Land of the rising allocation

Japanese LPs are looking to increase their exposure to private equity. But can they be tempted to invest outside their comfort zone, asks Sharon Lim.

Japan is home to an increasing number of large institutional investors whose appetite for private equity appears to be growing. Local LPs already making allocations to the asset class are raising their exposures, while plenty of newcomers are also looking to join the party.

While Japanese institutions have tended to be perceived as conservative and seldom credited for navigating uncharted waters, they have nonetheless been supportive of indigenous midmarket buyout groups. The success over the years of Japan's ‘big three’ – Advantage Partners, MKS Partners and Unison Capital – has been enabled in no small part by the close relationships they have developed with local LPs.

But these close ties are now being put to the test. At the same time as local LP appetite is growing, foreign investors are now scrambling to access the fundraisings of established Japan-focused managers. For domestic investors finding themselves unable to invest as much in these funds as they would like, spreading their allocations more widely in a domestic context is no straightforward task: market sources say not many Japanese GPs are regarded in as favourable a light as the ‘big three’.

Enrique Cuan, head of Merrill Lynch's private placement division in London, who spends much of his time in Asia, says he has observed a huge demandsupply imbalance whereby most local LP capital is concentrated among five or six domestically focused GPs. LPs canvassed by PEI Asia were generally upbeat about investing into Japanese buyout funds but expressed apprehension about backing first-time funds with limited track records, particularly in a market where access to deals has proven a challenge.

That said, at least three surveys point to an accelerated pace of investment. According to Astoria Consulting, Japanese institutional investors committed $5.72 billion to private equity funds in the 12 months ended March 2007 – 62 percent up from the amount invested over the corresponding period a year ago. Approximately 22 percent of that amount was allocated to Japan funds. This pace of investment is expected to hold steady over the next year, according to the LPs surveyed by Astoria.

Astoria's finding looks conservative compared with the conclusions reached by two other recent studies: one by London-based secondaries firm Coller Capital, and the other by Swiss funds of funds manager Adveq in conjunction with Kyoto University.

Adveq concluded that on average, the next two to five years will see Japanese investors increase their allocation to private equity by more than three times. Coller, meanwhile, concluded that almost two-thirds (62 percent) of Japanese institutional investors plan to increase their allocations to Japanese buyouts over the next two years.

Coller also found domestic LPs to be almost unanimous in their view that Japanese-managed funds offer the best way to invest in the Japanese private equity market, whereas a significant number of foreign investors believe Japan-focused funds managed by a foreign GP franchise offer the best route. Another sizable grouping sees pan-Asian funds as the best way of investing in Japanese private equity.

PEI Asia's own discussions with prominent Japanese LPs found many convinced that country-focused funds managed by local teams – including Carlyle Japan – are a better bet compared with pan-Asian funds.

Tokyo-based Alternative Investment Capital, for example, says it has identified a number of Japan-focused funds it is confident of investing in, but is less sure of its prospects for picking a winner among pan-Asian funds. AI Capital is a fund of funds joint-venture established by Mitsubishi Corporation and Daido Life Insurance.

Most Japanese investors view established local teams as having better networks, a critical ingredient to accessing deal flow in a culture which has not traditionally been well disposed toward merger and acquisition activity. Unsolicited takeover offers in particular have tended to be viewed unfavourably and some LPs prefer not to back funds engaging in this type of strategy.

“Japanese investors are among the most conservative in Asia. They like stable, established groups with track records, and prefer to shun groups that might expose them to headline risk issues such as hostile takeovers. This is one of the biggest differentiators between Japanese and foreign LPs,” according to Cuan.

“Japanese investors are among the most conservative in Asia. They like stable, established groups with track records, and prefer to shun groups that might expose them to headline risk issues such as hostile takeovers.”

Nippon Life, one of Japan's largest insurance groups, is one example of an LP that will not invest in funds conducting hostile takeovers. Hideya Sadanaga, deputy general manager of the credit and alternative investment department of Nippon Life, believes that hostile approaches “rarely make sense” in the context of private equity.

Cultural sensitivities such as these have deterred, and may continue to refrain, some institutional investors from participating in the asset class. Private equity, after all, is still perceived with distrust, if not disdain, by many in this nonconfrontational society.

For this very reason perhaps, Henry Kravis and George Roberts felt compelled to clarify the nature of KKR's long-term plans in Japan during a visit in April. At a rare appearance before the media, Roberts offered his view about how “change will come from within, not from outside.” KKR is near to closing a $4 billion Asia-dedicated buyout fund, which is expected to seek opportunities in Japan.

Sadanaga is “very bullish” on Japan based on his belief that plenty of investment opportunities should emerge in the future, but he also recognises that access to deals might prove a challenge in the near term.

He is not alone. Several other LPs canvassed for this article shared their concerns about deal flow, with one investor claiming there were “too many funds chasing so few opportunities”.

Despite this, Sadanaga believes “there is plenty of low-hanging fruit” at many corporations, particularly at the smaller end of the market where he sees room for efficiency improvements and refinement of business models.

Soichi Sam Takata, senior fund manager of the private equity group at Tokio Marine Asset Management, says: “We would like to establish relationships with GPs that see a good deal flow and are capable of deploying capital.”

Over the years, Tokio Marine has invested over $1 billion in over 100 funds managed by more than 50 managers globally. In Japan, its commitments total in excess of $400 million in over 30 funds managed by more than 15 managers.

Takata feels that private equity managers have had to “work on more difficult deals since the economic recovery”. He adds that it has taken from 6 to 12 months to induce vendors to sell in recent market conditions, and that this helps explain the hiatus in deal activity last year.

Part of the problem, says Motoya Kitamura, a vice-president at AI Capital, is that expectations of the Japanese private equity market tend to exceed reality. “Last year, there were only about 20 to 30 known buyouts that were sizeable and this has surprised a lot of people. ‘This is it?’ tends to be the reaction when people realise the actual number of deals that have been done,” he says.

With major international buyout firms such as KKR, TPG and Bain Capital having joined the chase for deals in Japan, there is an underlying concern that valuations that are getting too high and will be chased up even further, one LP told PEI Asia. “I hope to see strong results from these funds but what I don't want to see is them rushing to do deals and pushing prices up at auctions,” he said.

Another investor was of the opinion that foreign groups needed “grey-haired Japanese” with local networks to get their deal flow kick-started. Once these groups establish strong local connections, they may have a competitive edge over the local teams as they bring with them international networks and operational expertise which may be sought after by local businesses, he added.

For all GPs in Japan – whether foreign or local – challenges remain. “Overall, many of the older corporate guys in their 50s or 60s tend to hold on to values that are not conducive to private equity or risk-taking, and, as the economy improves, there is even less incentive to sell,” Takata of Tokio Marine says.

Many Japanese CEOs work their way up the ranks – most having worked in the same companies all of their careers – and are not known for shaking things up. They prefer to maintain the status quo for as long as they are in office before handing over to the next person in waiting, Takata explains.

Japan is also not a mature market for buyouts or M&A generally, and the size of the deal universe is relatively small considering it has the world's secondlargest economy, Kitamura notes.

For a long time, companies have approached M&A in Japan discreetly and seldom were auction processes seen. Where auctions did take place, they normally involved a select group of GPs being asked to participate. But this is now starting to change, sources say.

“A few years ago, there was less competition but the landscape has changed a lot today. Competition has resulted in higher valuations and the time has arrived for funds to prove their capability in adding value to an investment – more than in the past when the norm had been to buy low and sell high,” Kitamura says.

The potential for buyouts, most confer, is tremendous. But it remains to be seen whether the foreign private equity firms freshly arrived in Japan can successfully compete with established local groups – and in the process convince local LPs to commit outside their comfort zone.