Japan’s fund managers are catching up with their institutional investor compatriots when it comes to embracing the secondaries market.

Buyout firm J-STAR could be the next to do so. The Tokyo-headquartered firm is exploring whether the GP-led secondaries market could help it to avoid overstepping concentration limits during an “aggressive” programme of buy-and-builds, Secondaries Investor affiliate title Private Equity International reported in May.

J-STAR aims to complete an average of two to three add-ons for each portfolio company acquired by its fifth flagship fund, which closed on ¥75 billion ($576.3 million; €547.9 million) in April, partner Tatsuya Yumoto said. J-STAR No.5 is about 55 percent larger than its 2019-vintage predecessor.

“Because add-on acquisitions and roll-ups are one of our core investment strategies, we are planning to aggressively do follow-on investments,” Yumoto says.

“Historically, we have done about 50 primary investments so far and 50 add-on acquisitions as well, so the ratio is about one to one. If you look at successful American or European GPs nowadays, they’re doing about one to three, and we are planning to achieve a similar strategy in J-STAR No.5.”

Platform acquisitions are increasing in frequency. Nearly one-third of add-on acquisitions completed in 2019 represented at least the fourth acquisition by a single platform company, up from 21 percent in 2003, per Bain & Co. Some 10 percent of add-ons represented at least the 10th acquisition.

One possible risk associated with buy-and-builds is that of breaching a fund’s concentration limits, which prevent any single asset from receiving too much capital. These diversification rules may stipulate, for example, that no one investment can receive more than 20 percent of the capital from the fund.

Single-asset secondaries transactions can help with this issue: such deals enable the GP to lift the overly large asset out of its original fund and into a new vehicle, with LPs given the option of either rolling over into the latter or cashing out.

“We’re considering several new tools and techniques to maximise the return for our investors, one of which is GP-led secondary transactions,” J-STAR investor relations principal Kenta Shima says, noting that the firm has received pitches from advisers about the potential use of continuation vehicles for older vintages.

“Another idea we are considering is a single-asset GP-led secondary to provide liquidity to younger vintage funds whose DPI isn’t that high yet. And at the same time for us, because we do lots of add-on acquisitions, we also have to be very careful about the concentration limit of each one.”

GP-led growth

Japan’s secondaries market has historically been more seller-driven than asset-driven, according to Greenhill’s Asia-Pacific Private Market Review 2021. Norinchukin Bank, for example, offloaded two giant private equity portfolios – $1.3 billion and $5 billion – in 2019.

Still, the domestic market remains comparatively small. This is despite an accounting quirk in the Financial Services Agency’s Generally Accepted Accounting Principles that could present an opportunity for secondaries buyers and sellers alike.

“In Japanese GAAP, unlike US or international accounting, there’s not mark-to-market accounting – it’s book accounting,” Reijiro Samura, president at Japanese fund of funds Alternative Investment Capital told Secondaries Investor in October. “Net asset value should be lower than market value, so maybe in that sense sellers can enjoy a premium to the book value but a discount to the fair market value. Some GPs have international LPs and can give fair market value, but most domestic GPs are given only Japanese GAAP accounting.”

LP stake sales have traditionally been driven by corporates and regional banks that back private equity for more than just a return. The latter, for example, typically commit to the asset class on the understanding that the fund will deploy part of its capital in that region and syndicate its leveraged finance to the institution in question, as PEI reported in 2019.

“The reason why corporates and banks are investing, especially for the buyout funds, is that they’re expecting some synergy or additional benefit throughout the investment,” Atsuhiko Inoguchi, co-founder of Japan and Southeast Asia-focused secondaries firm Bee Alternatives, which spun out from Japan’s Ant Capital Partners last year, notes.

“In this case, the maximum benefit is coming during the investment period of the funds and after the investment period there’s no need to keep their exposure to the fund. They want to re-up to the next fund and improve their relationship with the GP, so they sell their existing fund stake.”

In October last year, Samura’s AI Capital partnered with growth firm WM Partners to launch a jointly managed fund to provide the country’s burgeoning limited partner community with greater access to liquidity. Japan Private Equity Opportunity 2021, which was also backed by AI Capital shareholder Sumitomo Mitsui Banking Corporation and WM shareholder Development Bank of Japan, is seeking up to ¥10 billion from domestic investors and has held a first close on an undisclosed sum.

Though the fund will primarily target LP interests from domestic investors, it will also have the flexibility to participate in GP-led transactions.

“I think there are many chances in the GP [space] in Japan, so we’d like to start preliminary discussions with Japanese GPs on how we can work together in GP-led secondaries,” Samura said. “WM Partners has a great network in the venture capital industry and AI Capital has great relationships with Japanese buyout GPs.”

As a result of Japan’s bias towards LP sales, some institutions are already more accepting of secondaries processes than even their manager counterparts.

“Some Japanese investors… have experienced GP-leds prior to covid-19 because they had invested in US funds,” Fumiki Otokuni, chief executive officer at Bee Alternatives, adds. “At this moment, GP-leds are growing rapidly,” he says, citing the pandemic’s impact on exit activity through IPOs as a primary driver. “We’re talking with some GPs about continuation funds, for example.”

Private equity exit value in Japan dropped 58 percent in 2020 to just $3 billion, according to Bain & Co. It has since recovered, with exits skyrocketing to $16 billion last year due to several large trade sales and secondary buyouts.

Despite an increase in managers’ willingness to explore GP-led opportunities – as is the case with J-STAR – questions remain over the depth of the potential pool of buyers. “Most Japanese fund statements are written in Japanese, meaning some global overseas buyers can’t enter the market,” Inoguchi says. “This is one reason buyers have the ability to negotiate on price – because there are limited secondaries buyers that can read Japanese.”