The debt deadline: Japans's SMEs at a crossroads

Small- and medium-sized enterprises (SMEs) are the backbone of Japan's economy. According to the Ministry of Economy, Trade & Industry, there are 4.69 million SMEs nationwide and they account for 99.7% of all enterprises and 70% of total employment.

As such, the Japanese government has been prepared to go to extraordinary lengths to protect its small businesses from bankruptcy in the face of a deepening economic crisis. One of these measures has been the enactment of the SME Finance Facilitation Act, also known as the Debt Moratorium Law.

Introduced in December 2009, the law was the brainchild of Minister for Financial Services Shizuka Kamei, the leader of a small faction within the Democratic Party of Japan-led coalition that had just broken the Liberal Democrats' 50 year hold on power in a general election. The legislation obliges financial institutions to alter loans terms at the behest of those borrowing from them - which essentially means that SMEs can defer repayment of their debts.

"It doesn't have any technical detail or mandatory procedures" explains Motoya Kitamura, a senior vice president with Macquarie Capital Securities who runs a fund-of-funds in Tokyo. "But it asks the banks to be more generous about the underperformance of portfolio companies. It has been met with lot of opposition from liberal economists but has nevertheless been able to dictate the behavior of the banks over the last three years."

Door opening?

The moratorium law has been controversial in a country where, according to a report by Mitsubishi UFJ Securities, SMEs make up 70% of bank borrowings, compared to just 30% in the US. And although it was supposed to expire within a year, the law has been extended twice in response to continuing economic difficulties in Japan, in part driven by the devastating earthquake and tsunami that struck the Tohoku region in 2010.

Now, though, the end really is nigh. The law is scheduled to be phased out on March 31 and private equity investors are looking forward to its demise. Some industry participants blame the legislation for stifling investment opportunities - 90% of PE transactions in Japan are less than $50 million - by enabling SMEs to put off debts and therefore avoid having to sell down equity. Its absence could bring a new crop of private equity deals into the pipeline.

Plenty of companies have taken advantage of the law to date. Statistics released by Japan's Tokyo Shoko Research Institute (TSR) show that by the first quarter of 2012 over 3.2 million SMEs, with debts totaling JPY88 trillion ($986 billion), had made applications to Japan's 404 financial institutions to renegotiate the terms of their loans. More than nine out of 10 applications were granted.

As the government hoped, there has also been a dramatic drop in the number of bankruptcies. TSR has records of 15,646 corporate bankruptcy cases in 2008, the most in five years. From 2009, when the moratorium law was brought in, the number has dropped every year, reaching 12,734 in 2011, the lowest in a decade.

These companies have been incubated from the realities of the economy, arguably at the expense of private equity. AVCJ research shows the numbers of PE deals in Japan did indeed see a slump in 2010, with just 198 transactions, versus 269 in 2008 and 229 in 2009. Yet there is no consensus on how much this has been affected by the law and what will happen once it expires.

"There could have been instances where companies should have been out of the banks' portfolios by now but have stayed because of the law," says Kitamura of Macquarie. "It is difficult to tell but from a PE viewpoint it may have taken away investment opportunities." He suggests one potential outcome of the law's expiry is a spike in turnaround and distress deals as money-losing companies are left out in the cold and forced to sell assets.

Gregory Hara, president of J-Star, a Japanese GP that focuses on mid-cap buyout opportunities, is not convinced, though. "Some GPs seem to think this will be the next 1998 event and there will be fire sale of companies but it is not happening," he says. "I am not saying there won't be any deals from an equity investment standpoint, there should be some and I don't deny that, but many are so small they may not be worthwhile."

Dealing in distress

One of the biggest criticisms of the law thus far has been that public pressure on banks to forgive payments has lead to an increase in non-performing loans (NPLs) on banks' balance sheets that are not recognized as such. This is because the Financial Services Authority (FSA), citing the legislation, requested that renegotiated loans not be classified as NPLs.

With that in mind, many of the country's regional banks have teamed up with investment banks and turnaround GPs to form locally-focused revitalization funds.

Among them are J-Will Partners, which in October formed an alliance with Hokuyo Bank to set up the Hokuyo SME Regeneration Fund to focus on distressed SME opportunities in Japan's north-most prefecture of Hokkaido. The Development Bank of Japan (DBJ) has created the SetoMirai Fund in Hiroshima while last December Real Integrated Solution & Advisory (RISA) Partners has formed SME revitalization funds with two Tokyo banks, Iyo Bank and Joyo Bank.

New Horizon Capital, which reached a first close of JPY5.3billion on its second corporate revitalization fund in November, has also explicitly stated that it will seek opportunities arising from the law's expiration by partnering with regional banks nationwide. The fund has a hard cap of JPY15bilion ($172 million) and expects its second close in the first quarter of 2013.

The government has been encouraging these funds wherever possible. In the case of New Horizon Capital, this has meant the government-backed Organization for Small- and Medium-size Enterprises and Regional Innovation Japan (SMRJ) contributing JPY2 billion towards the first close.

"At the moment we have as many as 20 deals in our pipeline" says Yasushi Ando, CEO and chairman of New Horizon Capital, "and our list is going to be a very long list because many banks are already beginning to change their stance."

Ando adds that the retail and manufacturing sectors have proven to be the biggest source of deals. "There are 10-15 manufacturers in our pipeline but, because of the high appreciation of the yen and the sluggish Japanese economy, we had expected more in this sector. Instead, we are seeing more retailers than expected."

Political uncertainty

However, whether the PE deal flow turns out to be a trickle or a flood could depend entirely on what steps the new Liberal Democrat government, which was voted back into power last December, and the FSA, take to mitigate the effects of the law's expiration.

"The new government will have to take some action as they will not look good if they allow these bankruptcies to go ahead," says Mangyo Kinoshita, a partner with law firm O'Melveny & Myers in Tokyo. "But I don't think whatever policy they come up with will be as strong as this current moratorium law. It will most likely come as an informal instruction from FSA to regional banks."

So far the FSA has given few details on what it will do once the law expires. The most significant announcement came in November when the out-going minister for financial services, Ikko Nakatsuka, said in a press conference that the FSA will instruct that loans renegotiated under the law should continue not to be classified as NPLs, even as the law expires.

Former Prime Minister Taro Aso, who replaced Nakatsuka, confirmed earlier this month that the law will not be extended. He has not yet clarified the government's position on the classification of renegotiated loans as NPLs but said it would be the FSA's responsibility to instruct banks on dealing with loans on a case-by-case basis.

New Horizon's Ando points out that while the FSA is making efforts to soften the blow of expiration, many banks are still eager to get the SME loans off their books.

"According to our interviews with many local banks, they are now worried about possible hidden loss caused by those bad debts," he says. "I visited more than 20 local banks in the last couple of months, they say the official bad debt ratio is 5-6% but in reality the number has tripled to 15-18%. The Japanese banking sector is not as good as it appears through the market."

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• Topics
• North Asia
• Expansion
• Credit/Special Situations
• Regulation
• SME
• Japan
• regulation
• Growth capital
• Distress
• Macquarie Funds Group
• J-Star
• New Horizon Investment Advisors