This article is sponsored by Sanne Group.
What role is private equity playing in the transformation of Japanese business as the pandemic lessens?
The private equity market is growing quickly in Japan and is playing an ever greater role in the Japanese economy. Japanese companies need more capital – both start-ups and early-stage companies, and more established small and medium-sized enterprises – and private equity is well placed to respond to that demand and spur growth.
For start-up ventures, private capital has the potential to provide risk money to support innovation, entrepreneurship and growth. For SMEs, there is also the opportunity to support hands-on turnaround activities as businesses emerge from the global pandemic.
According to official statistics from the Organisation for Small & Medium Enterprises and Regional Innovation for Japan, more than 99 percent of businesses in the country are categorised as SMEs.
These businesses employ 70 percent of the workforce and are instrumental to the economy, but many are unlisted and family-owned. A lot of those SMEs are delivering high-quality products and services locally, or are key to the supply chains of global companies, but they are inconspicuous and overlooked, like hidden gems. Private equity has the potential to play a key role in supporting these businesses with succession issues, by embracing technology and with sustainable global expansion to capitalise on their unique strengths.
Many companies in Japan need support to promote stronger corporate governance and discipline, as management increasingly focuses on value creation through efficient use of capital. Private equity firms can support management with the development of professional skillsets, and help companies access service providers that can drive efficiency, cost savings and meaningful change. Coming out of the pandemic, we are seeing a much more dynamic business environment emerging in Japan. For private equity firms, there is a real opportunity to back the reinvigoration of the economy.
What challenges and opportunities do PE funds face in the local market?
We are seeing a lot of global private equity firms looking to establish business in Japan, and it is not easy. The first challenge is around finding suitable LPs that can commit long-term capital and are ready to assume the investment risk inherent in the asset class.
Although there is a huge amount of investor demand, the Bank of Japan is maintaining its monetary policy of pumping more liquidity into the market to drive growth, contrary to the actions of peers such as the European Central Bank and the Federal Reserve.
There is therefore plenty of surplus capital seeking investment opportunities, but it is hard to find good LPs that are willing to commit to the typical 10-year lifespan of a private equity fund. Many struggle with the notion of the J-curve, and there is also an agency issue in large asset owners: most investment officers enjoy relatively short tenures in roles due to job rotation, which makes it difficult for GPs to build long-term partnerships at a personal level.
There is also cultural sensitivity among management teams towards private equity investors, with some local business owners still showing reservations and associating funds with the old ‘vulture fund’ stereotype of putting profit above everything else. Investors need to be prepared for some resistance to proposals and should be cautious when it comes to navigating the cultural hurdles.
The Japanese regulatory environment and tax legislation can also be difficult for outsiders to navigate and requires careful analysis when it comes to structuring a fund. Those coming into the market will need to work with additional professionals, including lawyers and tax advisers, to fully address cross-border considerations.
The language barrier should not be underestimated. All aspects of PE business, including all documentation of transactions, is carried out in Japanese, with the only exception being the raising of offshore capital. Many business owners cannot speak English and so, for those who are not local, it is essential to gain local language skills or work with partners that can communicate in Japanese.
For those that can overcome these challenges, there are plenty of opportunities to succeed in the market. Sectors that are particularly interesting to investors include renewable energy, pharmaceuticals and technology, but it is necessary to really dig into the details of opportunities to unearth the true gems and avoid the weaker companies.
Business succession is becoming a hot topic in Japan – what does that mean for private equity, and how can service providers assist?
According to a 2021 survey conducted by Teikoku Databank, more than 60 percent of Japan’s small and medium-sized companies lack succession plans. The results vary significantly across the country, but the good news is that there are signs of progress because the pandemic put a lot of pressure on management teams to address succession issues.
TDB found that the number of companies without succession plans had dropped since 2020, as businesses recognised these challenges and looked at what they needed to do to survive, but there is still a big gap. Private equity firms have been acknowledged by the government for having played a key role in supporting better business succession planning, and there is an understanding that they can do more going forward.
There is a lot being done by other players in Japan to address the issue. We see regional financial institutions supporting borrowers with succession through consultation, and the government has launched a hands-on programme for business restructuring. A new tax break has even been introduced, waiving estate tax on inherited shares in certain conditions. But still there is a big role for private equity to play, particularly in collaboration with government agencies to support the upskilling of management teams.
Again, it is important for investors to take into account cultural sensitivities and recognise that business owners in Japan will typically look to internal talent before seeking external support. The owner of a family business is not going to welcome an approach from a private equity firm professing to tell him or her how to run the company, but will instead be looking for a trusted partner to help address some of these challenges together.
What trends do you see emerging next in Japan and what does the future
It seems inevitable that private equity will continue to play a growing role in the Japanese economy, becoming increasingly instrumental in corporate finance and encouraging dynamic change in businesses to eventually reinvigorate an otherwise fairly stagnant economy.
At a time when companies are overhauling their business models to become more sustainable and ESG-orientated, and to take advantage of the latest technological innovations, PE can play an important role in providing the capital to support that evolution.
The other big opportunity for private equity is in supporting Japanese companies in the facilitation of cross-border investment, both inbound and outbound. My family used to be merchants and I grew up in a family business producing distinctive Japanese musical instruments. By the time I graduated, the company had been liquidated, but I often think how different things might have been if private equity had been available then, providing capital and know-how to grow the business and helping to deliver those instruments to an international market.
Today, private equity can support the hidden gems in the Japanese market that produce unique, high-quality products or services and help them expand on a global stage. The future certainly looks positive for private equity investors here, even if there are a lot of challenges to overcome for those looking to establish a footprint in the local market.
With many global PE players entering or scaling up in Japan, what challenges do they face in attracting and retaining talent?
Not being a partner in a private equity firm, I can only share my external view, but it is clear there is currently a very small pool of private equity talent in Japan. Unless you have an established local office, it will be difficult to hire someone suitable with the relevant experience and skills.
There are a lot of Japanese speakers advertising their skills as agents, but most lack a good understanding of private equity and so will struggle to make meaningful introductions. On the other hand, it is even more challenging to find PE professionals with adequate English skills to join a global firm, given that local private equity business has been conducted in Japanese for many years.
With so many new private equity firms looking to enter the market, the competition for scarce talent is only intensifying, which is driving up compensation and encouraging people to hop between jobs. Lots of global funds are attempting to overcome the issues by bringing in talent from overseas, but they will clearly need some local cultural background and language skills to be effective. It is hard to see the best way forward.
On the bright side, the increasing salaries on offer are driving more graduates to consider private equity over careers in big companies or large financial institutions. There is growing interest in private equity and venture capital at junior levels – good news for the expansion of the talent pool in the longer term.