More than a decade of corporate governance reform has driven major change in Japan’s stock market. Cross-shareholdings are unwinding, capital is flowing into activist funds, take-private transactions are growing rapidly, and even unsolicited takeover bids are no longer taboo.
As activist funds grow and increasingly take on larger, more powerful corporates, it was somewhat inevitable that the entrenched executive class would seek to push back. The news of business-lobby Keidanren asking for a meeting with Elliott Management around the time of its Toyota Industries intervention was symptomatic of this dynamic. Elliott, with stakes in storied companies such as Daikin, Mitsui Fudosan, and Mitsui O.S.K, has helped move activism from a peripheral nuisance to a place where it affects the core of Japan Inc.
The corporate governance reform project has the underlying goal of revitalising Japan’s economy. It was begun in earnest as part of Abenomics, and further enhanced by the Ministry of Economy, Trade and Industry’s 2023 takeover guidelines. After the bubble burst in 1989, the malaise that followed was compounded by rigidity in Japan’s capital and labour markets. Low-return and “zombie” businesses were preserved by managers focused on avoiding risk and without incentives to pursue restructuring, protected from outside influence by cross-shareholdings. Sprawling conglomerates lost out to rivals in China, Taiwan and South Korea that pursued focused scale and seized the lead in fields like consumer electronics and semiconductors.
Pushing boards of directors to focus more on company performance was the first step. Attracting private equity capital to purchase corporate carve-outs aided restructuring. But, the 2023 guidelines proved to be the major catalyst for the beginnings of a true market for corporate control – a necessary development if the reform’s aims are to be achieved.
What exactly are the recent developments?
In June, likely in response to lobbying by Keidanren, and the Takaichi government’s focus on growth, METI proposed supplementary commentary to its guidelines clarifying that desirable deals are those that enhance corporate value and are “not necessarily” those at the highest price. At the same time, the LDP has convened a project team that will, amongst other topics, examine whether activists and private equity funds are collaborating behind the scenes on take private transactions to the detriment of other shareholders, prompted by a number of deals where activists have reinvested alongside the PE fund post privatisation. The Justice Ministry has proposed increasing ownership thresholds for filing shareholder proposals, which will effectively remove this ability for all but the largest retail shareholders.
The common thread is a shift in emphasis from shareholder interests to management’s under the guise of stakeholder capitalism and “long-term” thinking. But is there any real change here that impacts the ongoing reform process and development of the market for corporate control?
The increase in shareholder proposal thresholds is a minor issue, with little practical effect as activists generally own enough of their target to meet the proposed thresholds. The METI commentary only further outlines what was already the case.
Price has never really been the deciding factor in takeover deals in Japan. It is almost always about the composition of the shareholder register. With no general duty owed to shareholders, directors have almost always acted in their own interests in deal situations, except where they fear raising the ire of their shareholders. Management buyouts and friendly deals with private equity firms frequently transfer value from the pockets of outside shareholders to those participating in the deal. It is only interventions by activists in such deals that have seen some balance restored.
Recently, we can observe this dynamic in cases like Soft99, Mandom, Pacific Industries, and of course Toyota Industries, where activist involvement delivered massive upside for shareholders. Activist intervention is only sensible, however, where the level of management-aligned / cross-shareholdings is not too great, so that the activist can have real influence. In other cases, the presence of a higher-priced offer has been broadly irrelevant – such as the recent Sanko Sangyo MBO where the Board turned down the significant premium offered by Steel Partners for an alternative deal.
Activists are a source of deal flow for PE funds in all markets, not just Japan. In Japan this dynamic is more pronounced because of the ease with which management teams can reject a private approach without fear of it being made public (PE firms do not want to be viewed as “hostile”) or facing a shareholder lawsuit (directors have broad discretion under the “business judgment” rule).
Activists push underperforming management teams to make major improvements or otherwise realise value through a sale of the company. PE funds are often the natural buyer. It is natural for a PE firm to negotiate any such purchase with all major shareholders, as well as management. If an activist holds a large stake, its consent will generally be required to secure the transaction.
Activist participation in deals should be viewed no differently to cases involving family or management shareholders. Indeed, activist-instigated deals are preferred by shareholders because activists have much greater incentive for a deal to be priced appropriately. The activist must justify the price it accepts to its public-market investors, who are unlikely to be identical to those that will invest alongside the PE fund. It is also odd with the discussion around price not being the primary consideration in take-private transactions, that activists are being criticised for not focusing more on price!
There is a danger that Boards will use METI’s guidance around negative impacts to stakeholders – including looking at potential post-deal labour force rationalisations, to refuse any deal that involves restructuring. METI makes clear that these issues should only be considered negative factors if they are likely to be detrimental to future cash flows, but the business judgment rule established by the courts provides a lot of leeway here. It would simplify things if Japan imposed a duty on directors to act in shareholders’ interests as South Korea wrote into law last year as part of its own corporate governance reform, but that is not on the cards. Ultimately, it will come down to the composition of the shareholder register.
The government is incentivised to continue with the reform. The Nikkei reported last week that the government is formalising a strategy that targets households lifting the share of their financial assets held in stocks, funds and bonds from around 23% today toward 40% by 2040. Solid equity returns are an important factor in funding the retirements of Japan’s aging population. This can only occur if listed companies are run to reward the people buying their shares.
Labour shortages are appearing across the economy, but in reality, this is more an issue of labour misallocation and mispricing. Ongoing industry consolidation, rationalisation, and corporate restructuring are necessary to address this.
In all, the announced changes amount to tinkering around the edges. They make some formalistic concessions to the executive class, without abandoning the substance of the reform. Foreign investors own roughly a third of the Tokyo market; a new generation of Japanese investors are much less tolerant of underperforming management teams; and the cross-shareholdings that once cocooned managers are still melting away.
The reform genie is out of the bottle, and Japan is the better for it. It is not going back in.
