It pays to know the local market – J-STAR

Some of the most attractive opporuntinities in Japan are in areas where private equity firms wouldn’t normally look, say J-STAR’s Kenichi Harada, Yutaka Tozaki and Takanori Unami.

This article is sponsored by J-STAR.

Economic and structural reforms have already helped unlock new deal opportunities in Japan over recent years and now the pandemic is prompting more business owners to look at their long-term options. While the past year has been a difficult one for many, it has presented some private equity firms in Japan with steady dealflow.

Despite the pandemic, J-STAR, a firm in operation since 2006, has had one of its busiest years to date for deals. We caught up with the firm’s managing partner Kenichi Harada, principal Yutaka Tozaki and manager Takanori Unami to find out where they see most promise in the market, what kinds of niches are most attractive and how the firm is working with portfolio companies to achieve sustainable growth.

How have deal opportunities developed in Japan over recent times?

Kenichi Harada

Kenichi Harada: We have been seeing a steady increase in the number of deals over the past two to four years. The big picture is that this is being driven by economic policies that aim to tackle the productivity problem in Japanese businesses, in particular at the smaller and mid-sized parts of the market. There is a clear direction of travel here – that business leaders, led by policy-makers, are setting out to achieve bigger economies of scale.

Yet there are also many deals coming from – and set to come from – the reforms of the Japanese stock exchanges. While not yet completed, we will see a significant reorganisation of the market and a change to the required listing criteria. This should lead to many more opportunities for private equity as fallen angels, consolidation and carve-out deals increasingly come to the M&A market. While succession deals will continue to feature large in the Japanese market for many years to come, these are new and different types of deal that will add dynamism. We’ve been able to seize chances in this environment – we completed seven new investments last year in the middle of a pandemic.

What would you say are some of the more interesting niches in the market?

KH: We invest across a whole range of small and medium-sized businesses in Japan, including food-related companies, consumer goods, manufacturing and education. However, there are particular niches that we are excited about. Waste management and recycling is one area where we have made four investments over the decade – it’s an important theme for our firm and we have built knowledge here.

It’s an attractive sector because recycling and the circular economy are global stories and so businesses that support sustainable economies have substantial growth potential. There are also some local attractions – in Japan there are very high barriers to entry, including strong regulation and high capital expenditure for recycling and waste management infrastructure. If a company has both these covered, there is scope for monopolistic-style growth.

Yutaka Tozaki

Yutaka Tozaki: A more recent theme we are exploring is aquaculture. We see a lot of opportunity here because there are certain characteristics that keep other private equity firms away. For example, most aquaculture businesses suffer from low margins and price fluctuations – they tend not to be the type of very predictable, cash-generative business that our competitors seek out. However, if you can find the right businesses in this niche, they can be very attractive and have significant growth opportunity.

How do you source deals in niches such as these?

KH: You really need to know the local markets. Even if there is a large investment bank involved in a sale, you can’t just rely on the headquarters. If you know the branch networks well, you can gain advantages in deals hundreds of miles from Tokyo like the aquaculture business. You need a local flavour to your deals to win – and that includes getting regional banks involved in financing the transaction.

You’ve made an aquaculture investment. Can you tell us about it?

YT: Of course – it’s called Dainichi and it has some very attractive characteristics. Normally, in aquaculture, businesses are vulnerable and exposed to cycles. They are small and tend to buy fish stock when it is expensive, grow the fish for two to four years and then sell at times when the market might have shifted from the peak. It’s a short-sighted, cyclical model and one that could really benefit from the kind of long horizons private equity is known for.

Dainichi is a little different because 60-70 percent of its sales are wholesale, with the rest coming from the sale of food for fish and aquaculture products, which clearly isn’t cyclical – this stability helps offset the inherent vulnerability of aquaculture. It also has a research and development division that helps customers optimise fishery practice as well as looking into how to avoid disease. The other point to bear in mind about the market is that the number of fish farmers has declined by around a third over the past decades, yet production has only gone sideways rather than down, so production at each fish farm has actually increased.

So what are your plans for the business?

KH: There are quite a few opportunities here. One is to grow fish themselves, in particular as the number of fish farmers is declining. In common with other sectors in Japan, many of the fish farmers are growing older and have succession issues, so there is potential in rolling up a number of fish farms to create a business of scale. There is also an opportunity to train up fish farmers to take over the farms where there are no successors – that way we can help create more sustainability in the sector in Japan. Then there are opportunities to expand Dainichi’s sales channels and products, such as frozen products, for example. And finally, Dainichi has already been exporting to North America for 10 years and we see further export expansion potential through Asian markets, as sustainable fish products supply is called for in order to protect the natural aquatic resources from growing protein consumption demands in the region. There’s a lot of growth to go for.

How will you work with Dainichi to achieve this?

KH: We always work in partnership with the companies we back – we don’t just walk in and take over 100 percent of the business. We usually invite the owner to remain with the company and as part of the management team because they know the business best. This is the case in more than half of our deals and it’s true of Dainichi.

Dainichi’s founders are retaining one-third of the stake in the business and we will be working together to grow the business. Alongside this, we will help the business attract and retain young talent – that’s so important in succession and growth hybrid deals.

Where do you see future promise in the Japanese market?

YT: The food industry is very interesting here – and Dainichi is obviously a part of the food supply chain. ‘Food in a pandemic’ sounds counterintuitive. But that is when the chances are highest that you will actually be able to spot businesses with a real competitive edge.

Takanori Unami

Takanori Unami: In addition, the food processing industry is one with distinctive reasons to keep your eyes on it. The pandemic prompts food manufacturers to increase investments for automation, and Japanese processing quality is likely to help them exploring overseas markets. This is a typical small-cap industry where business succession over to the next generation is about to be top of the agenda.

How important is sustainability in your investments?

KH: Sustainability is very important to us as a firm. We’ve been signatories to the Principles for Responsible Investment since 2014 and we see ESG issues as having the potential to impact both our own activities and those of our portfolio companies.

We see this as a particular issue for small and medium-sized companies because they often do not have the resources or knowledge to implement good ESG practice. As investors, we can support this process. And it can’t just be empty words – it has to be genuine because strong ESG practice makes good business sense. Our aquaculture business Dainichi, for example, is looking to gain market recognition for its sustainable credentials and it is aiming to abide by certain criteria around water chlorification and fish types. It has also developed eco-friendly fish feed. All this is good business because people increasingly want to work with companies that remain conscious about sustainability.