Revitalizing Japan's conglomerates: Big ticket

Stakeholder pressure to divest non-core assets and shore up balance sheets has been the biggest driver of corporate carve-out deal flow and a discrete theme among Japan’s overdiversified conglomerates since the 1990s. In more recent years, this backdrop has been complicated by parallel imperatives to digitize business models and modernize the industrial backbone of the country.

How these two forces react against one another in the years to come will decide nothing less than the fundamental long-term profile of the world’s third-largest economy.

For private equity investors, Toshiba is the most straightforward entry point for exploring the phenomenon. The sprawling electronics maker highlighted the trend in dramatic fashion last year with the sale of its memory chip business to a Bain Capital-led consortium which, at $18 billion, marked Asia’s largest-ever PE buyout. Much less ballyhooed at the time was the fact that the deal coincided precisely with the unveiling of an agenda for the new war chest called the Toshiba Next Plan. 

Toshiba Next says much about how tactical industrial changes are increasingly motivating Japan carve-out opportunities, even as financial performance-driven pressures to streamline business structures and improve governance persist. The plan calls for big new forays into cyber-physical tech, specifically with a view to leveraging artificial intelligence (AI), robotics, and biotech into modernized approaches to sectors facing changing demands at the societal level such as energy and urbanization. It’s thinking a little beyond conventional smart cities, and light-years past household appliances.

“The conglomerate scenario in Japan needs to change. The electronics giants are suffering from discounts and recognize they have to focus on their core businesses, but that also needs to include a digital strategy and a change in business model,” says Tom Noda, a Tokyo-based managing partner with consulting firm AlixPartners. “But it’s not just a business model shift – it’s a value chain shift. Japanese conglomerates have enjoyed manufacturing dominance for a long time, but now they need to provide more solution-type services.”

This view reflects a growing awareness that Japan’s leading corporations are approaching a critical crossroads, where some will be usurped by digital-savvy upstarts, while others form the basis of a new oligarchy for a more virtual economy. In-house capability development will be difficult, given inherent local challenges around talent availability, especially in areas such as AI. Therefore, the switch from hardware to software will require acquisitions, which will be financed by conglomerate divestments, thus driving M&A activity from multiple angles.

After the storm

Japan is tracking significant progress on the issue of conglomerate inertia, with return-on-equity among listed brand-name corporates now averaging around 10% versus 3-4% only six years ago. But local electronics heavyweights are still considered underperformers globally due to the operational drag of having divisional business interests sometimes numbering in the hundreds and a tendency for sister subsidiaries to agree contracts with each other outside of market pricing norms.

Regulatory moves to enforce stricter profit targeting and increase the presence of external corporate directors have helped, but it is a slow cultural process. Likewise, the idea of a uniquely Japanese business support network, or keiretsu, is eroding steadily to the benefit of more rational market behavior. However, the idea still appears strong enough to prevent the emergence of a General Electric-style conglomerate, where a highly diversified family of subsidiaries can be kept competitive under a single CEO through hard-nosed internal governance.

Still, the worst appears to be over for conglomerates. The cracks began to show in Japan’s economic slowdown known as the Lost Decade, which is often seen as extending from the mid-1990s to the global financial crisis, thereby overlapping the gamut of competition pressures for hardware during the dawn of the internet. Standout casualties of this period include Sharp, which went on to accept a $6 billion bailout from Taiwan’s Foxconn in 2016 after a string of heavy annual losses. It marked the first time a foreign entity had taken over a major Japanese electronics player.

“The top tier conglomerates are important for Japan’s macroeconomy. The Japanese electronics industry was devastated by the shift from analog to digital technologies in the 2000s,” explains Willem Thorbecke, a Tokyo-based economist with the Research Institute of Economy, Trade & Industry.   “Consumer goods became commoditized. Japan’s traditional advantage in craftsmanship meant little when low-cost producers in Korea, Taiwan, or China could build high-quality consumer electronics goods from their constituent parts.”

Few industry participants predict that Japan will become a global leader in digital, but the trend toward the servicification of production could play to the country’s traditional strengths around customer experience which, as a discipline, is expected to remain relatively concrete in nature. As a result, the move from asset-intensive to knowledge-based industries will not necessarily mean the substitution of hardware for a focus on intangibles such as intellectual property (IP).

Osaka-based sensor maker Keyence reinforced this point in May when it reported an annual profit margin of 54%, breaking its own record for the seventh straight year. This was achieved with a relative lack of IP competitiveness by focusing on a goods-plus-services approach that has prioritized data usage in sales efficiency, R&D, and tailored product packaging for clients.  

The urgency to move toward digital technologies and services is perhaps best embodied in Toyota, however. The carmaker’s transaction activity in recent years offers a clear narrative about the evolution of the equipment-based transportation industry into the more nebulous “mobility” space. The most visible of these has been the launch of a JPY300 billion autonomous driving technology investment program and several investments in ride-hailing company Grab. One contribution of $1 billion to a funding round gave Toyota’s product rollouts access to the start-up’s subscriber base and fleet data.

By comparison, the efforts of companies such as Hitachi appear less transparently motivated by financial stresses or a sense that their core hardware industries are disappearing into wholly separate cyberspace. Since launching its Lumada innovation program in 2016, major investments include the acquisition of an 80% stake in Swiss power grid technology company ABB for $9.4 billion and a 49% interest in Italian rail equipment maker Ansaldo for $1.4 billion. Last month, it confirmed a $1.4 billion buyout of US smart manufacturing supplier JR Automation.

There have also been divestments, such as a 60% stake in a Japan-based air conditioning subsidiary called Johnson Controls for $2.5 billion and Japanese audio-visual equipment supplier Clarion for about $1.4 billion. Meanwhile, KKR took majority control of Hitachi’s Koki (power tools) and Kokusai Electric (high-tech manufacturing) divisions at valuations of JPY147 billion and JPY322 billion, respectively. The private equity firm is now reportedly in the running alongside Bain and The Carlyle Group for a 51% stake in Hitachi Chemical.

Picking winners

For many analysts, the key takeaway is that most conglomerates are now divesting in a steadier way that rings more of strategic reinvention than fire-sale desperation. Hitachi, for its part, has pledged to reduce its number of group companies from 800 to 500 by 2022. If this encourages a broader pattern in Japan’s conglomerate universe – which is widely expected – private equity will have more exposure to carve-out opportunities, but perhaps all the more reason to be cautious.

“Hitachi is a model case on how to do this. It’s very measured with the integration of new businesses and the de-integration of other businesses,” says Jesper Koll, senior Japan advisor at WisdomTree Asset Management. “On the other hand, a company like Toshiba is running a conglomerate margin of 3.5% and targeting 5% even though its global peers are 10-12%. But at the end of the day, there’s still enormous upside with companies like Toshiba defining new core competencies. I think the main red flag will be if those companies say they’re going to become the next Alibaba, because they never will be.”

Identifying the most likely winners in this transition will be a deeper matter than simply recognizing traction in the replacement of traditional hardware with intelligent systems or assessing the market share represented by various service subscriber footprints. Instead, the differentiator will be in knowing how to capture the value of software as it begins to drive more of the physical world, and then how to capture the value of the data that is generated by that process.

In Japan, the first crop of homegrown internet companies to achieve scale with these skills includes Rakuten, Line Corporation and Gree, multidivisional entities in their own right that are increasingly seen as significant motivators for strategy pivots among their manufacturing counterparts. This trend could accelerate further as the likes of Bain and KKR continue to introduce international best practice to deal discovery and diligence, and a more global brand of digital competition finds new inroads.  

“The internet newcomers, including Amazon, Google, and Facebook, have been diversifying their digital portfolios in a conglomerate way, but they’re doing it with higher value creation,” says AlixPartners’ Noda. “They’ve done a lot of failed trials, but they’ve been courageous about diversifying, and they’ve been creating higher value across the value chain and finding synergies with companies that are more interesting in the capital markets. They pose a serious threat to the traditional conglomerates.”

One of the more noticeable ramifications of this effect has been the proliferation of corporate venture capital funds – an almost unheard-of phenomenon in Japan as recently as six years ago. But this is only a game for the parent companies. The smaller divested assets will be insufficiently resourced to achieve much modernization internally, playing nicely to the strengths of private equity. Most of the opportunity here will continue to focus on data-related operational improvements, but increasingly, it will also include the use of technology to enable the broader repositioning of corporate value propositions.

“In most businesses acquired by private equity in Japan, there is an opportunity to apply a more technology-enabled data-driven management approach as part of a GP’s playbook to improve operating decisions, enhance revenues and reduce costs,” says Paul Ford, a partner at KPMG in Japan. “One major variable across these situations, however, is the degree to which the core investment thesis itself is driven by technology shifts and related opportunities within the subject business and industry, versus technology as a tool simply to improve as-is operations.”

Practical considerations

Ford adds that private equity players will not be at a disadvantage vis-a-vis strategic investment from a technology perspective, especially considering their ability to continually upgrade tech talent and horizon-scan globally for new sector trends. The opportunity is offset, however, by a tendency for carve-outs in Japan to present plentiful operational enhancement opportunities even before looking at more intensive digital transformations.

In the macro, these inputs will result in some form of begrudgingly digitalized economy dominated by a mix old and new conglomerates, all stirred up by a more internationalized M&A market, itself characterized by a blend of familiar turnaround plays and new strategic repositioning opportunities. To be sure, technological advances are driving much of this transformation, even where deals appear rooted in the conventional. But for investors, the most immediate pitfalls will have more to do with basic supply-demand economics than innovation.

One of the subtler undercurrents of the reboot among Japanese conglomerates is a creeping pressure on carve-out valuations as investors direct rising levels of dry powder toward a slowly developing theme. KKR’s latest pan-Asian fund, for example, closed in 2017 at $9.3 billion, a more than $3 billion increase on its predecessor. Meanwhile, last year Bain scaled up from $3 billion for its third Asian fund to $4 billion for its fourth. The prevailing sentiment is that if the buildup in firepower outpaces the macro story, old deal sourcing hurdles could offset the promise of a new tech-based thesis. 

“Overall deal flow volume is still at such levels that any trends are a bit anecdotal, but we are seeing more flow of large divestments of $500 million to $1 billion and up than we did a few years ago,” says Jim Verbeeten, a partner at Bain & Company. “But an increase in deal flow is not the same as good deal flow. We see quite a few attempted sales of unattractive, underperforming assets. Sometimes it’s a business in a declining market. Sometimes it’s a business that should be global but is limited to the domestic market due to its cost position. Private equity might not be able to help there because those companies probably won’t be competitive enough to survive on a global scale.”

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• Topics
• North Asia
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• Industrials
• Buyouts
• Japan
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