Grafting and Bushido
- Despite the substantial amount of lip service being paid to the revitalizing role that could be played by mergers and acquisitions, the fact is that Japan remains a significantly under-developed market for public M&A activity. Year-on-year change rates are high but M&A as well as inward FDI are miniscule compared to other major OECD nations. Optimists will tell you this reflects significant upside potential for cross-border M&A.
- Japan’s cumulative FDI between 1994 and 2003 was lower than Poland’s, at $50.5 billion, and compared to cumulated FDI outflows of US$217.6 billion during the same period. Moreover, inward FDI in 2003 was roughly 1/10th that of China.
- While more attention has been paid to cross-border M&A into Japan, we however believe that M&A, once considered a "foreign" import by Japanese management, is now in the process of being "grafted" into Japanese business culture.
- The next stage of the Japanese "grafting" of western M&A practices will be the evolution of M&A into contested takeovers, poison pill countermeasures and active participation by Japanese financial institutions. Ironically, much of this will be done outside of the Industrial Revitalization Corporation of Japan (IRCJ), a semi-governmental organization set up with the express purpose of revitalizing Japan’s global competitiveness. The IRCJ has been acting too slowly and in too small a scale to make much of a difference.
- Much of the substantial rally in Japanese stocks over the past year was the repricing of weak companies that were being priced for bankruptcy. This rally came from the realization by investors that; a) the government was committed to avoiding a hard landing in the restructuring banking sector, and b) that many of these companies could indeed be saved by revitalization funds of all stripes and sizes. This included several revitalized banks, including the recently re-listed Shinsei bank (old Long-Term Credit Bank of Japan).
The Unfulfilled Promise of Japanese M&A
Despite the substantial amount of lip service being paid to the revitalizing role that could be played by mergers and acquisitions, the fact is that Japan remains a significantly under-developed market for public M&A activity.
There has never been a successful hostile takeover and most market observers would say that there has only been one truly hostile takeover attempt in recent years, that being the offer by M&A Consulting to acquire Shoei in 2000. Conversely, the successful acquisition by Cable & Wireless plc (C&W) of International Digital Communications Ltd. (IDC) in 1999 was not a hostile acquisition, but is the only successful "contested" acquisition in Japan to date.
The close relationship in terms of interlocking shareholdings between Japanese financial institutions and their industry clients, as well as the close relationship with government regulatory agencies, has worked to protect entrenched Japanese management against takeover attempts.
During the "Heisei Malaise" which began when the "bubble economy" burst in 1990, there have been an increasing number of large public company mergers in Japan, with all ostensibly being "friendly" mergers. In addition, almost all of these mergers have been either promoted, aided or abetted by the Japanese government and major financial institutions, for the express purpose of rationalizing and hopefully revitalizing Japanese industry.
These large domestic mergers have created much larger, more difficult to manage organizations and questionable results. Efficiencies from these mergers have been few and far between, as integration after the merger–and indeed the merger itself–proceeds at such a leisurely pace as to be incomprehensible from a global perspective. In many cases, these mergers lack any real strategy or synergy other than making the resulting organization "too big to fail" from the government’s perspective.
Ongoing Liberalization to Promote M&A
The Japanese government has taken several steps to make TOB offers easier in recent years, while paying strong lip service to the promotion of inward FDI (foreign direct investment). Generally, the economic factors promoting M&A in Japan are;
a) Unwinding of crossholdings.
The level of stable shareholdings is decreasing rapidly. According to NLI Research, the "free market capitalization" (i.e., excluding strategic stakeholders and pure cross-holdings) has increased from 35.9% in FY1987 to 65.6% by FY2002 and is expected to continue increasing, as strategic holdings by financial institutions in their customers has declined from 31.3% in FY1987 to 17.0% in FY2002 and will decline further under government pressure to get the banks holdings of equity securities under the value of their shareholder’s equity.
The unwinding of pure cross-holdings (i.e., where each company holds each others’ shares in equal amounts) and strategic holdings accelerated in the 1990s with the introduction of new mark-to-market accounting rules, and increasing pressure from shareholders to produce competitive returns.
b) Increasing fiduciary duty and pressure to maximize shareholder returns.
Financial institution and pension fund shareholders are coming under increasing fiduciary duty and pressure to demonstrate independence as well as better returns for their clients, i.e., public pension funds such as the Government Pension Investment Fund and the Pension Fund Association. These public pension funds now have clearly stated proxy voting rules and expect their fund managers (internally and externally) to vote their proxies accordingly.
c) Individual investors are searching for better returns.
Individual shareholders, who consistently sold their stock holdings during the Heisei Malaise, found the higher yields on foreign currency deposits and foreign equity funds much more attractive than domestic investments and imminently more attractive than zero interest rate savings. Thus aside from the net buying of Japanese equities over the past ten years, there has essentially no other investor group to offset the structure pressure of cross-holding unwinding.
d) New market-to-market and impairment accounting rules.
Asset deflation during the Heisei Malaise decimated equity and property asset values. Financial liberalization has also made new structures such as REITs available to individual investors. Vehicles are also now available for splitting up companies to sell off non-core lines of business and for removing expensive real estate holdings from the operating companies through trust and other off-balance sheet sale and lease-back structures.
As a result, much more focused and reasonably priced acquisition strategies can be created in Japan for the first time.
Since assets are increasingly marked-to-market with new accounting rules, unrealized profits and losses are increasingly disappearing from the balance sheet and flowing through the income statement, make the true value of the company more visible to analysts looking at publicly disclosed financials.
e) Impairment accounting for real assets.
A growing number of companies are selling depreciated real estate holdings before all listed companies are required to adopt asset impairment accounting from fiscal 2005 beginning next April. Under impairment accounting rules, firms must write down the value of fixed assets, such as land, buildings, plants, machinery and business rights, if their market value falls significantly from their carrying value.
Moreover, the method for valuing these assets is increasingly based on future potential cash flows, as the myth of ever-rising property and equity prices was dispelled with the Heisei Malaise, and property valuations shift toward the discounted value of future rental flows.
e) Liberalized Equity-Swap Rules
The government is expected to ease equity swap rules in 2006 following more revisions to the Commercial Code that will allow foreign companies to use their stock in Japanese acquisitions. The catch is that Japanese subsidiaries of foreign firms, rather than their overseas parents, will be the ones allowed to buy Japanese firms with stock instead of cash.
The Japanese subsidiary would however be able to pay shareholders of the target with stock in the overseas parent company in what is known as a "triangular merger".
A subcommittee of the Legislative Council, an advisory panel to the Justice Minister, is also recommending that so-called cash-out mergers be allowed, in which the buyer purchases the remaining shares of minority shareholders with cash, under certain conditions.
Relative Size of Japan’s M&A Activity is Tiny Vis-à-vis Japan’s Economy
Proponents of M&A in Japan point to the rapid growth in the number of cases and value of M&A. However, the vast majority of M&A activity in Japan to date has been "in-in", or mergers among Japanese companies, including management buy-outs (MBO). According to the IMF, inward FDI as a percentage of GDP in 2001 was a mere 1.2% for Japan, compared to 25.1% for the US, 38.6% for the UK, 24.2% for Germany, and 42.8% for France, and the percentage has not increased that dramatically since.
In terms of cumulative FDI (foreign direct inflows), Japan ranked #16 during the 1994-2003, behind Poland at US$50.5 billion, and compared to cumulated FDI outflows of US$217.6 billion during the same period. In 2003, FDI into Japan was a mere US$6.3 billion, versus US$53 of FDI that China attracted in the same year.
That said, the year-on-year change rate of Japanese M&A deals is high. The total amount of money put up by investment companies on corporate merger and acquisition deals between January and August came to ¥1.08 trillion, according to a recent survey by Recof Corp.
The figure is far above the previous record of ¥754.5 billion for 2003, as there have been major M&A deals this year as the Phoenix Capital (a local revitalization fund) investment in Mitsubishi Motors Corp. (stock code: 7211).
The number of M&A deals in the January-August 2004 period totaled 167, up more than 100% from the same period a year earlier. Domestic investment firms struck major deals, such as Nikko Principal Investments Japan Ltd., which bought into Bellsystem24 Inc. (stock code: 9614), and Nomura Principal Finance Co., which invested in Millennium Retailing Inc. Of the total value of M&A deals struck in the period, domestic investment firms accounted for 70%, up from 32% in 2003.
Japanese Managers Embrace "Grafting"
Thus it is increasingly clear that M&A is no longer a "foreign" concept, as the vast bulk of the M&A activity in Japan is now "in-in" or between domestic companies and their domestic intermediaries.
Indeed, Japanese managers are increasingly embracing the concept of "grafting", which was first described in a book by Inazo Nitobe called "Bushido: The Soul of Japan". "Bushido" is the so-called way of the Samurai which was recently glorified by Tom Cruise in The Last Samurai. However, unlike Ken Watanabe’s character who vainly resisted the lurching of Japan into the modern era with the Meiji Restoration, modern Japanese executive "samurai" are re-reading Bushido: The Soul of Japan". A key concept used in the book was "grafting", which Mr. Nitobe repeatedly used to describe the concept of grafting Christianity to the trunk of bushido.
In modern terms, this means adapting and incorporating Western concepts, technology and business methods that work in Japan and within Japanese culture and business practices.
The Age of Contested Takeovers
As previously mentioned, a "neutral" or "hostile" takeover attempt in Japan is still highly unusual. This is because management friendly shareholders and their main banks have historically circled the wagons to thwart any such attempts.
"Revolutionaries" like Yoshiaki Murakami of M&A Consulting are helping to break this mold by purchasing large positions in underperforming companies and using his proxy power to cajole, negotiate and otherwise force management to adopt policies to improve shareholder returns.
In addition, there are now numerous and growing numbers of Ripplewood clones. Ripplewood of course pioneered the concept of revitalization funds in Japan by acting as the syndicator for the purchase of the old nationalized Long-Term Credit Bank, which was later revitalized and relisted as Shinsei bank (code: 8303). We believe the next stage of the Japanese "grafting" of western M&A practices will be the evolution of contested takeovers and poison pill countermeasures to prevent such takeovers.
Mitsubishi Tokyo and Sumitomo Mitsui Slug it Out for UFJ
Heretofore, Japanese companies have depended on their network of cross holdings and strategic stakeholders to fend off such corporate "predators". However, the fight between Mitsubishi Tokyo Financial Group (MTFG, Code: 8306) and Sumitomo Mitsui Financial Group (SMFG, Code: 8316) for control of the UFJ Group has the potential to erupt into a full-scale takeover battle.
The long and short of it is that the management of UFJ Holdings (code: 8307) committed fraud in lying to the FSA (Financial Service Agency) inspectors and falsifying board meeting and management committee meeting minutes. They also lied to shareholders about the true extent of the NPL credit costs they would incure, and the true extent of profit losses that would be involved in realizing these losses.
From the onset, however, an inside deal seems to have been struck between UFJ management and MTFG management. Given; a) ¥400 billion in losses in FY2003, b) even larger losses now expected in FY2004 because of massive NPL write-offs exceeding ¥1 trillion, and a law suit that the FSA intends to file against the bank, it is increasingly obvious that UFJ Holdings has no future as an independent entity.
UFJ released a business revitalization plan projecting a ¥1.13 trillion yen nonperforming-loan disposal loss for the year ending March 2005. It also plans to suspend dividend payments on both common shares and government-held preferred shares this fiscal year.
The key to the success of the revival plan is the prospective merger with MTFG, and with MTFG’s agreeing to provide ¥700 billion of financial aid, including a package that is effectively a "poison pill" to ward off a hostile takeover bid by SMFG.
UFJ (given approval by shareholders) plans to issue ¥700 billion yen worth of non-voting preferred shares to MTFG on Sept. 29 in exchange for the capital assistance. However, the preferred shares have a trigger clause that allows the holder (MTFG) of the preferred shares to convert the shares to voting shares under certain conditions–effectively giving MTFG control of more than one-third of the voting shares of UFJ.
But SMFG has not yet given up. While SMFG President Yoshifumi Nishikawa says that its stance toward integrating with the UFJ group remains unchanged, its options are becoming more limited as the merger plan with MTFG continues to take shape. SMFG released comments Friday stating, "We will consider specific plans, including direct contact with UFJ shareholders."
The remaining options for SMFG are; 1) a proxy fight and b) a takeover bid.
Because the merger agreement would need the approval of a two-thirds majority at a general shareholders meeting, SMFG could block the MTFG-UFJ integration by securing proxies from one-third or more of UFJ shareholders. SMFG is offering UFJ a 1-to-1 merger ratio, which represents a nearly 30% premium over UFJ's recent stock price. Depending on the ratio to be released by MTFG, SMFG could lobby UFJ shareholders, for sufficient proxy votes to successfully vote down the proposal. Another option would be to wage a takeover bid for UFJ Holdings.
Defending Against the New "Black Ships"
When Admiral Perry and his fleet of "black ships" sailed into Shimoda south of Tokyo demanding that Japan open trade with the West, it was a visible shock to feudal Japan.
The liberalization of stock swaps for foreign companies wishing to acquire Japanese companies has gained quite a lot of domestic attention as a "black ships" phenomenon.
This is because the Heisei Malaise has shrunken market valuations of industry leading Japanese companies to a mere fraction of their global competitors. For example, Wal-Mart Stores (code: WMT) of the US already has a 37.8% stake in Seiyu, but has thrown its hat into the ring as a possible suitor for Daiei (code: 8263). Wal-Mart’s market capitalization exceeds ¥20 trillion, which means they could procure up to ¥2 trillion merely by issuing 10% more shares. With ¥2 trillion of new stock to swap for a target Japanese company, Wal-Mart ostensibly could take over a dozen companies with market capitalization equivalent to Daiei with this ¥2 trillion of new stock.
The same is true in other sectors, such as chemicals and technology, with the major exception being automobiles, where Japanese companies have managed to maintain their global competitiveness throughout the Heisei Malaise.
Indeed, upstarts such as Taiwan Semiconductor Mfg. (TSM) and United Microelectronics (UMC) in Taiwan would also ostensibly be able to take-over Japanese hi-tech majors with stock that has a higher market capitalization than their Japanese peers.
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