Japan demographics: New normal, new entries

Looming, glacially shifting issues on the scale of Japan’s growing demographics-based pressure have to be negotiated a bit like a Mount Everest expedition. Step back to take it all in, acknowledge the futility of a direct attack, and plot situation-specific inroads that bisect the enormity of the challenge.  

Aging population and workforce decline have been deeply rooted themes in Japan for decades, so investors are used to taking this kind of patient and deliberate tact. But as an increasing sense of urgency brings more attention into the opportunity set, differentiation is becoming a more critical part of the equation.  

According to official data, the current workforce of around 76 million is expected to fall to 54 million by 2050, at which point the over-60 age block will account for almost 40% of the population. About two million Japanese are now turning 70 every year, most of whom retire. That’s almost double the number of people entering the official workforce by turning 18.

To some extent, the timing of this escalation is playing into the hands of investors. Business owners under increasing pressure to sell are making their succession decisions with the economic fallout from the global financial crisis uncertainty and the Great East Japan Earthquake fresh in their memories – all in an environment of relatively stable equity markets and increased acceptance for foreign investment.  

Private equity is set to be one of the major beneficiaries of this context, especially considering the potential for consolidation and the reorganization of fragmented industries. Fund managers will therefore need to tackle Japan’s demographic openings with a heightened awareness of competition and a view to embracing creative, and at times contrarian, approaches.  

“The baby boomers are what everybody is talking about, but the real opportunity in Japan is in the young generation, the new middle class in their 20s and 30s,” says Jesper Koll, head of Japan for WisdomTree Asset Management. “For the people over 65, their purchasing power is going to gradually decline, but if you’re in your 20s, your pay is increasing.” 

Koll sees upside in the demographics issue by classing Japan as one of the few advanced industrial economies where the younger generations will be better off than their parents with better quality jobs and higher incomes. He notes that as the number of university graduates has dropped by about 10,000 every year, their value has increased, with starting salaries for new graduates rising 6.2% in 2017 compared to 5.3% the prior year.

Youth agenda

The outcome is said to be a new upmarket business environment, where young social groups have been filling most of the new positions as employers begin to move increasingly away from part-time work in favor of full-time job creation. This scenario clashes with much of the conventional wisdom about the younger generation in Japan, which is often seen as contributing to the aging dilemma by being reluctant to have children due to financial difficulties. 

As such, the “new middle class” viewpoint helps highlight a divergence in national trajectories regarding household incomes. While recent graduates are enjoying the perks of their own scarcity, a much larger generation of seniors are experiencing a natural decline in earning power. Personal income cycles typically peak at about 55 years of age in developed economies, after which they drop by 30% during the rest of an individual’s working life. 

Roughly a third of Japan’s population is therefore said to be experiencing a wage drop-off at a time when pensions are no longer index-linked to inflation and out-of-pocket medical expenses are slowly edging higher. Meanwhile, concerns about a shrinking middle class are amplified by alarming government data such as Ministry of Labor figures from earlier this year that charted a record number of households on welfare at about 1.6 million.   

This has led to mixed interpretations of the country’s spending outlook and what constitutes an appropriate corresponding investment strategy. Budget-priced household goods, for example, are increasingly on the private equity agenda at the same time as improved sentiment for areas targeting people with increased disposable income such as restaurants and tourism.  

A recent report by Goldman Sachs singled out a number of seemingly antithetical areas of likely growth, including aged care, childcare, pet care, and labor outsourcing. But no matter how the patterns of Japanese life evolve, effective exploitation of the new environment will be a matter of recognizing the impact of demographics on deal sourcing and value-add. Fundamentally, this means that M&A based on succession planning and consolidation will be applicable across almost every facet of the economy.  

“We’re seeing opportunities in changing lifestyles, but at the same time, the shrinking population is also linked with sales decline, which can be a challenge for portfolio companies,” says Greg Hara, CEO and managing partner at J-Star. “That’s why buy-and-build is really effective in Japan. You have to increase revenue and create efficiencies by combining several companies and managing them with a smaller number of people.” 

J-Star reacted to demographic cues in 2014 by establishing an operations team specifically to address consolidation opportunities, noting that during the prior 10 years, the total number of companies in Japan decreased 12% to 3.8 million. Service industries aimed at time-poor families have been a major theme, prompting recent investments in home tutoring and restaurants, as well as a roll-up of the local pet care segment. 

Backdoor entry

When it comes to sector targeting in response to Japan’s demographic changes, however, healthcare remains the elephant in the room. J-Star has been one of the more active GPs in this space, acquiring businesses such as medical insurer Nihon Hoken Service and drugstore chain Aisei Pharmacy. However, a number of factors have been gradually pinching the sector’s potential. 

The Japanese government is notoriously aggressive about regulating healthcare as aging-related demand picks up. This has included firm control of drug pricing, a ramp-up of service quality compliance standards, and the proactive modification of subsidies to keep services as affordable as possible. Margins have subsequently suffered at a time when new entrants, naturally attracted by the aging story, are heating up competition.   

“Healthcare is one of the few areas that directly benefits from the demographic changes we’re seeing in Japan, so those businesses tend to have quite expensive valuations,” says Shota Kuwaki, a director at CLSA Capital Partners (CLSA CP). “But we are able to get attractive entry multiples and exclusively negotiate good transactions by looking on the flipside of the aging trend. These kinds of macro shadow plays – that go against the demographic trends – are the ones that interest us the most.” 

One example of CLSA CP’s reverse approach to aging includes a long-term strategy of engaging the social group that will bear the brunt of the depopulation burden in years to come: children. The firm made what was said to be the first-ever PE deal in Japan’s cram school segment with an investment in BC Ings, an operator of about 70 schools that realized a bolt-on last year of Akasaka Gakuin, a similar company. 

“In general, investors have concerns about children-related businesses because the child population is declining, and it’s seen as a shrinking market,” Kuwaki adds. “But a lot of parents are quite concerned about their kids’ futures in this environment, so the number of children attending cram schools is actually increasing and will continue to rise. Education is an area where people are always willing to spend more money.” 

For J-Star, the concept of the backdoor entry is workable even in the cutthroat healthcare space. Although changes in government medical expenditure policy compelled the firm to exit Aisei in December after a holding period of less than two years, the sector remained attractive – from the right angle. 

This strategy is based on a distinction between care and cure. While high-profile segments that focus on diagnoses and prescribed treatment such as pharmaceuticals have proven prohibitively costly, service-oriented business models have been found to be capable of tapping the same demographic trends but with less unwanted attention from regulators and would-be competitors. J-Star portfolio companies exemplifying this approach include aged car providers Live Cross, Nurse Call and Kairos Tokyo.

“In most areas of healthcare where demographics are driving demand, revenue streams are linked with the national healthcare budget and the government is reducing subsidies to keep fees low,” explains J-Star’s Hara. “We have invested in general healthcare services for the elderly in the past, but nowadays, we prefer niche areas. Hospice care is still a relatively new concept in Japan and contributes to reducing expenses around hospital care services. Thus, it’s out of the scope of regulators.” 

Seeking alpha

In the longer term, the combination of deal targeting modifications based on lifestyle or public policy changes with an increased focus on succession-driven M&A could be only half of the demographics story for private equity. On the fundraising front, the overlap of more intense demand for retirement payouts and a reduced workforce could put pressure on pension funds to improve performance, pushing them increasingly toward asset classes like private equity, which can deliver outsize returns. 

Although pension funds have not been big supporters of private equity to date – private pension plans have some exposure, while public plans have historically steered clear – there appears reason to believe that the scale of the demographics issue in Japan could be enough to change the LP environment in a meaningful way. Earlier support for this outlook includes a decision last year by the Government Pension Investment Fund, the cornerstone of the public pension fund system, to diversify into alternatives. 

“When you see a large shift in the proportion who are not working and being supported by the working generation, you’re going to see a lack of funds in the pensions, which leads to increased pressure to enhance returns through private equity,” says Takahisa Koitabashi, co-founder and COO at Tokyo-based Phronesis Partners. “I don’t see a massive shift toward that in the short run, but it’s a real possibility.”  

 

SIDEBAR: Geography matters - fanning out

Succession age in regional areas of Japan tends to be a bit younger than in the major cities. Industry participants report that on the back of improving sentiment for private equity and a number of demographics-driven economic pressures, it is becoming increasingly common for founder-owners in their 40s and 50s to consider PE-backed M&A opportunities in the regions.

At the same time, labor shortages in these areas arising from an erosion of the workforce at a national level and a globally familiar urbanization trend have combined to leave smaller companies with even fewer options in terms of succession planning. As a result, a number of GPs are tracking a slight uptick in regional deal flow, or at least greater willingness among founder-owners to strike up a conversation. 

“The depopulation and aging trends are major drivers accelerating M&A activity in regional areas,” observes Shingo Kayama, a managing director at Deloitte, noting that his firm has recently established a brokerage unit called M&A Plus to fill demand for deals. “Having said that, the average deal size would be mid to small, which may not attract tier-one PE players.”

While this phenomenon may not result in tidal shift in private equity deal flow from urban to rural areas, it is said to be putting pressure on regional bank revenues and incentivizing lenders to diversify their businesses with similar M&A intermediary services. This could in turn expand the geographic footprint of private equity in a country where GPs tend to cling to the Tokyo and Osaka hubs. 

Jun Tsusaka, managing partner at NSSK, for example, doesn’t see a disproportionate increase in regional M&A due to demographic forces, but he does see an opening for deeper geographic penetration as succession related deal activity increases. His firm claims to be the only GP to set up an office in Nagoya and have a dedicated fund for the surrounding Chubu-Hokuriku region. 

“We were encouraged by local government and financial institutions in that market because they needed a PE partner that could bring not just growth capital but business processes and operational value-add to the table,” says Tsusaka. “So, it was a bit of the market calling us.” 

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• Topics
• North Asia
• GPs
• Consumer
• Healthcare
• Buyouts
• Japan
• J-Star
• CLSA Capital Partners
• NSSK