- Japan’s system of interlocking shareholdings is collapsing as Japan’s banks move to isolate their reported capital ratios from equity market volatility.
- The system of cross-holdings has become unsustainable due to: a) the introduction of current value accounting, necessitating the reporting of valuation losses and gains on stock holdings, b) the regulatory authorities have required the Banks to reduce stock holdings to below their Tier 1 capital, and c) the secular bear market in stocks during the "Heisei Malaise" has made once substantial unrealized gains significant unrealized losses.
- Foreign as well as domestic institutional investors have become more activist, voting against shareholder proposals they oppose, and openly advocating corporate governance change at Japanese companies.
- Contested take-overs, once virtually impossible, have now become commonplace, by both domestic as well as overseas "realtionship" funds.
- Now that even public pension funds have become "activist", given that the bulk of new accounting reforms are already in place, Japan’s reform proponents now have powerful ammunition to push through corporate governance reforms that will in the end make Japanese companies more competitive and usher in a new age of competition for capital in Japan.
Japan’s Brave New World of Competition for Capital
Japan’s system of interlocking shareholdings among financial institutions (banks and insurance companies) and their corporate clients, and between large companies and their subsidiaries and affiliates–in the form of cross holdings or "strategic" holdings–had been a major factor responsible for the ability of Japanese management to ostensibly concentrate on the long term and ignore the needs of minority investors, both foreign and individual. It has effectively prevented contested takeovers, and allowed the banks to report inflated capital ratios based on the market value of their strategic shareholdings.
However, this structure became unsustainable during the 1990s because of; a) a secular bear market in stock prices, b) shareholding restrictions imposed on banks (where these holdings cannot exceed their Tier 1 capital), c) and current market value accounting, which required companies to record valuation losses on these holdings. Consequently, NLI Research estimates that strategic shareholding ratios among Japanese companies have declined from 45.8% in fiscal 1987 to 27.1% by fiscal 2002, while crossholdings have fallen from 18.4% in 1987 to 7.4%.
The eventual demise of cross-holding and strategic holdings cannot not be averted if Japanese companies are to regain lost global competitiveness and economic vitality. Better shareholder value has recently become a mantra among Japanese firms, many of which have seen their stock price to stated book value ratios fall well below 1.0X at the low point in the Nikkei 225 in April 2003, and are seeing significant declines in the cross-holding relationship with their main banks. Banks in fiscal 2002 reduced their stake in 45% of cross-holdings, and the trend is believed to have continued in fiscal 2003. By September 2004, they are required by the Financial Services Agency to have reduced the value of their equity holdings to below that of their Tier 1 capital. Ironically, the more stock prices appreciate, the more stock the banks will have to sell to satisfy this requirement. Consequently, the major banks are if anything accelerating their unwinding of stock holdings as the market recovers, to not only bring the value of these holdings to below the value of the Tier 1 equity capital, but also to further reduce the risk that stock holdings present to their stated capital ratios.
The value of cross-held and strategic holdings is nevertheless still large (the value of cross-holdings as of March 2003 was still ¥17.4 trillion, or larger than the market capitalization of the listed banks of ¥16.3 trillion). In particular, banks and old-economy companies have been the most heavily dependent on strategic shareholders. However, research on the relationship between corporate governance, strategic shareholdings and poor financial performance/enterprise value indicates a positive correlation between performance and companies (including banks) whose shareholdings have been dominated by strategic shareholders and have been resistant to demands for better returns from shareholders.
Enter Activist Shareholders and Contested Takeovers
As the structure of cross-shareholdings in Japan collapses, shareholders in Japanese companies are becoming more activist. Not only are foreign investors now more actively making performance demands on Japanese management and voting their proxies, but public and corporate pension funds are as well. Japanese companies are being forced to change their management policies in order to effectively compete for capital.
Successive changes in the Commercial Code have made it increasingly easier for companies experiencing significant cross-holding unwinding to repurchase their shares with excess cash flow that is being created through restructuring and curtailment of capital expenditures. In fiscal 2002, listed companies authorized ¥9.8 trillion of stock buy-backs, and this trend continued in fiscal 2003. This notwithstanding the outflow of cross-holding and strategic holding unwinding continues to exceed the level of stock buy-backs. During most of the Heisei Malaise and unwinding of cross- and strategic holdings, foreign investors have essentially been the only consistent source of buying demand, and were net purchases of a record ¥9 trillion of Japanese equities so far in fiscal 2003 (to end March 2004). However, there are many companies listed in Japan in which foreign institutional investors simply have no interest, or have market capitalization that is too small for foreign institutional investors to buy.
Enter a new breed of "relationship investors", reminiscent of Robert Monk’s Lens Fund in the US, that are focusing on the "unloved" and "unwanted" among Japan’s listed companies. One of the most visible is Yoshiaki Murakami of M&A Consulting. An ex-government official, Mr. Murakami takes big stakes in cash-rich Japanese companies that are misusing or underutilizing their assets. He directly confronts management, asking them to optimize the allocation of funds available, and to concentrate management resources on core businesses. If the company is unable to find new investment opportunities that promise returns in excess of that firm’s cost of capital, he presses management to either raise their dividend and/or repurchase their shares.
But there are also an increasing number of foreign funds with the same operating strategy. Nippon Broadcasting System Inc. (4660), found last year that Southeastern Asset Management Inc., a U.S. investment advisory firm, had acquired 10% of its shares, becoming the top shareholder in the broadcaster. Southeastern Asset Management may aim to eventually take control of Fuji Television Network Inc. (4676), a major TV channel, in which Nippon Broadcasting has a stake of about 34%. Bull-Dog Sauce Co. (2804) also found a consortium of three U.S. investment funds capturing a leading 6% of the company.
This wave is not limited to "old-economy" companies. Emerging companies in fiscal 2002 began to experience a wave of takeover bids that has hit slumping firms that trade on the JASDAQ market. Nice Claup Co. (7598) and Nihon Computer Graphic Co. (4787) have both seen other listed companies suddenly emerge as lead shareholders this year. The two companies were both bleeding red ink and trading at price-book ratios of less than 1. Ultimately, both were ripe for a takeover. IXI Co. (4313) announced that it had received a takeover bid from CAC Corp. (4725), a TSE first-section company. IXI ultimately chose to come under the umbrella of CAC a mere six months after going public on the Nasdaq Japan Market. Digital Electronics Corp. (6884), a JASDAQ-listed maker of operational indicator devices, announced that it was being acquired by France's Schneider Electric. Jusphoto (4646) shares attracted buying after the announcement that it would be acquired by the Fuji Photo Film (4901) group.
Japan Equity Capital Co., launched by leading nonbank financier GE Capital, surprised a top executive of a major Japanese consumer-goods producer by meeting him at New Tokyo International Airport, getting in the car with the executive and telling him, "Please sell a subsidiary to us." These investment funds attracted public attention with large-scale buyouts of failed companies, including the former Long-Term Credit Bank of Japan, now Shinsei Bank. But their mainstay business has heretofore been buying bad debt from banks. As the cleanup of nonperforming loans has progressed (albeit at a snail's pace), they have been turning their attention to strategic investments based on expectations of industry reorganizations, and are launching takeover bids.
Restructuring Japanese companies are also being forced to spin off noncore businesses or subsidiaries. Lone Star Japan Acquisition has created a $4.25 billion fund to take advantage of such opportunities. JP Morgan Partners bought Rhythm Corp., an autoparts maker in Hamamatsu, Shizuoka Prefecture, as a first step in its Japanese business. Carlyle Group plans to delist Kito Corp. (6409), a crane manufacturer, from the JASDAQ over-the-counter market and list it on the Tokyo Stock Exchange. Ripplewood Holdings, famous for their purchase of LTCB from the Japanese government, has bought a total of four Japanese firms so far in what many regard as an outstanding example of navigating successfully through Japanese business waters. In all, cumulative investments by foreign funds in Japan are estimated to have surpassed ¥1 trillion yen.
Japanese funds are joining the fray. Unizon Capital took over the mainstay confectionery operation of failed Tohato Inc., after the loss-making golf course operation was split off from the cookie maker. Tokyo Marine Capital Co. acquired the retail business of Takarabune, a struggling confectionery producer. Japan Industrial Partners is purchasing a laser processing business from the NEC Corp. (6701) and is setting up a firm for the takeover. They will integrate the business into one company, aiming to improve the operation's competitive edge. Phoenix Capital has acquired beverage producer Gold-Pak Corp. from Tokyu Corp. (9005) in a leveraged buyout.
In 2003, the number of such M&As reached 74 in the April-September period, 3.9 times as many as the same term a year earlier and well above the 44 in all of fiscal 2002, according to Recof Corp., an M&A broker. Such firms accounted for 9% of all of 795 M&As involving Japanese companies in the fiscal first-half, up from 2% a year earlier.
These "relationship investment" companies are attracting increasing amounts of capital from institutional investors expecting investments in the funds to yield relatively quick returns, amid the growing reshuffling of operations among large corporations as well as increasing corporate turnaround deals.
But despite this new wave of relationship investing, most Japanese businessmen still favor a more long-term approach. Yoshiaki Murakami of M&A Consulting is still viewed as maverick investor, as he often takes a combative stance toward the companies in which he invests. Mr. Murakami’s critics say h focuses only on such short-term matters as share buybacks and dividend increases. While many feel it is important to beef up the monitoring of managers (corproate governance), they nevertheless believe that shareholders must take a long-term stance from the viewpoint of a company's continuity.
In contrast, a more acceptable approach by those who nevertheless support reform in Japan is being taken by Tomomi Yano, executive managing director of the Pension Fund Association, is the influential government affiliated investor who has set up guidelines to recall corporate managers with poor results. Mr. Yano’s approach is to not reappoint directors who cannot produce results, as many believe that stockholders at this stage should work on bolstering the functions of directors, especially outside ones.
The Pension Fund Association strongly makes the case at shareholders meetings that the board of directors' supervisory function needs to be reinforced to be on par with its other role of policy-setting, because the supervision is currently too weak. PFA standards for exercising voting rights, were in February, and require that more than one-third of a company's board members be outside directors, in the belief that a board consisting of only in-house directors tends to be tepid toward supervision. Management at a company which remained in the red and failed to pay dividends for the third straight year, or which posted a net loss for the fifth year in a row will see themselves voted against as executives by the PFA. The PFA will vote against a re-election of such executives at the shareholders meeting and demand their compensation be cut or suspended.
The Government Pension Investment Fund (GPIF), the world’s largest public pension fund, has drawn up their corporate governance policies and has clear instructions for their asset managers to follow in voting their proxies. Now that public pension funds have become "activist", and given that the bulk of new accounting reforms are in place, Japan’s reform proponents now have powerful ammunition to push through corporate governance reforms that will in the end make Japanese companies more competitive and usher in a new age of competition for capital in Japan.
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