Big brother: Japan's government LPs

When Kyushu BOLERO (Buyout for local enterprise and reform organization) Fund 2 closed last September at a modest JPY3.3 billion ($34 million), it registered barely a blip on the radar of Japanese private equity. The GP responsible, Fukoka-based boutique outfit Dogan Advisors, was arguably even more modest than the headline number.

Insignificant though it may seem, the Kyushu BOLERO vehicle is part of a broader trend that has emerged in recent years.

The fund, set up to assist small- and medium-sized enterprises (SMEs) in need of restructuring, is one of many to receive government backing. Around half of its corpus (JPY1.65 billion) came from the Organization for SMEs and Regional Innovation Japan (SMRJ) - a government agency operating under the Ministry of Economy, Trade and Industry (METI) with over JPY519 billion in assets under management.

SMRJ, which has contributed around JPY189 billion to 175 funds over its lifetime, is one of handful of state-affiliated groups that have become increasingly active in Japanese private equity. They are one of them main tools used by the government to revive the economy following two decades of stagnation, a global financial crisis and the devastation of the Tohoku earthquake and tsunami.

"Many Japanese funds have had difficulty fundraising," says Joji Takeuchi, CEO of Japanese private equity advisory Brightrust. "So, government agencies have become increasingly important, investing across mid-cap funds, venture funds and regional funds."

While it is difficult to argue against the short-term benefits, the government's expanding role as an LP is questionable in the context of broader structural reform and lasting economic recovery.

A rising tide

The impact of government investment can clearly been seen in PE fundraising figures over the past year.

According to AVCJ Research, 2013 saw a boom in the number of small-cap vehicles: Of the 85 funds that reached a close, 78 were targeting less than $200 million, nearly double that of the previous year. By contrast, the number of closes involving funds seeking more than $200 million numbered just seven, compared to six and 10 in 2012 and 2011, respectively.

A significant proportion of these small-cap funds count government-affiliated funds among their LPs. Indeed, an examination of the 2013 vintage suggests that most vehicles of this size wouldn't get off the ground without support. A total of 75 funds were launched last year with targets below $200 million and 47 have government-backed LPs, up from nine in 2008.

SMRJ is responsible for 25 of these while Agriculture, Forestry and Fisheries Fund Corporation for Innovation, Value-Chain and Expansion Japan (A-Five) made 18 investments. The remainder included three contributions from the Innovation Network Corporation of Japan (INCJ) - which has only recently started to make LP investments - and one from the Development Bank of Japan (DBJ).

While these are currently the only funds making LP commitments, when one takes direct investments into consideration, there are around seven major government-affiliated funds active in Japanese PE today, each with their own remit.

The three largest are INCJ, SMRJ and Regional Economy Vitalization Corporation of Japan (REVIC). INCJ and REVIC were both set up in the wake of the financial crisis and have predominately engaged in direct investment in distressed Japanese firms.

SMRJ was designed to be an LP, having been established in 1998 on the back of the Limited Partnership Act for Investment in Small and Medium-sized Enterprises. Its role, however, has changed over the years.

"In the beginning, SMRJ invested in venture funds," a representative of the agency tells AVCJ. "But in order to meet the demands of government policies, we have also started to invest in turnaround funds, buyout funds, and growth capital funds for small and medium enterprises (SMEs)."

SMRJ's role in channeling money to the 4.69 million Japanese SMEs that account for 99.7% of all enterprises and 70% of employment.

Much of the recent government-backed LP activity can be traced back to the enactment of the SME Finance Facilitation Act, also known as the Debt Moratorium Law, which was introduced in late 2009. The legislation obliged financial institutions to alter loan terms at the behest of those borrowing from them - which essentially meant that SMEs could defer repayment of their debts.

The law was intended as a temporary measure but was subsequently renewed in 2010 following the Tohoku earthquake and tsunami. It finally expired in May this year.

As a result, demand for alternative sources of capital among Japan's SMEs has spurred the proliferation of small regional turnaround-focused funds - like Kyushu BOLERO - many of which have receive SMRJ backing. Typical investments by SMRJ over the past year include the Kansai SME Rehabilitation fund managed by Renaissance Capital, the Kagawa SME Revitalization Fund managed by Risa Partners and the Shizuoka SME Support No.4 managed by Shizuoka Capital.

"Generally it is very difficult for the local GPs to secure investment from financial institutions based in Tokyo because the regional market is so small," says Shinya Kiyono, vice president with Dogan Advisors. "SMRJ, on the other hand, is more willing to take a risk take with local investment activity due to its political remit."

However, commitments come with caveats. For example, SMRJ can only provide up to 50% of the fund with the rest coming from the private sector. Meanwhile, investment targets must fall within the government definition of an SME, putting strict limits on the size of enterprise by workforce and amount of capital held.

Despite this, most small-cap fund managers see government-affiliated funds as an important lifeline in a difficult fundraising environment. WM Partners, a venture capital secondaries fund launched last year by Moriyoshi Matsumoto, former JAIC CEO, recently reached a JPY5.25 million first close on its maiden fund after receiving a JPY2 billion commitment from SMRJ.

"Japan has a shortage of investors and commitments from financial institutions and insurance companies often fluctuate depending on their own policies, their financial situation and the micro environment," says Matsumoto.

Cause for concern

While a number of GPs claim to benefit from this kind of intervention, the broader trend for the government to commit more capital to the asset class is a source of concern to other industry participants. Early last year, the Japan Private Equity Association (JPEA), the industry body that represents approximately 30 GPs in the country, outlined some of the issues surrounding government-affiliated funds.

In particular it pointed to the Emergency Economic Measures for the Revitalization for the Japanese Economy brought in by Prime Minister Shinzo Abe in January 2013, which called for a wider application of various government-controlled investment funds.

The JPEA said that while it welcomed government initiative in a difficult macro-economic environment, the "excessive sourcing and investment by the government and its affiliate institutions into high growth industries and troubled companies may jeopardize a proper division of role between the public and private sectors."

Much of this criticism has been the result of the investment activities of INCJ, which has put itself in direct competition with private sector GPs when making investments - the most high-profile example of this being the $1.8 billion buyout of Renesas. KKR was closing in on a deal for the distressed chipmaker only for INCJ to arrive on the scene supported by a consortium of domestic corporations.

There are also concerns over the purpose of this investment and whether it really represents the best use of public funds. "If the money is used as a substitute for government subsidies, the objective is to deploy capital rather than deliver better performance," observes one GP, who asked to remain anonymous. "This lack of capital discipline may put taxpayers' money at risk."

The same GP also makes the point that INCJ is not a permanent organization - it is due to be dissolved by 2024 - and therefore cannot be long-term supporter of the PE industry.

However, it is hard to level the same criticism to SMRJ or A-Five, which back funds that are too small to come into conflict with private sector GPs. In addition, SMRJ has long standing track record and, unlike INCJ, it is a permanent entity.

The future of government's involvement in the asset class depends greatly on Japan's recovery. Just as the long-term success of the Abe administration's economic stimulus package ultimately relies on the "third arrow" of lasting structural reform, some argue that the government needs to look beyond the emergency economic measures and temporary fixes that have spawned INCJ and the moratorium law.

The prevailing mood in the industry is that the government should focus its efforts on bringing in sustainable investors - such as the pension funds - to private equity, but progress is slow and the pension funds are inexperienced. As long as GPs like Dogan Advisors and WM Partners identify underserved areas of the economy that require risk capital and seek to raise capital for this purpose, there remains a case for government involvement in private equity.

"Some are doubtful about the government's role in the private equity space but Japan is not the US and we do not have many pension funds or a Silicon Valley," says WM Partners' Matsumoto. "I think these initiatives are the right way if Japan wants to recover."

SIDEBAR: Government-affiliate funds

Organization for Small & Medium Enterprises and Regional Innovation (SMRJ) - Set up in 1998, SMRJ is permanent organization operating under the auspices of the Ministry for Economy, Trade and Industry (METI). It has around JPY519 billion ($5 billion) in assets under management and is one of two funds which focus purely of LP investments.

Innovation Network Corporation of Japan (INCJ) - Set up in 2009 as public-private partnership between the government and 26 private corporations, INCJ is the largest of the all government funds with the ability to invest up to JPY2 trillion. It engages in both venture capital investment and larger buyout transactions. More recently it has started making VC investments as an LP.

Regional Economy Vitalization Corporation of Japan (REVIC) - Formerly known as the Enterprise Turnaround Initiative Corporation of Japan (ETIC-J), the fund is directly supervised by the cabinet office and has JPY1.2 trillion in assets. It specializes in venture debt and restructuring investments. It does not make LP investments.

Agriculture, Forestry and Fisheries Fund Corporation for Innovation, Value - Chain and Expansion Japan (A-Five) - Set up in 2013, A-Five focuses on investing in agriculture innovation and is the currently making the second-largest number of LP commitments after SMRJ. The fund is supervised by the Ministry of Agriculture.

Real Estate Sustainability & Energy-Efficiency Diffusion (Re-SEED) - Set up in 2013 and supervised by the Ministry of Land, Infrastructure, Transport & Tourism and the Ministry of the Environment, The Re-SEED fund is one of the smallest state-backed funds with JPY35 billion in capital.

Development Bank of Japan's (DBJ) Fund for Japanese Industrial Competitiveness - Launched in 2013, the fund falls under the remit of the Ministry of Finance and will provide mezzanine loans and equity investment to promote innovation and can invest up to JPY300 billion.

Cool Japan Promotion Organization - The Cool Japan Fund is supervised by METI and was launched last year. It can invest up to JPY60 billion in Japanese cultural exports.

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• Topics
• LPs
• North Asia
• Fundraising
• LPs
• Japan
• Organization for Small & Medium Enterprises and Regional Innovation, Japan (SMRJ)
• Innovation Network Corp. of Japan (INCJ)
• Fundraising
• Brightrust
• WM Partners