The Abe effect: Japan's economic reforms

When Japan's bubble burst in the early 1990s the period that followed was meant to be a lost decade. By the time the global financial crisis hit in 2008, followed three years later by a devastating earthquake and tsunami, it was clear the lost decade was more like two lost decades. By 2011, Japan's public debt had surpassed $13.6 trillion - at around 230% of its GDP, it was the largest percentage of any nation. Sagging economic growth and an aging population didn't help matters. 

Last December a new government came to power under Prime Minister Shinzo Abe with promises of drastic action to fix Japan. The Liberal Democratic Party (LDP) leader is an unlikely comeback kid, having ended his previous tenure as prime minister in 2007 after just one year in office. But following December's landslide election victory - and enjoying support from both the upper and lower houses of parliament - Abe is back and he has pushed through unprecedented economic reforms.

The markets have responded favorably, with the Nikkei 225 Index up 25% so far this year - although the initial impact is purely psychological. "I think foreign investors are interested in Japanese stocks not so much because of particular policies but because of the indication that policy makers are leading the country in a different direction and have indicated at least where they want to take it," says Joji Takeuchi, CEO of Tokyo-based consultancy Brightrust.

The "Abenomics" policy package has been described as a "three arrows" approach comprising monetary, fiscal and structural measures. Together they aim to tackle Japan's three economic problems of slow growth, deflation and a dependence on deficit spending. The idea is that on its own each policy can broken, but implemented together they cannot.

The first steps were taken earlier this month when Haruhiko Kuroda, newly installed governor of the Bank of Japan (BoJ), launched an aggressive monetary expansion campaign. It includes an annual inflation target of 2%, negative interest rates and increased public investment. In total, the bank plans to pump about $1.4 trillion into the economy over a two-year period in order to break Japan's deflationary cycle.

"The plan is to double the monetary base between now and the end of 2014," says Nicholas Smith, Japan equity strategist with CLSA in Tokyo, who describes Abenomics as a "print, pump and shape up" strategy. "At the moment the assets of the BOJ are about 33% of GDP, and they want to take that up to 60%. By comparison, the US Federal Reserve's assets are around 20% of GDP, so we are in totally unchartered territory."

Exits impact

So far, what has this meant for private equity? One of the short-terms effects, driven by the capital markets resurgence, has been an increase in IPOs. Last month, the Japan Venture Capital Association said it expects a 67% jump in public offerings this year with 80 new issues compared to 48 in 2012. Most of these are likely to come in the information technology sector, particularly in the social networking space.

A recent example has been The Carlyle Group's exit of its majority stake in software company Broadleaf, which generated JPY24.4 billion ($253 million), the private equity firm's second Japanese IPO in three months. The trend for more offerings is supported by data from AVCJ Research which show that the number of PE-backed IPOs in the country has increased every year since the global financial crisis. In 2012, there were 36 offerings on various Japanese bourses, which collectively raised more than $9 billion in total. Ten of those were in the information technology sector.

However, not all lucrative exits have come via IPO. KKR generated a 5x money multiple on selling recruitment service firm Intelligence Holdings to Temp Holdings for JPY68 billion last month. The PE player claims to be positive about the impact of Abe's policies and it has been busy bolstering its Japan team in recently, with three new hires taking the total headcount to 12.

"KKR views the Abe administration of one encouraging industries to grow and be more profitable," says Shu Minoda, CEO of KKR Japan, who expects investment opportunities to increase under the new leader. "As such, companies in Japan will find more value in partnering with a global private equity firms like KKR, which can work with Japanese companies through local teams and also by connecting them to their global network."

Global buyout firms have been more active in Japan in recent months, but it is debatable how much this is to do with Abenomics. Private equity investment has held steady at around $8 billion in each of the last three years - up from the post-global financial crisis slump but well short of the 2007 peak of $16.8 billion - although buyouts specifically have risen sharply. Control deals generated $6.9 billion in 2012, compared to $4.6 billion in 2011 and $2.5 billion in 2010.

"Generally, Japan is working off a pretty low base for private equity volume," says Josh Porter, a managing director with Advantage Partners in Tokyo. "There isn't a lot of room for volume to go down. So, with other positive trends, we are fairly optimistic about the outlook, irrespective of macro policy changes."

Although improving public market valuations have made the IPO route more attractive, it will still account for only a small minority of Advantage's exits. Porter notes that Abenomics has helped on a more general level by inspiring confidence among trade buyers and there is ongoing robust demand from corporate and other funds.

Industry practitioners expect to see more activity on the secondaries front in particular as large pan-regional funds pick up companies from country-focused GPs with a view to expansion outside of Japan. Permira's $1 billion acquisition of sushi chain Akindo Sushiro from Unison Capital was one of thestand-out transactions in 2012.

Double-edged sword

At the same time, higher public market valuations and strategic interest can make life tougher for GPs on the investment front as prices increase. However, not all see it as a bad thing. "I would say the effect is both good and bad to be honest," says Greg Hara, president of Tokyo-based mid-cap buyout firm J-Star. "Prices will go up but I believe this will be justified by leverage finance factors. Thanks to the BoJ's policies, banks are very keen to provide financing to increase returns on their assets."
Advantage's Porter adds that increased valuations reflects the growth opportunities in Japan, stressing that valuations have been low for such a long time that the recent jump is more a case of normalization rather than unwarranted inflation.
Distress-focused investors are unlikely to be so cheerful. Restructuring Japanese corporates, particularly in the electronics industry, is seen as a rich source of potential deal flow as evidenced by Advantage's recent acquisition of Sanyo Electric's digital camera unit. But improving macroeconomic conditions and the availability of cheap financing ease pressure on companies to divest.

In the four months since Abe returned to office, the yen has dropped 20% against the dollar, turning around the fortunes of export-oriented businesses. Sony, for example, appears to have stopped the rot by announcing a loss of just JPY10.7 billion in the final three months of 2012 compared to JPY158 billion in the corresponding period in 2011.

Porter, however, feels these opportunities may still persist, especially where corporates are beleaguered by structural issues in addition to weaker exports. "Certain companies have been fairly active in looking at selling off assets and that is been driven by challenges in the market and overseas competitors," he says. "If they see the macroeconomic environment is improving and that their fortunes might improve, it's possible they may hold off but I don't think that is necessarily the case."

Long-term gambit

The rebound in investor confidence that is the root cause of these private equity trends, while encouraging, doesn't represent a long-term fix to Japan's problems. The argument goes that without the third arrow of lasting structural change, monetary easing will only get the economy so far. "It is a bit like a firework display - you don't need a lot of skill to light the blue touch paper and return five yards," says CLSA's Smith.

Brightrust's Takeuchi adds that the long-term impact of Abenomics depends on whether the government can initiate actions that fundamentally increase the productivity of Japanese industry. "What is really dangerous is that they spend all this money without doing much regulatory reform," he says. "In a few years time, we could find ourselves in a situation nothing has really changed and it will create a huge sell off in yen and Japanese government bonds."

One development that suggests Tokyo has its eye on lasting change is the interest in participating in negotiations for the Trans-Pacific Partnership (TPP), a comprehensive free trade agreement designed to liberalize economies and facilitate cross-border capital flows. The TPP, which is an expanded version of the Trans-Pacific Strategic Economic Partnership between Brunei, Chile, New Zealand and Singapore, was a key point of debate in Japan's election last year.

The significance of such a move would be symbolic as much as anything else, adding weight to the government's existing commitments to encourage foreign investment through regulatory change. For example, the Japanese Ministry of Economy, Trade and Industry introduced a tax reform in 2009 that exempts foreign investors from domestic tax if they use a domestic limited partnership, which is the standard vehicle for most local GPs.

Possible future reforms include lifting restrictions on investment in the agriculture sector, relaxing the protracted approvals process for new medicines to boost activity in healthcare and life sciences, modifications to the tax law to facilitate the transfer of assets from older to younger generations, and the introduction of free-trade or free-regulation zones.

"By joining the TPP, Japan would be seen as taking action towards reform," says Takeuchi. "This would make the country a much more attractive place to invest."

SIDEBAR: Abenomics - the LP impact

The monetary, fiscal and structural reforms enshrined in Abenomics have created a greater appetite for Japanese private equity among foreign investors. The initial impact on the yen, which has dropped 20% against the dollar in the past four months, creates a clear economic rationale for participating in the asset class.

"The concern 12 months ago was whether investors were going to see a 20-30% reduction in the value of their investment due to yen depreciation over a fund cycle," says Josh Porter, a managing director with Advantage Partners. "If they were to invest at that time, because they are dollar based, the difference would need to be made up by additional investment returns. Now that concern seems to be less of a factor."

For Japanese LPs, this development is largely irrelevant. Longer lasting reforms are required before the country's traditionally conservative pension funds participate in private equity.

The Government Pension Investment Fund (GPIF) has completed the first stage of a feasibility study for launching a private equity and infrastructure investment program, a first for such a large Japanese pension fund. But most of the capital would be deployed overseas because the domestic PE market is too small for the world's largest public investment fund. With more than JPY108 trillion ($1.31 trillion) under management, a 10% allocation to private equity equates to $131 billion.
Regardless, if GPIF does start committing capital to the asset class, even abroad, some argue it will have a knock-on effect on institutional investors that are better placed to invest domestically.

"In the case of Japanese LPs, they are cautious and tend to follow the best practices offered by the likes of GPIF," says Kazushige Kobayashi , managing director at Capital Dynamics. "With the macroeconomic situation improving and more foreign investors looking to Japan, I think gradually Japanese investors will be investing more at home."

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• Topics
• North Asia
• GPs
• Japan
• Economy
• Advantage Partners
• Brightrust
• CLSA Capital Partners
• Capital Dynamics
• Government Pension Investment Fund (Japan)
• J-Star