J-STAR: Waste not, want not

The fragmented Japanese waste management industry represents a compelling private equity opportunity, say J-STAR principal Masayoshi Nakajima, manager Hisato Iwamoto and managing partner Hideaki Sakurai.

This article is sponsored by J-STAR.

Why do you believe Japan to be an attractive private equity market for investors at this point in time?

Hideaki Sakurai

Hideaki Sakurai: While the Japanese economy is stable and mature, Japan’s private equity industry is still small and nascent relative to other comparable countries. We therefore believe the opportunity for investors to generate attractive returns is significant, particularly in the small and mid-cap area where we operate.

Why the smaller end of the spectrum, in particular?

HS: Simply put, there are many, many more small and mid-cap opportunities in Japan than there are large opportunities. Approximately 3,000 M&A transactions take place in Japan every year. Only 20 or 30 of those involve a deal size of over $500 million. More than 90 percent of the deals that get done, meanwhile, are valued at less than $100 million. So, the supply and demand fundamentals are in our favour.

Which sectors within the Japanese mid-market do you focus on?

HS: J-STAR invests across the healthcare, manufacturing, TMT, retail, business services and environmental sectors. But among those, we view investments addressing Japan’s waste management problem as particularly attractive. We have completed six deals in that segment over the course of the past 16 years, including four deals in the past four years.

For example, we have invested in Harita Metals, a company that conducts waste treatment and recycling of metals such as those from automobiles and home appliances. We have also invested in Shinnihon Kaihatsu Group, which operates an incinerator and home appliance recycling business, and Sincere, which provides environmental services, including buildings maintenance, waste management and the incineration of industrial waste.

What is your approach to origination and asset selection in this space?

HS: Almost all the transactions we have completed in this space have come about as a result of succession issues. The reason for that is that the waste management industry in Japan was kickstarted when waste management laws were introduced in the 1990s and many of the first-generation founders are now much older, in their 70s and 80s, and are looking to hand over the reins.

The businesses we target also tend to be highly localised and we source opportunities through local business leaders throughout the different regions. There are very few nationwide companies in Japan when compared to the US and many European countries. M&A consolidation activity has not taken place in the same way. That, of course, creates an opportunity for the private equity industry. We have been driving consolidation in the waste management industry since 2006 when we made our first investments in ECOS Factory and Green Loop, two businesses focused on the recycling of waste plastic, which we later sold to renewable energy business Renova.

Meanwhile, our long history of investing in the waste management sector means that many business owners in the industry are aware of us. That means we have the opportunity to communicate directly with those leading these companies, helping us avoid competitive situations and giving us a significant edge when it comes to origination. These are replicable investments in a sector we now know very well.

In addition to the opportunity to drive consolidation, how else do you look to create value in the sector?

Hisato Iwamoto

Hisato Iwamoto: Finding good acquisition opportunities is certainly one of the ways in which we can support our portfolio companies and is an area where J-STAR invests a lot of time and resource. Another important source of value creation that we can bring to the table is our experience and knowledge of making waste management processes more efficient. We are able to share best practices from across our investments in the sector.
I would add that because many of these companies are family-owned firms, run by first-generation founders in their later years, governance practices can sometimes be outdated. We can implement new ideas, tools and technologies in order to upgrade business management. This is another common challenge that we need to overcome.

Take Harita Metal, for example. We helped transition that company from a family business management model to an organisational management model, while strengthening financial strategies. With Shinnihon Kaihatsu, meanwhile, we also introduced sales and facility operation capabilities that enabled the business to expand without relying on the founding family’s connections. In addition, we introduced a new president with a background in engineering, as well as a chief financial officer with strong internal management skills.

Finally, with Sincere, we established a board of directors and a series of key performance indicators addressing issues faced by different departments. We also reorganised the sales department around customer needs and improved the business’s ability to present solutions by leveraging outside resources.

What do you see as the most likely exit route for these companies?

HS: Of course, the two primary exit routes for any private equity-backed business are trade sales and IPOs. We believe both routes to be open to assets in this sector. A trade sale might involve a peer company in the same industry. Equally, Japan’s large trading companies, which are involved in a wide range of different segments, could represent potential buyers, as could a natural resource company.

How has the concept of ESG evolved within the context of Japan and how does that compare to other geographies?

HS: I would say that Japanese companies stand in pretty good stead when it comes to environmental, social and governance issues. Where we do encounter issues with governance in the context of these founder-owned businesses, we see it as our job as a private equity firm to help fix those.

One area where I do think Japan lags behind other developed economies is gender diversity. If you compare the gender ratio at management and board level with countries in Europe or North America, female representation is far lower. In fact, Japan ranked 120th out of 156 countries in the latest Global Gender Gap Report published by the World Economic Forum. It is important to identify that as a weak spot and try to make improvements during the private equity holding period.

Finally, by investing heavily in the waste management sector we are, of course, having a direct and positive impact on the environment. We are also sharing the knowledge and expertise we have gained through our exposure to these environmental services businesses with our portfolio companies in other sectors.

How would you describe LP attitudes towards ESG? Are Japanese investors as demanding in this sphere as investors from other markets?

HS: Having raised five funds now over the past 15 years – the most recent fund closed in April 2022 – we have definitely seen changes over time. We do continue to see differences, however, in the level of scrutiny that Japanese investors are placing on ESG issues when compared to investors from other jurisdictions. We feel that European investors are paying the closest attention to ESG topics, while many Japanese investors are still in a research phase.

Having said that, the direction of travel is clear and Japanese investors are also starting to ask more questions. It is a very important area for LPs today, no matter where in the world they are based.

What do you think the future holds for the Japanese private equity market?

Masayoshi Nakajima

HS: We believe that the Japanese mid-market private equity opportunity will continue to grow because, although the Japanese economy is less than half the size of the economy in the US, for example, there are a larger number of companies operating in the country. It is therefore highly fragmented and that has resulted in a lot of inefficiency.

When you combine that with Japan’s ageing demographic – it is one of the countries where the population is decreasing most steeply – it is clear that this level of inefficiency is not sustainable. Private equity firms, like us, can be a catalyst for consolidation and professionalisation within these fragmented industries, which means there is not only a strong financial rationale for investment in Japan but a social rationale as well.

Another reason that we believe strongly in the expansion of private equity in Japan is that the asset class, and M&A in general, is becoming far more familiar and commonplace. The number of M&A transactions per year has risen from around 2,000 a decade ago to well over 3,000 today. So, while the Japanese M&A market has lagged other mature economies, this is now changing, which is opening up additional investment opportunities for firms like us. There is a lot of scope for growth.

How do you see private equity investment in the waste management sector in Japan developing in the future?

Masayoshi Nakajima: Japan’s environmental industry is still very inefficient when compared to that of other developed countries and so there remains a lot of potential for further investment to professionalise and consolidate the space.

There are global investment firms that have made aggressive moves into the environmental sector in other parts of the world and it is clear that this is a worldwide theme that extends far beyond Japan. We hope to become an important part of that mega-trend.