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Recent Trends in Private Equity

The Japanese MBO market has grown rapidly in the past 18 months. As many Japanese companies are forced to undergo drastic restructuring and are spinning off non-core businesses, deal flow is extremely robust. Ross Kerley and Russell Taylor of PricewaterhouseCoopers give an overview of recent developments in Japan, which appear positive for the future of the private equity industry.

Historically, there has been little tradition of Private Equity activity in Japan. However, as the struggling corporate sector restructures and begins to look for alternative deal structuring options this is changing with the announcement recently of a number of high profile Private Equity deals. Private Equity activity may not be as vibrant as in some other Asian markets, however the outlook is positive and we are optimistic about the future for Private Equity in Japan.

With the exception of a few recent withdrawals, all the major foreign funds are in Japan and are hungry to do deals. There is certainly no shortage of funds. 

Source: Mitsubishi Research Institute/ ChuoAoyama Audit Corporation

According to a recently published survey by Mitsubishi Research Institute and ChuoAoyama Audit Corporation (a member firm of PricewaterhouseCoopers), 2001 represented a record in terms of number and value invested in the management buyout (MBO) market, with the number of MBO's exceeding the record 19 transactions (valued at approximately 40.4 billion yen, ($337.5 million) set in 1999, reaching 22 (valued at an estimated 116 billion yen ($969.1 million).

Behind the sharp rise in MBO's is the underlying weakness of Japanese companies, with more undertaking restructuring and spinning off subsidiaries and non-core businesses, which have been providing little synergistic effect for the parent company or group. The increase in the number of Private Equity Funds providing the financial support to MBO's is also a significant reason, effectively the coming together of willing sellers and buyers.

Deals Providing the Momentum for Change

Japan has seen several large Private Equity and MBO deals since the end of 1998. The best known was the acquisition of the bankrupt Long-Term Credit Bank (LTCB) by the U.S.-based Private Equity group Ripplewood Holdings L.L.C., in March 2000. Ripplewood also acquired the financially troubled audiovisual equipment maker Nippon Columbia Company, as well as the failed Japanese resort complex in Miyazaki prefecture, Seagaia, in May 2001.

Landmark MBO's by Schroder Ventures of Recruit Building Management in January 2000 (amount not disclosed), Benkan Corp. in October 2001 for 10 billion yen ($83.5 million) and by UK-based Private Equity group, 3i, of Vantec in January 2001 for 15 billion yen ($130 million) opened the door to MBO's of non-distressed businesses. Foreign affiliated firms are not the only ones active in Japanese MBO activity.

Japanese principal investment firms such as Japan Asia Investment, Tokio Marine, and Fujigin Capital, have also been heavily involved, with Nikko Principal Investments (the first Japanese Private Equity fund to make a significant MBO transaction) recently announcing the acquisition of Tower Records Japan for approximately $115 million in April 2002. A few years ago, MBO's of this size and style would have been unimaginable to foreign and domestic investors alike.

However, caution still exists in the Private Equity market, with DB Capital Partners announcing the acquisition of DX Antenna in October 2001 (transaction value not disclosed, although believed to be approximately 10 billion yen), only to withdraw a month later, on the verge of investing, reported as being due to lack of clarity over financial performance.

Expectation Gap Over Investment Returns

It is certainly not that the underlying model is inappropriate. The prevailing low interest rates in Japan mean that debt interest does not consume cash flow to the extent that it does in Europe or the U.S. leaving room for enhanced equity returns. Additionally, and especially in MBO situations, the tendency of Private Equity solutions to keep many of the existing management in place, thus maintaining personal relationships and business contacts, works well in a Japanese context.

As noted above, the volume of M&A transactions has continued to rise. Moreover overall M&A deal size has declined, which should play into the hands of the Private Equity firms. Yet Private Equity players in Japan speak of a lack of deal flow.

Certainly there is an expectation gap between the typical returns that Private Equity firms have enjoyed elsewhere and are looking for in Japan, and those that appear realistic or credible to Japanese players. Given the historical legacy of low equity returns and a lack of a shareholder orientated model of capitalism, it is perhaps too much to expect "western" equity return levels in the short term.

Private Equity funds must adjust their sights accordingly. Another factor is that Japanese sellers, and the companies being sold, generally look for investors to bring something to the table other that purely finance. Strategic investors are likely to have an easier ride than purely financial investors, and it is often also necessary to have demonstrable industry expertise to excite interest from sellers who are looking for the purchaser to add real operational value to the business.

Moreover it is often only by employing this industry specific operational expertise that the most value can be extracted from the acquisition. Another factor is that not all of the Private Equity funds have yet appreciated the importance of "localizing" their operations in Japan, and becoming "insiders" in the Japanese corporate world, albeit insiders who are savvy about western style capitalism and the benefits it can bring.

No single approach holds a monopoly of wisdom, and thus it is the fusion of western and Japanese approaches that often has the most to offer. Private Equity firms are learning this, and nearly all commentators are optimistic about the long-term prospects. But in the short term activity has slowed down considerably.

Leveraging the Deal

Debt providers are important because they ensure sufficient leverage for Private Equity financed transactions. It is certainly true that these debt providers are less accustomed to the kinds of financing structures attractive for Private Equity investors compared with providers of capital in some other markets, but that is changing.

Perhaps gearing ratios might be a little lower in Japan because of the attitude of lenders, but Private Equity can easily fill this gap, especially given that the low interest rates prevalent in Japan mean that debt interest does not impact cash flow to the same extent as it does in the U.S. or Western Europe. Equity investors realize this, and although it has consequences for the risk reward ratio, they are ready to plug the gap.

Japanese banking institutions are increasingly viewing Private Equity/ MBO deals as opportunities with no more risk than current corporate clients with well documented debt problems, but with higher return opportunities backed by motivated management and Private Equity funds looking to maximize returns. The returns on offer to the banks compared to ordinary commercial lending, coupled with the view that Private Equity/ MBO acquisitions may actually be lower risk is encouraging interest.

Exit and Returns to Investors

Perhaps the greatest area of uncertainty remains over the exit routes available to Private Equity firms, with limited evidence to date on the returns made on IPO or other exit routes traditionally utilized. The return horizon for Private Equity firms to date appears significantly longer than those in other Asian markets such as Hong Kong, as well as Europe and the U.S.

The additional barrier of post IPO lock up is compounded by the limited volume in trades witnessed on IPO's to date, providing a further barrier to exit routes. With corporate Japan having a limited appetite (and funds) for exits through trade sales, especially given current management focus on non-performing businesses and divestments, rather than future investments, the option of trade sales to domestic corporations appears less strong.

However, there have been a few successful exits that should give hope to Private Equity/ Venture Capital funds. Apax Globis completed 2 successful exits in 2001, of Pasona Tech Inc. and Bizseek, while Nikko Principal Investments completed the IPO of Yozan in September 2000. The availability of appropriate exit routes is still not fully demonstrated and is a key focus area for the Private Equity industry.

The Sun Beginning to Rise

It is safe to say that the institutional framework is set, and the legal and institutional obstacles mentioned above are fading. The cultural barrier exists because many of the top managers of the Japanese firms are senior executives who are not accustomed to entrepreneurship and risk taking.

However, as bigger deals occur and the Private Equity/ MBO model becomes more ingrained in Japanese business culture, the future appears bright for such transactions. The younger generation of Japanese managers is beginning to see Private Equity transactions as an opportunity to break free of the shackles of the parent company, and become masters of their own destiny.

The prerequisites for growth are all here, including an adequate supply and demand of funds and a corporate sector that needs to restructure and will undoubtedly offer a huge range of opportunities. Deals will create both the supply of, and appetite for, additional deals, and more people will realize the possibilities and the opportunities.

Overall, the market is moving in the right direction. With deals starting to materialize, greater cultural acceptance of MBO's as a mechanism for change while preserving management and employees and exits beginning to demonstrate returns to Private Equity funds, we believe that Private Equity/ MBO transactions are likely to grow steadily in Japan over the medium-term.

Copyright © 2002 PricewaterhouseCoopers

Ross Kerley is a Managing Director in PricewaterhouseCoopers Financial
Advisory Services, based in Tokyo. Russell Taylor is a Senior Manager in PricewaterhouseCoopers Transaction Services, based in London.

PricewaterhouseCoopers (www.pwcglobal.com) is the world's largest professional services organization. Drawing on the knowledge and skills of more than 150,000 people in 150 countries, we help our clients solve complex business problems and measurably enhance their ability to build value, manage risk and improve performance in an Internet-enabled world.