Mid-cap vs buyouts: may the best financing win

With household incomes shrinking, consumers were trying to save as much as possible, adversely affecting economic growth. Similarly, in the banking sector, lenders cut back loans to maintain their balance sheets and in the process starved SMEs of funds, leaving them unable to refinance their balance sheets, subsequently resulting in bankruptcies, and even greater unemployment and instability.

The Japanese government has considered this situation very carefully, and formed state-owned funds such as ETIC (the Enterprise Turnaround Initiative Corporation of Japan), which operates a JPY20.1 billion ($215 million) fund aimed at investing in failing companies; and INCJ (the Innovation Network Corporation of Japan, which operates a JPY92 billion ($986 million) vehicle, raised from the government and 19 Japanese companies to support local technology and venture businesses. Earlier this month, INCJ made its first investment in the spin-out of the electronic components unit of Alps Electric Co. ETIC has so far made three investments, including Japanese flagship airline company Japan Airlines (JAL), PHS (personal handy-phone system) service provider and Carlyle Group investee Willcom Inc., and Senoh Co., a specialized manufacturer and seller of gymnastics equipment.

Private equity in the downturn

But, with a heavy cloud hanging over the recovery of Japan’s economy, there have been several rays of sunshine as certain types of businesses show resilience and continue to grow. Healthcare and cost-effective lifestyle consumer businesses appear to be solid.

Japanese corporations, with their mature operations, multi-faceted business ideas and special technologies and skills, overall have unrealized potential to grow both domestically and internationally, so long as they have sufficient capital for development and the right manpower to improve their businesses. The recent ETIC and INCJ investments might be promising signs.

Market participants and observers in the private sector report persistently sluggish activity. Sebastiaan van den Berg, Principal at HarbourVest Partners (Asia) Ltd., said, “The Japanese private equity market has remained soft since the global financial crisis; both in terms of the amount of capital raised and the amount deployed. To the extent that large buyouts did occur, they were mostly secondary buyouts. Since the beginning of 2010, we have observed some signs of pick-up in deal activity, but the deals completed were typically of smaller enterprise value.”

Indeed, there were very few of the major transactions investors had long sought in Japan. The $1.68 billion acquisition of USJ Co., Ltd./Universal Studios Japan by investors comprising Universal Studio’s Chairman Glenn Gumpel, Goldman Sachs (Japan) Ltd., MBK Partners  and Owl Creek Asset Management; Bain Capital’s $1.1 billion investment in Bellsystem24, Inc.; and the Carlyle Group’s acquisition of restaurant chain Chimney for $231 million were the three largest deals of 2009.

 “Overall, restructuring of major industries has not been aggressive enough,” Hiroshi Nonomiya, Managing Director of RHJ International Japan, observed. “Actually, most large transactions have been derived from corporate failures or divestment by distressed parents or by non-Japanese parents.” As a result, he warned, “such industries have missed the opportunity to build up globally competitive businesses through consolidation by removing overcapacity. This was exactly the main thesis of discussion which led to the establishment of the IRCJ in 2003.”

Macro market and local market

Nonomiya cautioned that the situation facing Japanese companies in 2010 “is significantly different from the status quo ten years ago. It might be too late for some industries to be globally competitive, but private equity could work as a valid means to transform a business from a traditionally stable one in the Japanese market to one with a different strategic view and enhanced execution capability to compete in a much broader marketplace.”

Hiro Mizuno, Partner and Head of Asia at Coller Capital said, “We have been long looking forward to high deal volume in Japan during the long period of deflation after the Japanese financial crisis, but have been disappointed. It still seems like persistent high resistance to financial owners.”

Tamotsu Adachi, Managing Director of the Carlyle Group, said, “Buyouts have become more accepted by companies in Japan over the past few years, but [the market] has not developed as we expected. However, there are signs of recovering buyout activity as the economic situation improves, and I think that banks are ready to provide debt for good deals, albeit with a more conservative leverage.” He added that part of the reason for fewer large-sized deals in the market is that Japanese corporates are very cautious about spinning off subsidiaries, and also that it is very difficult to improve or change operations within a portfolio company due to the strong corporate cultures that exist.

Not all participants see so bleak a picture, though. A spokesperson for local buyout firm Advantage Partners said, “Generally we are seeing an increase in the number of new opportunities in the Japanese private equity market, along with a decrease in the price gap between buyers and sellers … As for activities in the near future, sales of subsidiaries and operating divisions or industry/market consolidation/reorganization are expected to resume, and may become a pipeline for opportunities in Japan. We believe founder/owner succession deals will also be another major source.”

HarbourVest’s van den Berg added that “private equity managers may find potential in mid-sized companies that are well-positioned to expand their businesses, and in the sale of non-core assets as conglomerates aim to focus on their core businesses.”

Movement in smaller deals?

Compared to the US and Europe, Japan’s private equity industry is still relatively new, and therefore is still developing. Post the GFC, what is the current direction of its evolution in Japan?

Mid-market firms, for one thing, see more attractive prospects. Masao Nakagawa, Senior Director of Nippon Mirai Capital, said, “The number of deals has been decreasing due to limited leverage, but the number of Japanese companies that seek business solutions from private equity seems to be increasing. It is essential that we should not be too dependent on leverage for investments.”

Ayumi Sakurai, Co-Representative Partner of Valiant Partners, said that corporate owners were initially quite cautious and wary about working with private equity after the onset of the GFC, but now the situation has gradually improved. In addition, he said, “Buyout activity shows some signs of resumption, together with core leverage providers, including local lenders.”

Ryosuke Iinuma, Partner at Ant Capital Partners, said, “Buyout funds started off by acquiring small-to-mid-cap companies, and then shifted to larger-scale deals for a time. Now the core market for private equity firms is returning to SMEs, due to the corrent economic environment.” Additionally, he noted, “What we have not seen is any increase of the spinoffs or divestment deals from conglomerates that we expected to see. M&A should be increasing due to competition among players, but the reality is that not many deals are materializing.” He believes business succession deals and private companies put up for sale by owners - all below JPY10 billion - will continue to rise.

Although most private equity players said that investments are gradually re-emerging, prices are still down, and there may not be many big-ticket deals in Japan. However, GPs predict that some significant wins might materialize over 2010-11.

Regarding investment in SMEs, Ant Capital’s Iinuma agrees that further growth can be expected in this space. He explained that exit opportunities for these types of companies would be much easier to negotiate. “It is possible to sell portfolio companies which we acquired for an enterprise value of about JPY10 billion, and see 2 or 3x returns.” 

“Given the limited number of large buyout transactions available, we expect to see managers trading down and investing more actively in the mid-market segment,” added van den Berg.

As to what the SMEs themselves might be looking for, RHJ’s Nonomiya said, “I keep hearing from management of mid-sized companies and heads of divisions in larger companies that acquisitions in the international market are indispensable to capture the growth potential and drastically transform their business. But because of lack of internal resources, they cannot be bold enough to step into such cross-border acquisitions, in particular because of post-acquisition management. Thus, they might miss the opportunity forever as such opportunities are often one-offs.”

Potential issues for private equity

With the potential – at least for smaller deals – on the rise, AVCJ asked GPs what concerns and issues they are currently facing. Kurosawa replied, “Foreign firms have capital, but may face difficulties in closing deals, while local funds receive numerous offers of potential deals. Independent funds in particular are experiencing a shortage of capital.”

Megumi Kiyozuka, Managing Director at CLSA Capital Partners, said, “The size of the private equity industry in Japan has become more balanced in terms of deals, after numerous funds have halted investments, or have withdrawn from Japan. I think funds that can collaborate with investee management for operational support – funds truly determined to act as partners with investee management – will survive in this market.”

Kensaku Mizutani, Partner of Integral Corporation also said that the number of private equity players in Japan now exceeded the available deals, adding that winners and losers would be clearly distinguishable from now on.

Tatsuo Kawasaki, Managing Director of Unison Capital Inc., said, “There are spaces for private equity to provide risk capital to Japanese companies while lenders are tightening. The current economic situation is better than in 2009, but it is still difficult to find financing for closing JPY200 billion [$2.1 billion]-class deals. With or without large debt financing, there are many investment opportunities with deal sizes between 5 to 10 billion yen [$53.6-107 million] to buy shares of small to medium size companies. These opportunities are partially [aimed at restoring the] balance sheets of target companies and partially to support their growth initiatives.”

He also noted that a number of large conglomerates are pushing through restructuring plans for their business portfolios. These sellers are looking at private equity funds as the one source which could provide capital and necessary support for future growth of the target companies by purchasing existing shares or through a straightforward capital injection.

As this illustrates, Japanese corporates are slowly realizing that private equity is the one source that could provide capital and additional value.

RHJ’s Nonomiya explained that private equity firms could play a meaningful role for mid-sized companies or even divisions of larger organizations by identifying acquisition or investment targets, providing human resources to better deal with post acquisition management and helping to achieve value creation through the integration of or separate listing of acquired business.

Mizuno at Coller Capital remarked that the “large buyout space failed to produce a very successful track record here.” But he added, “Given the quality, operational efficiency and technological sophistication of SMEs in the country, I have been always positive for prospects [for investment in] SMEs.”

“The attractions of investments in SMEs are: the wide range of investments and acquisition at attractive prices without auctions,” said Nakagawa at Nippon Mirai, while Kiyozuka added that the degree of improvement would be much greater when private equity becomes involved in management support of SMEs. He noted that exits of SMEs are considerably easier.

Offsetting the decline

With the economy remaining tight or experiencing at best a slow recovery, many companies facing business decline or a slump in demand are keen to find third-party helps and advice in order to improve their situation. Private equity’s prospects of being a sought-after partner for more than just equity support are growing correspondingly greater.

So what do Japanese corporates want from private equity? Sakurai at Valiant Partners said, “Generally speaking, Japanese companies do not clearly recognize what they should seek from private equity investors. But Japanese companies have slowly grown to understand that private equity firms could be good business partners as the private equity model has emerged in Japan over the last ten years.”

Meanwhile, with the government’s moves to bolster Japanese companies, state-backed funds with similar investment strategies to private equity could support, but might also threaten, the future activity of local private funds. 

Adachi at Carlyle said, “ETIC will turn around companies which would be find it hard to obtain forgiveness of loans by lenders. After portfolios increase their corporate values through ETIC’s involvement, the group will exit from the investments, providing opportunities to potential buyers, including private equity funds.”

Nakagawa at Mirai Capital, shared this view, saying, “We think that government should adjust investment policies such as taxation and legislation to encourage privately-held organizations to receive enhanced returns from investing risk capital in companies.”’

“We hope that private equity will become well known within the local community as a [way to] help companies increase their corporate value through the government fund activities in Japan,” Integral’s Mizutani said. However, he added that there are concerns about the allocation of public capital only to government private equity funds, as this does not necessarily support private market growth and development.
Sakurai at Valiant noted that the IRCJ and private equity funds shared the investment market in the early 2000s, and that privately-held and publicly-held vehicles could have complementary operations in Japan.

However, CLSA’s Kiyozuka added, “Although we have never competed with government-backed funds so far, I am afraid they [may be] crowding out privately held funds,” and thwart the growth of a healthy private equity market.

LP environment and local acceptance

With private equity slowly winning acceptance in Japanese society for its transformative value add, questions remain about how to foster a more active investment environment. Nakagawa at Nippon Mirai said, “Although there is a new tax policy on offshore LPs’ investments in Japanese funds, we hope to have a better environment to attract offshore investors to put their capital into Japan’s private equity firms. At the same time, privately-held funds need to make returns from investing risk capital.”

“We believe Japan will continue to present some attractive investment opportunities,” HarbourVest’s van den Berg concluded. “The Japanese banking system is relatively strong, as most banks have not suffered as much from the global financial crisis as banks in Europe or the US. We observe a continued willingness among Japanese banks to provide leverage for buyout activity and to support struggling portfolio companies through the downturn.”

Time will tell.

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• Topics
• North Asia
• Performance
• Buyouts
• Buyout
• Coller Capital
• Tamotsu Adachi
• Megumi Kiyozuka
• Hiromichi Mizuno
• Takashi Nakagawa
• Advantage Partners
• Ant Capital Partners
• Bain Capital Asia
• The Carlyle Group
• CLSA Capital Partners
• HarbourVest Partners
• MBK Partners
• Nippon Mirai Capital Co.