Denominator woes prompt Japanese LPs to get selective

Japanese institutions have found themselves cutting down ticket sizes and declining fund opportunities as currency fluctuations compound private equity’s denominator effect.

Japanese LPs are highly prized among the private equity community as a hungry, comparatively untapped source of capital. Over the past 12 months, however, a particularly severe case of the denominator effect has restricted their participation in the asset class.

Like many of their peers in the US and Australia, Japanese institutions have seen private markets exposure soar. As public markets come down, private equity’s quarterly lag and aversion to markdowns has pushed many portfolios north of their target allocations.

Japan’s denominator effect, however, has been made doubly severe by a simultaneous numerator effect: not only have their private markets portfolios remained strongly valued relative to the public markets, but a collapse in the value of the Japanese yen has inflated the value of their US dollar fund commitments.

“One of the concerns last year was the exchange rate, because the yen became so much cheaper against the dollar,” says Tomoko Kitao, a Tokyo-based managing director at Hamilton Lane. “So that also contributed to the denominator effect where private equity, being mainly denominated in US dollars, became an even larger part of many investors’ portfolios. I think globally there was a concern about allocation issues because private assets didn’t devalue as much as public assets, and that was even multiplied for Japanese investors because of the exchange rate.”

Though the yen has recovered some of its value this year, as of October it had hit a 24-year low against the US dollar. A weaker yen means that capital calls from US funds can become much more onerous for investors to meet. A $10 million capital call in March 2018, for example, would have cost roughly ¥1.06 billion, but about ¥1.33 billion ($10 million; €9.3 million) in March 2023. When this happens across multiple funds, the institution’s liquidity needs can end up being much higher than initially budgeted at the time of their commitments.

A weaker yen has meant that annual budgets – typically set in the months preceding the new financial year in April – do not go as far in private equity. As a result, some Japanese institutions have been forced to slash ticket sizes when re-upping to funds.

“No one’s stopped, but… they’ve been very conservative in terms of [commitment] size,” says Tuck Furuya, founder of Japanese LP gatekeeper, placement firm and secondaries advisory Ark Totan. “Ticket size… used to be $25 million, now it’s $20 million. Or just generally they have five funds on their mind, and in the second half they have to cut down to three. Of course, the alternative to slashing ticket sizes is to decline the re-up altogether.”

A good number appear to have embraced the latter option.

“Typically, investors don’t want to sever relationships – they want to maintain – so they often do try some size of re-up,” says Hamilton Lane’s Kitao. “But there are investors that don’t particularly worry about the relationship if they skip one, so it’s either reducing the ticket size or turning down opportunities.”

Picking a winner

This dynamic is prompting Japanese LPs to make tough decisions about their private equity portfolio in 2023. “Investors have to become more selective in terms of which GP they want to re-up with,” says Miho Hosoya, a Tokyo-based senior consultant at investment advisory firm Mercer.

“Of course, some investors may have reduced the average ticket sizes, but at the same time I think most investors are trying to be more selective in terms of the tickets that they invest. Everyone was in the market over the last few years, so they are not able to make assessments for all the re-ups because they have limited resources, so really they had to be more selective from their resource perspective as well.”

“One of the concerns last year was the exchange rate, because the yen became so much cheaper against the dollar”

Tomoko Kitao
Hamilton Lane

How, then, are investors deciding who makes the cut? “It’s always very complicated and there are different aspects involved in the decision, but performance, obviously, is the most important factor,” Hosoya notes. “Of course, investors look into any sort of changes within the teams and also investment style, and some may consider their feasibility to provide

There are other factors that inform which GPs will succeed in securing a commitment. “[Investors are] looking at the past track record like performance – not just the numbers, but also the kind of exposures, [like] who invested heavily into tech sectors in the last five years,” says Ark Totan’s Furuya. “And if the GP was lucky, they were able to exit these names before the bubble burst, but if they held it too long, they’re getting hit right now. But either way, I think they’re looking for GPs that are trend following and not… If the GP has been investing in the same sector for a very long time and they’re very sticky to the same sectors, that’d be highly encouraging for Japanese investors.”

Though US dollars have exacerbated the denominator effect, it may be European funds that find themselves without re-ups.

“Obviously US dollar investment is penalising for these people because of the currency volatility, but then where did they go next?” Furuya asks. “Europe? Typically that would be the case, but Europe in 2022 was not an easy place to bet,” he says, pointing to the war in Ukraine. “People held back [on] European investment compared to a regular year, I think.”

Europe-focused vehicles accounted for just 8 percent of global fundraising in 2022, the lowest proportion since 2012, per Private Equity International data. Asia-Pacific fundraising also declined nearly 40 percent year-on-year to $64 billion and, at 9 percent, its share of global fundraising was the lowest since 2009.

“Many GPs new to Japan were struggling over the past three years because most Japanese LPs were focusing on re-ups,” says Hideki Amemiya, head of Japan at Asia-focused placement firm TransPacific Group.

“However, we expect this may start to change in the latter half of 2023 and more significantly in 2024, because some LPs [have] started to look at new GPs and new strategies now. On a regional basis, there was a concern in Europe because of the geopolitical… issue but some established managers could raise successfully.”

Portfolio sales

For those who have been left overexposed as a result of private equity’s denominator effect, the secondaries market could offer some respite.

“Some of our clients are seriously considering selling fund interests, but I don’t think any have yet,” a senior executive at another Japanese LP gatekeeper tells PEI on condition of anonymity. “It will depend on pricing in the secondaries market; the current discounts don’t exactly incentivise them to sell.”

There are several obstacles to this route, the chief one being a gulf in buyer-seller expectations. Just 38 percent of global LP-led transactions priced at 90 percent of NAV or better last year, compared with 78 percent of transactions that generated that level of pricing in 2021, according to Campbell Lutyens’ 2023 Secondary Market Overview.

“We have a pipeline of LP-led transactions. Because of a combination of the weaker Japanese yen and a drop in the US tech market, sellers want to sell US venture capital exposures to rebalance or risk off their portfolio,” says Atsuhiko Inoguchi, a founding partner of Japan- and APAC-focused secondaries firm Bee Alternatives. “However, valuations have been very high and are now dropping, so we’ve got to provide a decent discount on that. But the seller still wants to keep some good profits, which is why there’s a gap between bid and ask.”

“Investors have to become more selective in terms of which GP they want to
re-up with”

Miho Hosoya

Portfolio sales are also limited by the nascency and scale of Japan’s secondaries market. “USD commitments from institutions like Japanese regional banks and Japanese corporate pension funds are not very big,” Fumiki Otokuni, chief executive officer at Bee Alternatives, adds. “We don’t see many global players in the Japanese market yet because not many want to purchase small pieces of LP interests. So there aren’t many bidders involved in Japanese secondaries transactions.”

None of this is to say that LP-led transactions haven’t come to market. In March, affiliate title Buyouts reported that Japan’s Norinchukin Bank was shopping an approximately $1.5 billion of private equity fund stakes on the secondaries market.

The motivations for selling differ greatly depending on the institution and are all company-specific, Ark Totan’s Furuya notes.

“One pension fund that I’ve spoken to wanted to trim down their private equity exposure because the CIO changed, and the new CIO isn’t a big fan of private equity investment,” Furuya says. “I also spoke to another large pension fund who had heavy exposure to venture capital when valuations were skyrocketing last year and [they] went above their limit for exposure to illiquid assets. So, for that reason, they were thinking about selling down their venture capital fund stakes, but instead they asked the board to increase their private equity allocation.”

New entrants

Of course, private equity is a long-term game; allocation decisions are made with years or even decades in mind, rather than anything as short-term or unpredictable as currency fluctuations. Indeed, Japan’s limited LP activity over the past year has been a consequence of their capacity to invest, rather than their desire.

And Japan’s LP landscape is only getting larger, with private markets firms increasingly drawn to the country’s burgeoning high-net-worth channel. Hamilton Lane, for example, started selling its $2.78 billion Global Private Assets Fund, which provides qualified investors outside the US access to a diversified portfolio of secondaries investments, direct equity investments and direct credit investments, in Japan last year. Sumitomo Mitsui Trust Bank has been investing in Hamilton Lane GPA on behalf of its clients through trust accounts since April 2022.

Hamilton Lane has dual exposure to Japan’s individual investor market: it is also part-owner of ADDX, a digital fundraising platform that offers tokenised exposure to the private markets for much smaller tickets than is typically required. Hamilton Lane’s fellow co-owners include the likes of Japanese Investment Corporation and Development Bank of Japan.

In 2021, ADDX partnered with Japanese financial services company Tokai Tokyo Financial Holdings to offer fractional private market investment products to domestic investors in Japan, after Tokai Tokyo secured a security tokens licence from the Japanese regulator. The partnership will first offer tokenised exposure to Japanese real estate.

“[Growth could come from] high-net-worth – and maybe in the future – retail [investors], through the restructuring of private equity into vehicles where smaller ticket investors could invest,” Hamilton Lane’s Kitao says. “Digitisation and technology could assist in that.”

There is more to come from Japan. Fundraising platform LUCA, founded by former Blackstone executive Keiko Sydenham, launched a beta version for Japanese users in November. Once fully live, it plans to offer business-to-business partners and high-net-worth individuals access to a variety of alternative investment products.

It’s not just private wealth coming to market. The new ¥10 trillion Japan Science and Technology Fund, for example, is in the midst of a mammoth alternatives build-out to achieve its goal of returning 4.38 percent each year. The country’s regional banks have also piled into private equity to help generate new deal financing and investment opportunities in their local areas.

Ark Totan runs private equity training sessions for potential entrants to the asset class. Topics covered include how to perform due diligence on funds, how to monitor funds and how to sell interests on the secondaries market. “During covid a lot of people called us… regional banks, even the mega-banks, insurance companies, pension funds, university endowments,” Furuya says.

“We don’t expect all of them to come back to become actual clients, but what we’re really trying to do here is we want these people at least to have a proper understanding of private equity markets and investments so they don’t get screwed over.”