PE must 'play to win' in Japan carve-outs - Bain & Co

Deals amounting to $21.9 billion have been announced so far this year, more than double the 12-month figure for 2016, which itself was the highest seen since before the global financial crisis, AVCJ Research’s records show. The agreed purchase of Toshiba Memory Corporation by a Bain Capital Private Equity-led consortium accounts for much of the 2017 total, but this deal is part of a broader trend.

There have been six $1 billion-plus transactions since the start of 2016 – compared to nine over the previous seven years – and five of them are corporate carve-outs. However, for private equity firms to prevail in these large-cap situations, they must pay rich valuations and ensure every facet of their bid is robust.

“Areas of weakness can include how seriously you take the first-round bid. It’s not a given that people invest in the initial bid and so it might be surprising who does and doesn't get to the second round,” said Jim Verbeeten, a partner at Bain. “Another issue is aggressively engaging post-acquisition. People know they should do it on very large deals, but with mid-size deals, the attitude is often ‘Let’s talk to management and we’ll get to alignment.’ However, they might not be speaking the same language.”

Most GPs with a presence in Japan form relationships with domestic conglomerates in the expectation that they might divest assets. The objective is to explain the nature of their value-add, build internal support, and put themselves in an advantageous position should a business be put up for sale, if not to preempt an auction and move directly to a bilateral negotiation.

Once a formal process begins, efforts by private equity firms to establish themselves as qualified investors crystallize into formal bid documents. The onus is on developing an understanding of the target business and conveying a credible post-acquisition strategy.

“Some investors do a quick analysis in the knowledge that there will be a second round in which more data is provided,” said Verbeeten. “The other extreme is they are a lot more assertive in the first round, finding industry experts and signing them up as advisors. They pay something for that and it could become a broken deal cost, but they prevent others from accessing that expertise.”

The more granular a GP gets in the earlier stages of a bid, the easier it is to get comfortable paying up for it – because there is an awareness of much value can be added during the holding period. For corporate divestments of JPY10-25 billion ($90-224 million), the median earnings multiple paid by PE since 2010 is 10.1x, compared to 10.7x for corporate buyers, according to Bain’s Japan Private Equity Report. The corporate multiple for deals of JPY25 billion or more is 10x; for private equity it is 11.9x.

Growth through M&A is a common method for de-risking a deal and driving returns post-acquisition: if a GP has paid 11.9x for a business then buys three smaller companies at 8x apiece, the overall cost of the investment falls, and that’s before synergies are considered. Other methods include early liquidation events – dividend recaps, spinning off non-core assets – and identifying likely exit routes.

Arguably the most important aspect, and often the most problematic, is securing alignment of interest with management. In most large Japanese divestments, the bulk of the existing senior leadership team remains in place. If a private equity firm doesn’t engage with them early on and later finds out they don’t agree with key tenets of the value creation plan, it can be costly.

“If you have significant headcount reduction in mind, you must be clear with management that it’s part of the plan,” Verbeeten explained. “You don’t want to be in a situation where you buy a company with management, don’t have clear replacements, and the management team then says it doesn’t think you should be reducing headcount.”

The volume of corporate divestments in Japan is likely to increase as governance reforms, an emphasis on return on equity, and a recognition that being competitive means being global force conglomerates to prioritize efficiency over size. But it is a gradual process and there is no guarantee that private equity can capitalize on every opportunity that materializes.

Indeed, Bain’s analysis of past deal flow points to a highly fragmented universe of corporate sellers and relatively low private equity penetration. From the start of 2015 to the mid-point of 2017, PE accounted for just 7% of Japanese M&A for transactions of JPY1-10 billion, rising to 10% for JPY10-25 billion, 15% for JPY25-50 billion, and 29% for JPY50 billion and above. There were only 14 deals in the latter category.

“Maybe in the near term the bigger driver is to get better at winning deals and eat into that M&A share rather than hoping more divestments will happen and there will be more auctions in which private equity can participate,” said Verbeeten.

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• Topics
• North Asia
• Buyouts
• Japan