When Washington, DC-headquartered Carlyle Group closed its debut $470 million (€370 million) Japanese buyout fund, Carlyle Japan Partners LP, earlier this year, it was revealed that around 60 percent of the committed capital had come from Japanese institutional investors. This was enough to raise eyebrows among market practitioners, even without the fact that the capital was raised without a placement agent. No wonder then that the firm was also voted best Fundraiser in Asia in our 2003 Private Equity Awards (see last month's Annual Review).

When you look at the amount of capital available to be invested by Japanese institutions, there seems nothing remarkable about Carlyle's achievement. The Japanese Government Retirement Pension Plan alone has assets under management greater than the total GDP of Switzerland (around $400 billion) and is the largest pension fund in the world. But, in line with many of its domestic peers, the fund is highly conservative in its investment approach, with the vast majority of its capital invested in Japanese government bonds and equities.

This is partly a historical legacy. Until the late 1990s, strict legislation meant that conservative asset allocations were forced upon institutional investors. Economic stagnation and woeful stock market under-performance led to these rules being relaxed, but funds are still dealing with the fallout. A survey in the spring of 2003 by consultants Greenwich Associates found that Japanese corporate pension funds were covering only 62 percent of their payment obligations – a funding gap that has been closed only slightly since the recent stock market rally.

These problems have led alternative assets to be taken more seriously, though statistics suggest progress has been slow. The Greenwich Associates survey reveals that in 2002, 1.3 percent of Japanese corporate pension fund assets were allocated to alternatives, compared with eight percent in the US. More startling still is the revelation that of this 1.3 percent, 1.1 percent is committed to hedge funds and just 0.1 percent each to private equity and real estate.

In a market accustomed to public equity investing, it is perhaps natural that Japanese investors should gravitate towards hedge funds that are liquid and often stock market based. But another recent study, published by Goldman Sachs and Russell Investment in 2003, suggests they are storing up trouble for themselves.

The study discovered a heavy reliance on only two types of hedge fund strategy, with 65 percent of Japanese investors adopting a so-called “equity market neutral” strategy and 35 percent selecting an “equity long-short” approach. No more than 25 percent of the investor community were estimated to be using any other strategy. This contrasts with the US, where at least five hedge fund strategies were used by 66 percent of investors. The study concluded that Japanese institutions were trying to be cautious by adopting the least complex strategies of those available, but their failure to diversify strategies could have the opposite effect to that intended.

With regard to private equity, there seems to be a smaller group of active investors who are as yet only committing very small percentage amounts to the asset class. Some suggest that many Japanese institutions are uncomfortable with the idea of the protracted draw-down of capital and the unpredictability of distributions. The long-term nature of the asset class seems at odds with what many understandably regard as the more urgent requirement of filling that funding gap. In 2003, total Japanese institutional commitment to private equity leapt an impressive-sounding 170 percent compared with the previous year. But the total still only reached a less than dazzling $360 million – and only around 12 percent of institutions are investing in the asset class at all, according to GS and Russell.

Slowly but surely though, things may be changing. Few fundraisers in the region are able to boast the level of support received by Carlyle's fund – though that did have the clear advantage of being Japan-focused and thus offer a comforting degree of familiarity. But anecdotal reports suggest that even fundraisers with a broader geographic remit are talking more seriously to potential Japanese investors, many of whom are eager to access opportunities in fast-growing neighbours, particularly China.

Japanese institutions' embrace of hedge funds challenges the notion that they are innately conservative. The question is, will their experience be a good one? If scepticism about their hedge fund investment strategies proves well founded, it is possible that this flirtation with alternatives will be short-lived. Or it may prompt these investors to look elsewhere, nearby. For instance, into the willing embrace of private equity: the alternative alternative.