Japan: Is this time different?

When I talk with foreign investors about Japanese Private Equity, many of them ask the question – “Is this time different?”

For 20 years, people have been debating the potential for a thriving private equity market in Japan. It is the third largest economy in the world, but private equity has not taken off yet. Many LPs were disappointed by investments made during the last boom period, between 2005 and 2008, which had a long-lasting negative effect on the level of subsequent deal activity in Japan.

Dealflows
Contrary to such perception, the Japanese private equity market has quietly evolved and now offers interesting opportunities.

On the dealflow side, the average age of a CEO is over 60, a reflection of an ageing society, so many family-owned companies face succession issues and in many cases GPs play an important role in solving such issues. In Japan, there are many SMEs that have high quality products or services but are not well managed. Once GPs invest in such companies, GPs can improve management and add value relatively easily.

Another source of dealflow is large corporations. Large Japanese companies are gradually focusing on their core business and divesting non-core businesses. They are under pressure from shareholders due to the newly introduced Corporate Governance Code and Stewardship Code and are paying more attention in order to improve ROE. In addition, they have learned how to deal with GPs through various types of deals. In addition to distressed sellers, we have also seen carve-out deals from top companies such as Panasonic, Sony and Suntory.

Based on our research, there were approximately 70 buyout deals in 2015, which includes an increased proportion of succession deals compared to previous deals. We expect gradual growth in this market, so this figure may increase to 100 in the near future.

Ecosystems
Another important factor is human resources. Over the last 20 years, and especially as a result of the tough environment following the Great Financial Crisis, the quality of GPs have been improving. GPs have had more talented staff with a wider range of backgrounds – not only investment banking, but also consulting and operations.

The universe of GPs is expanding again. In addition to experienced GPs, such as Advantage Partners and J-Star, we are seeing high quality emerging managers as well. There are approximately 40 buyout GPs in Japan (excluding global / regional players). Although they are all targeting mid-market companies, they have developed differentiated strategies and approaches to target companies. LPs now have a nice pool of GPs to choose from.

In addition, it’s getting easier for GPs to place quality management at a portfolio company level. Japan used to have a “lifetime employment system” and talented managers tended to stay in large established companies, but now we are seeing more “professional” management talent willing to work in smaller companies that are managed by GPs.

Lastly, banks are closely working with GPs. On top of mega banks, regional banks have established closer relationships with GPs; banks introduce GPs to their clients as solution providers and in turn, banks provide leveraged finance when deals are complete.

Return expectations
In general, GPs have achieved attractive returns by handling “low-hanging fruit” – a good combination of reasonable entry price, leverage and improvement of profitability through cost cutting and top line growth. The exit market is favorable as well. Except for large deals, which tend to be through auction and therefore carry a high entry price, anecdotal evidence suggests that 20% IRR / 2x of cost is a reasonable expectation for GPs. Although GPs are getting deals on a proprietary basis and there are still many low-hanging fruit deals, GPs are also preparing for more competition and are now focusing more on operational improvements to maintain good returns. Some GPs have introduced an “operating partner” model.

From now on
Based on the above mentioned structural factors in the Japanese market, we expect Japan Private Equity to continue providing interesting opportunities for foreign LPs, even after risk adjustments, including currency fluctuation. Having said that, there are challenges for foreign LPs, such as access to local GPs and how to build a reasonably diversified portfolio (Japanese GPs tend to have a concentrated portfolio in one fund with five to six companies). We recommend they establish closer relationships with local LPs to access local GPs in order to diversify across Japan, in addition to diversifying their portfolio with US and European investments. We are tracking almost all local GPs and can therefore help foreign LPs implement their investment strategies in Japan.

“Is this time different?” Based on what I’ve seen here, I’m confident that this time is different. Although private equity is a long term investment, now is a good time to start having exposure in Japan.