Getting back on its feet

Japan-focused private equity firms expect plenty of opportunities for investment – but attracting foreign and domestic limited partners remains a challenge.

Japan-focused fund managers’ most pressing business concerns after the country’s devastating 11 March earthquake and tsunami were related to safety – the safety of their firms’ and portfolio companies’ staff and their families. As previously reported by PE Asia, the uncertainty that had been surrounding the stricken Fukushima nuclear power plant had even prompted some foreign private equity and financial services firms – The Blackstone Group, Partners Group, and law firm Clifford Chance among them – to temporarily shutter their Tokyo offices and relocate staff in the immediate aftermath of the earthquake, until greater clarity could be gained on the situation at Fukushima.

While personal safety remained topmost in people’s minds, private equity professionals say business is getting back to normal. The rolling power cuts implemented to save energy following the earthquake (and affecting business operations) are not expected to continue. “If the summer is normal, and if we are careful not to consume unnecessary electricity, we might do without implementing the rolling blackouts,” says Hideaki Fukazawa, president and managing partner at Tokio Marine Capital, the private equity arm of Tokio Marine & Nichido Fire Insurance group.

And Japanese consumer confidence, which had been declining, is expected to make a comeback.  Fukazawa points to portfolio company Miki Shoko, a maker of children’s clothing, as a promising example. The company’s April sales figures were back to 95 percent of revenues recorded last year, compared to March when the figures were off by 70 percent. In addition, some of the company’s outlets in the western parts of Japan have had sales revenue increase in April compared to the same period in 2010.

One potential concern for GPs, however, is valuation. “In the near term it’s very difficult for the GPs to accurately [value] the companies they want to buy or sell,” says Joji Takeuchi, CEO and co-founder of Brightrust PE Japan, a Tokyo-based private equity investment advisory and fund management services firm. “Wider pricing differences between buyers and sellers will inevitably make new investments and exits more difficult and slower,” says Takeuchi. “It is similar to what happened after the great financial crisis. When the market becomes more predictable, there will be a good recovery in the transaction flow.”

Solid prospects

The fundamentals underpinning Japan’s private equity industry, which is centred on small- to mid-cap transactions, remain strong, market participants say.

“There are a lot of cash rich corporates that are keen to acquire good fund-cleansed companies,” says Takeuchi. “Foreign GPs in Tokyo will remain as aggressive buyers of companies over $200 million to $300 million; and Chinese and other foreign buyers have emerged as a new exit route.”

“We have two to three deal introductions from outside the company per week even after the earthquake,” says Ryosuke Iinuma, senior managing partner at Ant Capital, an 11-year-old private equity firm focused on Japan, who expects activity levels to normalise in a few months’ time.

“Japan is a market where there actually is privileged deal flow based on long term trust relationships and proven industry expertise,” says Mark Chiba, chairman and partner of The Longreach Group, a 7-year-old private equity firm focused on Japan and North Asia. “If you have that special positioning, you can avoid auctions and generate alpha returns through a classic old fashioned private equity strategy where you work with sellers and targets for a long time to create deep understanding of the investment, and you value buy globally interesting businesses with compelling operational value creation.  But it takes time … especially building the relationships that generate that special deal flow and the alpha returns implicit in it.”

Some of those long-established relationships are manifesting themselves post-earthquake in the form of large Japanese corporates accelerating the sale of non-core divisions.

“One of the things we’ve always thought is an investment theme for well positioned firms in Japan is the country’s industrial reconfiguration as conglomerates shed non-core businesses, as they slim down, as they compete particularly against Korean and Chinese rivals,” says Chiba. “That’s always been happening but as a result of March 11th, pre-existing situations are going to get sped up. So at the macro level, you are going to see more offshoring, more conglomerate merger activity and sales of non-core assets, you’re going to see more rationalisation of the business relationships and supply chains, and you’re going to see an accelerated repositioning of businesses out of Japan into Asia.”

Small- to mid-cap companies struggling to get back on their feet post-earthquake are also expected to seek private equity firms’ capital and management/operational expertise to get back on their feet. “[They need] to demonstrate to their creditors as to how to survive under the circumstances,” says Fukazawa.

The market segment is where many Japanese GPs expect to find the bulk of investment opportunities, irrespective of the earthquake’s effects on businesses. “In 2010, we had 44 buyout deals in Japan. However, there was no deal more than $1 billion, and only two transactions were more than $300 million,” says Iinuma.

Investor appetite

Fundraising remains the biggest challenge for Japan-focused GPs, which find themselves not just competing against other “emerging markets” for commitments but up against an oft-repeated market myth that good Japanese private equity deals are thin on the ground. Indeed, Fukazawa says foreign LPs’ most frequent question is, “Are there deals in Japan?”

Takeuchi notes there isn’t a shortage of good deals, but rather a lack of fund managers to explore investment opportunities. “There are only several dozens of Japanese GPs and many of them have only three to six investment professionals. Two-hundred or so people cannot cover [the] Japanese SME universe. Intermediaries do not focus on small deals.”

Investors’ doubts stem from their disappointment over past commitments made between roughly 2003 to 2007, a period when some local firms grew their fund sizes exponentially and many global firms turned their attention to Japan. The large influx of capital, says one market insider, caused a number of local firms to rush into investing in sectors they might not have been specialists in, while some foreign firms were under pressure to deploy capital and thus became reliant on auctions. “LPs got absolutely shafted” as a result, the source said, not just because of poor fund performance but because GPs that have since had portfolio companies breach covenants or fall on hard times will have trouble accessing future deals. “In the US or UK that’s a financial problem; in Japan that’s a reputational event,” the source says, noting LPs who have backed such managers will find themselves invested with a GP that has lost access to deal flow.

Despite the challenges, the country’s GPs report some increasing interest on the part of foreign institutional investors, particularly among US foundations and endowments. Some LPs see Western-style LBOs of mature Japanese companies as a safer alternative or complement to backing GPs that make minority growth stakes in Chinese and Indian companies, given Japanese companies’ ability to expand product lines (and shift production) into China and other markets.

Japan’s domestic LP base, however, still has room to grow. Currently the Japanese LP base is largely composed of insurance companies and banks, which have recently been showing more interest in developing markets like China and India. “The lack of pension money, zero from public pensions and very small from corporate pensions, into local private equity funds is a peculiar problem in Japan,” says one insider.

But that may be changing. Ant Capital secured a ¥6 billion ($75 million) commitment at the end of March from Japan’s Small and Medium Enterprises and Regional Innovation (SMRJ). “[The commitment] was the largest in the history for [SMRJ] as a government group to a private equity fund,” says Iinuma. “So it’s kind of an indication of domestic LPs’ appetite and expectation for private equity.”