The patient approach

Japanese private equity is a tough sell.

Investors have been burned there in the past. Deal size, pace and realisations haven’t lived up to expectations. Cultural barriers remain high. And some fund managers that opened in Tokyo over the past decade have since shut or revised strategies. No wonder Japan is typically perceived as a notoriously difficult market to crack.

What’s more, Japan’s growth prospects pale in comparison to other Asian markets. Its economy has been recovering following last year’s devastating earthquake and tsunami, but GDP growth projections – 2 percent this year and 1.75 percent next – are subdued. Among the issues the IMF flagged as ‘likely to dampen’ Japan’s 2013 growth was the eurozone crisis’ impact on exports, as well as potential energy shortages now there are fewer nuclear reactors.

Yet all these various challenges are actually good news for Japan-focused private equity firms, argues Mark Chiba, chairman of The Longreach Group, a Tokyo- and Hong Kong-based mid-market firm. “You can observe a reverse dynamic in Japan – when things are easy and there’s no pressure, managers, particularly in big corporations, just tend to sit on things that they should deal with and don’t resolve them,” he says, alluding to the divestiture of non-core divisions. “So macro pressure in Japan is good for our dealflow, it’s good for our investors, it’s good for our returns. We can buy cheaper, better assets, we [can bear] fruit from operational improvements and we can also harvest the Japan-Asia integration play.”

Chiba acknowledges that this is sometimes difficult to explain to LPs, when they “just look at headlines about economic growth in Japan and say ‘why would you want to be there?’ But I think our returns will prove out why we want to be there. And you know, even when we’ve had tsunamis and earthquakes and the effects of the European crisis and China slowing down, we still punch out growth in our companies because of that dynamic.”
 
ASIA UPSIDE, JAPAN PRICE

The Longreach Group was founded in 2003 on the assumption that Japan was poised to “re-pivot” back into Asia in terms of trade flows and vice versa. “That is being borne out. We’re looking at a situation now where around 40 percent of Japan’s trade is with Greater China or Korea – and you’re seeing very significant flow starting from Asia into Japan.”

That has important implications for the firm’s strategy, Chiba says, which is predicated on buying businesses with established technologies or a differentiating edge at ‘the Japan price’ of around five to six times trailing EBITDA and then driving operational improvements via its investment and operating professionals.

“If we can buy at ‘the Japan price’, which is a value buyout, if we can get control, get reasonable leverage, generate absolute return from restructuring and releasing the potential of businesses and then drive them into Asia upside, then effectively we can get the Asia upside, the beta, at the Japan price.”

Mark Chiba


That contrasts sharply, for example, with the risk-reward profile for some minority stake deals agreed at high multiples in China, Chiba says. And the approach can complement or help hedge investors’ Asian strategies, he adds. “Of course we are not saying to investors ‘Don’t do India or don’t do China’; we’re saying that Japan is a smart proxy play, a more risk-managed play into Asia growth. You can get Western-style buyout investing and Western-style alpha return outcomes, but still get the Asia growth upside off that Japan proxy play.”

One example of this, he says, is a business the firm recently exited: SANYO Electronic Logistics. In addition to implementing a new management and operational value creation strategy, “part of our plan was to capture Chinese and broader Asian growth – for example we won [Chinese electronics and appliances maker] Haier as a key new client. Hence our ability to rapidly improve the businesss.”


FIRST-TIMERS

Longreach has invested in a total of seven companies since the firm was founded eight years ago by Chiba, alongside partners Masamichi Yoshizawa and Yasuyuki Miyoshi. Chiba was the former chief executive of UBS Securities Japan, while Yoshizawa was formerly the head of technology investment banking at Morgan Stanley, and Miyoshi had worked for Merrill Lynch and Sumitomo Bank. (In 2010, Miyoshi returned to investment banking, joining Greenhill & Co.).

After a first close in 2004, the firm’s debut fund held a final close in 2006 on its $750 million hard-cap for Japan-related, control-oriented deals, with a particular focus on buyouts in the established technology and financial services sectors.

“We were technically an ‘06 vintage fund, which was a tough vintage to get going in,” says Chiba. “We were patient – we actually extended our investment period by a year to six years to avoid the whole traffic jam period in Japan’s private equity market. We’ve worked our way through that. We’re not perfect, not all of our outcomes are going to be spectacular, but it looks like we’re going to have a successful fund with a very good capital multiple and IRR.”

Chiba declines to give any specific returns information. But to date, the fund has recorded two partial exits as well as three full exits from portfolio companies including underwater cable maker OCC, McDonald’s Japan and SANYO Electronic Logistics. The latter exit was achieved in February via a trade sale that according to reports resulted in a 2x return for Longreach’s yen investors and a 2.4x return for its US dollar investors (Fund I was split between two vehicles allowing investors to commit in either currency). At press time, Longreach was also rumoured to be nearing an exit for Taiwanese bank EnTie, which was loss-making when purchased in 2007 and has since been returned to profitability.

CHANGING SHAPE

Asian private equity observers will be keenly watching Longreach’s results as it exits Fund I as well as its progress on raising Fund II – the firm held a $125 million first close just after the earthquake in March last year. Chiba declines to comment on the fundraising, beyond confirming the first close and the $750 million target that was included in the first close announcement.

Part of onlookers’ interest in Longreach is simply to do with the fact that there’s always a healthy level of interest in how first-time funds perform. But it’s also to do with wider changes to the Japanese private equity landscape, which is throwing a spotlight on all Japan-focused firms and strategies.

A few years ago the landscape, was “very well-ordered”, says Chiba. “You had some smaller local firms, you had foreign firms trying to get in; we were a new firm.”

 



That ‘order’ has been disrupted as a result of the 2003 to 2007 period, when some local firms grew fund sizes exponentially and many global firms turned their attention to Japan. The large influx of capital caused a number of GPs to deviate from their core expertise, while some managers entered the market mistakenly thinking there would be a greater number of large-cap opportunities – most deals are under €300 million – and, under pressure to deploy capital, became reliant on auctions.

“Money poured into Japan – but exits and returns have not panned out,” says Kelly DePonte, partner at placement and advisory firm Probitas Partners.

Another source told PEI previously that “LPs got absolutely shafted”, not just because of poor fund performance but because GPs that had portfolio companies breach covenants or otherwise fall on hard times would have trouble accessing future deals. “In the US or UK that’s a financial problem; in Japan that’s a reputational event,” the source said, noting such managers risk losing access to dealflow.

Chiba declines to discuss specific managers that have encountered problems, but says: “I think some of the larger firms that grew aggressively have had to rethink their strategies; I think some of the foreigners that came in and said ‘Japan’s on sale, we’re going to do a $1 billion deal every six months’ are rethinking their strategies.”

All that ‘rethinking’, set against the backdrop of an extremely tough global fundraising environment, has the market in a state of flux; which groups will survive, thrive or fall by the wayside remains very much to be seen.

“What’s very interesting is it’s in flux at a time – and I’ve been active in Japan since the mid-90s – when I have never seen so much activity on the sell-side of industrial Japan,” says Chiba. “I mean, you see the red ink that’s being bled at these conglomerates [and] they have got a queue of very interesting businesses for sale – but it comes at a time when there are question marks around which GPs are active and committed and credible to be buying. So it will resolve over the next few years.”

Tuck Furuya, an executive director at Tokyo-based placement firm Ark Alternative Advisors, anticipates some manager consolidation. “The next two to three years are going to be very critical here,” Furuya told sister publication PE Asia. “The ones who survive may not necessarily be the [groups doing] US- or European-style buyouts, but those who really understand the Japanese business culture and can implement that into their investment strategy.”
 
CULTURE CLASH

The need to understand and embrace Japanese culture and local practices is raised repeatedly by sources as a challenge to private equity firms.

“Japanese culture – including business culture – is in many ways at odds with the Anglo-Saxon model of buyouts. In the middle market the Anglo Saxon model is focused on quickly professionalising senior staff, making hard decisions quickly on staff reductions, eliminating non-core units and pushing hard on areas of growth,” says Probitas’ DePonte. The ‘culture’ clash isn’t unique to Japan, though, he adds: “The Anglo-Saxon model of the US and the UK had a tough time when originally extended to the European continent, if you recall.”

Chiba says Longreach tries to be as up-front as possible with potential investee companies about changes it deems necessary to improve a business. “We don’t do things gradually and wait; we move in transparently but quickly to really impact and transform the [company’s] culture.” That’s been warmly received by company management and employees when they understand it is to improve the business, Chiba says.

But he concedes that a local presence and deep relationships are key factors to acceptance. “I think what the Japanese sell-side is looking for is two things,” Chiba explains. “They are looking for, from an expertise point of view, the right buyer – somebody that understands Japan and will do the right thing; not just a financial engineer but somebody that has a genuine understanding and passion to improve the business. And they also want to deal with somebody local – not just a mailbox for a foreign firm. But you have to put those things together; if you have either one missing I think you’ll get into trouble.”

One manifestation of that ‘trouble’ is a reliance on auctions. “I think the biggest issue that GPs have faced in Japan and LPs have got frustrated about is that you have to be positioned in a particularly local way to originate good deal

 

flow otherwise you end up buying from each other in auctions.”

As an example he points to the company Longreach recently exited, Sanyo Logistics, which it acquired in 2010 after having informally helped its parent for many years on business unit divestments, including deals Longreach turned down. “We’ve spent years cultivating strong relationships and sector expertise demonstration with the sellers, to generate not only exclusive deal flow but also a solid understanding of the business and the management, operational and strategic change we need to bring to it.”

When Chiba says “relationship”, he clarifies, “it’s not just taking a guy out for a drink or two over 10 years – you have to demonstrate that you’re a safe and trusted credible buyer. This is the key point in Japan: a Japanese conglomerate selling a crown jewel asset under restructuring pressure will pick a buyer that it trusts to be a good steward and make sure that asset transitions to its next phase of life safely, over somebody that just puts a bigger cheque on the table but may not know what they’re doing.”


Demonstrating that you’re a credible buyer can take years, he says. “That’s the barrier to entry to that market; but once you’re over [it], you have exceptional buying opportunities compared to more easily contestable buyout markets.”

The unique challenge that Japan-focused fund managers really face, he says, is patience. “Sure, you can call up my favourite half a dozen investment banks and get good deal flow and get a fund deployed in six months, but it would be a disaster. I could go around Japan and jump into every auction [when] one private equity firm is selling an asset to another private equity firm – but that’s not the opportunity. The absolute gold mine is when you get the call from the chief executive of a big Japanese company saying ‘I have to sell this business’.”

If you get such a call, Chiba reckons you’ll have a 10- to 15-year relationship already established with the individual or the company. “I think the mistake some investors have made was thinking you can rush in there just with a lot of capital and get a result; you will get a result, but be patient.”

If you’ve got that patience, he suggests, the opportunity is bigger than many assume it to be in Japan. “I really do believe that competition between GPs is the enemy for returns,” Chiba says, “and the fact that the Japan landscape is relatively depopulated in terms of GPs and capital versus what’s happening on the sell-side is a very rare and fortunate confluence if you’re an investor.”

 

 

 

LOSING SLEEP

What keeps Longreach chairman Mark Chiba awake at night? Everything…

“We are in a post-2008 world… there are parallels between today and the 1930s. That should keep us all awake at night!

“I think policy makers are much smarter and averted a catastrophe but we are in a difficult world where there is a lot of pain, there’s a lot of clashes developing over large scale deleveraging, austerity, and the distribution of the pie because the pie is shrinking in many places like Europe or growing slowly in the US. Within Asia, the turbo-charged growth model of China we all know won’t continue forever, but when will it stop? Will India really transition into a better-regulated system and be a stable pillar of regional growth? Will Japan be able to restructure successfully?

“In our business we are paid to worry about these issues, but you can’t be paralysed by that. You’ve got to manage risk and move forward in a very considered way. I think you’ve got to create real value – I know everybody says that, but really the days of just leveraging and hoping for a macro tailwind are over. I think you’ll have to work harder for returns and returns might be lower, but maybe risk-adjusted they’ll be better.”