Japan Needs More Cowbell

I had the privilege of writing a letter to the FT's Alphaville in January titled "The GPIF and the complexity of stewardship" about some of the ESG and stewardship issues involved with passive investing, and particularly those which might concern the GPIF – the world’s largest pension fund at $1.5+trln.

During his tenure at the GPIF, then-CIO Hiro Mizuno promoted stronger stewardship, more rigorous voting practices, and true (not tick-the-box) engagement efforts from GPIF-allocated managers. He also changed the mandate and fee structure to aim for a win-win relationship with managers. Famously, he helped push for a policy of not lending out its foreign shares because he felt that stewardship could not be honest if the title were lent out (note the policy was already to not lend out the Japanese portfolio). However, passive funds (90% of the GPIF equity allocation) still face stewardship dilemmas.

Helpfully, the GPIF has developed a public stewardship policy, and in its recent Stewardship Activities Report there is a section dedicated specifically to passive management, including “the possibility of collaborative engagement” (working with other investors to engage with a company), matching the change in the Japan Stewardship Code in March 2020. Engagement by its managers with investee management is designed to “encourage investee companies to increase their corporate value and the sustainable growth of the entire market from the long-term perspectives.” A rising tide lifts all boats.

In my letter to Alphaville I suggested, “Eliminating one of the root causes of undervaluation — a lack of active investor confidence that Japanese companies will do the right thing with the capital allocated to them — might be the best long-term investment the GPIF could ever make.”

Indeed, a key aspect of Principle 1 of the Japan Corporate Governance Code requires that directors and companies not conduct capital action that is not necessary, and which might be deleterious to the interests of minority shareholders. Alas, when one company owns a large stake in another, the interests on one side can conflict with the interests of minorities.

Takeover Governance & Stewardship

Takeovers – effectively the inverse of public capital raises – are key governance bottlenecks because at the “wrong” price, they cement a sub-optimal return on that capital forever. Good voting policy in mergers will solve a lot of issues. However, the issue of engagement with corporate governance becomes complicated with cash takeovers.

Somebody bids. The target board approves.

It is announced. Investors accept, or do not.

There is no vote on cash takeovers in Japan and the Target Board decision usually comes before any shareholder input. With a good governance process managing a change-in-control proposal, general investors can be reasonably sure they are obtaining an appropriate price for losing the chance to stay invested. However, where the bidder is already a controlling owner or manager, there is a possibility of serious conflict of interest, and governance problems galore.

Recognizing this conflict of interest issue, METI created its MBO Guidelines in September 2007. Developments in Corporate Governance and the issue of listed subsidiaries meant newer guidelines for avoiding conflict of interest were desirable. METI presented revised Fair M&A Guidelines in June of 2019.

Those Guidelines (which are not law) are described as “ideal approaches to fair M&A” so as to mitigate the inherent conflicts of interest in transactions where the buyer has incumbent ownership, board position, and informational advantage.

The Guidelines note in implementing fair M&A...

• A “market check” helps assure arms' length pricing,
• Transparency to mitigate information asymmetry is desirable,
• Minority shareholders should benefit from a Special Committee made of independent directors, who should receive their own financial and legal advice - separate from that of the Board,
• The Special Committee should receive an independent valuation, and a fairness opinion,
• The Special Committee should demand a majority-of-minority threshold

Since then, many MBOs and parent-subsidiary sales/buyouts proposed in Japan have addressed these conflict of interests, following most if not all of the points mentioned in the Guidelines.

Some, however, have not. MBOs remain a sticking point. Recently, a few stand out.

Nichii Gakkan (9792)

Nichii Gakkan Co (9792 JP) - a decades-old company in one of the few natural growth industries in demographically-challenged Japan – nursing homes – saw its founder pass away last September. Board member heirs in management positions inherited shares, with an inheritance tax liability difficult to pay without selling some of the family’s combined 44% stake. An MBO proposal was made in conjunction with Bain with the stated goal of taking the company private to restructure some segments, promoting medium-long-term growth in corporate value without public investors suffering the indignities of a hit to short-term earnings. In May, the bidders offered a price 30% above the last traded price. That’s the pretty version of the story.

The less pretty version might be that the family, Bain, the Board, and management of Nichii Gakkan are irreparably conflicted with their general investors, who constitute the majority. They wanted to take the company private to get cash to pay their inheritance tax, but they wanted to keep control of the company, and they opportunistically lowballed investors. They started looking at the deal, concluding it was necessary, when the shares were trading near ¥1600/share and they would have expected to pay a 25+% premium. Markets fell, and they ended up bidding ¥1500/share.

To be clear, it is Bain's job as an investor to buy things cheaply. As an investor, they have no duty of care to minority investors in companies they would seek to take over.

But the Nichii Gakkan board does in this case.

Management is beholden to family control. Three quarters of the board is family or management. One director is from Bain Japan, joining the MBO. Two other board members are ‘independent’ (but were originally selected by the conflicted board) and it rested upon those two to defend the interests of the 56% of general shareholders against the conflicted 44% ownership and majority-conflicted Board.

The M&A Guidelines were an ideal place for the independent board members to look to ensure fairness. In the Nichii Gakkan case, investors got none of it.

No market check. No transparency on how “fair valuation” was calculated from the Board. Independent directors received no independent legal or financial advice or valuation, and no fairness opinion. And there is no majority of minority clause to ensure half the 56% of public shareholders agree.

The Special Committee agreed to use a valuation report prepared by a conflicted advisor, who was hired on a fee-for-success basis by the conflicted Board, based on conflicted management’s unchecked forward revenue and EBIT forecasts, to agree to a conflicted owner/management proposal to buy and squeeze out minority investors. And independent board members went with that. They could have asked for a Fairness Opinion, but did not.

Reasonable minds may disagree on price. The market obviously thinks the Tender Offer Price for Nichii Gakkan to be light. The self-interested buyers think it “fair.” But three things stand out.

• First, when the family engaged, they likely penciled in a premium to then-market price for control. Despite no subsequent change in profits or forecast, the offer price ended up lower.
• Second, the official ‘Vision 2025’ Mid-Term Management Plan, reaffirmed as late as November 2019, targets forward profit and revenue which are multiples of the management forecasts in the “valuation” considered by the Board. There is no explanation for why management lowballed its long-standing board-approved long-term public targets.
• Third, the banks’ lending package to fund this deal covers the entire purchase price. The equity being rolled over is just to finance the roll of some of the existing debt which may be covered by change of control clauses. If you LBO a company and the banks require zero money down, investors should consider if they are selling too cheaply.

These reasons, on top of the lack of appropriate governance procedure, are reasons for Nichii Gakkan investors to complain. It is, in fact, appropriate reason for all investors to sit up and take notice of what is happening in their portfolios.

What Can Be Done?

One could argue investors retain appraisal rights, and indeed the documents refer to those rights, but the Supreme Court decision on the JCOM takeover has neutered that avenue to some extent because a “fair process” is deemed to ensure a fair price.

My response to that is that when the only valuation to support board agreement on price is based on conflicted management forecasts, it is by definition impossible to achieve a “fair process” but this seems to have escaped the Court. More work is needed to ensure fairness.

There are a few ways to fix this.

1. One, changes could be made to law, mandating good behavior. The UK Takeover Code does just that to protect minority shareholders.
2. Two, directors could be made liable for bad governance decisions as in other countries.
3. Three, investors can spend years (or decades) trying to win hearts and minds of company management and boards through engagement.
4. Four, investors can try to win the hearts and minds of fellow investors to ensure minority investors know how to protect themselves against weak governance. The big issue for investors is bad actors ignoring Guidelines, and exercising conflict of interest not possible in other markets.

Legal changes in Japan require years or decades of lobbying. The Nichii Gakkan tender ends, so far with two delays, in two weeks' time. The board has approved the deal. Management agrees. That management happens to be affiliated with the buyer doesn’t help.

Engagement? Talk to the hand.

In this case and any other in the near-term, only “collaborative engagement” seems like a reasonable response. Unfortunately, in a foreshortened time frame (30 business days for many tender offers these days), “collaborative engagement” behind closed doors does not allow stewardship-minded investors to communicate their concerns so the wider investor base, perhaps less well-informed than pros, may digest the governance issues affecting long-term returns.

The only way left is public engagement.

So far, we know of one investor, LIM Advisors, which has presented its case to the Nichii Gakkan board and to the public. The board did not respond. LIM has re-presented its demands. From the 200+ other signatories to the Japan Stewardship Code who may also be concerned with governance and loss of capital due to management conflict of interest? Crickets.

That only one shows up publicly here, and only one showed up in the multi-month governance sham that was the Unizo takeover suggests signatories to the Japan Stewardship Code need to think more aggressively about how they engage. Stewardship Investors are mandated to follow a policy to achieve the best results for their investors. It should be no shame to engage publicly.

As always, more below the fold...