This article is sponsored by Neuberger Berman
Japan institutions have utilised separately managed accounts, or SMAs, to gain exposure to private equity. For PE investors, do current market conditions represent a challenge, an opportunity, or both?
Jonathan Shofet: We believe both. Operating and market challenges tend to create significant investment opportunities for private equity, given the long-term, operationally intensive nature of the asset class. Amid the volatility, we are seeing attractive investment opportunities on a global basis within take-private transactions, corporate carve-outs, growth investments at historically reasonable valuations and in sectors with strong secular tailwinds including within technology, business services, cybersecurity, healthcare and automation. In addition, private credit funds continue to be highly active even as banks have curtailed lending, allowing buyout transactions to be completed even at large scale.
That said, while there is no shortage of opportunity, we remain highly cautious in this environment and that stance has been underscored by events over the past month. Our underwriting bar is as high as it has ever been.
How is the SMA approach faring in today’s volatile environment?
JS: Over the past decade SMAs have become increasingly popular in Japan, as they have among large and sophisticated institutions around the world. The benefits of the SMA structure have been on full display in the past few years, and notably the past few weeks, amid material volatility and the complex interrelated challenges facing investors.
We have seen four key reasons for that. First is the dynamic allocation that is available through the SMA, which allows investors to efficiently allocate to the most attractive parts of private markets, both proactively and in response to changing market conditions.
Second is that SMAs tend to be extremely well diversified by investment strategy, asset class, geography, sector and time, all of which provide material safety during challenging time periods.
The third piece is that the SMA structure affords investors the ability to better understand, manage and control their private markets pacing, exposure and unfunded liability.
Lastly, these structures tend to afford a high level of transparency and customised reporting, which are important regardless of market conditions, but especially so during volatile market conditions. We believe the value proposition of SMAs is as high as it has ever been in this environment.
Are there any unique characteristics of Japanese investors that make SMAs particularly appealing from a structural standpoint?
Yoshi Yagisawa: SMAs can be customised based on a variety of investment aspects, but also by structure, jurisdiction, and back office and reporting requirements. This is different from commingled funds, which potentially have hundreds of LPs, making customisation for any one particular investor challenging.
Japan institutions vary by size, resources and historical activity within the asset class, and each have their own internal decision-making process, especially when it comes to primary investment focused SMAs. Certain institutions favour a fully outsourced solution, where an SMA provider builds and manages a portfolio without material input, while other institutions favour a more collaborative approach, where the SMA provider almost serves as an extension of staff. In the latter case, this often involves regular investment pipeline reviews, sharing of diligence insights and facilitating direct interactions with GPs. In addition, certain Japan investors have unique reporting requirements and guidelines that are incorporated into the SMAs.
For Neuberger Berman Private Markets, to understand the specific needs of our SMA clients we have a 100-person Tokyo team, which includes an institutional sales team, product specialists, and a PE-dedicated reporting and finance team. Those individuals can talk to our Japan clients daily to better understand their goals and objectives, which often evolve.
In addition to our Tokyo team, we have a New York-based PE Japan coverage team, who are Japanese or Japanese-speaking professionals that focus on SMA portfolio construction, programme management and client service for Japanese investors. This setup allows us to provide rapid and comprehensive client service.
Which investment strategies do Japanese investors tend to pursue within SMAs?
YY: It depends on the client’s specific needs and objectives, but we have observed that most SMAs in the Japan market are focused on opportunities in the US and Europe, and to some extent pan-Asia, across primaries and co-investments, in particular.
Japan institutions are historically active primary fund investors. Where is the opportunity today?
YY: Japan LPs have been active primary fund investors for many years and, depending on the institution and the strategy, they may invest directly, use an SMA provider, or utilise a combination of the two.
“Japanese LPs are highly sought after by private equity firms around the world”
Sophisticated Japan investors, like large financial institutions, tend to commit to Japanese funds on their own because they often have a local network and relationships. However, as their portfolios have grown, certain institutions have sought SMA providers to manage even those Japan investments to reduce the administrative burden, such as cash management. For funds outside of the country, many Japanese investors may be able to gain better access to highly sought-after funds through an SMA provider, to the extent those providers have desirable relationships.
In terms of the opportunity today, a critical component of successful fund investing is access. Due to a combination of the numerator effect from strong PE performance and the denominator effect from public market volatility, a number of LPs have slowed new PE commitments. Therefore, for the first time in about a decade, access to numerous world class funds has somewhat loosened.
Well-positioned and desirable LPs with capital, resources and relationships have been able to increase allocations and establish new relationships for the long term. We believe the Japan LP community will be the beneficiary of this dynamic given their strong commitment to the asset class.
You referenced that Japan institutions utilise SMAs to access co-investments. What are you seeing in that segment of the market?
JS: The volume of co-investment opportunities over the past year and into 2023 has been strong, despite overall mixed new deal volume. Specifically, new buyout deal volume overall was down in 2022, especially in the second half, as buyers and sellers adjusted to rising inflation, higher interest rates and public market volatility in addition to material supply chain issues, labour tightness and the impacts of the war in Ukraine.
Counterintuitively, however, during that time period and amid ongoing volatility in 2023, we have seen an increased need for co-investment capital from GPs to fund new deals and for add-on M&A of existing portfolio companies, as they face both a slowing fundraising environment and tighter debt markets.
In addition, GPs are focused on providing liquidity to LPs and continue to explore partial stake sales and equity recapitalisations that do not entail a change of control and hence do not require a refinancing of the debt capital structure. We believe that market participants who have historically pursued co-investments on a more opportunistic basis, or have become overallocated to the PE asset class, have pulled back. This has led to dedicated or programmatic co-investors seeing a larger share of available co-investment dealflow.
Are there any specific challenges facing Japan institutions as they invest in PE?
YY: Japanese investors have shown strong appetite for private markets investing despite rising interest rates in the US and Europe, and heightened market volatility and recessionary fears. There is one notable constraint that we have seen over the past year: the depreciation of the yen. As a result, some Japanese investors now make investments on a more selective basis and have slightly reduced bite size or the number of investments they make.
On the other hand, as mentioned, many investors see this environment as a great opportunity to gain access to GPs whom they have not had prior relationships with, because a lot of overseas investors are somewhat constrained or impacted by the numerator/denominator effect. In fact, some of our existing SMA investors have been quite active in building new primary relationships with US and European large-cap, mid-cap and growth equity managers over the past six months.
Are you getting more inbound enquiries from international GPs looking for introductions to Japanese investors?
YY: A handful of publicly traded PE firms have offices in Tokyo, but most large-cap, mid-cap and growth equity GPs in the US, Europe and elsewhere do not have local offices in Japan. For GPs to cover the Japan market directly would require a great expenditure of resources. They would have to set up local offices and/or make frequent trips to Japan over many years in order to achieve investor traction.
As a result, many GPs tend to work with providers like NB Private Markets in order to access capital pools in Japan, as well as elsewhere in the world where they face similar challenges. We continue to receive more and more inbound calls and enquiries from GPs about Japanese investors’ trends.
JS: Japanese LPs are highly sought after by private equity firms around the world due to their size, sophistication and commitment to the asset class. Just as GPs want to build diversified portfolios when they invest, they also want to create a diversified base of strong LPs around the world.
How much room is left for growth?
YY: We believe there is still a lot of room to grow. A number of large investors only started their private investment programmes within the past five years. Some of the financial institutions, such as banks and insurance companies, have a long history of investing, but many of them have accelerated their private investments after the global financial crisis. So, primary investment should continue to grow, and some of the larger investors are also increasingly interested in co-investments and secondaries.