Cerberus faces new obstacle at Aozora

Cerberus's efforts to exit Aozora Bank, more than a decade after the private equity firm's initial investment in the Japanese lender, have been further complicated with the Japanese government poised to become the bank's second-largest shareholder.

Tokyo owns preference shares in Aozora, which it acquired when it nationalised Nippon Credit Bank, Aozora's predecessor, in 1998, before selling large stakes to investors including Cerberus.

A chunk of those preference shares faces mandatory conversion into common shares on October 3. That would give the government 20 per cent of the voting rights in Aozora and is an outcome all parties would prefer to avoid.

Brian Prince, Aozora's president, highlighted the bank's efforts to avert such a scenario when he revealed last week that it was in talks with the government and shareholders to repay part of the government's funds as soon as possible.

"Aozora wants to cut its ties to the government, and if the shares are converted that will become difficult," says Hironori Nozaki, a banking analyst at Citigroup in Tokyo.

Analysts believe Cerberus, which controls 55 per cent of Aozora's voting rights, will want to prevent conversion of the preference shares because having the government as a significant shareholder would make the lender less attractive to potential buyers.

Cerberus's situation highlights the difficulty facing private equity groups that invested in Japan but failed to exit their investments before the latest bout of economic weakness.

JC Flowers is sitting on substantial losses stemming from investment in Shinsei Bank, while Ripplewood, one of the most successful foreign private equity funds in Japan, this year managed to exit its investment in Seagaia only at a substantial loss.

Aozora, with its strong capital base, could easily repay the government and still have sufficient capital, says Toyoki Sameshima, a banking analyst at BNP Paribas in Tokyo. Aozora has a core tier one capital ratio of nearly 18 per cent, one of the highest among global banks.

The problem is Aozora's stock, which is trading at less than half the Y450 strike price of the government's preference shares, having lost two-thirds of its value since it was relisted on the Tokyo Stock Exchange in 2006. The shares closed at Y176 on Monday.

To make matters worse, the government is committed to recouping Y222.3bn ($2.8bn) - a face value of Y489 per share - from its tranche of 345m preference shares coming due this year with a face value of Y155.3bn.

If Aozora were to repay the government at face value, not to mention the higher price Tokyo seeks, it could face criticism if not lawsuits from other shareholders.

Aozora is therefore proposing to repay the government at face value over time, and compensate shareholders by buying back shares and increasing the dividend, say people familiar with the situation.

That, it hopes, would enable it to offer the government a premium over the current share price - thereby helping the regulator, which is keen to avoid setting a precedent - while deflecting any accusations of favouritism.

For the government, the option of seeing its investment plunge in value when the preference shares are converted is unlikely to be attractive, particularly as it would no doubt trigger criticism from politicians.

The question is whether the government will agree to repayment at face value, says Mr Nozaki. That would have to pass the test of Diet deliberations, he says, which could lead to a barrage of criticism in the Japanese parliament over the original deal.

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