be made within 45 days of the investment.

Aside from the regulations under the Anti-Monopoly Act and the FEFTA, going-private transactions must comply with security regulations governed by the FSA, including the mandatory tender offer and disclosure requirements (see 7. Takeovers), and the listing rules of the Tokyo Stock Exchange.

In response to the global trend of respect for human rights in corporate activities, METI released the “Guidelines on Respect for Human Rights in Responsible Supply Chains” in 2022. While global private equity players have already applied global human rights diligence requirements in their activities in Japan, the adoption of the Guidelines may require private equity investors in Japan to pay closer attention to the supply chain management of the targets of Japanese companies.

Following the war in Ukraine, the Japanese government adopted economic sanctions against Russia and Belarus, like many other countries. These sanctions and countersanctions of Russia are putting Japanese companies with Russian operations in a very difficult situation, which may in turn present the same difficult questions to private equity buyers when considering the acquisition of such companies.

An acquirer typically conducts a due diligence investigation with the assistance of legal counsel and other advisers, and it typically covers business, legal, finance and tax matters. Of course, if the acquisition is made by way of an unsolicited offer, the acquirer would need to rely on annual reports and publicly available information on the target. However, it should be noted that Japan does not have any public database for litigation or lien searches, which limits the ability to conduct due diligence without the co-operation of the target.

A typical legal due diligence investigation of a Japanese target covers capitalisation, corporate governance, material contracts and assets, debt and other liabilities, employment, governmental authorisations, legal compliance, and litigation and disputes. For a private equity acquirer, the investigation of debt and material assets would involve analysis of the prepayment terms of existing indebtedness and consideration of a security package to be negotiated with the debt provider.

Corruption risks pertaining to business conducted in Japan are generally considered low, but the Japanese government is paying closer attention to foreign corrupt practices of Japanese companies, and strengthening enforcement. As such, due attention should be paid to whether the target has sufficient systems in place to control foreign corruption risk.

Like many other jurisdictions, there is increasing business focus on customer and user data, which means that data protection compliance is becoming a new focus of legal due diligence.

It is not common for a buyer to be able to see or rely upon a vendor financial due diligence report or vendor legal due diligence report, even in an auction sale. A vendor may conduct its own due diligence investigation in order to prepare it for negotiations with potential buyers, but that is different from full-scale due diligence, and results would not typically be shared with potential buyers.

If a vendor were to provide any due diligence report to a potential buyer, it would usually be on a non-reliance basis only.

On the other hand, a buyer would usually be able to rely on due diligence reports prepared by its own advisers, but the buyer’s equity and debt providers are not typically permitted to rely on reports prepared by the buyer’s advisers.

The acquisition of a non-listed company by a private equity buyer would typically be structured as a stock sale, unless there is a specific reason to prefer an asset sale (eg, a high risk of hidden liabilities).

The acquisition of a business by a private equity buyer from a company, whether listed or non-listed, would typically be carried out in the form of a straightforward asset sale or statutory demerger (kaisha bunkatsu) under the Companies Act. The transferred assets and assumed liabilities can be specified in both scenarios, and there is no difference in the effectiveness of the separation of liabilities. It is not necessary to obtain consent from creditors in order to complete a statutory demerger. Instead, there are required procedures that must be implemented to protect creditors and employees, which would take at least a month to complete.

A going-private transaction of a listed company would typically be carried out in a two-step acquisition, comprising a first-step tender offer and a subsequent squeeze-out transaction. See 7.6 Acquiring Less Than 100% for details of the squeeze-out transaction.

A one-step cash merger is not typical, as it would trigger a revaluation of the transferred assets for tax purposes, and taxable income will be recognised on the difference between book value and fair value. In general, deal terms would be more competitive in an auction sale and there would be fewer representations and warranties made by the seller.

A private equity fund would typically form an acquisition entity, which is usually a corporation (kabushiki kaisha). As a general matter, a limited liability company (godo kaisha) could be used, but that is not usually an option because there is a legal hurdle for a limited liability company to enter into a commitment line agreement with banks to secure working capital.

Generally speaking, it is not common for a private equity fund to be a party to any acquisition or sale documentation itself, or to provide a separate guarantee.

A private equity buyer would fund its acquisition entity with its own capital and with loans from banks, sometimes accompanied by mezzanine investments in the form of subordinated loans, preferred shares or convertible bonds. A private equity fund would typically acquire a controlling stake in the target, and the senior lenders will take security over material company assets.

In a tender offer, the acquisition entity will be required to provide evidence of its financing, both equity and debt, and must submit equity and debt commitment letters to the regulator, which will be publicly disclosed together with the registration statement. A seller in an auction process of a private target would also often require a private equity bidder to submit debt and equity commitment letters as part of the binding offer package.

Club deals are not frequently seen in Japan, partly because the deal size may not be as large as in the United States or some other jurisdictions. In a transaction with a large deal value, a consortium may be formed, as were the cases in the acquisition of Kioxia (then known as Toshiba Memory) by a consortium formed by Bain Capital and strategic investors (where the aggregate value of the equity and debt investments was approximately JPY2 trillion) and the public-to-private transaction of Toshiba launched in August 2023 by a consortium led by Japan Industrial Partners for JPY2.1 trillion.

In Japan, both fixed price arrangements and completion account mechanisms with respect to consideration structures are commonly used in private equity transactions, while locked-box mechanisms are rare. Earn-outs are not frequently seen, but are sometimes used in the acquisition of pharmaceutical and start-up companies to bridge a valuation gap between the seller and the buyer resulting from the inherent uncertainty regarding the target’s success. As discussed in 8.1 Equity Incentivisation and Ownership, rollover-structures are sometimes seen in Japanese private equity deals.

Fixed price arrangements are common in relatively small transactions, or in transactions where the interim period between the signing and the closing is expected to be relatively short. In such cases, parties may want to minimise the administrative burden and expense of post-closing adjustments, and buyers tend to rely on interim covenants (covering conduct of business prior to closing) and representations and warranties (such as no material adverse effect after the latest financial statements date).

In transactions where there are completion account mechanisms, the purchase price is usually adjusted based on net indebtedness and net working capital.

In Japan, it is not common for private equity sellers to provide specific protections in relation to consideration mechanisms (such as adjustment escrows), and the terms relating to consideration mechanisms do not usually differ much from those with a corporate seller.

Private equity buyers cannot usually provide a guarantee to secure the obligations of the acquiring entity. To deal with their concerns regarding closing uncertainties in relation to financing, sellers often ask the buyer to submit binding debt commitment letters from banks prior to the execution of transaction documents (especially in an auction process). Equity commitment letters are less common but – specifically for going-private transactions, where tender offers are regulated under the Financial Instrument and Exchange Act (the FIEA) – a private equity buyer that is the tender offeror will be required to submit and publicly disclose equity commitment letters from its fund entities and debt commitment letters from its banks to show that it has secured sufficient funds to complete settlement.

As discussed in 6.1 Types of Consideration Mechanisms, locked-box mechanisms, in the strict sense of the term, are rare in Japan. There are a number of transactions where the purchase price is agreed as a fixed amount and is not subject to any closing adjustment. However, in such transactions, there are no mechanisms for leakage indemnification or interest accrual on the purchase price; the protections for the buyer are typically the seller’s interim covenants to conduct the target’s business in the ordinary course and not to:

• distribute dividends;
• enter into transactions with the seller and its affiliates; or
• enter into other specified transactions.

It is quite typical to have a dispute resolution mechanism in place for completion accounts consideration structures. A typical dispute resolution mechanism would include:

• a good faith discussion period between the parties to resolve any differences; and
• determination by an independent third party (usually an accounting firm) if the parties are unable to reach agreement.

The selection of such third party is often agreed in the transaction agreement beforehand, or the parties can agree to each select an independent firm and use the average figure of both firms’ results.

Closing conditions are usually heavily negotiated between the seller and the buyer, and it is difficult to generalise what is “market” because the outcome will largely depend on the specifics of the transaction.

In most cases, private equity sellers emphasise deal certainty and will therefore resist any closing conditions that are not within the seller’s control, except for regulatory approvals, which are in most cases provided as a closing condition. Non-controllable conditions include:

• the buyer’s financing;
• third party consents;
• the absence of material adverse changes; and
• the retention of key personnel.

It is generally difficult for a private equity buyer to include financing as a closing condition, especially in an auction process. Other closing conditions do not generally differ much from the conditions provided for in transactions by a corporate buyer.

If the transaction involves a tender offer, conditions are kept to the minimum due to the rather stringent restrictions on withdrawing a tender offer, as further discussed in 7.5 Conditions in Takeovers.

“Hell or high water” undertakings are sometimes negotiated between the seller and the buyer, especially with respect to securing clearance under merger-controls, but are still not very common in Japan, regardless of whether the transaction involves a private equity fund as a buyer or not. Sellers would usually mitigate clearance risk through a simpler covenant obliging the buyer to use its best or reasonable efforts to obtain the clearance.

Break fees payable by the seller are not common in private equity transactions without tender offers (see 7.5 Conditions in Takeovers for transactions that involve tender offers), nor are fiduciary-out provisions. Reverse break fees payable by the buyer are also not common, but are used in some transactions where the seller is particularly concerned about the deal certainty. While it depends on the specificities of the relevant transaction, a typical trigger for a reverse break fee is the failure to obtain regulatory clearance and the amount is typically less than 10% of the transaction value.

There are no specific legal limits on break fees or reverse break fees, but they are usually structured as liquidated damages that would restrict the seller from pursuing additional damages claims against the buyer. Structuring them as a penalty (which does not preclude a separate damages claim) is also possible, but such intention must be expressly provided in the transaction agreement.

In general, termination events provided in the transaction documents for private equity sellers or buyers do not differ significantly from those for corporate sellers or buyers. Usually, the termination right is only exercisable before the closing of the transaction.

Typical termination events include:

• material breach of representations or covenants by the counterparty;
• the insolvency of the counterparty; and
• the passing of a long-stop date.

While it depends on the specificities of the relevant transaction, a long-stop date would be typically negotiated based on the anticipated timeline for securing regulatory clearances.

Typical methods to allocate risk between the buyer and the seller in Japan do not differ substantially from general practices in other jurisdictions. Risks are allocated through:

• representations and warranties;
• pre and post-closing covenants;
• closing conditions;
• indemnification; and
• post-closing adjustments of the purchase price.

Even when the seller of the target is a private equity fund, the seller’s representations and warranties would usually include representations and warranties regarding the target’s business, although the scope of such representations and warranties would be more limited compared to those that would be given by sellers that are not private equity funds.

Private equity sellers tend to avoid any post-closing exposures and to limit post-closing covenants and indemnification terms. Limitations on indemnification include short survival periods for representations and warranties (sometimes such survivals are less than a year after the closing) and limitations such as de minimis exclusions, deductibles or baskets, and caps on indemnity. Cap amounts negotiated by private equity sellers are often lower than those negotiated by corporate sellers.

As discussed in 6.8 Allocation of Risk, even when the seller of the target is a private equity fund, the seller’s representations and warranties would usually include representations and warranties regarding the target’s business, although the scope of such representations and warranties would be more limited compared to those that would be given by sellers that are not private equity funds.

Also, representations and warranties given by private equity sellers are often qualified by materiality (which may be simple materiality or “material adverse effect”) and seller’s knowledge (actual or constructive). A private equity seller would negotiate anti-sandbagging provisions. Although there are a limited number of court precedents, it is generally understood that the courts could deny indemnification claims with respect to breaches of warranties known to the buyer at the time of execution of the transaction document if the transaction document is silent about sandbagging.

Exceptions to the representations and warranties are typically carved out by disclosure schedules, and sometimes by full disclosure of the data room. Limitations on indemnification include short survival periods for representations and warranties (sometimes such period is less than a year after the closing) and limitations such as de minimis exclusions, deductibles or baskets, and caps on indemnity. Cap amounts negotiated by private equity sellers are often lower than those negotiated by corporate sellers.

The management team of the target seldom provides separate representations and warranties to a buyer, unless the management team itself is a seller in the transaction.

While private equity sellers accept indemnification to a certain extent, a seller would negotiate to limit its exposure as much as possible, as explained in 6.8 Allocation of Risk and 6.9 Warranty and Indemnity Protection. There are cases where private equity funds agree to set up an indemnity escrow as the buyer’s sole recourse, although such practice is still relatively rare.

While warranty and indemnity (W&I) insurance has been used by Japanese companies in cross-border M&A, it has not been widely used in domestic M&A, partly because no insurance company has been able to provide the insurance based on a Japanese language due diligence report and transaction documents.

However, an increasing number of Japanese auction sellers are requesting bidders to rely on W&I insurance in place of their recourses against the sellers. Furthermore, insurance companies have recently started to actively provide W&I insurance in Japan based on Japanese language documents. There has been an increasing opportunity for providers of this insurance in connection with the increasing number of small to mid-cap M&A conducted for the purpose of “business succession”.

In these transactions, individual sellers tend to prefer little to no recourse surviving the closing, and buyers are seeking alternative protection to accommodate the sellers’ request to limit the recourse and mitigate the credit risk of individual sellers. As a result, W&I insurance is expected to become more common, even in domestic M&A.

W&I insurance policies purchased for Japanese targets usually provide coverage for both fundamental and business representations and warranties.

Breaches of representations and warranties, such as inaccurate financial statements, are often negotiated and disputed between the seller and the buyer following the closing. However, the parties tend to resolve such disputes outside court.

For a going-private transaction, it is not uncommon to see appraisal rights litigation initiated by dissenting shareholders who have been squeezed out.

Going-private transactions have been common in the Japanese M&A market. Management buyouts sponsored by private equity funds were very popular in the late 2000s, and peaked in 2011. Management buyouts were not as frequent over the past decade, but there has been an increasing number of management buyouts in the last few years.

Recent going-private transactions sponsored by private equity funds include:

• the acquisition of Hitachi Metals, Ltd. by a consortium made up of private equity firms Bain Capital, Japan Industrial Partners and Japan Industrial Solutions in 2022;
• KKR’s acquisition of Hitachi Transport System, Ltd. in 2022;
• Bain Capital’s acquisition of Nichiigakkan in 2020 and of Kirindo Holdings in 2021; and
• the anticipated acquisition of Toshiba by a consortium led by Japan Industrial Partners, and acquisition of JSR Corporation by Japan Investment Corporation, announced in 2023, respectively.

In going-private transactions, the target company must, after the commencement of the tender offer, file a document stating its position (for, against or neutral) on the tender offer under the FIEA, and also make a public announcement regarding its position in accordance with the stock exchange’s rules and regulations. The target company’s directors must reach a decision on the company’s position in accordance with their duties of care and loyalty. While permissible, it is not very common for the bidder and the target company to enter into an agreement regarding the tender offer. If such agreement is executed, it usually contains provisions obliging the target company to express its affirmative opinion regarding the tender offer. In such a case, the bidder and the target company would likely negotiate fiduciary out provisions and break fees, whereby such an agreement must also be disclosed in the tender offer registration statement.

The FIEA imposes a reporting requirement on holders of more than 5% of the shares of a listed Japanese company. In calculating the shareholding ratio, the number of shares held by certain affiliated parties and other shareholders acting in concert (with respect to decisions on the acquisition or disposition of the shares or the exercise of the voting rights) will be aggregated. The reporting must be made to the relevant local finance bureau (zaimu-kyoku) within five business days of the 5% threshold being exceeded. Following the initial reporting, the shareholder must file an amendment whenever there is an increase or decrease in its shareholding ratio by 1% or more, or a change to the name, address or other material information in the previous reporting.

The FIEA sets forth mandatory tender offer requirements that apply to the acquisition of shares of listed companies (and non-listed reporting companies, which are rare). The rules are fairly complex, but the most important of the various requirements is a so-called “one third rule”, which requires a buyer intending to acquire shares of a listed company to conduct a tender offer if it intends to purchase shares off-market and would acquire more than one-third of the total voting rights of the listed company as a result of such purchase.

It should be noted that the one third threshold is tested against the voting rights after the acquisition, and even an acquisition by a buyer not holding any voting right before the acquisition could be subject to the requirement; while the requirement will not generally apply to an on-market purchase of shares, it will apply to off-floor trading, which does not provide general market participants with an opportunity to be a party to the trading. The voting rights will be calculated in accordance with the detailed rules set forth in the FIEA, which include aggregation of the voting rights held by certain affiliated parties and other shareholders acting in concert (with respect to decisions on the acquisition or disposition of the shares or the exercise of the voting rights). Such affiliated parties and other shareholders acting in concert could include affiliated or related funds or portfolio companies of private equity-backed bidders.

In almost all tender offers for Japanese targets, consideration has been cash only. Stock or mixed consideration has not been used, mainly because the Japanese tax law did not grant a tax deferral on capital gains upon the sale of stock for stock or mixed consideration, which led dispersed shareholders of a listed company to face an immediate need for cash to pay taxes, and because the acquirer was subject to prohibitively burdensome requirements under the Companies Act, including an investigation by a court-appointed inspector into the value of the target’s shares prior to the issuance of the acquirer’s shares, and an obligation for the acquirer to indemnify the target’s shareholders if it later turns out that the value of the target’s shares they received was significantly less than the value on which the issuance of the acquirer’s shares was based.

However, as discussed in 2.1 Impact on Funds and Transactions, there have been some legal and tax changes to facilitate stock-for-stock acquisitions by Japanese companies, and an exchange offer may finally come into play following such changes.

There are no minimum price rules applicable to tender offers in Japan.

Offer conditions are strictly regulated, with the FIEA setting out the limited list of permitted conditions, including the occurrence of the following:

• a decision by the target to effect a merger, reduction of stated capital, issuance of new shares, and other specified material corporate actions;
• revocation of government authorisations held by the target, natural disaster and other specified material events relating to the target;
• failure to obtain regulatory approvals; and
• the dissolution and bankruptcy of the acquirer.

Financing cannot be an offer condition, and the offeror must submit equity and debt commitment letters to the regulator as evidence of financing, which will be publicly disclosed together with the registration statement.

In order to secure successful completion of the tender offer, an offeror often enters into an agreement with the target or the principal shareholders pursuant to which the offeror agrees to launch the tender offer in accordance with the agreed terms; in exchange, the target agrees to support – or the principal shareholders agree to tender their shares to – the tender offer so long as it is conducted in accordance with the agreed terms. In each case, the existence and contents of such agreement must be publicly disclosed in the registration statement. The target board would often negotiate a fiduciary-out clause in such agreement, and the offeror would negotiate a break fee in response.

If an offeror wishes to acquire only a certain percentage of the shares of a listed company, it can generally set a cap for the acquisition in its tender offer. However, if the offeror will obtain two thirds or more of the total voting rights as a result of the tender offer, it cannot set any cap on its offer and must make an offer to purchase all the tendered shares.

If an offeror obtains 90% or more of the total voting rights of a listed company, it can squeeze out the minority shareholders by exercising a statutory call option available under the Companies Act. This requires approval from the board of the target (which can be controlled by the 90% shareholder), but not from the shareholders. Dissenting shareholders can exercise appraisal rights, and can seek an injunction in limited circumstances (eg, when the exercise of the call option is in breach of law or when the call price is grossly improper).

If an offeror does not obtain 90% of the total voting rights but secures two thirds, it can still squeeze out the minority shareholders by alternative methods available under the Companies Act (all of which would require a two-thirds super-majority approval of shareholders). Such alternatives include a short-form cash merger, but a reverse stock split (kabushiki heigou) is the option predominantly used. The reverse stock split would be structured so that, following its completion, shareholders of the target other than the offeror would hold only fractional shares and would be subsequently cashed out. Dissenting shareholders can exercise appraisal rights and seek an injunction if the reverse stock split is completed in breach of the law or the articles of incorporation of the target, and the shareholders could be adversely affected.

Due to corporate governance concerns, it would be difficult for the target to grant a shareholder additional governance rights that are disproportionate to its shareholding. As such, it is typically not possible to obtain only a minority position or a limited number of shares of a listed company through a tender offer and concurrently negotiate additional governance rights.

Similarly, debt push-down into the target company is not common in Japan due to concerns regarding minority shareholder protection.

If the target has a principal shareholder, it is customary for an offeror to enter into a tender offer agreement with such principal shareholder at the same time as the announcement of the tender offer. In a tender offer agreement, the offeror agrees to launch the tender offer in accordance with the agreed terms, and, in exchange, the principal shareholder(s) agrees to tender its shares to the tender offer so long as it is conducted in accordance with the agreed terms. The tender offer agreement would usually include certain conditions to tender, and often a set of representations and warranties and indemnification provisions. In addition to such conditions to tender, the principal shareholder would sometimes negotiate an “out” for the tender obligation in case a better offer is made by a competing bidder.

While cash compensation is a common form of incentivisation for the management team in private equity transactions, there are cases where equity incentives are provided to the management team. The level of equity ownership in such cases depends on various circumstances, but typically falls within a range of 5% to 20%.

Equity-based incentive schemes vary in structure, but are typically structured as a rollover of existing equity into new equity or a grant of stock options in either the post-buyout target company or its holding company. Typically, the management will subscribe for ordinary equity, and preferred instruments are not often used in the management equity structures.

In Japan, no specific tax rules apply to management rollovers (eg, tax-free rollovers) or parachute payments (eg, the prohibition of deduction for such payments and the imposition of excise taxes on such payments). Regarding stock options granted to individuals, “qualified stock options” (ie, certain qualified options that meet specific criteria) will be subject to tax at capital gains rates (about 20%) upon the sale of the underlying shares. In contrast, holders of non-qualified stock options are first taxed based on the economic gain reflected in the difference in the value of the shares underlying such options compared to the exercise price of the options at the time of exercise of the options; such gain is taxed as salary income (which would usually subject such holder to a higher progressive tax rate compared to tax at the capital gains rates). Such holders are taxed a second time at the time of sale of the shares underlying such options; the capital gains rate tax will apply on any increase in the value of the shares since the exercise of the options.

Typical leaver provisions for management shareholders would include good leaver provisions whereby the management shareholder is entitled to retain equity (eg, if the employment is terminated by the private equity fund without cause), and bad leaver provisions whereby the management shareholder loses its equity in the target company (eg, if the employment is terminated for cause or the management’s breach of the employment agreement). In typical cases where the bad leaver provisions are triggered, shares are compulsorily transferred to the private equity shareholder at market price or the original issue price, and share options are waived and become no longer exercisable.

Vesting is usually tied to time or performance. Time-based vesting is generally linear and the typical vesting period is around five years. With respect to performance-based vesting, equity will vest annually if a certain target is met (eg, EBITDA targets) or upon exit (ie, vesting will not occur before the exit, and the amount of equity to vest is tied to the sale price).

Management shareholders are usually subject to restrictive covenants (non-compete, non-solicitation and sometimes non-disparagement undertakings) under the shareholders’ agreements or executive services agreements with the private equity shareholder. Even where there is no express undertaking in such agreements, management shareholders who are directors will be subject to statutory non-compete obligations under the Companies Act of Japan, and will be prohibited from engaging in transactions that belong to or are within the scope of the business of the target company, unless the target board approves such transactions. Whether any post-employment non-compete and non-solicitation obligations apply to such management shareholders will, in principle, depend on whether there is any express agreement binding such management shareholders.

Japanese courts will typically enforce post-employment non-compete obligations that extend for a period of one to two years, and in some instances even longer if there are rational reasons to uphold long-term non-compete obligations. Non-compete obligations that are determined to be overly broad and restrictive by the court will be rendered unenforceable. In determining the enforceability of particular non-compete obligations, the courts typically consider and weigh factors such as:

• the position and responsibility of the former managers;
• whether the former managers were adequately compensated; and
• the scope and breadth of the non-compete obligations.

In general, shareholders’ agreements entered into between management shareholders and a private equity shareholder do not afford much minority protection for management shareholders. Normally, minority protections such as anti-dilution provisions, veto rights, director appointment rights or the right to control or influence the exit of the private equity shareholder are not provided for, unless the management shareholder is also the seller/founder of the company, in which case the founder management shareholder may have some veto rights and board appointment rights.

A private equity shareholder would typically hold a majority of the voting rights and would accordingly have veto rights over certain fundamental corporate actions and events relating to the portfolio company that are subject to shareholder approvals, including amendments of articles of incorporation and mergers and other corporate reorganisations. The private equity shareholder would also be able to appoint and remove directors as a majority shareholder.

Furthermore, a private equity shareholder will enter into management services agreements with the key management members, and may control the individual directors through such agreements. The management services agreement would set forth the roles and responsibilities of the key management members, compensation and certain reporting requirements, among other matters.

A private equity shareholder would also typically nominate one or more directors to serve in each portfolio company to facilitate its oversight of the portfolio company’s business operations. Such directors would attend the board meetings at which material business issues and agenda items would be discussed and approved.

Generally, a private equity fund majority shareholder will not be held liable for the actions of its portfolio company. However, in instances where it is unreasonable to treat the portfolio company as an independent juridical person, Japanese courts may apply the doctrine of piercing the corporate veil and deny the independent legal personality of the portfolio company, holding the shareholders liable for the liabilities of the portfolio company. According to judicial precedents, the doctrine requires that the legal personality either is abused to avoid the application of laws or has no substance.

The typical holding period for a private equity fund is around five years. The most common form of private equity exit is through M&A, but IPOs remain an attractive option for private equity exits because a Tokyo Stock Exchange listing is available even to companies with relatively small market capitalisation. An M&A/IPO dual-track process (ie, running an M&A sale track alongside an IPO track) is sometimes seen in Japan, but is not as popular as in other jurisdictions. An M&A/IPO/recapitalisation triple-track process is not yet common in Japan. Reinvestment by private equity sellers upon exit is not common practice.

Drag-along arrangements are typical in shareholders’ agreements between private equity shareholders and management shareholders. While it depends on negotiations, drag-along rights of private equity funds can also be found in shareholders’ agreements between private equity and institutional co-investors. Key terms of the drag rights are not substantially different from those agreed in non-private equity transactions. The typical drag threshold would be the sale of a controlling stake in the portfolio company.

In some cases, the drag-along rights of private equity shareholders are coupled with the management shareholders’ tag-along rights, which may be exercised upon the sale of all or a controlling stake by the private equity fund. The thresholds of the tag rights are typically not substantially different between management and institutional investors.

Under the Tokyo Stock Exchange’s listing rules, shareholders who were allotted shares within a one-year period prior to the last date of the business year immediately before the IPO application date are subject to a lock-up period of six months after the IPO (or one year after such allotment). In addition, underwriters will require major shareholders of the company to execute lock-up letters that prohibit the disposal of shares for a certain period after the date of the IPO (most commonly 180 days). After these lock-up periods, shareholders are allowed to freely sell the shares in the market.

In Japan, controlling shareholders and target companies will not enter into relationship agreements, but listing rules and disclosure requirements are designed to provide governance over the relationship between the controlling shareholder and the target company.