Surge in Japanese buyouts will happen... someday?

The case for investing in Japan buyouts seemed overwhelming to me early last year when we made our first commitment to a fund. It wasn't a 'slam dunk' that transaction volume would surge but, if it did, the sheer size of Japan Inc. made it an opportunity too big to ignore. The following piece from the WSJ surveys the landscape a year later as a new law comes into effect that will rachet up the pressure another notch. I'm not holding my breath.

Why Japan Inc.'s Alarm on Shift
In Merger Rules May Be Overdone

By ANDREW MORSE
April 30, 2007

TOKYO -- 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.