My partner Ethan Klingsberg in our NY office has recently shared his thoughts on M&A trends in 2022. His predictions include an increase in regulatory covenant litigation; regulatory headwinds impacting deal terms; interim operating covenants becoming trip-wires due to extended regulatory review processes and increased scrutiny by regulators; supply chain issues fuelling M&A; and a change of the SPAC landscape. Many of these trends will show in the Japan M&A market as well, some more prominently than others. Here is our take on what will be the distinct characteristics of Japan M&A in 2022, both inbound and outbound. Some of these thoughts will already be evident, others involve crystal-ball gazing and some, admittedly, reflect a bit of wishful thinking.
The wave of domestic M&A will move offshore. Japan saw an M&A boom in 2021 with a total of 4280 transactions*. However, the vast majority of these deals (78%) were domestic; some did not involve any foreign operations at all. This has been reflective of the large amount of mid-sized Japanese companies in need of consolidation for a number of reasons: lack of scale; lack of dry powder or knowhow to go global; family-owned businesses without natural successors; etc. While this trend will continue, the inevitable, overdue flexing of travel restrictions will see more Japanese buyers looking for M&A opportunities abroad. Many Japanese companies have been working quietly on off-shore acquisitions while COVID-19 was keeping them grounded. When actual site-visits and physical meetings, which are so fundamental to Japanese deal-making, become less of an ordeal, these transactions will go live and deal activity in Southeast Asia, Europe and the US is likely to rise sharply.
The unbundling of Japan Inc will gain momentum. The unwinding of the notorious Japanese conglomerates will continue to be a necessity. Inefficient management of non-core assets, government incentivization and increased shareholder activism (see below) require a streamlining of portfolios. However, Japanese sellers have been somewhat reluctant to put sizable assets up for grabs. With travel to Japan impossible for foreign buyers because of the government’s entry restrictions, sellers have been wary of auction processes failing for lack of an addressable foreign investor audience. There is no shortage of keen financial sponsors looking to invest in Japanese assets through established local teams, but their bench strength is limited. There are rumours about assets not being put on the market because the compact private equity teams on the ground in Japan were assumed to be too busy with other transactions. As COVID-19 subsides and travel restrictions are relaxed, sellers may feel encouraged to start sale processes they have been shying away from so far.
The Toshiba saga will be a blueprint for the unbundling, but then again not. The M&A industry in Japan is reported to be waiting for the Toshiba reorganisation to provide a blueprint for the streamlining of Japanese conglomerates. While the split of Toshiba into two parts and the associated divesture of some businesses may indeed pave the way in some respects, the Toshiba saga is too particular to provide a template for the unbundling of other conglomerates. Shareholder activism, government involvement, management calamities and national treasure characteristics will not feature so prominently on most other demergers. More importantly, conglomerates would be ill-advised to wait for the entirely unpredictable course of the Toshiba tale. The outcome of Toshiba’s upcoming general meeting is highly uncertain. Even if the shareholders vote to approve management’s separation plan, such plan is scheduled to be implemented in 2023. If the plan falls through, it will take time for alternatives (e.g., a take-over by a club of financial sponsors and subsequent reshuffling of the portfolio) to go ahead. Other Japanese conglomerates cannot and should not wait that long to kick off their M&A projects.
Shareholder activism will drive M&A activity more visibly. Toshiba is not the only Japanese company targeted by activists. Japan is already the second largest market for shareholder activism, after the US. And yet, activism activity is going to increase and become more broadly visible. Activists have recently done a lot of back-door campaigning (acknowledging Japanese business culture). However, the generally favourable view of activists as agents of change, the government’s general endorsement of activism and a changing corporate landscape where the number of hostile takeovers is increasing (eight deals in 2021 compared to five deals in each of 2020 and 2019*) are encouraging activists, not prone to shun publicity anyway, to stage their plays. Here again, Toshiba may be a catalyst of developments. Another prominent example is Seven & i Holdings, Japan’s largest retail group, being pressured by activists to divest its supermarket and department store businesses.
Off-shore financial sponsors might fall for Japan (but may be ghosted). International financial sponsors with strong local teams have been driving inbound M&A in recent years (165 transactions in 2021, an increase of 38.7% from 2020, with a value of 2.1177 trillion yen, which was 2.7 times higher than in 2020*). They will continue to benefit from the untangling of Japanese conglomerates picking up and consolidating ‘Cinderella’ non-core assets. Additional players have recently set up presence on the ground. Other players may follow driven by full war chests, competitiveness in mature Western markets and the appeal and abundance of opportunities in Japan. However, they may soon realize that becoming a credible player in the Japan market requires more than deep pockets and a great track-record in other arenas. It requires solid and long-standing relationships with the Japanese business community, a strong local team, and a deep understanding of Japanese (deal) culture. That is why most international sponsors have hired experienced Japanese players to run their Japanese operations. However, the talent market may well be exhausted, and international teams parachuted in may find themselves ignored by Japan Inc.
ESG will drive deal activity and deal technology. Not long ago, a surprising number of Japanese companies responded to offers of ESG workshops by stating that ESG does not really apply to them. They have all come around and realized that ESG is not just about being a good corporate citizen but a business and, in many cases, legal necessity. ESG concerns will drive supply chain M&A in the same way as COVID-19 and the China/US trade war do. ESG considerations – fuelled by new regulations, pressure from investors and NGOs, increased litigation risk, etc – will also broaden the way in which (M&A) due diligence is done and reported. They may also result in ESG-specific provisions being introduced in transaction documents, such as tailored representations and distinct remedies.
Japanese buyers will need to take a new approach to post-merger integration. The outbound M&A opportunities for Japanese companies are evident and plentiful. With China experiencing increased regulatory scrutiny and obstacles in many relevant jurisdictions, Japanese buyers will be welcomed by European, US and Asian companies looking for fresh money, consolidation, or business partnerships. Many Japanese companies will be hesitant to go near distressed situations due to an aversion to the perceived risk of these opportunities. More so, many are generally wary of the challenges of integrating businesses having had their fingers burnt on more than one occasion. Against this backdrop, it is somewhat startling that some Japanese buyers do not seem to appreciate the value of post-merger integration (PMI) advice offered by the established international consultancies (supported indeed by law firms). Tackling PMI head-on early in the M&A process with support from seasoned experts has been moving the dial on quite a few offshore acquisitions.
*All data sourced from Tokyo-based research company Recof.
Japan is going to experience a surge in cross-border M&A in 2022.