Roundtable: Japan private equity is a family affair

Hideo Aomatsu 180

Chief executive, DRC Capital. 
Prior to establishing the firm, he was the chief executive and head of the investment management team at ACTIV Investments Partners and a former president of Rothschild Japan. Earlier in his career, he was an associate at McKinsey in Tokyo, vice-president for M&A at JPMorgan in New York and an industrial project finance officer for the World Bank. 

mark chiba 180

Group chairman and partner, The Longreach Group.
He is responsible for senior relationship-driven deal sourcing across Longreach’s sector and geographic focus, with a special focus on financial services sector investments, and on building the firm’s general partner capabilities, capital base and global networks. Before Longreach, Mark served as chief executive and president of UBS Securities Japan, co-head of Investment Banking Japan and a member of the global UBS Investment Bank Board.

Rejiro Samura 180

Chief investment officer and head of business development, Alternative Investment Capital.
Prior to joining the firm in November last year, he worked on both private equity and hedge funds investments as a director at Mizuho Global Alternative Investments. He was also a former managing partner at Ant Capital Partners. Earlier in his career, he served as a head of private equity at the Mitsubishi Trust and Banking Corporation.

Koji sasaki 180

President and managing partner, head of buyout team, Tokio Marine Capital.
He 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 also serves as a director in several Japanese corporations such as Miki Shoko, Bushu Pharmaceuticals and Showa Yakuhin.

Japan’s family business operators were traditionally hesitant to hand their companies over to private equity, but a new generation may be changing that. Private Equity International gathered four long-standing GPs in Tokyo to discuss succession issues, the mid-market’s a buzz of activity and whether offshore capital is returning to the country.

How would you characterise the current fundraising environment in Japan?
Reijiro Samura: These days the fundraising market is booming, and much better than I expected in the last couple of months. From the limited partner standpoint, it’s very difficult to secure our commitment because everybody is back in market and active again, some are even oversubscribed. It’s probably the first time I have witnessed this in Japanese private equity history. Our investors ask us: ‘Now that the fundraising market is active, is that a good thing for LPs?’ You see, going back to 2006-07, history has shown us that usually a good fundraising year equals a bad vintage year. We have to wait and see what’s going on here.

Mark Chiba: If we look at all the Japan-focused funds being raised, even assuming they raise at their targets or hard-caps, there is not a lot of capital coming into the market relative to size of the opportunity. We segment the Japan-focused market into three buckets: the large-cap global and pan-Asian funds operating in Japan, the mid-market space and then the small-cap. If you take out the large-cap regional and global, there is only around $1 billion to $1.5 billion a year of dry powder on average coming out of the general partner base over the next four years, which is tight in terms of the market opportunity in Japan. If you look at the sophisticated upper mid-market space we execute in, it is even less. So I think the idea that Japan is suddenly being flooded by LP money is not arithmetically right.

Japan has got healthy interest coming back from foreign LPs but it’s not exuberant. I think that’s important because the amount of capital that we have as GPs to put to work versus the amount of dealflow opportunities is in a heathy imbalance in the sense that it’s not too much capital chasing deals. I think that’s very important to understand.

There’s an interesting population of GPs who are now on multiple funds – lessons have been learned, teams are more seasoned, they’ve had successes and also learned from some failures. All of that is saying the market is in a healthy position of maturing but being still relatively young in terms of the number of GPs, and relatively modest fund sizes relative to dealflow. On the Japan level, relative to what it used to be, it feels like a healthy environment that’s leading to good LP interest.

Hideo Aomatsu: Despite almost two decades of the Japanese private equity market, each year we have only 50 or 60 buyout deals totalling ¥500 billion ($4.4 billion; €4.1 billion), but that includes a few mega-deals and spin-offs of subsidiaries of large corporations taken by international mega-funds. Thus, if these large deals are excluded, the average size of transactions is still small, the number of ordinary transactions is also still small but steady. The market is maturing; while I do not have the impression that it’s booming, it is steadily progressing.

Who are the emerging LPs in Japan?
Koji Sasaki: We are in the middle of a fundraise and, so far, our recent strategy has been to target regional banks who are interested to make investments in mid-sized companies.

Because of Japan’s ageing population and the issue of business succession, regional banks, especially in the rural areas, are playing a bigger role providing services to these companies. However, they feel that they are running short on capability and know-how to extend such services. From a strategic point of view that is why they work with private equity funds to create new deals. That is the new trend we are now observing. 

For example, Tokio Marine Capital and Shizuoka Bank – a regional bank based in Shizuoka prefecture and an investor in our firm – work closely to contact family-owned businesses residing in the region. The bank has a wide network with good local reputation and wants to provide equity solutions to customers that face business succession issues. Shizuoka Bank introduces us to these companies and through this process we are able to source proprietary deals.

RS:Regional banks are playing an important role in fundraising. The number of tier one regional banks in Japan such as Yokohama Bank and Chiba Bank is over 60, and my guess is more than one-third are already invested in private equity funds, which shows there’s still big potential.

They have invested in private equity funds for several reasons – the low interest rates, the increasing shift from Japanese government bonds to alternative investment, as well as their clients’ needs in terms of business continuity. The big names entering the market like Japan Post Bank have a very large minimum commitment size compared with other Japanese investors who would commit between $30 million and $50 million.

And for a mid-market buyout fund with a $300 million to $500 million fund,  $50 million is already a big cheque. Regional banks are entering the market as LPs. However, it’s difficult to secure the desired commitment. Japanese investors generally have a desire to commit to private equity but that number is limited because of illiquidity. In addition, the J-curve is still a critical issue for inexperienced investors.

HA: I agree that regional banks are increasingly interested in the asset class because they are being pressured to invest in securities (other than Japanese government bonds) to yield higher returns since their ratio of lending amounts to deposit amounts has been deteriorating to as low as 50 percent in some cases. Regional banks are not experienced in investing in securities except for government bonds, which means the alternative investments provided by experienced private equity firms are attractive to them.

What are your views on large Japanese pension funds slowly but steadily moving into the asset class and building their private equity programmes? 
MC: I think that approach is good. When an LP wants to get into alternatives they usually start with a global fund of funds, then they go to the global mega-buyout firm, and then start looking at regional or country strategy. There is a learning curve these LPs have to move up. If you look at the Australian pension funds, who have been at this for a longer period, they are moving now towards more focused GPs. Five years ago they wouldn’t touch it, all they would do is buy US big-cap or global funds of funds.

In addition, I think it’s important for the asset class in Japan that this proceeds in a very orderly and sophisticated way. We’ll perhaps see the Government Pension Investment Fund, then Japan Post Bank, do the funds of funds and then the big-cap before they start moving into more boutique strategies. 

The regional banks, however, may work differently. Many of the banks work with the GPs very closely, in succession deals or in corporate carve-outs. They know us, they’re close to us, they are inside our deals already as debt providers. They can go straight to committing to a GP based on their very informed due diligence. But if you’re a pension fund faced with government bureaucracy and the public is watching, you make a mistake and you are in trouble. I have some sympathy, and I think we should be a little patient. There may be many ways pension funds investing into private equity will kick off. It will not be linear, but when that point comes we will all feel it.

HA: The large pension funds are looking at private equity very closely, but the size of their assets is too big for Japanese private equity firms, so naturally they would invest in foreign firms first. But they also seem to be considering whether to allocate some portion to domestic players. The question is whether the same criteria for selecting foreign firms will be applied to Japanese firms whose fund sizes are smaller. 

In addition, the track record of domestic GPs is rather short compared with international GPs. Maybe Japanese GPs want to have funding from the government or public sector but we should demonstrate we are worthy of their investment – from our track record to the quality of deals. Also, rather than arbitrage of capital through leverage, we should show we are delivering a real increase in the value of the target companies, and that we are turning around the business for good. For me this is about coming back to old-fashioned, traditional and hands-on value-adding investments.

KS:One of the reasons government pensions have increasingly moved into private equity is because of the low interest rates in Japan. In general, the total expected rates of return of pensions in Japan remain very low, much lower compared with US or Europe. Nevertheless, a portfolio with only traditional assets like fixed income products cannot attain their expectation due to the current market negative-yield environment. By looking at higher level of returns generated by private equity funds, the pension funds are changing their investment strategy and starting to invest in private equity, even with additional higher risks.

RS: Japanese pension funds’ expected return is 1.5 percent to 2 percent, while the US pension funds expect over 7 percent. Private equity investment works for US pensions, but doesn’t always work for Japanese pensions because the normal returns for private equity (15 percent to 20 percent) are higher than their expectation for their alternatives. They need to shift from JGB to more yield-oriented investments, but private equity is sometimes relatively too much given their target return.

How is private equity playing a role in family business succession and conglomerate divestments?
MC:In Japan the trust issue and the broader stakeholder capitalism concept – the employees, the customers – are very important. In corporate carve-outs that’s there as well but it’s more of a corporate decision. There is one similarity, however, that’s very interesting. There are so many businesses in Japan in different sectors that are stuck in this demographically flat and declining market. These have huge upsides if you can consolidate them in Japan, grow their market share domestically, and then grow them into a growth market in Asia like greater China or South-East Asia.

But these smaller conglomerate subsidiaries and family companies generally do not have the people or capabilities for cross-border execution, they’re very domestic. They’re very good at what they do but they don’t have the network, or the skills to go out into growth markets. And one thing private equity can do in being a successful buyer and making money for our LPs is to actually make these businesses better by empowering them to go out of Japan and grow. I think that is real operational and strategic repositioning, a value-added skillset.

With the current number of GPs in Japan, we’re just scratching the surface of the opportunity. This is still the third largest economy in the world, there are still very few private equity firms, very little private equity capital, huge demographic pressures, and many opportunities in conglomerate divestments and family businesses. It is a very big opportunity we are just opening up now. 

HA: There’s no business relief for inheritance tax in Japan as [there is] in the UK where it’s relatively easier to inherit the business almost tax-free. In Japan, the inheritance is taxed at a maximum of 50 percent. For example, a chairman has a 50 percent stake in a family company whose net worth is $500 million equivalent. If he dies, the expected inheritance tax is about $125 million.

This means the heirs have to prepare that large amount of money, which is quite crazy. The inheritance tax burden is pressuring family business, especially those with no successor, for change. I think that’s a big opportunity for private equity firms besides spinning-off a non-core business of a large corporation.

Business succession is the biggest market if properly tapped, as many owner-CEOs of myriad excellent Japanese family businesses are in their 70s and 80s.

KS:Investments in family businesses is a market we’ve been targeting for decades. We were not so confident previously because founder-owners used to be very reluctant to sell their company to private equity firms – they were not familiar with the asset class. Here’s what used to happen: we would knock on a company owner’s door and he would say: ‘Come back 10 years later and I’ll be ready.’ We come back 10 years later and then he goes: ‘Okay come back after five years.’ 

Now, when we knock on the door, the owner would tell us: ‘Okay, let’s talk.’ The ageing society issue has indeed become more serious and, thus, the reception towards private equity firms has changed.

Also, we are now observing a new type of family business succession scenario in which the sons and daughters are very entrepreneurial. Under the traditional Japanese succession style, the father manages the business until he is unable, then passes it on to his successor at the final stage of his life. What’s happening now is that the son or daughter inherits the business, tries to engage private equity firms and use their governance structure to grow the company. In some cases, they may wish to change the mindset of the people within, or they may want to use our resources, such as reputation, networks and access to new customers, to make the company much bigger. It’s a new wave of transactions we are seeing and I call the style “partnership investment with families”.

HA: Private equity firms, however, are still the last candidates in a sale because most Japanese business owners are so concerned with the ultimate shareholder or owner because they know private equity firms would resell the business later. Of course, they do not want to see their company in the hands of competitors, foreign companies or management who will lay off employees inconsiderately. This is a peculiar mentality of most Japanese business owners, who hate to be seen as running away from their companies with a large amount of cash, and dumping their employees in strangers’ hands.

Also, the old reputation of private equity firms as vultures does not give any comfort to business owners. The remaining management is also quite unmotivated when they see their companies heavily indebted by LBO schemes. Private equity firms need to assure business owners that they are able to provide more stable ownership and make bolt-on acquisitions, as well as grow the company in new markets. They need to do this constantly, otherwise they will be the last person invited for purchase. This is one issue private equity firms have to resolve in order to tap this huge investment market.

Which sectors offer the best opportunities?
RS: In my conversations with GPs I find that healthcare and business process outsourcing are attractive opportunities. My impression, however, is that GP portfolios we look at are heavily weighted on retail and consumer sectors, as opposed to manufacturing or services. Manufacturing companies need too much capex and are a little bit riskier, so the GPs tend to get into consumer/retail services since that’s an easier place for them to grow and scale the business.

HA: Carve-outs in the manufacturing sector are increasing, but the problem is some of the transactions are too big for domestic players. Some deals are taken up by big international funds, so it’s a pity that we don’t have domestic funds big enough to capture these large opportunities.

MC: The big three industries for us are mature industrial, consumer and business services. I think our portfolio, which includes Wendy’s Japan/First Kitchen in consumer and Nippon Outsourcing in business services, is a good representation of where the opportunities are. What we are looking for in our areas is that we can get attractively valued companies, we can do operational turnaround, find new growth in Japan and move them cross-border in Asia.

What are the key components LPs are looking for in Japanese fund managers?
RS: On manager selection, dealflow is very important. Currently for many domestic private equity firms their fund size is increasing which means competition is getting fierce. The important thing is to have one’s own dealflow through individual or organisational networks. Another thing would be performance. The number of companies available in Japan are relatively smaller compared with what US buyout funds may find in their market. Say a GP has six to eight companies in its portfolio (the average size in Japan), if one company doesn’t do well the damage to the overall portfolio is very huge.

Lastly, we look at the team composition. Japan private equity history is nearly 20 years old. It started in the late 1990s so first generation GPs have already experienced one cycle, the Asian financial crisis, and the global financial crisis in 2008. The current generation of GPs who are in their 30s or early 40s would probably not have experienced these cycles. For us, just one or two first generation guys out of a team of 10 is a little bit of an issue.

KS: LPs are mainly concerned about dealflow. Though we review nearly 100 deals per year, we invest on average in just two or three companies. It is our wish to cultivate more proprietary deals and I think the current strategy to focus on business succession is aligned with this objective. With time and effort, we can get the trust from the family owner.

HA: I thought that good consistent returns and sufficient disclosure with our LPs was good enough but I’ve realised that dealflow is an important factor, too. In our case, fundraising is not always easy; the size of the fund limits potential deals. We can’t put in $100 million in one deal so it ends up being a chicken and egg situation for us, which is something we can’t control. Also, the deals that we do require some holistic business skills of staff, ie, we need someone who has experience in real business, not just in financial engineering, and most importantly our hope is that our staff continue to have great integrity in the business. For new entrants in Japanese private equity, integrity and motivation (to improve Japanese companies) are very important.

MC: Returns are essential and LPs also want to see that returns are repeatable. If you’re a big name multibillion-dollar fund and take $500 million from a US pension fund and you give them a 1.5x or 2x back fairly quickly, you are done and they might ask, ‘How much more do you want?’ As a mid-market firm, if we take $30 million from an American university endowment, they expect a 3x. This means our cost of capital is actually high versus those big firms doing the big deals. LPs are looking for that and expect 3x but they can’t always get that. But what they do get is the confidence that directionally Japan is heading in a way over time where you can get those endowment-type returns. We are, however, in a different market for LP capital versus the mega-firms. Ultimately, the domestic market will be globally benchmarked, and LPs simply want to see that GPs can perform at that level. 

Japan’s regional banks, facing negative yield on hefty allocations to Japanese government bonds, are becoming the latest source of investor capital. They are not new to private equity. Historically, they would have teamed up with the Regional Vitalization Corporation of Japan – a government institution tasked to support SMEs with excessive debt – to find companies to invest in and support business improvement, much like a fund manager. But because the funds had low impact and a low success rate, and the banks lacked operational capability, they switched gears and became LPs.

According to DRC Capital chief executive Hideo Aomatsu these private equity funds are, however, region-specific and small (about ¥1 billion to ¥2 billion in size). The approach, he says, is currently being tried by several regional banks such as Juroku Bank in Gifu Prefecture. Last year, several banks, including Juroku, Hiroshima and Yamagata Bank each put in $100 million to establish an asset management company. These regional banks are playing an important role in fundraising, Reijiro Samura, chief investment officer of Alternative Investment Capital, points out. He estimates that only a third of the 64 tier-one regional banks in Japan have invested in private equity funds, which shows “there’s still big potential”. 

Japan attracted 24 million visitors in 2016. The government set a new goal of 40 million visitors by 2020 and 60 million by 2030. It also set an economic goal of ¥8 trillion in tourist spending by 2020 and ¥15 trillion by 2030. 

With tourist spending at an all-time high at ¥3.75 trillion last year (helped by Chinese travellers’ buying sprees), there is no doubt Japan will exceed its target in the years to come. From cherry blossoms and hot springs to summer fire festivals and skiing, Japan is becoming the upmarket tourism and consumption destination for Asia’s middle class.
Mark Chiba, group chairman and partner of The Longreach Group, says: “A good example of this is the way the traditional Japanese ryokan sector is beginning to finally professionalise itself to cope with tourism. Also, Japan as a ski destination is becoming one of the world’s best.

“If you want to find a way to play rising per capita GDP in China, there are many ways to do it. but one of the safest ways I believe is investing in Japan to capture that market. The era of cheap tourism is over. What’s happening now is that Asian tourists are spending more like $10,000 to $30,000 when they come on a holiday, on higher-end hotels and restaurants, on high quality consumer goods and services, on things they cannot find outside Japan.”