Japan digitization: Easy targets, hard to hit

When Japanese private equity firm NSSK acquired Bunkasha Publishing, the 80-year-old manga comics company was part anachronism, part stereotype. Paper was everywhere, and artists and editors had wooden pencils lodged behind their ears. The CEO was using a flip-open mobile phone – in 2017. NSSK calculated the business would go bankrupt within five years.

A digitization drive had already been initiated, but there was only one person working on it in-house. Meanwhile, the pain points of remaining analog in a digital world were intensifying. Bunkasha had to estimate how much to print and absorb the cost of returned copies, while still paying royalties to authors and juggling paper and ink expenses. A good EBITDA margin for this model is 4-6%.

Digital transformation in cases such as this is not exactly rocket science. The technological aspect was mostly as simple as incorporating paperless illustration tools and converting content to a PDF format. This not only streamlined production processes and opened up intellectual contracting prospects with e-booksellers, but it also revitalized a warehouse of back issues for 8,000 titles by bringing them online for the first time.

NSSK accepted the challenge based on several fundamental strengths, including a leading sales position in certain manga genres, as well as a loyal, longstanding, and mostly female readership. It also noted that manga has proven to be a category where users are willing to pay for online content rather than seek illegal free downloads.

With management support, the investor reshuffled leadership, recruiting a digital department head from local e-commerce giant Rakuten, and redirected the company economics to favor the best performing business lines. By the time Bunkasha was sold to internet content provider Beaglee last year, almost half of production output had gone online.

Digital revenue increased 50% during the holding period, with thousands of new releases distributed, and came to represent about 70% of overall earnings, while the EBITDA margin grew to 20%. NSSK realized a 3x return and a 40% IRR on what was its second-largest investment at the time of acquisition.

“In Japan, the three tenants of conventional wisdom are: don’t mess with the business strategy, don’t change compensation systems, and don’t change seniority systems. We violated all three, which was the reason we were successful,” says Jun Tsusaka, a managing partner at NSSK. “Just because you’ve been doing it one way for 80 years doesn’t mean that’s the right way in the digital world. Changing that mindset and getting buy-in from the management is the only way to survive.”

Global laggard?

A distinctive cultural export like manga makes for a fitting case study on digital transformation in Japan because so much about this opportunity set is colored by a uniquely local style. The country is in an odd position in that it doesn’t have the robust digital innovation industry like many other developed markets nor the leapfrogging technology adoption benefits of emerging economies.

Instead, it has a population of 3.8 million mid-sized companies established between the 1960s and 1980s that either don’t know they need to change, don’t know how, or simply can’t justify investing in systems they don’t understand. Digital talent is sparse and usually finds its way to a handful of brand-name service providers, leaving the broader business sector without sufficient in-house strategic guidance.

According to McKinsey & Company, a mix of developed and developing countries represent best-in-class when it comes to digitization, but Japan is never among them. For example, only 9% of Japanese retail is online (versus 24% in China); digital talent represents 1% of the workforce (3% in the US); penetration of mobile banking is 6.9% (35.2% in China); and telemedicine penetration is 5% (31% in Saudi Arabia).

COVID-19 has brought these shortcomings into clearer focus and, last month, prompted the government to establish a “Digital Agency” that will employ 500 officials. “The delay in digitization of the bureaucracy and private sector has become apparent,” then-Prime Minister Yoshihide Suga said following the launch. “Japan cannot move forward unless we take the plunge with digitization, for which we need a strong command tower.”

This could be an important development for private equity as a signal of a much-needed cultural shift and high-level buy-in for the concept of digital transformation. Most GPs recognize this aspect of operational value-add as a challenge of hearts and minds, not widgets, and consequently approach management with due diplomacy. Talking business rather than technology is the preferred inroad.

“We start with a strategy-driven approach. What is the purpose of this kind of work? What do we want to get out of it? People tend to want to use a more bottom-up approach with digital transformation, but you can lose sight of your original target,” says Hiroshi Hayakawa, a partner at Advantage Partners who leads digital transformation in the buyout portfolio.

“We try to keep our minds at a high business strategy level, and if there’s a certain action is needed, we can allocate for that. However, in reality, in the middle market, our first step is usually to make legacy IT systems cloud-ready.”

Strategic alignment

This exercise is mostly a matter of running the numbers, showing that non-digital processes are unsustainable and how other players that failed to evolve have gone bust. Next steps involve onboarding new systems and tools, guidance on engaging a new set of stakeholders, and bringing in the necessary talent. The last of these is arguably the most uniquely challenging in a Japan context.

Advantage’s solution is a partnership with NTT Docomo. The local telecoms giant has anchored a fund under Advantage’s public markets strategy – known as Private Solutions – and offers technical support across the broader portfolio.

Recent investments include coffee shop chain Saint Marc, which has recorded slumping sales in recent quarters as it faces pandemic-related pressures with an underdeveloped digital strategy. Transformation is still in the planning stages but there is an intention to implement customer engagement management technology, with Docomo also supporting data-driven advertising and cafe location selection.

“It’s hard for retail, restaurant, and B2C companies like that to hire IT experts, so it’s useful for us to help them recruit a digital transformation head and eventually building out a department of several people,” says Noriatsu Furukawa, a partner at Advantage who leads the Private Solutions strategy.

“Due to the higher salaries, that requires a different structure, so we commit that talent across several companies. Those teams also get support from NTT Docomo.”

Although they struggle to attract digital talent, retail and B2C businesses benefit from more direct paths to bottom line improvement through transformation versus B2B areas such as manufacturing. Effectively, data about customers represents intuitive new revenue streams and easily monetizable insights, while smart factory upgrades, for example, represent a longer-dated cost-saving paradigm.

In industries where the fruits of a digitization program take longer to come to light, private equity investors need to flex their people skills. For CLSA Capital Partners, this is being put into practice in one of Japan’s most stubbornly conservative industries – automotive.

The GP acquired Hokuto, a manufacturing systems supplier for the likes of Toyota, General Motors and Tesla, in February with a view to putting its global data sharing procedures on the cloud. The longstanding practice – burning data onto USB thumb drives and physically delivering them clients – was an efficiency and security disaster. The company could see that it needed revamping, but management wasn’t prepared to take the risk.

“People don’t want to be held personally liable for trying to carry out digital transformation projects, so it helps for PE to come in and take the lead. But the biggest challenge is still explaining why we are incurring the cost,” says Shota Kuwaki, an executive director at CLSA CP. “It’s typical for companies to focus on the upfront expense of IT personnel and consulting firms, so we really have to explain the big picture and benefits they receive from the return on investment.”

Systems upgrade

CLSA CP has also been active in healthcare, which is commonly flagged as one of the most difficult sectors to digitize due to its large teams and a strong human nature factor. For example, persuading veteran nurses to take up new ways of treating patients can be a delicate process. Still, Masamune Konakamura, a vice president at the firm, notes that because medical institutions have significant budgets and a larger market size, they can adopt digital transformations more quickly.

Dentistry is another matter, especially in Japan. There are more dentist clinics in the country than convenience stores, and most of them are mom-and-pop operations. Less than 20% of these businesses, which number some 68,000 in total, have virtual private network (VPN) access for managing patient data and interactions with insurance companies.

CLSA CP tackled this space in 2018 with the acquisition of an 85% stake in Nhosa Corporation, an IT provider specializing in dental clinics, for about JPY8 billion. It made a partial exit in February to Tokyo-listed healthcare IT player EM Systems but retains a majority position. Nhosa started in 1979 as a packaged software seller and graduated to cloud infrastructure to fill the VPN hole. It now has more than 9,500 dentistry clients.

“Companies in Japan have been spending big on customized IT systems, but there are so many venture companies providing cloud-based services out there now, you can get better results for less money,” says Konakamura, who led the deals for Hokuto, Nhosa, and Rise Consulting Group, a service provider helping modernize Hokuto’s file sharing system.

“Those cloud services don’t sound that advanced, but the midcap companies, especially, are slower in adopting these new services and behind from a digital transformation perspective. What they need is more like basic IT as a starting point.”

This is a fertile theme for venture capital. Although Japan’s fledgling start-up space is mostly known for consumer-oriented success stories such as e-commerce players Mercari and Paidy, it has a strong B2B bent and corporate VC presence. As a result, the ecosystem is gradually beginning to attract the digital talent that historically has channeled into groups such as Fujitsu or NEC.

One of the start-ups most directly leveraging these themes is Herp, a human resources software-as-a-service (SaaS) provider that is handling talent management, applicant tracking, and job description creation for Digital Agency. It received a JPY950 million Series B round this month featuring DCM Ventures, Money Forward, Japan Finance, and DNX Ventures.

DNX, a B2B specialist formerly known as Draper Nexus Ventures, focuses on horizontal SaaS plays and therefore has exposure to transformation-resistant industries, including automotive. Kyohei Mukaigawa, a principal at the firm, observes that in some of these areas, start-ups are active, but they’re not necessarily getting access to the true pain points.

“We’ve seen a lot of start-ups in things like consumer services or customer relationships, but in order to really make an industry efficient, digital transformation has to go into the back-end systems and the core of the manufacturing plants,” he says. “In that sense, it’s been superficial.”

All in the mind

Service provider headwinds like this are yet another reminder of the psychological – rather than technological – nature of digital transformation in this market. And it’s one of the reasons NSSK tapped its “philosophy program” and “happiness index” strategies during value-add work with Bunkasha.

The idea involves an understanding that digital transformation plans are often targeted at struggling companies and industries – places where cost-cutting is the mantra and morale is low. This requires working closely with staff who might feel expendable as well as keeping the most essential talent from leaving the company by tying compensation schemes to performance, not seniority.

Japan is not an easy market to do this, although it is one of the most in need. When companies are digitized, young professionals tend to begin outranking their older colleagues, causing cultural chaos. In the case of Bunkasha, this process involved bringing in a woman in her 40s – some 10 years younger than the existing all-male leadership – as head the company’s now-dominant digital division.

“Not all PE firms have the experience or personnel for digital transformation, so you outsource to parties that have the tools and software packages you need. But the training and education element is key. That’s where PE firms need to spend a lot of their internal resources, time, and attention,” says NSSK’s Tsusaka. “You can’t just have these digital people flying in and flying out. You need everyone in the company to be fluent in the digital world to be successful.”

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• Topics
• North Asia
• Technology
• Support services
• GPs
• Advisory
• Consumer
• Healthcare
• Industrials
• Japan
• NSSK
• Advantage Partners
• CLSA Capital Partners
• digitalization