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Enhancing the Value of Japanese Companies: Some Practical Advice for Private Equity Investors

Japan continues to suffer from slow growth due to the poor domestic economic situation and a world economy that continues to teeter on the brink of recession. As the Japanese economy continues to sputter, many of the companies that were on a worldwide buying spree in the 1980s are now struggling simply to maintain profitability, say Mark A Guidi and Russell J Taylor of PricewaterhouseCoopers. This situation has had a tremendous impact on many Japanese companies' value and their ability to compete in the global economy.

Japan's economic woes will take a long time to turn around, but there are actions individual companies can take to improve their specific situations.  While there are many ways for a company to enhance its value, for many Japanese companies it is as simple as refocusing on business fundamentals.  By concentrating on key business drivers as a means to start their recovery, value can be increased which will provide companies the capability to stand on their own or make themselves more attractive for capital infusion plans (e.g., being partially or wholly acquired).  Each company and situation is different and needs to be evaluated separately, however, for the now all-to-common distressed company in Japan options for the initial recovery steps may be limited. In the M&A marketplace, the principal approach should be one of improving commonly valued business basics that will generally yield respect in the market with the least amount of initial investment.  One of the best ways to accomplish this is to increase the company's profitability margin.

This is of particular importance to the fledgling private equity industry in Japan, which is principally focusing on companies that are in need of significant turn around/operating improvement. While this represents an opportunity for private equity funds, impacting on exit earnings multiples, the realization of such upside requires significant hands on management rather than being able to rely on company management to effect the turn around in isolation.

Classic examples of private equity funds in Japan, which have been able to demonstrate the positive impacts of such hands on involvement in management decisions and change management, exist. Advantage Partners, which acquired a loss making powdered milk company, changed the sales structure and invested in system improvements, resulting in the company turning a profit after a year of control. This investment was subsequently sold for at more than double the initial price. MKS Partners (formerly Schroder Ventures KK) acquired the joints division of bankrupt Benkan Corp., despite scepticism about the revival of the firm, following suspension of its business for about three months. Through changing the decision-making process, through the holding of weekly management meetings, MKS Partners were able to successfully return the business to profitability soon after acquiring it. Cases of distressed, low-margin companies in Japan abound. However, examining the situations and solution options of a few can provide some examples of the types of issues many Japanese companies face and some options for improving. 

Approaches to enhancing profitability
While not the only determining factor of a company's value, sustained, high profitability is a good indicator of strength that is commonly reflected in a company's value (e.g., stock price). There are two general ways of improving profitability (1) increasing revenue or (2) cutting costs, with each having pros and cons associated with it.

Management generally understands the need to focus on both cost and revenue when looking to improve a business.  However, many Japanese companies are currently faced with the situation that they do not have the fiscal resources to mount a comprehensive change program.  Such was the case at a Japanese electronics manufacturer where management knew that long term they needed to increase their revenues and market share.  However, their current financial position made it impossible to muster the economic investments necessary to implement their plans.  What they needed was some short-term wins, over the time frame of a year or less, that would reduce costs and free up cash.  This cash could then be invested in longer-term initiatives such as new product R&D and marketing campaigns.

This situation of wanting to attack the core problem with longer-term solutions, but not having the financial where-with-all, is common among Japanese companies. In particular, Japanese companies historically have been guilty of concentrating on top line revenue growth, particularly compared to foreign competitors, to the distraction of bottom line profitability and cash flows. The key focus of private equity funds is on net profitability and returns on invested capital, areas that generally are not the focus of Japanese corporate management due to differing priorities.  Companies should ultimately focus on the revenue side of the business equation when looking to improve profitability. However, distressed companies may not have the luxury of time or money to immediately tackle this generally longer-term solution. In addition, for private equity funds, the desire to demonstrate the effects of a change in ownership and improvement in short term results, including early repayment of debt, is high on the agenda, once the deal has been completed. Consequently, improving the cost side of the equation may be a good first step in that it helps improve the business while freeing up cash to repay debt, or invest in longer-term solutions.

Cost reduction opportunities
Private equity firms, when assessing an investment opportunity, generally look to eliminate excess “fat” from the cost side of the business in their investment appraisals. There are usually numerous areas management can attack when they start seriously considering how to take costs out of the business.  Each business is different and thorough analysis should be done prior to undertaking cost reduction initiatives.  However, at a number of different Japanese companies, three specific areas consistently appeared to provide significant benefits with relatively minimal investment.  These areas include: (1) back office functions (e.g., finance, IT, HR); (2) Supply chain - especially the areas of procurement and inventory management; and (3) customer facing functions such as sales, marketing, and customer service.  A brief review of each of these areas along with examples of how some Japanese companies are addressing issues should prove insightful for other companies looking to similarly improve their situation.

Back office
The most common area for companies to look at when trying to reduce cost is G&A. While often ripe with opportunity, knowing specifically where to look and how to reap the greatest benefit is key to not cutting too deeply or in the wrong place. 

Many companies have the opportunity to improve the cost effectiveness of their organization by consolidating similar functions performed in various business units or divisions into a central location.  A lot of companies believe this was done long ago, however, upon further review, many found consolidation was less complete than expected.  One example of this was a company that discovered while they had a single consolidated treasury function for the enterprise, four of its larger business units were also performing treasury functions thus putting the overall enterprise at greater currency risk.  In another example, management found significant redundancies in the HR and IT functions across business units that had been “consolidated” years earlier.

Often it is possible to consolidate these back office areas into a single, enterprise-wide function or shared service center that can yield significant cost savings.  It has been reported that shared service centers, when implemented properly, yield an average Return On Investment (ROI) of 27%*. Many Japanese companies have not taken this route yet due to the initial capital investment required to create a new-shared service center.  But such an action appears to be in many company's longer-term business improvement plans.

Another functional area where Japanese companies tend to have substantial organizations is strategy and planning.  Often the overall value added to the business by these functions is minimal and the number of people in these organizations is large due to poor process management.  An example of this comes from a company where it was possible to identify a 70% reduction in their approximately 50 person strategic planning division by eliminating redundant work and streamlining processes.

In addition to specific functional areas, significant benefits can often be gained through back office process improvements.  Two specific areas that Japanese companies can often benefit from are improvements in their financial closing process and management reporting. 

The first area, financial closing, often involves a long and complicated process compared with other similar companies in different parts of the world.  There are numerous examples of where Japanese companies take 30 or more days to close their books, with questionable quality.

Simplification and streamlining of this process can often yield higher-quality results in a more timely manner.  Additionally, it often provides companies with the ability to eliminate a considerable number of people from the process and allow those people to be re-allocated to higher-value added work, such as customer or product profitability analysis.  Such was the case at a large Japanese manufacturing company where within 10 weeks processes were redesigned to improve closing times by 33%, reduce closing costs by 25% and reduce closing errors by 13%. 

Enhancements to the second area, management reporting, can allow a new investor to begin to make proactive rather than reactive decisions regarding the business.  It can also allow them to more directly monitor the value and benefits to the business of other cost reduction initiatives and better allocate freed up resources to longer-term business improvement projects.

One of the most common issues arising for private equity funds is tracking key performance metrics of a newly acquired business. With the limited focus on profitability, and more importantly cash flows, most Japanese companies are not positioned to immediately provide accurate and timely information on these areas most commonly considered critical to private equity buyers.

Using the reporting systems to manage the business post acquisition, allowing the fund to achieve the savings projected in their investment plan, is often an issue overlooked in acquisitions. Significant gains can be made by small adaptations to management reporting and management systems, allowing disclosure of key performance indicators, cash flow information, etc.  This will allow management to focus on the key areas of potential improvement, as well as more timely reporting of business performance and will allow better management decisions over the direction of the business.

Consideration of the investment costs and time to change existing systems and management monitoring tools should therefore be factored into any investment appraisal and resources dedicated to such implementation made available post completion.

Supply chain
Another area that often yields significant cost benefits for relatively minimal up front investment is a company's supply chain, particularly the areas of purchasing and inventory management.

From the purchasing side it has been reported that, on average, across all industries, companies can realize annual cost savings, directly attributable to purchasing, of over 6%2.  While this may not look significant, when one realizes that the cross-industry average of purchasing spending is over 39% of sales**, this can translate into huge cash savings. 

The most common ways to realize improvements in purchasing are to centralize the function and rationalize the supplier base.  The first time doing this companies may require some external assistance as the process can be cumbersome and complicated if it has never been done before.  However, once completed, the end results are easy to maintain with minimal human resources and the cost savings are relatively simple to track.  In conjunction with centralization, partnering with a small number of suppliers and negotiating lower costs based on greater volume can drive additional cost reductions.

In terms of inventory management costs, it is not uncommon for management to discover huge amounts of inventory not contained within the company's “standard” inventory management processes.  Such was the case at one company where individual sales offices were stockpiling inventory for “emergency use” or “in case an order is delayed in shipping”.  The result is higher inventory carrying costs, greater obsolesce, and wasted warehouse space storing excess product.  All this ultimately impacts a company's working capital.

The example cited above was directly attributed to the company's poor order-to-promise process that resulted in field sales representatives not having faith that promised delivery dates would be met.  By improving the order-to-promise process, this company is looking to make significant improvements in how product movement is managed and tracked.  This in turn should lead to the ability to consolidate warehouse storage space, improve order response cycle times and reduce inventory.  All of these will yield cost reductions to the company as well as improved timeliness in responding to customer orders.

Customer facing functions
A third area that often yields significant cost reduction opportunities, and can begin to make in-roads into revenue enhancement, is implementing improvements to customer facing processes such as sales, marketing and customer support.  Reducing costs in these areas should not mean adversely impacting customers.  In fact, customer service and satisfaction should improve.  While care must be taken to ensure nothing is done to damage customer relations, modifying the processes that directly support the customer to make them more efficient can usually generate significant cost savings. 

For example, one Japanese company realized that their sales force was spending almost 50% of their time on traditional customer service work (e.g., inquiries on product availability, order delivery dates, etc.)  This time was taking away from the sales representatives “selling” time.  By consolidating customer support into a single, central function the company hopes to improve customer service, support their client base with fewer people, while simultaneously freeing up their sales force to focus more on selling.

Companies can also benefit from better understanding their customer base through a detailed analysis of customer profitability and buying habits.  While not new, this understanding is not common among Japanese companies.  Such an understanding can help companies better target future marketing campaigns thus minimizing the costs associated with providing every client with the same promotional material, as one example.  In addition, incentives and discounts can be better targeted and high-profit clients can be given a greater discount thus making the client happier while still maintaining a significant profit margin.  Understanding a company's client base also allows different businesses or divisions, within a company to better target clients.  It is not uncommon for different divisions within a large company to be doing business with the same client and not know about each other's activities.  Through better coordination more opportunities for work can be generated and a single face to the customer maintained. 

Some tips for improving the odds of success
So once a fund has identified areas to improve its investment, in order to enhance profitability, the next logical question is … now what?  There is nothing magic about undertaking a successful cost reduction initiative, however, there are some things when not done well, can have a significant impact on the success of a project.  Some of the characteristics shared among most successful cost reduction initiatives include:

Manageable and measurable projects - Cost reduction initiatives should be well defined before being undertaken.  This means the scope of the project should be clearly and simply outlined, a senior management champion identified, and realistic results and corresponding measures of success for the project articulated.  Having the senior management sponsorship is critical for project visibility and rapid decision-making.  Metrics by which the project will be considered a success are critical both for helping drive solutions that will yield the desired result, but also to measure the success of the project team.

Good project management - While much has been written on this area over the years, this is still probably the most overlooked area in any company.  While many companies, and people, claim they are “project managers” few have had significant experience in the discipline and even fewer formal training. To effectively manage a cost reduction initiative the person leading the initiative should have experience in the area being addressed, but does not need to be an expert.  While this may sound contradictory, it is not.  The key is for the project manager to know enough about the area to ask tough questions and drive the improvement team to consider “out-of-the-box” ideas.  However, if the project manager is an expert in the current process their thinking may be limited by how they know the process currently works.

Focus on process rather than systems - It is not uncommon for management to believe, and consultants to sell, the need for a new system.  Often automating seems like the way to make a process more efficient, however, automation of a poor process simply generates the same poor results more quickly.  Additionally, often the amount of time and money required for investment will substantially out weigh the benefits of undertaking the project, particularly if the goal is short-term wins to improve profitability.

It has been shown over the last ten years that companies can realize significant benefits by focusing on process improvement alone with minimal systems investment. Numerous techniques have been documented regarding process re-engineering, process management and a number of other buzzword phrases.  While most of these improvement methodologies include a systems component, companies who are looking to undertake cost savings initiatives should be extremely cautious when it comes to investing money in automation.  While occasionally implementation of a new system or modification of an existing system will be required, automation should be considered as the last step in the process improvement, not the first. 

Internal involvement at all levels - It is absolutely critical to ensure people at all levels of the business are involved in any cost reduction initiative.  While, as stated earlier, senior executive sponsorship is critical to success, equally important is involvement by the lower level staff that currently works on a process and will be directly impacted by the project.  Ultimately, it is these staff that will determine the success or failure of a process improvement project.  In addition, they are the ones who know exactly how a process works, where it is “broken” and how best to improve it.

Final Thoughts
For private equity funds in Japan, the focus for a successful transaction should not just be the identification of suitable targets and efficient execution of the deal, but the post acquisition changes and improvements in operations required to further enhance the value of businesses.

PE funds investing in distressed Japanese companies could benefit from following the examples cited.  While the Japanese economy continues to stagnate and competition continues to grow, there are tremendous opportunities available to many Japanese enterprises to begin the process of returning to a competitive position on the global stage. This is recognized by private equity funds, eager to invest and undertake turnarounds, realizing significant gains in the process.

Copyright © 2003 PricewaterhouseCoopers

References:
* Reason, Tim.  Shared services centers helped companies eliminate redundancies.  Now the web may eliminate the centers.  CFO Magazine.  September 2000.  Also available on-line at http://www.cfo.com/article/1,5309,929||M|286,00.html

** Centre for Advanced Purchasing Studies (CAPS). Report of Cross-Industry Standard Benchmarks.  August 16, 2002.  http://www.capsresearch.org/BenchPDFs/CrossIndSum08302002.pdf

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.

Mark A Guidi is a Director in the PricewaterhouseCoopers Transaction Services group, based in Tokyo. He specializes in M&A post-acquisition integration and business value enhancement. He can be reached at Mark.A.Guidi@jp.pwcglobal.com

Russell J Taylor is a Senior Manager in the PricewaterhouseCoopers Transaction Services group, based in London.  He has recently returned from Japan, where he was significantly involved in Private Equity transactions, and continues to specialize in financial due diligence for financial and strategic buyers.  He can be reached at russell.j.taylor@uk.pwcglobal.com