This roundtable was sponsored by J-STAR and Tokio Marine Capital and first appeared in the Japan supplement which accompanied the April 2019 issue of Private Equity International.
The industry is grappling with record levels of dry powder – $2 trillion according to McKinsey’s 2019 private markets annual review – does this worry you? And has it been the same story for Japan?
Tadasu Matsuo: Dry powder is piling up to a certain degree but at the same time the deal pipeline for GPs is increasing both in business succession and divestiture of non-core businesses. We expect this trend to continue in the next three to five years. I am personally not worried that the dry powder is chasing scarce opportunities in Japan. It is, in fact, the opposite. There are many opportunities in the domestic market.
Yasuyuki Tomita: A concern for LPs globally is that the fundraising cycle has become too short and there are too many funds coming back to the market, which means too many choices for LPs. It’s a very challenging situation for LPs right now, assessing existing GP relationships and re-upping commitments. This is not the case in Japan. We recognise that many Japanese GPs are disciplined in their investment pace and do not rush into investments.
Satoru Arakawa: In Japan there are now too many funds rushing into the same vintage and with the same themes. But the dealflow is robust enough that our investment pace is increasing compared with the last decade. This is why we expect to return to market earlier than before.
How has the mid-market landscape changed in recent years?
SA: The Japanese M&A market has developed significantly, especially in the small-cap segment, for two reasons.
One, several M&A boutique advisory firms have cropped up and they are very keen to develop deals. These firms are often listed companies, so they have to accelerate the transaction activity and cut deals every quarter. As a result, many sellers have emerged.
Second, many potential sellers have seen other companies’ success with private equity firms, not just with the exits but also in the development of the company post-acquisition. There are just so many of these success stories now that local businesses are confident to sell the company to private equity firms.
Koji Sasaki: Intermediaries such as banks and M&A advisories have played an important part in mid-market deal activity.
In the past, if a founder and owner of the business thought about succession, he would never have thought private equity, because the asset class was not widely recognised then. As a matter of fact, it was feared.
But as the number of successful deals piled up and data has become more easily available, business owners have studied past cases and have come to understand how private equity might work for them. Therefore, intermediaries are now approaching private equity firms to know more about their activities and investment philosophies so that they can recommend the GPs to the families.
Nowadays in some cases word of mouth among families is becoming an important source of dealflow. We have actual cases in which families refer us to other families. Sometimes such referral occurs on the golf course even in our absence.
YT: Many GPs now have a lot of value-adding approach. There are few managers that have operational partners, but they have done many successful deals, learned lessons from the bad deals and increased capability in finding good companies.
Typically, family-owned businesses have no interest in strategic companies but after Japanese GPs have come in and made changes in management and enhanced the management incentive structure, they have shown much more interest.
Business succession has long been the favoured investment strategy of Japan-focused GPs. Are there any changes in the last year that have boosted dealmaking in this space?
SA: About half of Japan’s 2.5 million small and medium-sized enterprises do not have successors so the government is now in talks on whether to allow regional banks to invest directly in companies. However, with no investment experience it will be very hard to manage such companies.
In the last three years many regional banks teamed up with their peers for M&A activities and information-sharing about potential investment opportunities. They have now grown their local network and beefed up buyers and sellers information. Regional banks are also developing their M&A capabilities, which will in return mean more deal opportunities for firms like us.
KS: Dealflow in Japan has been increasing and it’s worthwhile to note that this rapid increase in family business deals has pushed up overall deal volumes. Japan’s ageing demographic has been a driving force of this.
But if you take a closer look behind this explosive increase in family business investments, you will notice that the lack of successor is not the only reason. We define family business succession deals in two ways. One, the founder is in his 60s or 70s, wants to retire but has no successor, so he sells. Second, the founder passes his stake to his son or daughter, after which the younger generation after two to three years thinks about enhancing the business and increasing the value of the company by partnering with a firm that has the capital, network and resources to make the company much bigger. These younger entrepreneurs want to make a big change for the future and unlike the older generation are more open to talk to other sponsors to work with.
Foreign private equity firms have stepped up hiring and investment activity in Japan in the last two years. How will they fare in a “highly local market”?
KS: That means more competition, but we welcome it because they give us mid-market players new ideas on how to add value to companies. While there are new entrants, there are also firms that have ceased to operate in Japan. The reason for this is that there aren’t as many large deals in the domestic market, unlike in the US or Europe.
TM: When we undergo due diligence of GPs in the US or Europe, we always consider that they have local staff or boots on the ground. To invest in Japan, they need to have Japanese staff who are well-versed in Japanese culture. However, I think it will take time before we will have a sufficient number of Japanese professionals who have a long-term track record of private equity fund investment.
YT: Foreign firms with a global platform give us comfort but I feel there is a of lot potential among domestic GPs to develop their businesses globally. Mid-cap investment is the sweet spot for us compared to complicated and large carve-out deals that the foreign firms often do. I do hope many GPs stay in the mid-cap even if they raise a larger fund.
Shuzo Takahashi: We like the small and mid-market, but we need large players in Japan. After all, the country is still the third-largest economy in the world. I don’t mean that bigger is better. But almost every GP plays in the same stage and strategy. I don’t think this is healthy. For the domestic industry to grow, we need a variety of players in the market.
Co-investments and direct deals have gained momentum in the last couple of years. Are you seeing co-investing opportunities in Japan?
ST: PFA has been active in the co-investment space in the last five years. For large investors like us, it’s a must-have nowadays and an important component of the private equity programme. However, there are many risks associated with co-investments, so we do these selectively and carefully.
LPs nowadays face tough competition in co-investment deal opportunities. The supply and demand balance has definitely changed from five years ago.
In light of this, we have been trying to invest in relatively less competitive spaces like Japan, not only for buyouts but also for growth capital opportunities or even in mid to late-stage venture deals. We try to take advantage of the good and long-term relationships we have with many Japanese GPs.
YT: At this moment in Japan co-investments are limited but growing. DBJ AM has teamed up with GPs and done co-investments in the domestic market and hope to act as liaison partner for domestic and foreign investors that may have difficulty understanding Japanese culture.
We have also managed a co-investment programme with many Japanese regional banks to invest in foreign private equity funds. The aim is to develop investment and business opportunities with overseas private equity funds for regional banks and sustain regional communities.
Last year Japan Post Group initiated their co-investment programme in Japan and Asia markets. I think this stimulated activity in the Japanese market and some LPs have started thinking about this more proactively. However, most LPs cannot do co-investments because of some limitation. They may not have the team and resources to evaluate the investment company and they cannot move quickly alongside GPs.
TM: JPI just started our alternatives programme in the last two years, so we are in the initial stage where we work with third-party gatekeepers and advisors to build up the portfolio from scratch. In the second stage, two or three years from now, we hope we can be ready to make direct fund commitments by ourselves (not all of the annual budget but a portion of it). And in the third stage, about seven to 10 years from now, our goal is to do co-investments as well as fund commitments. Doing co-investments by ourselves requires a number of experienced staff and speed of execution. If we are not able to start a co-investment programme, then the other alternative is to work with gatekeepers and advisors.
What would you like to see in the Japanese private equity market?
TM: The Japanese private equity market is predominantly a buyout market. There are some venture capital and growth capital focused firms, but that is a small number. As the domestic market deepens, we hope to see more variety. Hopefully we will also see the emergence of growth managers here, like in the US and Europe.
ST: There are far fewer sector-specific private equity funds in Japan than in the US and Europe. In addition, only a small number of GPs have sector teams. Private equity is becoming more specialised, so in the future we expect to see more sector-specific players in Japan. Also, buy-and-build has become an important value creation strategy globally, however, we haven’t seen many of these in Japan. Perhaps domestic GPs are doing well generating organic growth, but I think there’s a lot of upside potential or room for improvement.
An economic downturn is on the horizon. How has your firm prepared for this?
ST: Having a consistent investment pace is key. We have already experienced several market cycles in our programme over the years and learned a lot. Our investment strategy is all about achieving a good balance between a diversified portfolio and concentrating exposure to high quality GPs.
From a diversification point of view, we invest in some distressed debt and turnarounds, but we are not just focused on that. We don’t bet on any specific investment strategies.
TM: Private equity is a long-term investment, so whether we have good economic conditions or not, this does not really matter with the results expected 10 years from now. For me we don’t have to worry too much about the current conditions, or whether to stop commitments or to increase the size of our budget allocation. The important thing is to keep allocating to good performing funds within the annual budget. Continuous deployment in private equity is the key to success in the long-term period.
SA: From the GP standpoint, the market downturn could be an advantage for us because pricing is coming down. We see better priced assets in the next three or four years.
What are you looking forward to this year?
YT: Many Japanese LPs have shown increasing interest in private equity and demand for the asset class remains robust. We want to manage assets for them as much as we can. This year we tried to focus on the optimisation of our resources and partnerships with third-party, foreign fund managers to make us differentiated on the asset management side.
On the investment side, financial institutions are facing new regulations like Basel III and Solvency II capital standards, which might be a headwind for new commitments. That’s one challenge for us, how to construct the portfolio given the changes in the regulatory environment.
TM: Japan Post Insurance started the alternatives programme with eight investment professionals less than two years ago. That number is now 13 today, so we have made good progress. We expect to hire more in the future as we develop and construct our programme. This year we plan to have more facetime with domestic as well as overseas GPs, meeting them, getting to know them better, and enhancing communications with them.
ST: We expect to see more positive stories from private equity, that the industry brings more gyokai-saihen or industry reorganisation through more consolidation, regional acquisitions, and ultimately increasing Japan’s competitive power again. We believe private equity has a very important role in this.
Meet the roundtable
Satoru Arakawa is a partner and investment committee member at J-STAR. Since joining J-STAR in 2007, he has been involved in deal origination, execution, and monitoring and exits. He has led the firm’s investments in Sanwa Service, Echigoya, JVCC, Platia and
Tadasu Matsuo is the managing director and head of alternative investment at Japan Post Insurance. Prior to joining JPI in 2016, he was senior managing director at Alternative Investment Capital and previously head of alternative investment at Daido Life Insurance.
Koji Sasaki is the president and managing partner of Tokio Marine Capital and has been with the firm for almost two decades. Sasaki previously worked with the Long-Term Credit Bank of Japan where he was involved with M&A advisory. He serves as a director in several Japanese corporations including Ropia, CONFEX and Asahi House Industry.
Shuzo Takahashi is the head of private equity investment group at Japan’s Pension Fund Association, which invests on behalf of local corporate pensions. He has been covering a broad range of assets in PFA for more than 20 years.
Yasuyuki Tomita is the managing director of DBJ Asset Management in charge of managing mandates of private equity funds from the Development Bank of Japan as well as other Japanese institutional investors. Prior to this, he was vice-president at DBJ.