Japan consumer: Big spenders

In fashion-conscious Japan the domestic apparel market is currently worth JPY11.5 trillion ($93 billion), according to the Ministry of Economy, Trade, and Industry (METI). Clothing label Mark Styler has been spending the last decade trying a grab its chunk of it.

The company has made substantial progress since its founding up in Tokyo's trendy Shibuya district in 2005. Mark Styler has built a portfolio of 17 women's fashion labels, opened 170 own-branded stores, and developed its own e-commerce portal, Runway Channel. The company is understood to have generated JPY37 billion of revenue in the 2014 financial year.

CITIC Capital, which acquired Mark Styler last month for an undisclosed sum, wants to build on this success in Japan by expanding the brand portfolio and scaling up the online stores. At the same time the Chinese GP hopes to replicate the company's success overseas.

Mark Styler is one example of an attractive niche within Japan's consumer retail space for private equity investors both inside and outside the country. But the sector is still recovering from its share of macroeconomic headwinds.

The most recent challenge was the consumption tax hike introduced in April of last year - the first increase in 17 years - that saw the value-added tax on retail goods rise from 5% to 8%. A further planned hike to 10% was scheduled for October but has since been kicked back to 2017. Consumer appetite has further been impacted by a weakening yen, which has added to the cost of imported goods.

For GPs seeking to create value, simply relying on the resilience of the Japanese shopper and the sector reclaiming some semblance of its former strength is not enough. There are longer-term trends, notably the changing needs of an ageing domestic population and rising demand for Japanese products overseas, to be leveraged. Private equity firms' skill-sets must evolve in line with the sector.

Consumer analysis

AVCJ data show there have been seven private equity investments so far this year in the consumer and retail space worth a combined $346 million. This compares to $410 million across nine deals for the whole of 2014. The last time consumer sector saw similar levels of activity was 2012 when $719 million was committed to 11 companies. Given the concentration of capital into a small number of investments, it is all but impossible to gauge the impact of the macroeconomic climate on deal flow.

An understanding of the broader economic trends, however, does offer some interesting context. According to METI, consumer activity appears to be recovering. Overall retail sales came to JPY11.5 trillion in April, up 5% year-on-year - the first monthly increase since the consumer tax was introduced. However, this was tempered by the release of the consumer confidence index for May, which at 41.4 was down slightly from the previous month.

As for the general economy, last week it was announced that first-quarter annualized GDP growth reached 3.9%, beating a preliminary estimate of 2.4%. On a quarter-on-quarter basis, the economy expanded by one percentage point, a second consecutive three-month period of growth since last year's recession. Meanwhile, the Nikkei 225 Index is at its highest level in 15 years, having gained 34% in the last 12 months.

For private equity, this means valuations are continuing an upward trend that began when Prime Minister Shinzo Abe introduced his three-pronged package of economic reforms in 2013.

"It is a good thing overall, but in terms of entry valuations, some companies are even in the 10-12x EBTIDA range as a result of the current condition of the equity markets," says Takaomi Tomioka, managing director with The Carlyle Group. "This is higher than the historical sector average, but it is still lower than in the US."

When it comes to the types of consumer sub-sectors GPs are targeting, there are a couple of different strategies. The overwhelming majority of private equity investment has tended toward consumables, such as food and clothing, over durables, such as cars, electronics and refrigerators. The obvious reason is that durables include larger, non-essential purchases that are more likely to be impacted by a sudden downturn in consumer confidence.

"Durables have traditionally been a very difficult segment and generally speaking these companies are too large for us to pursue," says Megumi Kiyozuka, managing director at CLSA Capital Partners. "On the other hand, consumables are a more realistic area for growth."

CLSA's recent investment in food and beverage maker Asamiya falls into this category. The company's strength lies in its focus on low-cost manufacturing achieved through operational efficiencies and value chain integration. The PE firm hopes to expand Asamiya's product lines across the country.

CLSA's activity in the high-end consumer products space stands in stark contrast to this strategy. Kiyozuka explains this is a symptom of increasingly bifurcation in the consumer space where the best opportunities for growth can be found in companies that offer either a premium brand that taps into rising disposable incomes or a cost-competitive growth model.

If Asamiya sits at one end, then Baroque Japan, an apparel business CLSA sold to China-focused CDH Investments and Belle International in 2013 sits at the other.

Carlyle's Tomioka expresses a similar view. "Anything with a luxury brand for which people are willing to pay a premium is in a good segment of the consumer sector," he says. "Otherwise it has to be something that people need to purchase, for example skincare products for women."

Emmett Thomas, head of Asia with Advantage Partners, notes that bifurcation is also a function of geography. The private equity firm's portfolio includes apparel firm Credge, which has much in common with Baroque Japan and is concentrated in urban areas, specifically Tokyo. Then in the lower-cost space, Komeda Coffee - which has since been sold to MBK Partners - targeted lower middle income consumers by focusing on locations outside of Tokyo.

"There is no doubt a theme of low cost innovation, of finding business models that deliver value to consumers who are not in a position to pay high prices for products and services," Thomas says. He goes on to describe another current Advantage investee - massage chain Riraku - as "a very innovative company with a business model that is tapping into the low-cost mentality."

Improved access

Valuations aside, getting access to consumer companies has arguably never been easier. The sector remains highly fragmented in Japan, dominated by family-owned businesses that in many cases face succession issues and require a partner to assume control and drive future growth.

Carlyle's Tomioka says there are plenty of consumer-focused companies where the founding family still owns 51% or more and is directly responsible for day-to-day management. "Based on our data, more than two thirds of Japanese corporations are not able to identify successors," he adds. "They must do something with their businesses and they are looking to private equity for a means of monetizing their shareholding and introducing new management."

Indeed, succession opportunities often represent the situations in which private equity is best placed to add value. Founders are often well-equipped to handle the marketing and customer side - that is how they achieved scale in the first place - but have neglected to build up a management team suitable to run their business. As a result, it can harder to attract a higher level of professionals with functional experience in areas such as supply chain management and procurement.

Bain Capital's investment in Domino's Pizza Japan captures several of these issues. The PE firm acquired the master franchise in 2010 in deal that valued the business at JPY6 billion ($66.5 million). One of the first steps was to use the Bain network to bring in a new CEO and management team that could improve operations and aggressively expand the restaurant chain's footprint. Domino's Pizza Japan is also an example of the capacity for growth in the domestic market.

"There is still a lot of opportunity in Japan and this is underappreciated. There is a lot of operational improvement potential, and store footprints haven't necessarily been built out nationally," says David Gross-Loh, managing director at Bain. "There is often a lot you can do on the product and pricing side. These companies are usually under-run and undermanaged."

Tatsuo Kawasaki, co-founder of Unison Capital, reports a similar experience with Akindo Sushiro, a sushi restaurant chain the firm acquired between 2007 and 2008 for around JPY18 billion. Unison reinforced management and then drove up profits through marketing and bringing in part-time workers. Once the platform was improved, the company was able to roll-out additional stores and it was eventually sold to Permira for $1 billion in 2012.

"There is a certain consistent methodology in approaching multi-locational strategy-based retail businesses," say Kawasaki. "We think there is some sector growth to be obtained on one hand, and efficiency gains on the other hand, through operational improvements."

Focusing on making a business better at home is also a lower-risk strategy than seeking expansion overseas - especially in markets where local tastes are so different that it requires a fundamental re-thinking of the business model. And the Japan model is itself unique by Asian standards: there is an opportunity to leverage the country's ageing population.

Carlyle's Tomioka estimates that around 25% of the population is above 65 years old, and more than 40% will 65 or more by 2050. His firm sought to capitalize on this trend by investing in dietary supplements manufacturer Sunsho Pharmaceutical last year. Unison also sees opportunities by targeting consumer groups that are not only ageing but also have rising disposable incomes.

"It means there is a higher propensity to consume certain services," Kawasaki says. "This could include leisure activities, and a wide range of health-orientated activities and services such as health clubs, massage and wellbeing."

Outward bound

These dynamics do not apply to all investments. In certain cases, there is not room for companies to expand at home or the changing demographic trends are just not relevant to the product. Alternatively, the overseas potential of a business might be too big to ignore. Advantage's Thomas, who is based in the firm's Hong Kong office, explains that around two third of his firm's portfolio companies are pursuing some kind of cross-border strategy.

Pokka, a drinks company that Advantage delisted in 2005 and later sold to brewery giant in Sapporo in 2011, is an example of this.

The business already had presence overseas but wasn't making any money. However, its brand was strong and there was every reason to believe it could achieve popularity in the region simply by virtue of being Japanese. "As it was Japanese, the product was seen as being very safe, and having little food safety risk," says Thomas. "It is also from a country that is perceived to be developed and have very fashion-forward type products."

Like many other consumer companies, Pokka's problem was poor overseas distribution. Advantage drew up a development plan with the management team that identified countries into which the business should expand first. It effectively targeted geographies in which Coca-Cola was not the market leader: the Middle East, and parts of Asia and Africa. With a proper distribution strategy in place, Pokka's overseas operation went from accounting for around 5% of profit to 40% over a five-year period.

"When we eventually sold it to Sapporo, they really valued the fact there was a strong set of brands and strong set of distribution channels that they could use for with their bigger assets," Thomas adds.

Advantage is not the only GP to have recognized the potential in leveraging the so-called "cool Japan" factor. Overseas brand recognition was also central to the value creation thesis when Carlyle acquired Oyatsu, the company behind ramen snack brand Baby Star, in May of last year. Baby Star is something a cultural icon in its home market but this market wasn't growing fast enough. The PE firm was never going to achieve its desired returns without launching the brand elsewhere in Asia.

"More and more people like Japanese food and Japanese tastes," says Carlyle's Tomioka. "Now is a good time for Japan to export its culture and grow businesses that tie into this culture and into Japanese intangible assets."

This phenomenon is not limited to food and drink. Earlier this year, The Longreach Group bought bridal jewelry specialist Primo Japan from Baring Private Equity Asia. The domestic market is solid but gradually shrinking due to the same demographic factors that make other businesses attractive.

Longreach therefore plans to use Primo's current network of 10 stores in Taiwan and two in Hong Kong as a platform for expansion into Greater China, where demand for high-end Japanese goods such as jewelry is expanding.

A new skill-set

While it may not be appropriate in all cases, overseas expansion is increasingly part of consumer-oriented companies' business model - not least to insulate against macroeconomic headwinds back home. On this basis, transactions such as CITIC's investment in Mark Styler could be more common place. For global and pan-regional private equity players, these companies are a good fit: they are natural partners for brands that may lack the resources of expertise to go overseas independently.

This is not lost on the Japanese GPs, some of which are adapting their traditionally domestic-focused coverage and competencies in order to meet the needs of such companies.

Advantage has been present in Hong Kong since 2008, but is increasingly looking at how Asian activities can support its Japanese portfolio. Thomas stresses there is a growing number of success stories his firm can point to that underscores the value of looking overseas.

"Offering this value is important to our success in Japan. If we can't configure ourselves, to deliver that value to our investee companies then we think that is going to undermine our competitiveness as a GP in Japan," he says. "So for us having the ability to help companies move overseas is an important part of being successful in Japan."

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• Topics
• Consumer
• Buyouts
• North Asia
• Japan
• Consumer
• buyout
• Outbound investment
• Advantage Partners
• Bain Capital Asia
• Unison Capital
• The Carlyle Group
• CITIC Capital