Japanese private equity: Mount Fuji rumbles?

Japan, the island nation, has been hard put of late to develop the brands, business ideas and new technologies to keep its status as the No.2 largest economy in the world. Private equity players, of course, did not pass up the chance to capitalize on the commensurate investment opportunities, and many large global firms, Kohlberg Kravis Roberts & Co. (KKR), Carlyle Group, the Blackstone Group and Permira among them, set up shop in the market, opening regional offices in Tokyo between 2005 and 2007.

At the time, many outside players had high hopes of taking over high-profile local companies for high returns, but as times have passed, most of their ambitions have come to grief – because there were huge gaps between their expectations and what they could achieve from investments in Japan. Now, after the succession of economic crises triggered by the US subprime debacle, foreign firms are having to decide whether they want to maintain their operations in Japan, or downsize their Japan-based teams. The economic turmoil has also led to very hard times for local companies, shrinking their corporate value. With no deals and no IPOs, what will happen next?

High-end problems?

According to AVCJ Research data, the total number and volume of private equity transactions for 2009 was $4.77 billion for 140 transactions in total, down by 34.8% from 2008. As for the total amount of funds raised for Japan over the period, this was $1.3 billion, down by 66.5% compared with a year before.
 
If we look at those numbers purely in isolation, Japan does not appear to be a particularly attractive market for private equity. But, what AVCJ has seen and observed from the market suggests that Japan may still be a surprisingly appealing place to invest. Talking to local players, rather than some of the large market-entry international firms, what we often hear is plenty of “small-to-mid-size” investment opportunities are waiting for alternative financial sources.

Since the credit crunch broke, Japanese lenders are being very selective in their loans to local companies. Large-size buyout deals, often backed with leverage from local lenders, are barely moving, but occasionally close. Bankers in Japan said that they are not totally closed to lending, but did say that they are very cautious in what they support.

So there may be a few scattered opportunities for major buyout firms to invest in billion-dollar deals, but these are few and far between. RHJ International for one pointed out that most large-size deals in Japan are distressed or sold by non-Japanese sellers. Domestic companies who wish to sell off part of their valued portfolios must have reasons to sell.

Value at the small end

Except for those very limited large-size deals, what continues to be very attractive for both onshore and offshore investors are SME deals, particularly buyout deals in mid-sized companies in Japan. In Japan, the definition of SMEs is larger than in the US and European markets – some $100-300 million in enterprise value – so that SME investments can still deliver good returns.

Interestingly, AVCJ heard from leading  private equity funds with a special focus on SMEs, including Phoenix’s New Horizon Capital (not the China fund), CLSA Capital Partners, Mirai Capital and Ant Capital, that there are many mid-sized companies to invest in, that investment activity at this level is considerable, and that they are raising capital for their next funds.

The outbound push for growth

Iwakaze Corporation in particular mentioned that Japanese companies with high-value skills and business potential could look to exploring overseas markets, like neighbor China. If companies look for further growth, some would have to consider shifting their core market overseas, as the Japanese market is shrinking due to economic stagnation, just as the population declines with the lower birth rate. Many large corporate brands, such as beverage giants Asahi and Sapporo, and Oji Paper Co.,Ltd, the largest local paper player, have recently made aggressive outbound moves in search of growth, such as Oji’s acquisition of Malaysia’s largest cardboard producer  GS Paper & Packaging from private equity firm CVC Asia Pacific.

Indeed, in 2009, cross-border M&A transactions made by Japanese companies reached about JPY2 trillion ($22.1 billion) for 336 deals, down 72% from 2008, but transaction numbers declined by just 17%, suggesting that Japanese companies are still eager to expand overseas businesses at the small end. Those buyers are already reshaping their company’s structure by selling off their non-core subsidiaries though trade sales and other means, and have cash to buy out foreign companies. 

Offshore private equity players are also eyeing Japanese companies as one of their exit options. Cash-rich Japanese companies that are keen on developing alternative income source s are becoming exit targets for these funds, as in the case of Oji Paper.

Supporting the mid-size market?

One other common remark in Tokyo private equity circles of late is that foreign LPs are hesitating to commit to local mid-sized funds. Leading mid-sized GPs such as Mirai Capital and Polaris Principal Finance, as well as other SME funds, noted that one of the key issues for the development of their funds is to bring foreign LPs into Japan.

Some of the key LP players already supporting the Japan market are HarbourVest Partners, Partners Group, Adveq Management and Capital Dynamics, but what Japanese private equity needs is to have serious institutional LP capital allocation from overseas in addition to local capital. And in April 2009, the Japanese government implemented a new tax policy for overseas investors to support investments in local funds.

Under the existing law, a foreign partner of an investment limited partnership or similar type of partnership formed in a foreign country (collectively, LPs) will not be subject to withholding tax or required to file tax returns if they are limited partners and meet certain conditions. In theory, this could mean that LPs will have no tax burden for investing into Japanese private equity and VC firms.

Therefore, in theory, Japan could now be much more attractive for foreign LPs. However, this one-year-old law is still not well enough understood or appreciated by foreign investors, and there has been no consequent influx of capital to Japan’s private equity and VC sector. Of course, foreign LPs have their own views, as many say that Japan has underperformed for so long, but industry participants may still expect to find further cooperation between local GPs, LPs and foreign LPs. In the current economic climate, some Japanese LPs are downsizing their private equity allocation, but now it appears the industry itself needs to globalize, and support active internationally-minded Japanese investments in strong and durable companies. According to highly-placed sources in Japan, emerging markets, and especially China, the nearby economic giant, are the major destinations for Japanese exports. Japanese companies – and the private equity firms that seek to support them – should ride on this commercial trend and embrace globalization.

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• Topics
• North Asia
• Performance
• Partners Group
• The Blackstone Group
• Adveq Management AG
• The Carlyle Group
• CLSA Capital Partners
• CVC Capital Partners
• HarbourVest Partners
• KKR
• Permira Advisers
• Nippon Mirai Capital Co.