This article is sponsored by Neuberger Berman
One of the most marked investment trends to emerge from Japan in the last decade is the increased interest of domestic investors in alternatives. That is reflected in the significant growth in assets under management by Neuberger Berman Japan since it established its Tokyo office in 2008, with private assets now comprising about 10 percent of its $50 billion Japan portfolio. Ryo Ohira, managing director and head of East Asia, says domestic LPs are taking a more sophisticated approach to private equity, especially towards co-investments and secondaries transactions.
How did the firm begin accessing the local market? What strategies worked?
Since our inception, Japanese investors have valued our long-term global experience, “client-first” culture and diverse investment strategies across various asset classes. That has driven growth of our private asset business which now comprises $5 billion or about 10 percent of our Japan portfolio. Japan is now the second-largest country within our firm-wide private equity business in terms of commitments managed and we continue to commit our resources here.
The firm’s private assets in Japan have increased significantly in the last three years because of domestic LPs’ growing appetite for alternatives. They have also gotten more sophisticated and have more custom investment goals. Some prefer large-cap buyouts while others ask for more investments in infrastructure/real assets. Because of our global resources and solid infrastructure including our middle and back office, we can customise our offerings towards their specific needs in separate account format while scaling the business.
Historically-conservative Japanese institutional investors have pushed into alternatives in recent years. What are they seeking?
In the last decade our client relationships for private assets have grown steadily. Back in 2008, our private assets product offering was mostly commingled funds including diversified fund of funds and secondary fund products. In the last three years, we have worked on more than 10 customised separate account programmes with Japanese LPs.
Having an on-the-ground presence is essential to understanding what the domestic LPs want and need. We have a team of 80 people in Tokyo who can deal with detailed reporting timely and accurately in the local language. In addition, our local back-office operations here are smoothly executing capital calls and distributions which is very important. Finally, access to dealflow is another benefit of having a local presence.
We also cover Japanese clients in the same time zone from our Hong Kong office. In addition, we established in 2014 a “Private Equity Japan Desk” within our private equity investment team in New York with a Japanese professional who works exclusively on portfolio management and client services for our Japanese LPs. That team is expanding to better serve our domestic clients, which is another reason why they have started to give us more complicated mandates in the last three years.
How do you customise your offerings for each LP?
As our institutional investors acquire more experience in private equity investing, each investor has a unique investment goal. Sometimes we construct a separate account programme that is income-oriented. We also manage separate account programmes that are buyout-focused, as well as those with more globally diversified portfolios. For example, one of the large financial institutions that has experience in investing in well-known mega/large-cap buyout funds leverages Neuberger Berman’s relationships with premier small/middle market buyout funds as it is often difficult to access those firms and maintain the relationships from Japan. Those investors use our platform as an extension of their resources to complement their overall private equity investment activities.
How are you expanding your private equity platform in Japan?
We are focused on expanding co-investments and secondaries transactions. We have been selectively reviewing and executing co-investments in Japan over the last decade. Our co-investment platform has several advantages in the market that we bring to Japan. In addition to looking at traditional syndicated transactions, our deep resources give us the ability to “co-underwrite” transactions alongside GPs. We have the ability to write large cheques for transactions we like, which differentiates us from other co-investors. Additionally, we can invest in mid-life opportunities in which we invest in existing portfolio companies of leading private equity firms. These situations can provide additional capital for growth and acquisitions or allow a GP to return some capital while still maintaining the ability to benefit from continued upside.
Part of our approach as a co-investor is to be user-friendly for the GP. Gathering co-investors can be a challenging process – we seek to identify our key diligence issues for a GP early and to provide quick feedback on our level of interest. This includes providing a quick decline to a GP if a transaction does not fit our profile. This allows the GP to move on to other potential co-investors early in the process rather than needing to scramble at the end of a deal to find capital.
We bring this same approach to the Japanese co-investment market. The challenge in Japan is that it has not seen as many transactions needing co-investment as other markets. But this is changing, as the market sees more carve-out deals from big conglomerates due to pressure from shareholders these days.
Are there any co-investment risks that are unique to the Japanese market?
We find the co-investment risks similar to the risks of other developed markets around the world. Japan GPs are interested in partnering with their LPs, and the companies they are investing in are generally high-quality, well-run and productive.
The Japanese market has been favourable for exits and recapitalisations, so we are not concerned about liquidity in the market. This allows us to focus on the risks and opportunities of individual deals.
One unique characteristic of the Japanese market is the lending market. We find that banks are willing to lend aggressively to transactions, especially deals where they find a margin of safety. This translates to relatively high debt to EBITDA levels and low interest rates. In the US, larger loans have limited covenants, but in Japan banks still require very strong covenants.
As a global investor, we need to focus on currency risk. When we underwrite a transaction in Japanese yen, we take into account the potential depreciation of the currency. Apart from this, there is not a lot of risk involved that is specific to Japan. Counterbalancing the potential risks, we consider Japan to be an attractive market for control buyout transactions as many companies targeted by private equity are well managed, and leverage is available at very low interest rates. In addition, there is a strong pipeline of potential investments with small and middle market Japanese companies, which have a need for succession planning.
How would you characterise the secondaries market in Japan?
Historically, secondary transactions in Japanese private equity funds have been fairly limited. However, with the growth of the market we expect secondary transaction volumes to increase, including both traditional LP-secondaries as well as GP-led transactions.
In the US and Europe, GPs are increasingly using structured, GP-led transactions as a portfolio management tool in order to provide liquidity options for LPs.
One area where we would expect to see more activity is among GPs that are preparing to raise new funds but have not yet generated meaningful liquidity from their prior fund. As fundraising cycles have gotten compressed, many GPs are looking for alternative ways to generate liquidity rather than selling one of their best-performing portfolio companies prematurely. GP-led strip sale structures provide an attractive alternative, allowing the GP to generate liquidity for their LPs while also validating their net asset value through a third-party investment. This has not happened yet in Japan, but I think local GPs will begin to evaluate these techniques – via a continuation fund, strip sale or tender offer – especially for those who are about to raise their next fund without showing any realised investments.
Are there any specific strategies that are set to grow in Japan?
Another transaction that we believe will happen as the Japanese market evolves is GP stakes investments. By becoming minority owners of the GP, rather than a limited partner in the manager’s funds, investors can “sit on the manager’s side of the table” and actually receive a portion of the management fees, carried interest and other economics paid to the private equity firm by other investors. Many times, these minority stake sales are driven by succession planning as the founding generation begins to consider retirement. The next generation of management typically does not have the capital to buy out the founders on an arms-length basis and may also lack the personal wealth to fund future GP commitments by themselves. In addition, many LPs are now looking for their managers to actually increase the size of their GP commitments in order to create a better alignment of interest. Outside capital from a minority investor can help solve these issues and smooth the transition from one generation to the next. Japanese GPs, many of whom were founded in the late 1990s or early 2000s, will need to think more seriously about succession and we believe that minority stake sales will become much more common domestically just as they have abroad.
What other parts of the business do you plan to build?
We have expanded our private equity team in the region and hired former senior investment professionals from Singapore’s GIC, the Hong Kong Monetary Authority and Canada Pension Plan Investment Board in recent years. We envision continuing with this expansion.
We want to be a one-stop shop for Japanese GPs, similar to the US: becoming not just a primary capital provider but also providing secondaries, co-investment, debt and GP-stake capital to partner with GPs.
Lastly, we also want to continue to be a leader, educator, and resource for the region on integrating ESG into investments. We have focused on ESG investing, are awarded top score (A+) for private equity in the most recent PRI assessment report*, and are highly committed to constructive engagement with both public and private companies, assessing ESG factors in their private equity transactions in a transparent way. Japanese asset owners recognise the importance of sustainable investing and they are eager to actively engage their GPs and portfolio companies.
The rest of the world is a bit ahead of Japan private equity, but the regional investor community, both GPs and LPs, are getting more sophisticated and are starting to embrace such changes. Slowly but surely, I believe these changes will come.
* PRI scores are based on information reported directly by PRI signatories, of which investment managers totalled 1,120 for 2018
Registered Company Name: Neuberger Berman East Asia Limited
Registration Number: Director of Kanto Local Finance Bureau (Financial instruments firms) No. 2094
Associations in which a Member: The Investment Trusts Association, Japan; The Japan Investment Advisers Association; Type II Financial Instruments Firms Association