Are SPACs a viable option for the unbundling of Japan Inc?

SPACs – The final frontier. To explore strange new worlds, to boldly go where no one has gone before.

We may have taken a few liberties with this quote from every boomer’s favorite sci-fi television show, Star Trek. Nonetheless, it is safe to say that the host of Japanese companies currently seeking to divest non-core businesses would be wise to familiarize themselves with the unchartered territories soon: the structures, technologies, strategies and peculiarities of special purpose acquisition companies (SPACs). Given the astonishing volume of funds that SPACs have been raising (the first quarter of 2021 has eclipsed the US$83 billion record fundraising in all of 2020), the sheer number of SPACs looking for targets (more than 400) and the perception that the US may have been exhausted as a source of public-company ready targets, it is not surprising that SPACs have started to turn their attention to other regions, with significant deals announced in Europe and Asia.

Japan Inc may prove to be good hunting ground for SPAC sponsors. Already Japan Inc’s ongoing unbundling activities – fueled by government prodding, shareholder activists breathing down Japanese corporates’ necks and post-pandemic restructuring necessities – have attracted a lot of financial sponsor interest. SPACs can move nimbly and across regions, whereas several international private equity houses do not yet have the established teams and network in Japan they typically require to execute on a deal, or perhaps lack their limited partners’ mandate for investments in Japan in the first place. At the same time, Japan Inc may struggle to divest some of its “Cinderella” (attractive but underdressed and sidelined) or less attractive non-core businesses to fellow Japanese or foreign strategic buyers, particularly in the industrials sector, where many a prospective strategic buyer is too busy weathering the pandemic and the disruptive effects of digitization to “boldly go” and drive industrial consolidation.

So, what does a Japanese seller need to be mindful of when a SPAC emerges as a prospective buyer? It is worth highlighting a few aspects for our Japanese audience:

1. Structuring

Selling to a SPAC is unlikely to result in a full exit. 53% of the 2020 de-SPAC deals (i.e., the combination of a target business with a SPAC) involved all-equity consideration, i.e. where the seller exclusively received shares of the SPAC, and a further 45% provided for mixed stock and cash consideration, but with an average of only 20% cash. Accordingly, sellers will need to assume they will stay invested in (or even continue to lead) the carve-out business, unless they distribute the SPAC shares to their own shareholders. Absent such passing on of the equity, post-de-SPAC governance (board seats, veto rights, etc.), lock-up periods (typically six months for the seller, 12 months for the SPAC sponsor), ultimate exit (lock-ups, registration rights) and regulatory consequences of remaining invested are amongst the issues to think through.

The structuring of the deal will invariably be more complicated than a straight sale of a carve-out business to a strategic buyer or private equity – because of the stock consideration paid to the seller, which will be shares in a company listed in another jurisdiction. The seller also needs to ensure appropriate governance rights in the foreign entity. Additionally, the target company’s capital structure may have to be transformed into that of a public company, and the de-SPAC transaction will, most likely, trigger a default under the company’s financing, which will need to be addressed. These steps may appear technical in nature but will need to be explained to a debtholder audience in Japan that may as yet be unfamiliar with SPAC structures.

2. Counterparties

It is true that SoftBank has been launching SPACs, yet it is likely that a selling Japanese corporate will find itself opposite a US SPAC sponsor. Established financial institutions such as TPG, Goldman Sachs, Apollo and Fortress have set up SPACs, but you may also come across individuals such as (former) PE professionals, business executives or even those that are less M&A savvy (while we may not see “Captain Kirk” William Shatner “explore the strange new world” of SPAC, you will see professional athletes, such as former basketball player Shaquille O'Neal and baseball player Alex Rodriguez and other celebrities in the space). In any event, a seller needs to assume that the sponsor may not be overly familiar with Japanese business and M&A culture, which will have an impact on the dynamics of the deal.

Sellers should also factor in that current SPAC practice is to raise additional capital through PIPE (private investment in public equity) financing at the time of executing definitive agreements. Such financing generally comes from institutional or strategic investors, who may want to have a say in the post-closing SPAC and target governance, but in any event will want to move the timeline forward at an accelerated pace.

3. Projections, financials, going-forward reporting

It is one of the defining features of the current SPAC market that SPACs and their targets are using target projections to help justify the valuations and market the transaction. The use of financial projections is prohibited in some jurisdictions around the world (and universally avoided in Japan). While not strictly prohibited in the US, they are quite rare due to underwriter liability and limitations on the use of the safe harbor for forward-looking statements. Since the safe harbor protection applies on de-SPAC transactions and there are no underwriters, projections are a regular feature of de-SPACs. The 3 to 5 year projections that are usually provided allow for higher valuations than in IPOs. However, they will need to be made public and may create potential liability in the future.

In many carve-out sales, standalone financials for the carve-out business are not available for historical periods and sometimes not even for the last financial year. The challenge of getting the buyer comfortable with this lack of reliable (audited) financials is aggravated on a de-SPAC deal as regulators and stock exchanges will insist on audited historical accounts for up to three years, and for US-listed SPACs the auditing standards must comport with the requirements of the US Public Company Accounting Oversight Board (PCAOB). Preparing and auditing these financials will be relatively expensive and take a considerable amount of time and effort and may even become a condition to closing of the transaction.

Regulatory and reporting requirements may be burdensome and unfamiliar for a Japanese target as the SPAC will be listed outside of Japan (for the time being at least as Japan does not currently have a SPAC regime). With stock exchanges around the globe competing for SPAC listings, the regulatory landscape may also be diverse, so divesting companies will need proper advice to ensure compliance.

4. Deal terms

The de-SPAC transaction is, at its core, a standard private M&A transaction and as such will be negotiated accordingly. Nonetheless, deal terms tend to differ in some respects. For example, conditionality often has a different twist. While antitrust and other regulatory approvals are in all likelihood not going to be an issue given the SPAC’s operational inactivity and diverse shareholder base, the SPAC may have to request other unpopular closing conditions. It will need the approval of its shareholders as these have not given carte blanche for any transaction. Most de-SPACs are overwhelmingly approved, however. More importantly, many SPACs will need to secure the required cash between signing and closing, through debt and PIPE financing and by convincing shareholders not to redeem their shares. Where such conditionality is unavoidable, a standard method of bridging that gap, a reverse break fee, is a rare feature on de-SPACs.

There is no reason why a de-SPAC transaction should not come with some kind of indemnification for breaches of representations and warranties. Yet only 30% of the 2020 deals had seller indemnification provisions. Increasing bargaining power of sellers in a market where cash-rich financial sponsors, SPACs and strategic buyers all compete for attractive assets may reinforce that trend.

5. Timing

De-SPAC transactions are praised for their velocity. However, this may not be much of a game changer for a Japanese corporate seeking to divest a business. First of all, any sale process will need proper preparation in any case, including a “dressing-up the bride” exercise and the preparation of a data room and the deal documentation. Secondly, the traditionally lengthy decision-making processes in Japan may not reward the odd week a de-SPAC transaction gains over an alternative exit route.

Conversely, the limited time available to a SPAC to complete the business combination (typically 24 month from its listing) may be an impediment to doing a deal with a Japanese seller if the SPAC is approaching its so-called outside date and the seller is yet to go through its internal approval processes. On the flip side, the seller will have additional bargaining power if the SPAC sponsor is desperate to do a deal before an upcoming outside date.

Typically, approval of the business combination by SPAC shareholders will require a filing with the US Securities and Exchange Commission (SEC), assuming the SPAC is listed in the US. This should not impact the timeline in a meaningful way as the median amount of time between signing and the initial filing was only 21 days in 2020. However, after the SEC approval, the median amount of time between signing and closing was 3.5 months in 2020, which is roughly comparable to a straight trade sale with no material antirust issues.  SPAC transactions rarely have merger clearance or other regulatory approval requirements. 

6. Communication

Domestic stakeholders of a Japanese company selling to a SPAC will be skeptical of the business’s new owner and structure. Sellers to a SPAC are therefore well advised to devise a communication strategy for employees, key customers, suppliers and creditors, as well as the general public and the media. International communications advisors with strong local teams in Japan will be best positioned to support the exercise given their experience with SPACs in other markets and their in-depth knowledge of the markets in Japan.