Japan M&A: growing, but from a low base

Positive developments only marginally outweigh negative outcomes for M&A deals in Japan this year, yet participants remain upbeat about the future.
Two steps forward, one step back seems an apt description of JapanÆs M&A market. For every positive development, which seems to propel the market forward towards a more active M&A arena, another development moves it back.

ôThere is a lot of head room in Japan for M&A volumes to continue to grow on a sustained basis,ö says Shunichiro Tsunokawa, a managing director in Morgan StanleyÆs M&A division in Tokyo.

ThatÆs not surprising given the small base. M&A activity in Japan during 2006 is estimated at around $103 billion, compared to record volumes of $1.6 trillion in the US alone and $3.8 trillion worldwide. Global M&A volume rose around 38% year on year compared to 2005. The US and Europe broadly mirrored the consolidated rate of growth while Asia ex Japan exceeded it at 40%. But in the worldÆs second largest financial market M&A activity declined 36%.

While the overall market size may still be small, it is undeniable that recent M&A activity in Japan is re-shaping the existing landscape. And despite the slowdown in 2006, market participants remain bullish on the current year and the future.

ôThe Japanese M&A market, in general, is at its most vibrant and diverse ever,ö remarks Matthew Hanning, head of M&A and corporate advisory for Asia Pacific at UBS. ôOur sense is that pipelines remain filled with deals, indicating that activity will remain busy into 2008 and beyond.ö

A takeover launched by Oji Paper for Hokuetsu Paper in 2006, the first ever hostile bid by one Japanese company for another, captures the change. The deal was unsuccessful for Oji, but still successful in changing prevailing perceptions of hostile deals.

ôThe idea that a company would talk of going unfriendly if their negotiated overtures were rebuffed was unspeakable earlier,ö says Morgan StanleyÆs Tsunokawa. ôBut that has changed.ö

Now Japanese companies themselves suggest exploring all available avenues if there is a strong strategic rationale underlying their pursuit of a target. Indeed, two cross-border deals that Japanese companies pursued in 2007 capture the degree of change.

In May Japanese technology company Fujitsu offered a $563 million takeover bid for French application services vendor, GFI Informatique. GFI had already announced plans to induct Apex Partners, a private equity firm, as a financial investor.

Fujitsu termed its overture ôfriendlyö and in April initiated dialogue with GFI management but Fujitsu may have been galvanised into action by the impending shareholder vote on the Apax investment.

The GFI board did not share FujitsuÆs view. The proposed price was too low and the offer was ôunsolicited and hostile and highly unusual in the information technology services industry where human capital is a companyÆs main assetö said GFI to shareholders while asking them to vote against the Fujitsu proposal. Not surprisingly Fujitsu could not achieve the minimum 67% shareholding it needed and the bid failed.

Then, in July JapanÆs Fast Retailing locked horns with Dubai investment vehicle Istithmar for US department store chain, Barneys. Jones Apparel Group, the owners of Barneys, had already announced in June, a deal to sell the asset to the Middle Eastern sovereign fund for $825 million. After Fast Retailing entered the fray the asset was bid up and Istithmar finally paid $942 million to emerge as the winner.

Advisers are not surprised at the outcomes. Companies that make unsolicited bids, especially those termed hostile by the target, or enter the fray for an asset already in play know the odds are stacked against them. The willingness of Fujitsu and Fast Retailing to embark on these bids, knowing the low likelihood of success, suggests a considerable change in the mindset of Japanese companies.

ôJapanese companies are being driven to look outwards by the demographics in Japan,ö says Morgan StanleyÆs Tsunokawa. ôGrowth rates, especially for consumer and healthcare businesses, are dwindling and to continue to grow companies will have to pursue new avenues and target new markets.ö

And Japanese companies are being helped in their aspirations by liquidity in the local banking system.

ôJapanese local banks are in relatively better shape than many of their counterparts elsewhere in the world and, despite fundamentally taking a conservative approach, have the appetite and willingness to fund the cross-border aspirations of their clients,ö explains Morgan StanleyÆs Tsunokawa.

Increasing shareholder activism is also driving change. The idea that shareholders could question deals seemed to have permeated the consciousness of corporate Japan as a result of some high-profile deals that shareholder-led resistance thwarted this year.

After Ichigo Asset management led the first-ever shareholder resistance to a proposed merger, resulting in Tokyo Kotetsu shareholders voting down a pair up with Osaka Steel, a merger between Hoya and Pentax was abandoned as Pentax shareholders felt the deal under-valued the company.

Then in June, shareholders of Bull-Dog Sauce approved a ôpoison pillö scheme to block a proposed takeover attempt by Warren LichtensteinÆs fund, Steel Partners. Steel Partners ownership was whittled down to 3% of Bull-Dog, from the 10% it had accumulated, by a fresh issuance of shares to all shareholders other than the US hedge fund. Steel Partners took the case all the way to JapanÆs Supreme Court before conceding defeat.

Like the Oji-Hokuetsu case, the Bull-Dog one has supporters in both camps. Some right-wingers term the outcome a setback for the ability of activist-led reform to succeed.

But others are more sensitive to the nuances of the specific situation.

ôThe court observed, while upholding the poison pill, that Steel Partners was not constructive enough in explaining its plans for Bull-Dog,ö comments a specialist. ôThis suggests a window for activist shareholders to effect change still exists if they engage management and other stakeholders in productive dialogue before they take further action.ö

And it is also well-accepted that hedge fund-sponsored activism suffers from greenmail type perceptions û or buying a companyÆs stock and using the perceived threat of a takeover to either sell the shares back at a premium or force change on the management. Obviously, this is not something corporate Japan is likely to endorse in a hurry.

Companies with strong underlying strategic motivations for our acquisition will go back to the drawing board and try again to put together a deal. This is what Hoya, represented by UBS, did. It tabled a revised offer for Pentax that this time contemplated a takeover via a tender offer bid û and declared in August that it had been successful in making Pentax a Hoya subsidiary.

Another positive development for inbound Japanese M&A activity is recent legislation permitting triangular mergers. JapanÆs new company law, which went into effect May 1, lets foreign corporations use shares to acquire Japanese targets.

On October 2 Citi announced it would pioneer the use of triangular mergers in the country to effect its acquisition of Japanese brokerage firm, Nikko Cordial. Earlier this year Citi paid $8 billion to acquire 68% of Nikko. It will acquire the remaining 32% for $4.6 billion via a triangular merger by which Nikko CordialÆs minority shareholders will receive Citigroup shares.

The tax treatment governing the structure is complex and this has led to some rumblings of discontent from advisers about how many companies will actually adopt this route.

But this is still a positive change for foreign companies. ôThe new legislation surrounding triangular mergers is a welcome development as this provides one more alternative on deal structuring,ö says Morgan StanleyÆs Tsunokawa.

Some recent deals have been driven by the desire to wholly own a Japanese subsidiary, to either drive growth or change.

In April Polo Ralph Lauren offered to acquire the 80% of Impact 21, its Japanese sub-licensee that Polo did not own. Polo simultaneously acquired the 50% interest in its Japanese master licensee from its partner. Polo spent $370 million to gain 100% ownership in a market that it entered in 1978 and which is currently its second largest country in terms of sales of Polo products after the US.

ôThe Polo Ralph Lauren case illustrates well how companies which may have entered Japan with one foot in the door now want to squarely place two feet inside,ö elaborates Tsunokawa, who advised Polo on the transaction. ôThe strategic rationale for the deal was compelling.ö

More recently in October Wal-Mart offered $878 million to buy the 49% of Japanese retail chain Seiyu that it does not own. Seiyu has been loss-making for five consecutive years since Wal-Mart entered the Japanese market via a partnership with the Japanese retailer in 2002.

ôWal-Mart sees Japan as a top strategic priority, based on the significant size and structure of the market and economy,ö explains a source. ôWal-Mart considers it can best leverage this opportunity with Seiyu under its full control.ö UBS, along with Citi and Dresdner, is advising Wal-Mart on the deal.

Taking one step back still means reaching nearer your destination with every move. As UBSÆs Hanning summarises: ôM&A in Japan has shown some definite green shoots; we feel confident this is a sign of more to come over the next 12 monthsö.

This story first appeared in the Japan supplement which was published with FinanceAsia's November issue.
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