Much of the optimism around Japanese private equity is around its more active investor community and solid dealflow. Private Equity International was in Tokyo for a week in March to dig deeper into these two positives, as well as to find out what is on managers’ and investors’ minds.

JAPAN PRIVATE EQUITY IS DELIVERING
Shuzo Takahashi, head of private equity at the Pension Fund Association, tells PEI the market is one of the “best performing” in its private equity portfolio, although he declined to disclose returns. Looking at vintage years 1992 to 2018, data from eFront Pevara show Japanese leveraged buyout funds rank among their developed markets peers in terms of risk-return.

While exit overhang is the challenge for some of the older Asian funds, Japanese funds have been more efficient in exiting and creating returns, adds Jeff Acton, a Tokyo-based managing director of Asia-focused investment banking advisor BDA Partners. “It comes as no surprise that Japan is now a top priority on pan-Asian and global funds’ radars, who are either looking to do buyouts or co-investments,” he says.

MOMENTUM IS NOW COMING INTO THE MARKET
Japan has also made encouraging progress on the acceptance of private equity. Managers are no longer seen as “vultures”, having gone through three or four rounds of investment and establishing themselves as a respectable option for sellers. In fact, word of mouth and referrals by families – including on the golf course – have become an important source of dealflow, says Koji Sasaki, president and managing partner of Tokio Marine Capital.

Or as Kazushige Kobayashi, managing director and head of primaries at Capital Dynamics, puts it: “Owners have now seen how private equity funds operate. They have seen some successful deals happen now. Japanese companies used to view private equity as vulture funds, but that attitude has changed and so they are more willing to work with funds than they used to be.”

In terms of opportunities, Japan has two key things to offer: there are 2.5 million small and medium enterprises which are facing succession issues, and there are troubled, industrials-linked sectors which are ripe for carve-outs.

“The historic culture of cross-shareholdings across groups has diminished over the past two decades,” says Motoya Kitamura, managing partner at AB Value Capital Partners. “Under these structures, businesses could easily defend against take-over approaches. Now, however, management teams have much more flexibility around buying and selling.”

This has led to a broader uptick in M&A across the market. In 2018, there were 3,132 M&A deals in Japan, a figure that has risen steadily over the past few years, from 2,104 in 2011. What is more, banks are throwing money at deals – the negative interest rate policy means capital is cheap – and valuations of listed companies are much lower than other markets, thus GPs see this as an opportunity to improve margins.

In terms of sectors, there is also more of a push towards service-based businesses than has been the case in the past. Care homes, healthcare and businesses targeting Japan’s ageing population are clear growth areas.

As Jun Tsusaka, founding partner of Nippon Sangyo Suishin Kiko (NSSK), a firm established in 2014, points out, “with a life expectancy of 86, retirees are the wealthiest part of the population and they increasingly want to make the most of their post-work lives. Travel for over-65s is booming and many are looking for new hobbies, are volunteering and are seeking out second vocations”.

BUT GOING TO JAPAN IS  ‘NOT THAT EASY’
The last two years have seen an influx of new entrants to the market. Foreign firms have stepped up local hires and opened Tokyo outposts to access dealflow better as well as get closer to institutional investor capital.

But setting up in Japan and having a dedicated team is not always that easy. The biggest roadblock of all is talent. For foreigners, learning the local language and culture takes time. Meanwhile, for local talent, only very few have knowledge and experience in alternatives, investors tells us. What is more, both investors and GPs are on the lookout for more talent as they bulk up their investment teams.

From an exit perspective, another unique factor in Japan is the firm’s reputation in the market with the management teams of portfolio companies. “If you make one misstep, it is going to be very difficult as a fund to make new investments,” Acton says. “You have to toe the line in Japan and respect the wishes and desires of the management team.”

Increased activity means that deal prices are increasing. “Around two years ago, it was still the norm to buy businesses at around 6x EBITDA,” says Kobayashi.

“That’s much lower than you see in other markets. It’s now at around 8x EBITDA, in part because of the rise of the Nikkei over the past couple of years, which has increased the value of private businesses as well as public ones.”

PUBLIC INVESTMENT FUNDS ARE NOT PRIVATE EQUITY FUNDS
Japan Investment Corporation, the $18 billion public investment fund that had big ambitions to invest in overseas tech companies, ceased operations early this year over public outcry on senior management pay. Japanese GP and investor sources tell us public investment funds like JIC have faced criticism over the years because of “dismal performance, while making money out of taxpayers’ money”.

Sources point out several issues with such funds: unfair access to assets, no disciplined entry price, and no pressure to yield returns. “They come in and have the look and smell of GPs, but do not really do private equity,” says one Tokyo-based partner.

THE NEXT FIVE YEARS WILL BE CRUCIAL
Investors would want to see how record capital raising and deployment in the last three years have played out. This means growing the market to the next level will depend on domestic funds maintaining strong returns over the next five years.

Competition is getting fierce, GPs and LPs told us. Even the gatekeeping business has become more competitive. As Japanese GPs continue to expand their assets under management in this dynamic environment, some LPs have observed eagerness and enthusiasm when it comes to deal pace.

“It is always tough to decide how much to grow the fund size, but the general understanding among LPs is that they do not want too large a fund,” a fund of funds manager says. A healthy dose of Japanese self-discipline must be employed.

So what of the future? “If past trends persist, private equity performance should be looked for in industries driven largely by resilient local demand,” says Marija Djordjevic, research manager at eFront. “Local LPs are increasingly investing in the asset class and Japan is appealing to foreign investors interested in a low-risk environment and seeking geographical diversification.”

Additional reporting by Vicky Meek