Our Japan report last year came out just as covid-19 had forced economies around the world to shut down. At the time, we reported on the optimism felt by many in that Japan’s private equity market would not only weather the storm well, but may even thrive through the crisis.
That optimism seems to have been well placed. Far from shutting down deal activity, the pandemic may even have boosted a market that had been only gradually warming to the type of transformative change private equity ownership can bring. In 2020, there were 986 private equity deals inbound and outbound involving home-grown and international private equity and venture capital firms, up from 945 in 2019 and 967 in 2018, according to S&P Global Market Intelligence figures. At $24.5 billion, transaction value did not match the 2018 record of more than $41 billion, but it beat all other previous years – some feat given the pandemic’s disruption.
“Last year was much better than we originally anticipated,” says Kazuhiro Yamada, head of Carlyle’s Japan advisory group. “We had thought early on that deal activity would be suspended and that we’d only be spending time with portfolio companies. It didn’t turn out that way – the market was pretty active.”
Carve-outs come online
Many of the larger deals in the market are corporate carve-outs, a trend that has been in evidence for some time now as corporate governance reforms have taken root. Yet progress on this front had been slower than some anticipated, much to the disappointment of the – largely international – private equity houses circling these deals.
Until the pandemic struck, that is. “The covid environment has accelerated the pace of portfolio transformation,” says Tetsuji Okamoto, partner and head of Japan at Apollo Global Management. “Japanese conglomerates were already examining how they should reshuffle and optimise their portfolios, especially as they face pressure to create shareholder value, but the disruption caused by covid has really concentrated minds. As a result, we are seeing increased deal activity across the board, but especially around corporate carve-outs.”
It is a point picked up by Yamada, who has also seen a notable pick-up in carve-out opportunities. “We’ve seen corporates really think about how they will survive and thrive both now and in the future,” he says. “They were already doing this – many Japanese corporates are very diversified – but the pandemic has brought this into sharper focus, especially as it has necessitated a change in business model for some.”
Yet the pandemic’s effects are not just being felt at the larger, corporate and conglomerate end of the market. It has forced many founders and owners of Japan’s long tail of small and medium-sized businesses to confront succession issues with greater urgency than they might otherwise have done. With the average age of an SME founder at 66 and with two-thirds of businesses this size without a successor, according to NSSK CEO and CIO
Jun Tsusaka, “the pandemic has created a tailwind for business succession deals as owners seek to take risk off the table while they are still healthy”.
He explains why this has become more important: “If founders have provided personal guarantees on loans, the debt owed passes to the family, who also have to pay 50 percent inheritance tax when the patriarch or matriarch passes away.”
As a result, succession deals have therefore seen substantial growth. “In 2020, they represented 60 percent of all private equity transactions in Japan – up from 15 percent a decade ago,” adds Tsusaka. “There were many owners on the sidelines in 2019 and businesses that haven’t been hit hard by the pandemic are taking the opportunity to sell now. The deal activity today is the best we’ve ever seen – both in quantity and quality.”
Kenichi Harada, managing partner at J-STAR, agrees, saying that last year was particularly busy for his firm. It completed seven deals in 2020, compared with three in 2019 and four in 2018. J-STAR has also already completed another deal this year – Aki-Japan, a company that sources engineering staff for the construction industry. “Before the pandemic, there were many business owners sitting on the fence – they were not sure how they wanted to proceed,” he says. “But over the past year, we’ve seen many make up their mind, and this is offering private equity many more opportunities.”
Recruitment on the rise
These shifts are not going unnoticed by the wider world. As Tsusaka notes: “Many of the global players are either entering or doubling down here.”
Earlier this year, EQT established a Tokyo office and it is currently recruiting, the firm’s head of private equity in Asia-Pacific, Simon Griffiths, told Private Equity International in January. “We start to see that the market is opening, so we’ve just decided to push ahead,” he said at the time.
Bain Capital, Carlyle, KKR and Blackstone are also reported to have been hiring over the past few months, while Nomura is believed to be undergoing a reorganisation that will bolster its private equity and private debt capabilities.
And it’s not just GPs that are looking more closely at the market. Japan has a supportive group of domestic LPs, many of which are building out their private markets allocations. The country is home to the world’s largest pension fund, the Government Pension Investment Fund of Japan, for example, which had more than doubled its exposure to alternatives in the year to July 2020 – albeit from a low base of 0.26 percent of its assets. Yet with a target allocation to alternatives of 5 percent, there is much scope for further investment, both domestically and internationally.
In addition, overseas LPs are increasingly spotting opportunity in Japan. “Investors with exposure to Asia-Pacific are usually heavily skewed towards China,” says Mounir Guen, CEO of MVision. “When looking further afield, they have often been attracted to Korea because it is a very dynamic market. But over the past couple of years, we’ve seen LPs make joint allocations to Japan and Korea, especially as some of the larger Korean GPs are now expanding into Japan.”
Some are looking for more granular exposure to Japan in particular. Last year, Carlyle Japan raised its fourth fund, which closed at ¥258 billion ($2.4 billion; €2 billion) more than double the size of its predecessor fund, which launched in 2013.
“I have seen a massive change since we last raised a fund,” says Yamada. “Previously, LPs viewed Japan as part of their Asia allocation. There is now much greater awareness that Japan is distinct from other Asian markets in terms of culture, business practices, depth of economy and industrial structure, among other things. The opportunities are very different here. So, we are seeing Japan-specific allocations among many LPs now.”
New deal types
Perhaps as a result of this interest, the market has become noticeably more crowded, say some. “We are seeing more dealflow,” says Okamoto, “but we are also seeing increased competition on the buyer side. It has become more important to be differentiated.”
One of the ways in which Apollo intends to stand out from the crowd is through offering what it calls “capital solutions” in special situations. Okamoto points to Apollo’s $600 million investment in travel group Expedia last year as an example of the type of deal the firm may pursue.
“Flexible and tailored capital solutions investments are an opportunity we are exploring,” he says. “Many companies in Japan have been affected by covid-19 and they need liquidity or capital to strengthen their balance sheets. These may gain traction here because they are not control situations and allow companies to remain independent while we provide a combined capital and operating solution.”
Other GPs are looking at more unloved sectors in a bid to avoid competition. “We are seeing a lot of opportunity in sectors that may, on the surface seem to be in weaker parts of the economy, but when you look to the business itself, it has resilient features,” says Harada. “Food is one of these, as is apparel – some other investors may be avoiding these sectors, but we believe there are individual opportunities if you look closely enough.”
A waiting game?
Of course, much of this activity, while boosted by pandemic-related disruption, is a direct result of the years private equity firms have spent reaching out to business owners and management teams.
“Japan’s private equity market stretches back to the 1990s and it’s therefore made up of some very experienced teams,” says Guen.
Yet many players say that it has taken a long time for management teams and owners to get comfortable with the idea of working with, or selling to, private equity and that may have previously held back the market’s growth.
It has certainly required patience to succeed – to date, at least. “For founders, the reputation of the buyer of their business is especially important – they really want to be sure that the company is in safe hands. It takes time to build up a reputation in Japan,” says Yamada.
Carlyle Japan’s recent investment in Rigaku is a case in point. “We have built a relationship with the CEO of Rigaku over 10 years,” says Yamada. “He didn’t originally want to sell to private equity, but we built trust over a decade and he was able to see our industry expertise and our ability to support the company’s global expansion.”
And it’s deals such as these, struck at a time of uncertainty, that may ultimately unlock further opportunities for Japan’s private equity investors, not just this year, but well into the future.
“The current situation will underscore one of private equity’s advantages that is only starting to be well appreciated in Japan,” says Harada. “That we can continue to invest through the cycle, provided we have dry powder. Private equity investors haven’t generally received the first calls when there is an M&A opportunity but I think that will change in private equity’s favour because we are able to keep buying now.”
As a result, the market may well be set for an even busier time ahead. “Over the next five years,” says Tsusaka, “we expect to see more deals of all types – definitely a dramatic increase in succession deals, but also more carve-outs, public to privates, special situations and secondary transactions.”
TSE reforms spark deals
It is not just the pandemic that is spurring corporates into action.
The long-trailed Tokyo Stock Exchange reorganisation, which will see a rationalisation of its current five market sections to three from April 2022, is also bringing opportunity. “The stock exchange reforms will create some significant changes and this will drive further corporate governance reforms, building on what we’ve seen over the past seven years or so,” says Carlyle’s Yamada. “The customer always used to be the top priority for Japanese companies, with shareholders last. This has really changed, and CEOs’ mentalities have had to shift significantly. We now see them discussing strategy more openly and they care much more about share price and profitability.”
We may see an uptick in public to private deals as a result, particularly given Japan’s large proportion of public companies. “One of the differences about the Japanese market is that, unlike many other developed economies where the number of public companies has been in decline, listed company totals have been increasing,” says Yamada. “Yet many of these businesses now see that there is a burden and cost associated with being a public company, especially if they are not raising capital from the markets. Many CEOs are looking at going private because they can take a longer-term view of growth and strategy.”
There has also been some pressure on parent-subsidiary dual listings over recent years, with some shareholders suggesting these can result in conflicts of interest. As Apollo’s Okamoto says: “Parent-subsidiary dual listings are being unravelled for governance reasons. We are seeing listed subsidiaries being acquired by parents or sold. That can present opportunities for private equity investors.”