Why Japan Inc.'s Alarm on Shift
In Merger Rules May Be OverdoneBy ANDREW MORSE
April 30, 2007TOKYO -- A change in corporate law that allows foreign companies to buy Japanese companies with their own shares may help spur merger-and-acquisition activity in the world's second-largest economy -- but not for the reasons many big Japanese companies seem to expect.
Beginning tomorrow, foreign companies will be allowed to conduct mergers through a subsidiary in Japan that can use shares of the parent to pay for a local acquisition target. This type of transaction, called a triangular merger because three entities are involved in the deal, is already allowed in the U.S. It is often chosen by companies that want flexibility in how they pay for an acquisition.
The potential for foreign companies to use their own shares to complete acquisitions has alarmed big business in Japan. The Nippon Keidanren, a business lobby that represents many of Japan's blue-chip companies, has said the rule change is dangerous and hasty. It has warned that foreign companies -- many with bigger market capitalizations than their Japanese competitors -- may use the technique to try to buy the country's most important and valuable firms in hostile transactions.
Nippon Keidanren was so concerned about the introduction of triangular mergers, originally scheduled for last year, that it successfully lobbied to postpone the change for a year.
Corporate Japan's concerns over a wave of hostile foreign takeovers are unfounded, analysts, lawyers and bankers say. But the rule change will likely serve its purpose: quickening the pace of mergers, both foreign and domestic, in Japan's many overcrowded industries.
"The main implication of triangular mergers will be to provoke greater consolidation of domestic industries," Kathy Matsui, a strategist at Goldman Sachs Group, wrote in a recent report on triangular mergers. That could help boost many sectors -- including construction, chemicals, retail and food-and-drink -- because they suffer from excess capacity and limited pricing power, which cap their profitability.
While cash remains king in most acquisitions, companies undertaking them may choose to pursue a triangular merger for a host of reasons. Because a triangular merger doesn't require cash, a company can use that money for other, productive endeavors, like research and development. The technique also allows a company to avoid the interest expense it would have incurred if it borrowed money to pay for a deal. Lastly, companies with high price-equity ratios -- a measure of how greatly investors value a firm -- can take advantage of the premium their stock prices have.
Analysts, lawyers and bankers say the advantages offered by triangular mergers will tempt some foreign companies to look for deals in Japan and increase the growing interest foreigners have in buying corporations here. Last year, foreign firms bought 151 Japanese companies for a total of $5 billion, according to data tracker Thomson Financial. That was up from 142 companies bought the previous year and from 48 companies that were purchased by overseas buyers 10 years ago.
Last week, U.S. bank Citigroup spent $7.7 billion to buy most of Nikko Cordial, Japan's third-biggest brokerage. It was the biggest foreign acquisition of a Japanese company ever, according to Thomson Financial.
Very little of the expected cross-border activity will be hostile and none of the deals using the triangular merger method will be. That's because the law change requires an acquiring company to get approval from both the board of directors and two-thirds of shareholders of the target company. Lawyers and bankers say they already have received inquiries from clients interested in exploring possible triangular mergers, though no deals are in the offing.
To be sure, there are obstacles to using the triangular merger method. In order for triangular mergers to be tax-free -- the most desirable format -- foreign companies have to use a subsidiary that meets a stringent set of requirements, including maintenance of a physical office and staff. That means use of a special purpose vehicle, an entity established just to complete the merger, is unacceptable for such a deal.
And fear over triangular mergers could prompt Japanese companies to take pre-emptive measures to protect themselves, such as poison pills. Corporate governance advisory Institutional Shareholder Services estimates that more than 200 companies have adopted so-called poison pills since the first one was put in place in March 2005. As many as 300 more could be adopted at annual meetings that start in June.
At the same time, acquisitive Japanese companies may be prompted to use the technique to go on the prowl. Many companies, such as Nidec, a motor maker, and Aeon, a supermarket operator, have embraced acquisitions as a driver of growth. Companies looking to expand by acquisition may consider triangular mergers as a new way to finance their transactions.
Triangular mergers "might be one of the options that they are going to be aware of and be advised to consider," says Etsuo Doi, a mergers lawyer at Paul, Hastings, Janofsky & Walker. Mr. Doi says that awareness is already starting to crop up.
This month, his firm hosted a pair of seminars on triangular mergers. One, conducted in English, attracted about 100 people. The other, in Japanese, drew around 250 attendees.
When Sanjay Kapadia, a Mumbai consultant, took out a mortgage on a flat in August, he opted for a variable rate to avoid the high charges attached to fixed-rate loans. It proved to be an unlucky choice.
Starting in December, the central bank began tightening interest rates. The average mortgage, already inflated by big rises in property prices, became 250 basis points more expensive, an increase of more than 20 per cent in the space of five months. “I pretty much got hit with a double whammy. I paid 50 per cent more than an apartment would have cost previously and I got hit with higher rates. Now even a 25 basis point jump hurts,” he said.
Mr Kapadia’s hardships are typical of the strains on Indian homebuyers following what has become a war by the Reserve Bank of India on inflation, which is running above 6 per cent.
While it is too early to see the impact on credit quality, some bankers are already warning that the RBI’s campaign could have consequences for their loan portfolios.
“We have to keep an eye on the credit risk building up in the system,” said Sanjay Nayar, chief executive of Citigroup in India. “It’s going to become more and more important to keep that at the front of our minds rather than at the back of our minds.”
Chetan Ahya, of Morgan Stanley, said mortgage rates had risen from a low of 7.5 per cent in September 2004 to 12 per cent. More than half the rise had occurred in the past five months.
On Tuesday the RBI held its key lending rate at 7.75 per cent but the effect on consumer demand of its rate increases and other measures to tighten credit supply has been dramatic.
Car sales rose only 2.9 per cent in March from a year earlier, the slowest gain in 13 months. Output of consumer durables rose 1.6 per cent year on year in February, against 5.3 per cent in January.
The housing market has been more stubborn. Karthik Srinivasan, analyst at Icra, the ratings agency, said the largest mortgage lenders were reporting 25-30 per cent loan growth, down from previous levels in excess of 30 per cent but above the government’s target of 20 per cent.
Some bankers said that, while demand for mortgages and consumer loan growth were expected to slow, they saw no marked deterioration in credit quality.
Nick Winsor, head of personal financial services at HSBC India, pointed to the equity many Indian borrowers had in their homes, estimated by some at up to 30 per cent. The macroeconomic environment remains benign: the rate increases are designed to take only some of the froth out of the economy. Wages are rising and job creation is proceeding.
“Clearly the rising interest rates will mean it’s more expensive for people to borrow but generally all of the data we have suggest that rising incomes mean affordability of housing is actually a lot greater now than it was,” said Mr Winsor.
Unsecured lending, such as credit cards, tends to be affected more by factors such as unemployment than by rate increases. HSBC had 2m credit cards in circulation in India by the end of last year, up 60 per cent on a year earlier.
“We continue to see very good growth in credit card issuance,” said Mr Winsor.
Many banks are taking steps to mitigate the impact on borrowers. Rajiv Sabharwal, senior general manager, retail assets, at ICICI, India’s largest private sector bank, said banks were increasing the terms of loans for some borrowers to help cut their monthly repayments.
A slowdown in credit growth could cause a 10-15 per cent fall in real estate prices in some areas, he said. But he expected the economy to be able to absorb this.
“Demand is still strong, incomes are still growing, jobs are increasing, migration to cities is still going on,” Mr Sabharwal said.
That may be so, but for many Indian borrowers the coming year promises to be one of the toughest financially in a long time.
