J-STAR: Venturing into tech

J-STAR partner Tatsuya Yumoto and principal Naohito Yamashita explain how it applies buyout expertise to deals more akin to venture capital opportunities

This article is sponsored by J-STAR

J-STAR – investors since 2006 in small and medium-sized Japanese businesses – is considered an old hand in the Japanese private equity space. The Tokyo-based mid-market firm returned to market with its fourth flagship vehicle last year closing at ¥48.5 billion ($470 million; €420 million). However, alongside its proven buyout strategy, it has been carving an unusual niche by investing in what it describes as “venture-ish” businesses. We spoke to partner Tatsuya Yumoto and principal Naohito Yamashita to find out more.

How do you characterise a “venture-ish” business?

Tatsuya Yumoto

Tatsuya Yumoto: We typically acquire a controlling stake in small to medium-sized businesses with a strong management team operating in a sector niche and ready to grow. As part of that buyout strategy, we can make growth support investments in smaller-cap businesses with significant growth potential. For example, last year, we successfully conducted an initial public offering when Japan Hospice Holdings – the country’s very first terminal care business – listed on the Tokyo Stock Exchange. When we invested in 2014 it was very small, and we undertook one roll up after another to scale the business into a hospice care platform.

Our venture-type deals – which we also invest in through our flagship vehicle – are a bit different. The transaction sizes are very small, perhaps ¥1 billion or less, the businesses are newer with a short track record and managed by a small team that relies on a key person or entrepreneur, and they are growing aggressively in a fast-expanding market segment. However, although these deals have a venture flavour, we believe the risk return profile is closer to a buyout. On the other hand, we keep control unlike the pure venture capital approach.

How is the deal landscape changing?

TY: Years ago, before private equity funds arrived on the scene in Japan, aging business owners faced two extreme choices: one to keep their business, or to sell it to someone else for good through a 100 percent exit or IPO. Today, funds offer a hybrid option of allowing the entrepreneur or founder to retain a stake in the business while receiving a capital contribution from a larger player like ourselves.

Over the past few years, not only older founder-owners, but newer business owners have also begun to appreciate this option. Younger entrepreneurs are looking to make better use of external capital to propel their businesses. This is a trend we are trying to encourage as it fits with our venture-ish strategy. In many cases, the entrepreneur’s business has taken off and they have had some initial success that they want to lock in by selling a majority stake, or even exiting completely. These people are good at getting a business off the ground, making it move from zero to one, but whether they can keep it growing to take it to 100, that’s a different question. Increasingly, they recognise that they need external support.

Why the focus on venture-type companies?

TY: It goes back to J-STAR’s relationship with JAFCO, which was the pioneer in Japanese venture capital investing. Back in the day, myself and three other J-STAR founding partners worked there before we spun-out of the buyout unit as a separate firm. At JAFCO, I dealt with both pure venture and pure buyout transactions. I noticed that often investments fell through the crack in the middle.

Both venture and buyout guys were interested in certain businesses but they ended up being overlooked as they didn’t fit clearly into one category or the other. We thought that there was no reason to miss out on the significant opportunity such businesses provide just because of a classification system. That sparked our thesis that we should pay more attention to the companies that are not entirely one thing or the other.

Naohito Yamashita

Naohito Yamashita: Venture-ish deals form a minority of our portfolio, although this proportion is growing. We believe that a fund such as ourselves needs to keep searching for new places to invest capital to generate upside. Looking at Japanese society and what’s driving the economy, there’s clearly been a shift from tangible goods to the “softer economy” of IT and web-related businesses. We look for enduring and repeatable return opportunities and today they happen to be in technology businesses. But there are not any 50-year old companies in IT or web-related segments with a long track record, so it was natural for us to develop growth and venture themes in this space.

TY: Overall, the change in the domestic business landscape is prompting traditional buyout funds to take a step back and tweak their investment orientation, although we are not aware of anyone exploring the venture space to the extent that we do.

How do you identify opportunities?

TY: Prior to investment, we apply the same criteria as we would to a traditional buyout deal. Critically, we examine whether the business is generating cashflow and whether it is sustainable. In pure venture capital investing, you don’t care much about that; you are concerned about scalability. As buyout professionals, we examine the viability of cashflow more in depth.

Post investment, we are concerned with growth in the business’s market segment. No matter how entrepreneurial the owner or CEO is, if the market it resides in isn’t expanding fast, its prospects are slim. And, if the market segment is rapidly expanding, then naturally more players will enter and in order to compete with them, the portfolio company needs to have a proactive mindset. Pre-deal, we assess whether management is working hard to professionalise and update internal systems and processes.

How do you differ from a typical VC investor?

NY: The biggest one would be the required success ratio. A VC partner may aim to hit the jackpot one in every 10 tries. We need to hit the jackpot every time. We really examine the character and proficiency of the management team because we aim to form a real partnership with them, working together to share our success. We are more hands-on. We are not gamblers.

TY: Venture is simply buy, hold and exit. They don’t spend the same amount of time as we do to support the management team to build a better organisation or to implement a strategy. That’s what we specialise in, and that’s what companies appreciate.

What’s an example of a “venture-ish” deal?

On the line: The
deals have a venture
flavour, but the risk
return profile is
closer to a buyout

TY: Periplus is a perfect one. This is the name we gave to the web media platform after we acquired three distinct web affiliate companies in April 2019: Kurashi-no, an outdoor living online publisher; Folk, which carried interior and lifestyle content; and Belcy, which was also a women’s lifestyle site. We identified that each of the individual companies had a certain edge such as a superior contents management system, efficient search engine optimisation technologies, or sophisticated banding and site-specific world views, but they also needed some improvement.

We realised that by combining them they could leverage each other’s strengths, learn from each other, realise synergies and grow together. Initially our role was to introduce them and help them see the mutual benefits they could share by working together. Post-investment, we are helping them execute on the plan. The platform has already achieved its initial success in terms of an advertisement price increase through the improved bargaining power with the combined audience. We will keep exploring newer growth initiatives together with Periplus’ young management team.

Is your sourcing of venture deals different?

NY: The approach is the same. We use our network – which we’ve built by connecting to other businesses through our portfolio companies – to get to know new potential targets. We also use boutique investment advisors. As these companies are small and low profile, there is some information asymmetry, which some established private equity firms may not be aware of or tapped into. We know that to be connected to younger entrepreneurs you have to act young. Boutique advisors in this sector tend to be younger and have extensive networks within certain generation layers.

How do tech valuations in Japan compare?

TY: We don’t buy dreams. As buyout players, we are concerned with topics like past track record, sales growth and the strength of the management team. Target companies with a venture profile may lack these factors compared with more conventional buyout targets. So, even if a tech entrepreneur’s business is growing, it still might exhibit some issues that offset that growth in terms of value, which means we can buy at a reasonable price. For these sorts of companies, over the past few years multiples have ranged from five to seven times, which by any standard is not expensive. There is not much difference to conventional small-cap buyout prices.

We try to avoid sellers seeking the highest possible valuation and a fast exit. Our preferred target companies are those with whom we can establish a partnership, even if it’s for a limited amount of time, to make organisational improvements or execute a merger and acquisition strategy or an IPO together. Those owners can still expect to realise the upside thanks to the time they spent with us.

What’s your approach, post-investment?

NY: Post-investment, our relationship with the entrepreneur is similar to any buyout deal, particularly our growth support investments. I would describe our relationship with venture-ish companies as brotherly. The beauty of dealing with younger entrepreneurs is that we talk the same language. Firing the management team is not on the agenda. In fact, in a third of our traditional buyout deals we retain management.

And at exit?

TY: We’ve yet to exit a venture-ish investment from our portfolio, but with all our deals we expect to follow the same process. We hope to make our first exit this year with an online wholesaler of affordable beauty supplies targeting customers in the 20-40-year-old age bracket.

When we invested in November 2017, we thought that with the injection of some risk capital it was inevitable that the business would grow. So far, sales have grown by ¥1.2 billion over the course of our investment. We also made some organisational changes. The management hierarchy was flat with a CEO at the top and a single tier below.

We restructured it into a pyramid shape with the addition of a middle management layer to make it more robust. Our plan is to sell to a trade buyer. The business is very attractive to traditional domestic firms interested in e-commerce who want to expand their customer base to include younger purchasers.

We are receiving a lot of unexpected reverse inquiries from trade buyers interested in our venture-ish companies. An IPO is also an option. Compared to many businesses, it is much easier for companies in IT-related segments – as long as they can exhibit certain growth criteria – to list on the stock exchange.