Corporate Restructuring & Opportunities in M&A & Private Equity Investment in Japan

June 26, 2003

Co-organized by

Astoria Consulting Group, LLC
Japan Society, Inc.

Citigroup, Inc.
Deloitte Touche Tohmatsu
Mizuho Securities USA
Advantage Partners, Inc.
Morgan Lewis & Bockius LLP
AC Capital, Inc.

In-kind support
Continental Airlines

Supporting organization

Atsushi Saito, CEO, Industrial Revitalization Corporation of Japan (IRCJ)

Richard Gitlin, Chairman & CEO, Gitlin & Company, LLC

Richard Folsom, Representative Partner, Advantage Partners, Inc.
Hiroshi Kuwabara, Deputy General Manager, Corporate Revival Project Department, Nomura Securities
Masayoshi Nawa, Partner, AC Capital, Inc.
Wilbur Ross, Chairman & CEO, WL Ross & Co. LLC
Gregory R. Salathé, Partner, Morgan Lewis & Bockius LLP
Satoshi Tomii, Director, Business Restructuring Department, Development Bank of Japan

Mark Mason
, Director, Program on Alternative Investments, Columbia Business School

Professionals at the front lines of buyout and turnaround investments and corporate M&A in Japan gathered to discuss the state of play and latest developments from the perspectives of structural and financial reforms initiatives that are being undertaken in Japan.

According to Atsushi Saito, CEO, Industrial Revitalization Corporation of Japan (IRCJ), Japan's original corporate reorganization law was an obstacle to industry revitalization. The process was so lengthy that it threatened the vitality of the firm. It removed all managers, replacing them with court-appointed administrators and trustees. It also required cancellation of all issued stock. Its stringency drove people to settle outside the court system, but there was a lack of coordination between creditors and debtors, and the main banks bore a disproportionate share of the risks until they could not absorb further losses, he explained.

All this has changed with recent amendments, said Mr. Saito. The law today is more transparent, solicits more information, simplifies the standards of collateral valuation and expedites release of funds to creditors. For Debtor-in-Possession (DIP) cases, the court may appoint existing managers as trustees or deputy trustees; however, stock cancellation is still mandatory if the court finds the firm insolvent. The October 2002 Takenaka Plan accelerates the rehabilitation of companies and sets benchmarks for the reduction of non-performing loans (NPLs), according to Mr. Saito. Under this Plan, the Industrial Restructuring Company of Japan (IRCJ) was created to "facilitate consensus" between creditors and buyers over the market value of loans made by no-name banks to troubled but essentially viable firms--in Mr. Saito's words, "to resuscitate ailing companies, not to collect bad loans." The government has set side ¥10 trillion (about $83 billion) for the IRCJ to purchase loans and supply new funds to targeted firms, and banks will have a tax incentive to participate under a new tax policy of debt forgiveness, he said.

Target firms for IRCJ sponsorship are those that the IRCJ judges capable of realizing a 2 percent higher return on assets (ROA), a 6 percent improvement in productivity per employee, a 5 percent improvement in fixed asset turnover, a debt ratio less than 10 times flow, and positive, recurring profit. Another criterion, the reduction of excess capacity, will be set based on the industry. The IRCJ is required to use discounted cash flow (DCF) as the method of firm valuation, and the Financial Services Agency (FSA) will require detailed disclosures of the DCF analyses by the IRCJ and the banks.

The IRCJ will consult with the Minister of Industrial Revitalization on the review of target companies, and other ministers who have jurisdictional interest may offer advice or opinions, but the final decision-making power rests with an IRCJ committee known as the Industrial Revitalization Committee.

Mr. Saito described the IRCJ sponsorship decision as a seven-step process. First, companies and their main banks apply and present their restructuring plans. Second, IRCJ stock members perform valuations using the DCF method and formulate an exit strategy by consulting with private equity funds and potential sponsors. Third, the board members decide whether or not to proceed. Fourth, the IRCJ negotiates with the non-main banks and can issue a notice of standstill for up to three months. Fifth, if an agreement is reached with the non-main banks, the IRCJ purchases the loans and may convert part of loan into equity. The period of loan purchase should end by March 31, 2005. Sixth, the IRCJ monitors the progress of rehabilitation plans in collaboration with banks and sponsors, and may solicit input from consulting firms. Seventh, the IRCJ sells the loan assets and equity to funds or sponsors within three years of purchase, not necessarily at a high profit.

Mr. Saito predicted that the IRCJ would stimulate more domestic private equity funds and turnaround specialists, and that the auction process of the IRCJ would eventually take on the character of a secondary loan market.

Japan's environment for corporate restructuring today may be the best in the world in the view of bankruptcy expert Richard Gitlin, Chairman and CEO, Gitlin & Company, LLC. He described the new Civil Rehabilitation Law as "more efficient than Chapter 11." Mr. Gitlin said the IRC has recruited the "best and brightest" people from the finance ministries, central bank and private industry, and that there is a new attitude within government. Mr. Gitlin recommended the October 2002 Takenaka Plan as a "Roadmap to the future." However, he said the real challenge would be getting the banks' valuations to converge with those of the IRCJ using the discounted cash flow (DCF) method. "If that happens, the market will explode," he predicted.

What are the obstacles to getting that first deal done?

According to Chairman Saito, the IRCJ expected the banks to be initially reluctant to surrender cases, but they have been all too happy to do so. The real problem is that the banks are turning over raw material without an accompanying plan, which significantly increases the IRCJ workload, he said. "I am not at liberty to say when the first deal will be forthcoming, but I can tell you that it will not materialize this month," said Mr. Saito.

Does the IRCJ have a mandate to reduce overcapacity in the construction industry?

Mr. Gitlin confirmed that the construction industry wants to play a driving role in the consolidation process.

Mr. Saito said that before undertaking a mandate, the IRCJ must report to the ministry in the related sector, who will also shape the restructuring. He explained that the ministries set deal criteria based on their own targets for industry revitalization. "We cannot accept deals if they don't allow the industry to reach its thresholds, too," he declared.

Does the IRCJ answer to public opinion, or does it lead public opinion? The public is far from reaching consensus that commercial expediency is a good thing.

"The chairman of Nissan is greatly respected for his success," and also for his decency in hiring back all the people he laid off, and the Japanese understand this is the style of revitalization, Mr. Saito stated. However, he noted that the rehabilitation process also entails advance consultation with labor unions.

Are you open to suggestions directly from private equity investors?

Replied Mr. Saito, "I don't have to make money, but if I lose taxpayers' money, I will be punished in the Diet. So, from the buyers' standpoint, our price will be very attractive."

What are the prospects for mergers and acquisition and private equity investment in Japan?

It is now possible to do U.S.-style merger and acquisitions and private equity investments given legal reforms and an increased flexibility in corporate capital structures, according to Gregory R. Salathé, Parner, Morgan Lewis & Bockius LLP. For instance, incentive stock option plans can be created to align investors and managers, he said. Mr. Salathé predicted that stock options would be increasingly used as a M&A tool (as the WalMart-Seiyu merger demonstrated), and might be used in poison-pill tactics.

Multiple classes of stock may now be issued, with different priorities in the capital structure, dividends and veto rights; and director seats may be allocated among the classes, Mr. Salathé said. De-merger structures (like Mitsubishi Motors' spin-off of Mitsubishi Fuso) in which transfers of assets, liabilities, contracts or employees may be made without creditor consents, are possible, he also noted. For example the spin-off may be a new, wholly-owned subsidiary, or there may be absorption in exchange for stock (typical of rollup structures). Japan has also developed some efficient M&A structures like stock swaps, he said. The stock swap has been effectively used in Japan to squeeze out minority investors, Mr. Salathé commented.

The Development Bank of Japan (DBJ), which is 100 percent owned by the Japanese government, is a policy-based financial institution providing financing to private sector companies or projects in Japan, according to Satoshi Tomii, Director, Business Restructuring Departmen, Development Bank of Japan. Since 2002, DBJ has been specifically involved in DIP financing and investment in corporate restructuring activities as a Fund of Funds.

Mr. Tomii expressed optimism for the future of economic restructuring in Japan, given the existence of DBJ as a funding source and the role of the IRCJ as coordinator. He detailed three investment structures used by the DBF: acting as a limited partner in private equity funds (for example, investment to the fund which Advantage Partners is now raising); co-investing with the main sponsor of restructuring companies (for example, the Niigata Engineering transaction); or as a co-investor to a general partner (for example, the company created by Mizuho in order to reconstruct their impaired borrowers).

Wilbur Ross, Chairman and CEO, WL Ross & Co. LLC, slyly described himself as "forced into retirement as a Kansai regional banker" now that his Kansai-based bank is being acquired by Sumitomo-Mitsui's local affiliate, partly in cash and partly via a convertible preferred stock. Kansai Bank will remain a shareholder, and the shareholders will make a profit. "It could be the first time the DIC has made a profit from an SIC bank," he quipped. His firm will now turn to launching a corporate governance fund with CALPERS as a minority shareholder and a distressed real estate fund with Daiwa as a shareholder.

Mr. Ross named the following reasons to invest in Japan today. First, it is cheap in absolute terms, with asset prices at 20-year lows. Second, the strength of the U.S. economy makes it also cheap in relative terms. Third; cross-bank shareholdings continue to decrease. Fourth, low leverage is good for equity. Fifth, bankrupt-listed companies are targets for opportunity and the number is increasing. Sixth, it is possible to effect tangible improvement with corporate ROAs of under 3 percent. Seventh, there is negative carry on ¥-$ swaps: "Japan is the only place in the world where you make money allowing your counterparty to absolve you of FX risk, he said." Finally, the competition is limited because the average deal size is dropping below $30 million, and that is a barrier for institutional investors, who need larger investment minima.

According to Hiroshi Kuwabara, Deputy General Manager, Corporate Revival Project Department, Nomura Securities, M&A has become a "common and indispensable tool" for management, and is strongly linked with Japan's corporate restructuring process by the creation of efficiencies through either horizontal integration or a group restructuring process. Although Japan is reforming, it still needs risk capital to clean up the financial system and professional organizers to resolve conflicts among stakeholders, he said. Lack of price discovery mechanisms in Japan's capital asset markets contribute to the lack of ongoing liquidity, although the regulators have now stipulated that DCF is the proper method for valuation, Mr. Kuwabara declared.

Nomura, as a financial advisor, is contributing to revitalization through revival planning, financial restructuring and implementation management. As an arranger, Nomura looks to foreign equity funds that have a track record, asset management experience, negotiation skills, business analytical skills, and the capacity to support the business as well as provide funds, noted Mr. Kuwabara.

"Fundamental changes in underlying attitudes in Japan are gradual but real," asserted Richard Folsom, Representative Partner, Advantage Partners, Inc. and a former management consultant and long-time resident of Japan. He noted that buying and selling businesses is now viewed as an acceptable business practice, and that Japan's best talent is shifting away from stable employment towards riskier work with real responsibility. Most Japanese have begun turning from an ideal of a managed economy to capitalist concepts to achieve desired social goals such as shareholder value, asset efficiency and productivity improvement, he said. Firms are taking the initiative in restructuring rather than being reactive; they are shifting lower level production overseas and moving up the value chain by investing more in R&D, he observed. His firm, Advantage Partners, was founded in 1992 and is about to launch its third fund.

"I am worried that unless financial concepts are strictly applied, the best opportunities will not find funding."

Mr. Kuwabara replied that there are both industrial and financial dimensions to restructuring. "Business restructuring comes first. If it's possible to make a profit by changing the business model, we may need to negotiate with main banks or creditors." He commented that, on a case-by-case basis, individual approaches might be appropriate, but not if the industry in which the firm finds itself is local and old--for example, chemical, steel or cement.

What accounts for the modest pace of investment by the Development Bank of Japan?

"The investment amount is being increased to ¥200 billion, and ¥50 billion has been committed in the past year and a half. Others have told us this is a rapid pace. I don't think it's been a slow pace, myself," said Mr. Tomii. He suggested that simply having a large budget is not enough--the ultimate hurdle is finding good transaction opportunities. "I expect IRC will become more active. If not, it would become more difficult for us to use our funds."

What further pieces of infrastructure are needed for real reform to happen?

"The changes have been so dramatic, it's time to use them," said Mr. Salathé.

Mr. Tomii noted that while legal and accounting systems have undergone change, tax reform is lagging. Putting aside structure and system, the most important thing is that there have been some very dramatic changes in culture occuring in both banks and companies. However, the pace of change has lagged at many regional banks (which hold many of the loans of troubled small- and medium-sized companies) because of various local relationships, he said.

Do your investment strategies assume micro-level changes will achieve macro-level results, or do they assume no change?

Mr. Ross said there was no underlying assumption of an immediate economic turnaround in the thinking of his firm.

What factors will make the IRCJ successful?

Mr. Folsom said it was important that the "entry price" of IRCJ-sponsored debt reflect fair value.

"What should be done with small and medium-sized enterprises in terms of restructuring? Are you not interested in investing in such companies?"

"We are, and we have--a third of our investments are outside Tokyo. Two are in Kyushu, and two in Osaka," replied Mr. Folsom. He observed that, while there was no difference in receptivity among operating companies outside Tokyo, regional banks sometimes experienced difficulty in having to adjust to a new investor.

"Banks often have an aggressive view on the value of the loan," Mr. Ross wryly observed.

Among the companies you have invested in, besides financial restructuring, what else do you do in reorganization?

"We look at every aspect. Nobody believes this, but the first few months post-acquisition are almost entirely occupied with determining the firm's priorities," Mr. Folsom said.

--Ann Rutledge

Topics:  Business, Policy

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