The highly developed and diverse company landscape of Japan has, for decades, held promise for private equity. The world’s third-largest economy is home to large corporates with sprawling, conglomerate-style structures that are ripe for simplification as well as being the base for nearly 4 million small and medium-sized enterprises, according to OECD figures, many of which are owned by people at, or reaching, retirement age. And yet, until recently, the Japanese private equity market has required huge stores of patience as many of these opportunities failed to materialise to any great degree.

However, the past few years have seen a significant increase in private equity activity, with many predicting that this time, the uptick is sustainable. In 2018, there were 686 private equity and venture capital deals with a Japanese target, worth a combined $21.5 billion, according to S&P figures.

The volume figures have risen steadily over the past two years, while the value totals have increased substantially,  from 478 deals in 2016 valued at $3.7 billion. Part of the rise in values can be explained by some hefty deals, such as the $18 billion Bain Capital buyout of Toshiba Memory Corporation, but even parking aside the outliers, there does appear to be momentum behind the increased number of deals. There are now around 170 private equity firms that invest in Japan, according to Deloitte figures, with a number of experienced local players that have cut their teeth either in independent firms such as Advantage Partners or at the global houses, such as TPG.

And international firms with bases in Japan, such as KKR, Permira, Bain Capital and Carlyle are now being joined by others – Blackstone built a buyout team in Japan in 2017 and Apollo followed suit in 2018.

PERSPECTIVE FROM THE PAST

What this means – more so than for most other private equity markets – is that past performance may not serve as a guide as to how well current and future portfolios will do. According to eFront Pevara data, the performance of Japanese private equity has lagged that of other markets.

However, he also suggests that Japanese performance may be better than the figures imply. “My experience is that Japanese funds have outperformed US and Western European counterparts,” says Kobayashi. “Japanese managers tend to be more conservative than their international peers. Many still keep their investments at cost right through to exit.” It’s a point noted by eFront, which says in its report on Japanese performance: “Even though many fund managers apply a mark-to-market valuation to their portfolio companies, many remain rather conservative in their approach.”

This may also partly explain another key finding of the eFront research – that Japanese funds tend to offer investors lower risk than those in other markets (see box-out). If Japanese funds are holding investments at – or close to – cost, the good or poor performance of portfolio companies that have not yet been exited won’t be reflected in the data.

LOOKING AHEAD

So what has changed in the Japanese market to unblock opportunities and how might that drive future private equity performance? Some of the activity may be driven by the amount of dry powder among funds in Japan. In 2017, 18 Japan-focused funds raised $5.61 billion, according to PEI figures. This is a clear outlier compared with other years – in 2016, for example, seven funds raised just $390 million between them and in 2018 five funds attracted $1.49 billion. It’s a lumpiness to be expected in a market that remains relatively small, but the fact is that 2017 provided significant private equity firepower.

However, the fact that activity has increased appears to have more to do with changes on the ground. “There has been a change in mentality among Japanese companies,” explains Motoya Kitamura, managing partner at AB Value Capital Partners. “They are now concentrating on return on investment, streamlining and focusing on their core business. This has been advocated for the past 20 years, but the pace of this happening has picked up only in the past six, seven years. That is creating supply of investment opportunity for private equity houses.”

YOUTHFUL OPPORTUNITY

Yet perhaps the most striking shift has been a change in attitude among owners of small and medium-sized businesses. “Succession-type buyouts are increasingly common in Japan,” says Kitamura. “Many funds have been chasing these opportunities for 10 to 15 years, but owners were previously reluctant to sell majority shareholdings to private equity funds, or even at all. Now, there is increased pressure to do so – it’s 70 years since the end of World War II, when many of these businesses were established. Also, we are seeing more entrepreneurial owners who are not shy about exiting their business at a younger age.”

This has led to a flourishing of the typical private equity ecosystem as intermediaries have stepped up their activity in the market to cater to the demand of an increased seller pool.
Yet the market is atypical in one regard. This makes for a different dynamic in Japan, according to Kitamura, and one that may see the market continue to present fewer risks for fund investors than might be the case for other markets.

“Intermediaries are now a big source of deals in Japan,” he says. “However, they operate differently from other markets. First, they take fees from both sellers and the buyers, claiming themselves as brokers instead of advisors. Second, they tend not to run public auctions but rather identify buying opportunities, match them with a specific fund and give it first refusal. Only if that fund does not go ahead will the intermediary then offer the business to another fund and so on. That makes the market much less competitive.”

OPERATIONAL FOCUS

So, while entry prices may have increased, lower competition for deals should mean that valuations at the point of investment remain subdued by international standards. But in addition to this, there have been some shifts in approach by local teams.

“There remains a focus among GPs on buying at low multiples, but the past few years has seen firms here build stronger operational teams to improve the companies they back,” says Kobayashi. “That has been very important for returns over the past two years or so.”

Kitamura agrees. “There is no magic wand when it comes to performance,” he says. “There is still a lot of low-hanging fruit in the Japanese market and there is less competition than in regions such as the US or Europe, but fund managers can no longer rely on buying cheaply. Buyout funds now spend time on operational improvements, governance improvements, domestic and international expansion and roll ups as well as IT development.”

So what might we see in terms of performance from Japanese funds over the coming few years?

“It’s inevitable that future performance will, to some extent, be affected by the economy and public markets performance,” says Kitamura.

“We’ve had an incredible run since 2012 in the public market, driven in part by QE – we still have negative interest rates. Yet there is a very high elasticity of the Japanese public markets [compared] to those in the US and the global economy. The real test for the Japanese private equity funds will come when it is time to exit the businesses that have been bought in the current cycle.”

LOW RISK, BUT LOWER RETURNS?
Data from eFront suggest past Japanese private equity performance has some interesting distinctions from those of other markets. It finds that IRRs for Japan-focused funds to Q3 2017 were 7.61 percent versus 9.06 percent for the rest of developed Asia Pacific, with Total Value to Total Paid In ratios also lower, at 1.29x versus 1.45x, respectively. And, when looking purely at LBOs, the performance gap remains, with Japanese funds returning 1.26x against 1.48x for developed Asia-Pacific, 1.56x for the US and 1.61x for Europe.

And, when stripping out the top and bottom 5 percent of funds by performance, Japanese funds present lower risk than the US or Western Europe, although higher risk than developed Asia-Pacific, yet when the top and bottom quartile are moved from the equation, Japanese funds are the least risky for investors of the four markets. As Marija Djordjevic, research manager at eFront explains: “The fact that the spread for Japanese funds is significantly lower than for Western Europe and North America is the consequence of higher returns generated by underperforming funds relative to those in other regions, but also of the relatively limited upside of investing in the Japanese buyout market.”

At a more granular level, there are certain areas of the Japanese economy that have produced strong returns, according to Djordjevic, even as GDP growth has remained low relative to many other markets (the Japanese government forecast 1.3 percent GDP growth for 2019). “Private demand has contributed most to the growth of the Japanese economy over the past two years,” she says. “Local private consumption has been particularly resilient, resulting in the best performing Japanese funds investing in consumer goods and services and retail sectors.”

Overall, the report highlights that investors could consider Japanese funds as “a useful diversifier to Western LBO exposure”, in particular for those “willing to sacrifice some performance in exchange for more predictable returns”.