The Longreach Group: Untapped opportunities

Today’s dealfow dynamics offer a rich source of value-creation potential for investors in Japanese private equity, says Mark Chiba at The Longreach Group.

This article is sponsored by The Longreach Group

How is the Japanese economy currently faring in relation to other parts of the world?

Mark Chiba

Japan is still in the process of shedding covid inhibitions. For example, the return to large scale tourism is ongoing. That means the economy is running a little behind a full demand recovery, but the process clearly is underway.

Japan also has a more moderate inflation outlook than some other regions. Japan has been trying to defeat deflation for the past 30 years and looks to have finally succeeded. The challenge will be managing its way out of zero interest rates and quantitative easing in an orderly fashion. What remains to develop is real wages growth, which is important for stimulating consumption but will need to be carefully managed in terms of inflationary impacts.

Finally, the yen clearly weakened significantly against the dollar last year. That presents a strong advantage for Japanese exporters and incoming investors, of course, but currency fluctuations need to be carefully managed.

How is Japan positioned globally in terms of the current geopolitical situation?

Our basic thesis is that the world is developing into two rival spheres led by the US and China. Japan sits at an intersection point, being fully embedded in the US-led system from a security perspective, but with China as its largest trading partner. That economic relationship with China is vital, even with rising opportunities in Southeast Asia. So Japan will need to manage geopolitics carefully for prosperity as well as security.

Against this backdrop, where are you seeing the most interesting investment opportunities?

From a sector perspective, we continue to see more and more opportunities to buy mid-market industrial technology, consumer and business services companies, bringing them up to the right management and performance levels and taking them out into the world, especially the high growth Asian markets. In terms of deal types, we continue to see a solid flow of corporate divestments across all three of those sectors. We also increasingly see succession opportunities, including as founders who were previously unwilling to sell pass away, leaving families to deal with inheritance issues.

Where are you focusing your value-creation efforts and how does that differ in carve-out and succession situations?

With corporate carve-outs, the first step is to bring an independent mindset and performance-driven culture into the company. When you extract an asset from a conglomerate, you need to turn it into a successful, independent value-creation-focused business, one that can compete globally and ultimately one that can find a good home with a strategic buyer, another fund or on the listed markets.

To get there, you need to fix mismanagement or undermanagement. Typically, you need new leadership. You need to address cost structures and focus on winning segments and customers, while de-emphasising or removing parts of the business that are unable to thrive.

You also need to give talent in the business the chance to perform, so that they can grow the company both domestically and internationally.

With family succession deals, meanwhile, you often find that businesses have been run in a successful but thrifty fashion, lacking institutionalised management, strategy and growth. Bringing in that professional management and a more thoughtful metrics-based growth strategy is important.

Family-run businesses also tend to be very domestic, so bringing the capabilities to expand into Asia and beyond creates new upside.

The access to talent you referred to has become a real challenge around the world. What is the situation in Japan?

The good news is that private equity is now viewed as a legitimate and thriving asset class in Japan and there is a growing bench of people that have been involved in private equity-backed businesses and are keen to do so again. In that sense, attracting strong management teams to come into businesses has become a great deal easier over the past decade.

At the same time, identifying and nurturing previously overlooked or underutilised talent that already exists in companies is critical. This is particularly the case when businesses have been extracted from big bureaucratic conglomerates or from family-owned businesses that have been run on a parsimonious basis.

Arming these businesses with clear, disciplined investment and strategy can empower their human capital as individuals see new opportunities for growth and success.

Are you seeing attractive opportunities when it comes to bolt-on acquisitions in this environment?

“There is a growing bench of people that have been involved in private equity-backed businesses and are keen to do so again”

The opportunity for bolt-on acquisitions is very real. For example, we have put together one of the largest café chains in Japan by merging three separate companies, and we see more opportunities to consolidate industries in our portfolio. Cross-border M&A capabilities are also important, both on entry and at exit. In 2021, we acquired Tokyo Stock Exchange-listed software company Japan Systems and being able to deal with its US parent company, DXC Technology, was integral to our ability to seal that deal. Equally, during our ownership of assets, we seek to transform them into businesses that are attractive to global strategic buyers.

Is digitalisation another facet of the value-creation tool kit?

Japan was a laggard when it came to digitalisation before covid hit. It struggled when it came to remote working, for example, due to the absence of digitalised processes and platforms. But the country is now catching up quickly. That creates two avenues of opportunity for us as a firm.

First, we can bring growth and efficiencies to our portfolio companies through the integration of digital solutions. The next stage of that evolution, of course, will be generative artificial intelligence. In the context of a tight labour market and declining population, these innovations will prove extremely important.

Second, we see opportunities to invest in Japan’s accelerating digitalisation trend. For example, Japan Systems provides accounting software and outsourcing solutions for regional governments and SMEs. That space was catalysed by covid and continues to grow rapidly.

Do you see ESG as a source of value creation?

Absolutely – we think about ESG not only in terms of compliance but also in terms of increasing earnings and valuation multiples, and therefore delivering a better exit. These initiatives are not only the right thing to do but also extremely profitable.

How would you describe today’s exit environment?

Japan has a liquid exit market. There were a couple of tough years through covid due to border closures. Those physical restrictions meant it was difficult for buyers to execute cross-border due diligence on operations and customers. However, the execution environment has normalised, which means strategic buyers and funds are both now strongly back in play.

“The majority of dry powder is in the large-cap space, while the mid-market is less heavily competed”

In addition, Japan is a stable, well-governed environment. This is particularly the case given the 10 years of policy consensus we have had around ‘Abenomics’, which refers not just to a fiscal and monetary policy approach but also an approach to promoting business, investment and cross-border activity. That all leads to a growing momentum that underwrites a healthy investment and exit environment.

How do you anticipate the Japanese market evolving over the next few years?

The Japanese market today is well ordered. It is overwhelmingly focused on control buyouts and is well stratified into large-cap, mid-cap and small-cap segments. We focus on the sophisticated mid-cap buyout space, buying companies that require global sector expertise as well as cross-border execution skills. We also see an opportunity to harness long-term and proprietary deal sourcing channels in the mid-market, while bigger deals tend to go to auction. The majority of dry powder is in the large-cap space, while the mid-market is less heavily competed.

Something else we find interesting is the growing interaction between activist investors and private equity, which is starting to occur as it does in other markets, such as the US and western Europe. We see situations catalysed by activist investors who take a position and then look for a private equity firm to come and broker a solution, potentially leading to a take private. But we also see opportunities to come in on a friendly basis and take the company forward with better strategy and value creation.

Finally, the Japanese LP community has developed remarkably over the past decade, becoming increasingly sophisticated and experienced. The fact that we can access local funding from investors that know what they are doing and have proper performance requirements of their GPs is an extremely healthy development for the market.

How much LP appetite is there for Japanese private equity?

Japan was overlooked by LPs for many years, especially when compared with the high-growth economy and entrepreneurial dynamism of China. Yet China is now facing both geopolitical issues and reduced growth, and while nowhere offers an entirely safe harbour, Japan is certainly being viewed as relatively sheltered.

It is also being recognised as a source of untapped control buyout dealflow with relatively simple value-creation opportunities in terms of fixing mismanagement and getting business configurations right. LPs have woken up to these advantages and are proactively seeking to reallocate capital to this market.

Mark Chiba is group chairman and partner at The Longreach Group