Briefing: Rediscovering Japan

Long shunned as uninspiring, Japan is getting a second look from global firms and LPs – thanks partly to its underperforming neighbours.

Attendees at industry conferences tend to go for coffee when it comes time for the Japan panel. The prevailing wisdom about the country’s private equity industry has been the same for years: returns are poor; there are no deals; a stagnant economy saps portfolio company growth; and the cultural disdain for change will prolong the above indefinitely.

Finally, those views seem to be receding. The flat economy and aging population haven’t gone away. But Japan fatigue peaked perhaps 12-18 months ago, sources say – and the country has, for several reasons, started to look compelling again. 

Externally, interest has been sparked by the disillusionment with China and India. Last year, it became clear that GDP growth in Asia’s two most attractive markets was slowing, and fund managers are struggling to exit. “The fast and big return potential represented by China doesn’t seem to be happening,” says Tatsuo Kawasaki, partner at Unison Capital. 

Another boost is the new government’s $116 billion stimulus package that has, at least in the short term, pushed stock prices higher and the yen lower, aiding exports and boosting business confidence. “[The measures] are enhancing the Japanese economy upward, but more importantly they have a positive effect on the mindset of Japanese business leaders,” says Tamotsu Adachi, managing director of the Carlyle Group in Japan.

Exits (in comparatively illiquid Asia) are another positive indicator. Unison Capital’s 2012 exit of Akindo Sushiro, a sushi restaurant chain that it sold to UK-based Permira for $1 billion, generated an 8x exit multiple, says Kawasaki. He admits this was an “outlier”; he doesn’t expect to see many returns like this in Japan.

Nonetheless, there have been some eye-catchingly large exits lately (see chart following article), in stark contrast to the fund managers in China and India that continue to hold assets and collect management fees, waiting for better times. 

“Exits can yield multi-baggers and that’s drawing attention to Japan,” says Kyung Kim, CIO of Diamond Dragon Advisors, which is raising a $400 million Japan fund for mid-market buyout firm CLSA Sunrise Capital Partners. “LPs haven’t seen their money coming back [in China and India], and disappointment has made them look elsewhere.”

The result? “A lot of investors are giving Japan a re-look,” says Kawasaki.

THINKING BIG AND SMALL

In anticipation of an uptick, firms are building up their local investment teams. In March, The Longreach Group, which closed a $400 million Japan fund last year, hired two professionals for its Tokyo investment team; while Unison Capital Partners, which intends to raise a new fund, promoted four executives to partner level. The same month, Kohlberg Kravis Roberts hired two directors for its Japan office, increasing its team in the country to 12 people as it prepares to close a $6 billion Asia fund.

Sources say the biggest, most persistent myth about Japan is that there aren’t enough deals. Perhaps because it’s the land of giants like Toyota, Sony and Honda, Japan has been wrongly perceived as a big-ticket LBO market. Bain Capital has certainly done a few such deals, including last year’s $1.24 billion purchase of a 50 percent stake in Jupiter Shop Channel. 

But big buyouts like this are exceedingly rare. Between 1998 – the real beginning of private equity in Japan – and the end of 2012, only 3 percent of all deals (by volume) were over $1 billion (JPY 100 billion), according to data from Brightrust PE Japan, a Tokyo-based private-equity investment advisory firm. During the same period, the largest proportion of private equity deals (41 percent) were between $10 million and $50 million (JPY 1-5 billion).

The real potential for deals in Japan lies with its 4.7 million SMEs, which account for 99.7 percent of all enterprises and 70 percent of all employment, according to government figures.

“I don’t buy any argument that Japan lacks transactions,” says Joji Takeuchi, CEO of Brightrust. “They are there in the small and mid-cap market.”

Some firms known for large buyouts have adjusted their targets accordingly. Unison, for example, seeks companies with enterprise value in the $100 million to $500 million range, while Carlyle looks at businesses worth $100 million to $150 million. 

“Real deal flow is in the small-to-mid cap space – and we may look at sub-$100 million targets,” says Adachi. “Equity cheque deals larger than $200 million are very rare.”

Steering clear of big auction deals and companies with more than 1,000 employees seems to have worked for Carlyle. Generally, an expected IRR in Japan is 20-25 percent, sources say. But the firm recently announced that its 2001 Carlyle Japan Partners I, which is fully invested, posted a multiple on invested capital of 2.8x and a net IRR of 37 percent.

More recently, Longreach made a 2.3x return and 57 percent IRR when it sold SANYO Electric Logistics to Mitsui-Soko last February in a $301 million deal, PEI reported.

“If you find the right target where you can add value, you can get a good return,” says partner Masamichi Yoshizawa. “It’s a myth that nobody can make money in Japan.”

However, non-auction deal sourcing requires a long, continuous presence to foster reputation and personal relationships. A Japanese owner is deeply concerned about his company’s fate in a new owner’s hands, sources say. And for sub-$200 million transactions, investment banks are not involved. 

“The potential universe for buyout of SME candidates is huge, but there is a very limited number of people who can knock on the door and get them,” says Diamond Dragon’s Kim. “You don’t call Morgan Stanley to find those deals.” 

Likely deal sources include family businesses with no viable succession plans (a category that is growing as Japan’s population ages); public to private deals, which hit an all-time high of 25 in 2011; and turnaround and distressed opportunities, particularly those grappling with the very Japanese contradiction of high quality employees and products crippled by a resistance to change. 

In addition, the story that’s been talked about for years – corporate divestitures of underperforming or unaligned units – is actually happening this time, sources say. Global giants like Sony, Sharp and Panasonic have reported massive losses, leaving them no choice but to sell inefficient or non-core (even conflicted) parts of their business. 

One example of this came in December, when Advantage Partners acquired the Sanyo digital camera division from Panasonic for an undisclosed sum. The two brands were under the same roof and yet competing against each other, according to Richard Folsom, the firm’s representative partner.

Japan has hundreds of thousands of large company subsidiaries, he adds. “Advantage and every investment bank in Japan has been pitching them for a decade – and [we’re] just getting to the tip of the iceberg in terms of dealflow.”

Japan’s demographic problem – i.e. its ageing population – is well-known. But several sources spoke about opportunities to buy businesses that address this growing consumer segment. Japanese aged 60-plus own about 80 percent of public financial assets – which, according to Brightrust, total $17 trillion, three times larger than Japan’s GDP.

“If you buy in a sector that is non-cyclical and related to healthcare and senior spending, it’s hard to see how things could go wrong,” Takeuchi says.

One issue Japan doesn’t appear to have is a lack of available leverage. “Japanese banks are fairly active and aggressive,” says Advantage’s Folsom. “They have much more capacity to lend than there are deals.”

At the same time, valuations are low. Comparing the average Japanese stock market price-to-earnings against the equivalent US figure, Japan is two times lower, Takeuchi says. Japanese SMEs’ entry valuations can be around 4x EBITDA, and still return 2x-3x.

THE BIG CAPITAL PROBLEM

Despite the opportunities, Japan has few GPs. “There is a very keen sense that Japan is short of equity capital,” Unison’s Kawasaki says.

“After the Lehman shock, we noticed quite a bit of resource reallocation among international private equity funds to opportunities in emerging markets like China. As a result, fewer players are active in Japan.”

Carlyle’s Adachi agrees. “It’s a favourable environment because we have no strong competitors. Having said that, we don’t have enough GPs who can do the good deals, so we cannot grow the market. We welcome good GPs coming in, developing deals and making the private equity presence much larger.” 

The market certainly has plenty of room for growth. Private equity-backed M&A has ranged between three and five percent of total M&A in Japan in any given year, while in the US and Europe the range is between 10 and 25 percent, according to Advantage figures.

Yet cultural and regulatory barriers to M&A have faded. “There’s a lack of PE resources chasing deals in Japan,” Advantage’s Folsom says. “Most global and regional firms are not here consistently.”

Advantage and Unison have been operating in Japan for about 15 years. Among the global firms, bragging rights for longevity in the country – a significant factor in deal sourcing – go to Carlyle. The firm has had a Japan office since 2000 (KKR, Bain and TPG opened in 2005-2006); it employs 18 professionals in Tokyo, runs a Japanese Yen fund and since 2000 has made 16 investments (including two in 2012), which Adachi says is more than other global firms.

KKR’s last Japan deal was in 2010; recently it failed to buy a stake in semiconductor maker Renesas Electronics. Nonetheless, the firm is extremely upbeat on Japan, like most of its competitors. At an industry event earlier this year, KKR Asia managing partner Joseph Bae singled out Japan as “very relevant” and said he expects three or four investments in the country from the new $6 billion Asia fund. KKR has recently made two strategic partnerships with Japanese corporations, which Bae hopes will ultimately foster investment opportunities.

What’s more, private equity penetration remains extremely low. During 2010-2011, Japanese firms raised $0.09 per $1,000 of GDP, compared to $2.83 in China, $1.24 in Australasia and $1.23 in India, according to data compiled by Advantage. Japan has averaged roughly 40 buyouts per year since 2009, Brightrust data shows. 

Despite the sense that an uptick is imminent, sources insist that Japan is not about to explode with activity. “It’s a very active market, and we have a tail wind this time,” Folsom says.”We’ll continue to see steady market development, but I don’t think we’ll see an explosion of activity as has often been the expectation.”

Folsom believes a realistic forecast is a doubling or tripling of the private equity market over a five-year period. No paradigm shift, maybe – but enough to start filling the Japan sessions at industry conferences again.

19
Japanese funds currently in market

$3.6bn
Total targeted amount

$0.09
PE funds raised per $1k of GDP in Japan

$2.83
PE funds raised per $1k of GDP in China

Exit scorecard

Though knockout exits are rare in Japan, recent divestments have been particularly bright compared to China and India

Firm Portfolio company Exit multiple Year Type

Advantage Partners Komeda Coffee 7x 2013 Secondary sale
Commercial One 22x 2013 Trade sale
Bain Capital Sun Telephone 8x 2012 Trade sale
J-Star Iki Iki 8x 2012 Trade sale
Unison Akindo Sushiro 8x 2012 Secondary sale 

Source: PEI sources. No firm would comment on exit multiples.


Join us at the Global Alternative Investment Forum: Japan on 17 April in Tokyo to hear from leading Japanese investors and LPs on their increasing appetite for outbound investments.