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Private equity in Japan

As the pace of Japan's corporate restructuring gathers momentum, there is a growing awareness of the positive role that foreign private equity funds can play in this process. On 20 March 2002, the Japan External Trade Organisation (JETRO) held a conference in New York to discuss the evolution of the industry in the region. The following is a summary of the presentations given.

Panel one: viewpoints of the institutional investor

John Flannery, the president of GE Equity, said that when considering an investment in Japan, one must take into account the inherent challenges of the Japanese economy, such as the capital demand/supply imbalance, the hollowing out of the manufacturing base, deflation and difficulties associated with the banking system. However, according to Mr Flannery, Japan has started opening up as political reforms and corporate rethinking take hold. Formerly protected sectors, such as retail, distribution, construction and financial services, are being opened up and offer growth opportunities. In addition, Japan has many attractive small and medium-sized companies. Japan continues to produce companies with cutting edge product design and ‘very, very innovative technologies'. Mr Flannery said, ‘Japan is an economy going through an evolution in management culture.' He concluded, ‘Japan is at a historical turning point.'

John Baily, the president of Swiss Re Capital Partners, suggested that poor economic conditions along with ongoing efforts to support restructuring are increasingly creating opportunities for buy-out and special situation investors. He claimed that buy-outs are still viewed negatively by some in Japan, like they once were in the US. However, buy-out deals are increasing in both number and size. M&A activity has increased four-fold since 1995, he said. In addition, Mr Baily speculated that Japan could host up to 40 buy-outs this year, an ‘incredible number'. Opportunities for private equity investing in Japan include healthy subsidiaries of troubled parent companies and orphaned public companies. Mr Zwingg, the vice president of Swiss Re, added, ‘This conference demonstrates that there is momentum in the private equity movement in Japan. It may prove to be the point when the market takes off.'

Shunichi Maeda, president and CEO of MC Capital, Inc., commented on factors contributing to new opportunities in Japan's buy-out market. According to Mr Maeda, these factors include macroeconomic policy, financial systems reform, regulatory change and corporate behaviour. He mentioned that the Japanese capital market includes companies with ‘pools of idle cash', as well as with levels of market capitalisation below break-up value, etc. There are many ideal ‘targets', from the perspective of US investors, he said. Furthermore, as the negative perception of acquisitions and non-Japanese management declines, a greater acceptance of foreign investments such as Shinsei Bank is taking hold. He took the view that, ‘traditionally, management is not recognised as an independent skill in Japan. With the guidance of fund managers, you can make it work.' Mr Maeda recommended the following points to companies interested in investing in Japan: a) develop a win-win structure, b) develop an effective public relations strategy, c) pursue a long-term commitment, d) and be patient.

Panel two: industry perspectives

Tatsuo Kawasaki of Unison Capital Partners discussed private equity in Japan from the perspective of the manufacturing industry. The manufacturing sector in Japan, said Mr Kawasaki, has many opportunities: ‘Although Japanese management may not emphasize profit maximisation or the balance sheet, still they are very good at pursuing operational efficiency.' He stated that one of the major factors contributing to opportunities in this sector is that the captive system is breaking down: suppliers formerly dependent on one buyer are now pursuing their core competences. Mr Kawasaki described Unison's acquisition of Kiriu, a car parts manufacturer that had formerly depended primarily on Nissan for sales. In Kiriu's case, Unison helped improve the capital structure, introduce depth, and create enough capacity to pursue business where Kiriu's strength lies. He concluded, ‘Ultimately, success comes down to whether or not management can focus on core competences.'

Jonathan Colby, the managing director of The Carlyle Group, described private equity trends in the business services industry. He suggested that Japanese service companies are looking to spin off or divest non-core subsidiaries and divisions to generate cash with which to pay off debt and to focus on core competencies. However, he mentioned, not all of these spin offs are distressed - many are ‘corporate orphans' which have potential as separate entities. Asahi Security Systems, a provider of cash management and electronic services, purchased by Carlyle, was a classic case of a ‘corporate orphan'. He added, ‘the most challenging part of our involvement in Japan was finding a partner. Now we have a terrific fund with two-thirds Japanese capital. We have an increasing interest in Japan for sure.'

Tomoya Shiraishi, the group officer of JAFCO's Structured Investment Group, discussed private equity investments into the retail market in Japan in the context of JAFCO's acquisition of Victoria Sporting Goods, a sporting goods retail chain. The rationale behind his investment, he said, was that the sporting goods retail market in Japan is declining and is tending towards consolidation. Mr Shiraishi pointed out that Victoria's advantages included: a) a leading position in the Tokyo Metro area, b) two million registered customers, c) quality customer relations. However, Victoria had room for improvement in such areas as, inventory control, the renewal of existing outlets, and decreasing SG&A. He speculated, ‘Victoria will experience a few years in a declining market including deflation. But gross margins, at 27-30 per cent, are relatively high (as opposed to 20-25 per cent in the retail industry as a whole). If Victoria can survive the market's consolidation, it will be able to increase market share.'

Tatsuya Terazawa spoke from the point of view of the Japanese government. Mr Terazawa is a special advisor to the Ministry of Economy Trade and Industry (METI), the director for industrial research at JETRO New York, and also a senior visiting fellow of the Research Institute of Economy, Trade and Indsutry (RIETI). He mentioned that the problems affecting the Japanese corporate sector included both damaged balance sheets and low profitability. However, the government has enacted various policies to address these issues including the following: a) efficient restructuring process, b) flexibility for reorganisation, c) better accounting, d) stronger corporate governance, e) stronger incentives, such as stock options. Mr Terazawa took an optimistic view of such policy changes: ‘If the corporate sector had a wish list in 1995 for government reforms, I think that most items, such as reforms in the tax environment and in the legal environment have been accomplished at this point.' The role of private equity funds, said Mr Terazawa, was to invest in distressed firms, as well as invest in divestiture opportunities. Furthermore, foreign investment into Japan has three advantages: a) the capability to realise changes, b) the implementation of new expertise, c) the identification of global partners. ‘Even though the press, politicians and others have created the image of private equity funds as being “vulture funds”,' said Mr Terazawa, ‘if these funds prove that they can create value, rather than destroy value, the opposition in Japan will decrease.'

Keynote: financial services

Wilbur Ross, the chairman and CEO of WL Ross and Co. LLC, described private equity investments into financial service companies in Japan in the context of his firm's acquisition of Kansai Sawayaka Bank (KSB), formerly Kofuku Bank. He suggested that Japan has the most outstanding potential of any major economy for productivity improvement - corporate profits per employee in the US are $14,400; in the EU they are $13,000; in Japan, however, they are only $4,200. According to Mr Ross, Japan has three factors in its favour in terms of attracting foreign investment: a) Japan is the world's second largest economy, b) asset values may be close to bottoming out, c) Japan has recently revised its insolvency regimes. In addition, Japan has the unique combination of potentially rapid productivity growth and savings propensities that are much higher than in the west. Mr Ross concluded, ‘The best proof that private equity funds can make money by investing in Japanese financial institutions and turning them around is that the three Japanese banks owned by such funds all have been very successful: despite the public controversy, Ripplewood has made money with Shinsei, so has Lone Star with Tokyo Sowa, and so have we [in the case of KSB].'

Panel three: transaction and operational issues

Paul Slawson, the managing principal for EastPoint Capital Management, discussed the topics of private equity deal sourcing and deal structuring. He described the sources of private equity deals taking place in Japan as follows: a) non-core divisions of large corporations, b) companies with balance sheet problems, c) orphaned subsidiaries of retreating foreign multinationals, d) companies faced with a new business model paradigm, e) businesses facing management issues. He mentioned that deal structuring in Japan includes the following: a) use of leverage, b) debt to equity swaps, c) bank financing. However, according to Mr Slawson, ‘Japan is not a leveraged buyout market; it is a late stage buy-out market.'

Dean Yoost, the CEO of PricewaterhouseCoopers Financial Advisory Services in Japan, spoke on due diligence. He thought that Japan's new accounting rules and disclosure requirements were a major step forward in terms of corporate transparency. However, Japan has proportionally less accountants than in the US: whereas there are 350,000 accountants in the US, there are only 13,000 in Japan, he said. When evaluating an entity for a potential private equity investment, Mr Slawson advised that caution is still required in the following areas: a) investment values, b) receivables, c) pensions, d) guarantees and commitments off-balance sheet, e) related-party transactions, f) budget projections, g) inventories. Because M&As are typically viewed in Japan as ‘business failures' and for other reasons, Mr Slawson suggested that one contemplating an investment should expect delays in the due diligence process as well as inadequate sell-side support. He concluded that ‘in Japan, due diligence is more of an art than a science.'

Nobuo Matsuki, the CEO and managing partner of Schroder Ventures, talked about restructuring and exit strategies. At the moment, distressed companies in Japan are trying to divest non-core assets, said Mr Matsuki. He added that the rise in the number of M&A deals in Japan has started to accelerate and buy-out deals are increasing both in number and size as large corporations begin to accept MBOs as a means of divestiture. Exit opportunities have been enhanced by the creation of Nasdaq Japan and Mothers. Mr Matsuki stipulated that a large number of private equity firms have recognised the opportunities in Japan and are seeking to enter the market. Nevertheless, extensive experience of the Japanese private equity and buy-out markets is rare, he explained. ‘This type of revolution happens once every 50 years,' said Mr Matsuki, ‘once in my lifetime, and once in your lifetime.'

Arnold Chavkin, executive partner at JP Morgan Partners, took a historical view of the development of private equity in Japan. Prior to 1997, he said, there were almost no private equity transactions in East Asia, including Japan. Firms raised money mostly through IPOs. However, Mr Chavkin stated that in the last four years, buy-outs have become more common. In describing the trend in South Korea towards restructuring through buy-outs, he mentioned, ‘In the past, management did not understand that they were in control of their own destinies. But exposing management to international practices through an active buy-out market, they are able to adjust and take control.' He suggested that this is becoming the case for Japan. He concluded, ‘For firms to survive, they must think globally and be tied into the international markets. Soon, this discussion about what is foreign and what is global, versus what is local, will no longer be applicable.'

Timothy Collins, CEO of Ripplewood Holdings LLC, opened his keynote presentation by discussing his personal background and the history of Ripplewood. He stated that Ripplewood was established in 1995 to pursue industrially focused investment activity, which he described as a hybrid between successful corporate strategies and traditional private equity approaches. Ripplewood has several investments in Japan including: a) Shinsei Bank: the ninth largest bank in Japan, b) Nippon Columbia: a record label business, c) Phoenix Seagaia Resort: a resort with four golf courses and five lodgings. He suggested that ‘Ripplewood intends to do three or four more transactions in Japan over the next 18 months'. Responding to a question from the audience, Mr Collins said, ‘The results of freeing Shinsei Bank from the burdens of excess debt and allowing its management to going back to growing business and improving productivity have exceeded my wildest expectations'. Mr Collins concluded by saying that ‘Private equity can be a positive vehicle for change, a positive lubricant, and can play a positive role in bringing the Japanese economy back to its former pre-eminence in the world economy'.

Copyright 2002 JETRO

The Japan External Trade Organisation (JETRO) is a Japanese government-supported organisation that promotes mutually beneficial trade and investment relations between Japan and other nations. JETRO has over 100 offices worldwide including 8 locations in the United States. For more information please visit www.jetro.org or www.jetro.go.jp