Patience pays

The exodus of foreign GPs from Japan over the last few months shows many have been unable to endure the wait required to see this notoriously tough private equity market fulfil its potential. However, not everyone there is faring badly – and the economic downturn may even be opening more doors for private equity. Emma Cusworth reports.

According to a Japanese proverb, ‘a proposal without patience breaks its own heart.’ Those attempting to enter Japan’s private equity market in the last decade or so may have sought comfort from this expression: though a tough nut to crack, the perceived outcomes were expected to be well worth the wait.

And for some, it has been. As one of the world’s largest economies, full of entrepreneurs and companies with disposable assets, Japan seemed ripe for development of a thriving private equity industry. In fact, between 2000 and 2007, the value of deals per year increased fifteen-fold from $744 million to $11.2 billion, according to statistics from data provider Dealogic. Additional analysis from Switzerland’s Strategic Capital Management shows Japan emerging as Asia’s strongest private equity market in 2008, with deal volume quadrupling compared to 2007.

But the wait has proved too long for some international GPs, who have recently closed Tokyo offices. Several of the firms that set up in Japan in recent years have yet to do a deal and others are suffering as previous highly-leveraged investments create problems in their portfolios.

Names like Merrill Lynch Global Private Equity, Unitas Capital, Sun Capital Partners and Intermediate Capital Group have all shut shop in the past couple of months.

In a recent interview with PEI Asia, Andrew Liu, CEO of Unitas Capital, which closed it Tokyo office in April but will continue to look at deals in the country, said: “Japan is a very difficult market.
Few, if any, multinational firms have been successful there. The market is so local – the issue is the length of time it takes for companies to make decisions and the fact the decision is not just dependant on price. A lot of people thought it had to be a big market because of the size of the GDP. I don’t know when it will take off.”

For many of these retreating GPs, an additional factor in the decision to close the Tokyo office may have been the impact of the economic downturn, which has hit Japan hard. In fact, the IMF is predicting GDP growth of as little as -2.6 percent this year for the country. External shocks from the run-up in commodity prices and international financial turbulence have combined with plummeting equity prices and substantial Yen appreciation. As exports fall, continued weak activity will likely push up unemployment, delaying a recovery in domestic demand.

Select success

However, despite the slowing market, buyouts are still being done by some home-grown and international firms.

The value of deals for 2009 to the middle of April exceeds $3.3 billion, more than half the total for 2008, Dealogic figures show. This includes the $1.4 billion acquisition of Universal Studios Japan by Goldman Sachs Group, MBK Partners and Owl Creek Asset Management, and the $1.1 billion rescue of New City Residence Investment Corp by Lone Star Funds.

Why then have some international names failed where others are succeeding?

People are crucial to success in Japan. “Firms with well-respected and well-connected teams find it easier to get better deals and debt finance,” says Toshifumi Mori, partner-in-charge at executive search company Heidrick & Struggles.

For Western private equity firms, which tend to prefer larger deals in the $1 billion plus bracket, having the right talent is paramount for gaining access to big corporates and banks.

Those trying to enter the Japanese market typically recruit high-profile local names. The extent to which this pays off is, however, not clear. While both KKR Asia and Permira have completed investments in Japan, both lost a senior Tokyo-based investment professional in January. At the time, a Japanese LP told PEI Asia neither had led a deal during their tenures.

Whilst strong local sensitivity is key to any of the highly diverse Asian markets, relationships are the cornerstone of business in Japan and finding the right people is the biggest barrier to success.
Alex Emery, managing director and head of Permira’s Tokyo office, says: “There is no easy formula and private equity firms need to have their eyes wide open. It is no secret that it is difficult and time-consuming. Patience, relationships and trust are very important.”

Some international firms, however, may have teams of local expertise that are better suited to the more aggressive Anglo-Saxon private equity environment. Richard Pyvis, executive chairman of CLSA Capital Partners, which recently launched a second buyout fund focused on Japan’s midmarket, says: “So often foreign firms appoint teams that may be a really good fit to the US or European private equity model, but may not be aligned to the Japanese market.”

In part, this is because they fail to properly communicate their domestic investment hypothesis, decreasing their chances of finding the right talent. Furthermore, decision making often still takes place outside the region in firms’ global head offices, exacerbating the impact of cultural differences.
While US banks might be worrying about nationalisation, for example, employees in cash-rich Japan might be frustrated by the lack of commitment from Western head offices.

Commitment is key

Commitment is, however, essential in Japan, where aggressive, short-term investors have proven unpopular. Funds that have tried to get quick results have drawn negative sentiment and dramatic reactions.

According to Hideaki Fukazawa, president and managing partner at local private equity firm Tokio Marine Capital, firms need to commit for at least 10 years. “If a player exits too soon, they will face more scepticism and suspicion if they try to do subsequent deals.”

Another potentially dangerous repercussion of the rash of recent closures is a step backwards in reputation for the whole private equity industry. According to Emery, the more good professionals there are on the ground explaining private equity and demonstrating its success, the better.
“The ultimate prize is growing the overall pie,” he says. “It is better to have more professional competitors working to increase the overall market potential.”

Others believe the withdrawals will have little to no effect as many of those who left were not ‘active’ in the market, having completed few, if any deals. Furthermore, the impact of the current global crisis is likely to force more Japanese firms towards divesting their non-core assets.

Crisis as catalyst

As the initial shock of the economic crisis settled, the mindset of Japanese corporates has shifted towards preparing for the future.

The crisis will, undoubtedly, create increased pressure on companies in export-driven and domestic demand sectors such as consumer finance, where balance sheets need bolstering.

Japanese companies with fiscal year-ends in March face the prospect of shareholder meetings in coming months for which, Fukazawa says, “many executives are considering how to reassure disappointed shareholders and demonstrate a clear message of corporate thinking. They will have to clearly identify which areas are core and which aren’t.”

The crisis will likely force some wind into the sails of Japanese private equity. Emery says: “It is the mother of all events. Whether for an over-leveraged conglomerate that needs to sell loss-making assets or for sectors like exporters where demand is contracting, operating pressure is increasing. This is good for private equity as it forces companies to consider selling non-core assets and also to look at non-traditional options for raising capital.”

Nonetheless, while the crisis does provide many companies with the excuse to continue restructuring, many are relatively well positioned to deal with shocks given the high levels of part-time employment and a general reduction in credit availability, which has forced up automation and efficiency.

The availability of debt finance has also been dramatically affected, suggesting the impact of the crisis will more likely be gradual.

As deals become more abundant, the capital supply is becoming more limited. Where deals used to be three or four times leveraged, multiples are now closer to one as banks, which historically provided cheap lending on loose terms, face capital constraints themselves.

Return dynamics are also changing as future sale prices, based on historic profits, are being revised down, affecting the amount of debt GPs can raise.

Despite this, debt finance is available in Japan on select deals. “Banks are being much more choosy about who they will lend to based on individual deal drivers,” Fukazawa says.

There appears to be no distinction made between Japanese and non-Japanese private equity firms, but for those who have run into trouble through over-leveraging previous deals, for example, raising finance will become increasingly tough.

The result could be a decrease in the pool of GPs investors are willing to consider in favour of local players.

Adveq, a Swiss fund of funds, prefers backing local GPs, citing better networks, their ability to buy at better prices and negotiate with debt providers.

“What it boils down to,” Bruno Raschle, Adveq’s founder and managing director, says: “is the investable universe of private equity funds in Japan is very limited.”

Despite the fact that the three largest Asian buyout deals of 2008 took place in Japan, transaction size will be limited by tighter lending. Those focussing on bigger deals will suffer, adding another thorn in the side of Western GPs.

The opportunity, Fukazawa says, lies primarily with small to mid-caps with deals of between $50 million to $500 million. “While that is not a lot, there will be a more consistent stream of transactions.”
Even beyond the crisis, however, Japan presents a demographic opportunity for GPs as the generation of post-WWII entrepreneurs retire or pass away, creating succession pressures for many local businesses.

“The next generation or two are often not interested,” Pyvis says. “There is a huge generational issue and GPs have to work closely with existing shareholders who typically have a huge empathy with employees. They have to be in tune with local sensitivities.”

Despite increasing the need for cultural know-how, succession issues will be a key future market driver. Private equity is becoming more accepted as an alternative source of capital by ageing entrepreneurs as its reputation improves.

In its early days, private equity suffered from a terrible, ‘vulture’ reputation in Japan, where transition occurred only through succession and capital exit was considered shameful.

This has slowly changed as GPs demonstrated their willingness to pay full prices and ensure good stewardship of companies’ futures. A clear differentiation is still made, however, between those committed to turning around and reviving Japanese companies in the long term, and short-term buyers and sellers.

Another sign attitudes towards foreign capital and the industry generally are changing for the better has been the recent softening of the so-called Shinsei Tax. The Shinsei Tax, in reality a capital gains tax of up to 40 percent on all foreign direct investment, was introduced by the Japanese government after US firm Ripplewood Holdings purchased the failed Long-Term Credit Bank in 1999. Ripplewood relaunched the bank as Shinsei Bank in 2000 and floated it in a US$2.4 billion initial public offering that made millions for Ripplewood and its investors – an aggressive short-term approach to private equity that irked the Japanese government. However, in a significant change of stance, as of 1 April this year, the government has amended these rules to allow for exemptions, removing the need for expensive off-shore structures and paving the way for foreign investment in private equity.

“The Shinsei Bank Tax frightened away many GPs and LPs,” says Jeremie Le Febvre, head of Asia for placement agency, Triago. “It is still too early to say what impact the softening will have.”
Raschle, for one, remains sceptical, believing this change reflects the initiatives of a few private equity firms, rather than a governmental policy change.

“The environment in Japan is as difficult as ever and this isolated action doesn’t constitute a softening or opening of the market,” he says. “On the contrary, it should increase cautiousness as who knows whether the government will tighten the applications of some policies or regulations in the years to come.”

Despite the seemingly positive outlook, closures and staff cuts suggest caution. According to Mori: “Although several firms are replacing and upgrading teams, others are simply reducing numbers of employees and promoting internally in case a senior executive is let go, mainly because they want to reduce the total number and do not want to spend extra expense to search for a new figurehead.

“For those taking the opportunity to recruit, there is plenty of good talent available,” Mori says. “Those who ride through the current turmoil will be better positioned for the future.”

In the longer term, the drivers of a successful private equity market do seem to be lining up in Japan. Target companies face increasing pressure and the historical context of succession issues will drive demand for private equity capital.

According to Le Febvre: “There is a tremendous opportunity for deals to get done and the potential to create growth and capital is huge. The trick is convincing investors Japan is worth another go as there is a considerable degree of fatigue in waiting for returns.”

For those committed to private equity as a long-term asset class in Japan, the promise of returns is alive and well. Patience, however, lies at the heart of success. It has always been that way.